PP14.ppt

Chapter 14 - Company
Analysis and Stock Valuation
Questions to be answered:
• Why is it important to differentiate between
company analysis and stock valuation?
• What is the difference between a growth
company and a growth stock?
• How do we apply the two valuation approaches
and the several valuation techniques to
Walgreens?

• What techniques are useful when estimating
the inputs to alternative valuation models?
• What techniques aid estimating company
sales?
• How do we estimate the profit margins and
earnings per share for a company?

• What factors are considered when
estimating the earnings multiplier for a
firm?
• What two specific competitive strategies
can a firm use to cope with the competitive
environment in its industry?

• In addition to the earnings multiplier, what
are some other relative valuation ratios?
• How do you apply the several present value
of cash models to the valuation of a
company?
• What value-added measures are available to
evaluate the performance of a firm?

• How do we compute economic value-added
(EVA), market value-added (MVA), and the
franchise value for a firm?
• What is the relationship between these
value-added measures and changes in the
market value of firms?

• When should we consider selling a stock?
• What is meant by a true growth company?
• What is the relationship between positive
EVA and a growth company?

• Why is it inappropriate to use the standard
dividend discount model to value a true
growth company?
• What is the difference between no growth,
simple growth, and dynamic growth?
• What is the growth duration model and
what information does it provide when
analyzing a true growth company and
evaluating its stock?

• How can you use the growth duration model
to derive an estimate of the P/E for a growth
company?
• What are some additional factors that
should be considered when analyzing a
company on a global basis?

Company Analysis and Stock
Valuation
• After analyzing the economy and stock markets
for several countries, you have decided to invest
some portion of your portfolio in common stocks
• After analyzing various industries, you have
identified those industries that appear to offer
above-average risk-adjusted performance over
your investment horizon
• Which are the best companies?
• Are they overpriced?

Company Analysis and Stock
Valuation
• Good companies are not necessarily good
investments
• Compare the intrinsic value of a stock to its
market value
• Stock of a great company may be overpriced
• Stock of a growth company may not be growth
stock

• Growth companies have historically been
defined as companies that consistently
experience above-average increases in sales
and earnings
• Financial theorists define a growth company
as one with management and opportunities
that yield rates of return greater than the
firm’s required rate of return
Growth Companies

Growth Stocks
• Growth stocks are not necessarily shares in
growth companies
• A growth stock has a higher rate of return
than other stocks with similar risk
• Superior risk-adjusted rate of return occurs
because of market undervaluation compared
to other stocks

Defensive Companies and Stocks
• Defensive companies’ future earnings are
more likely to withstand an economic
downturn
• Low business risk
• Not excessive financial risk
• Stocks with low or negative systematic risk

Cyclical Companies and Stocks
• Cyclical companies are those whose sales
and earnings will be heavily influenced by
aggregate business activity
• Cyclical stocks are those that will
experience changes in their rates of return
greater than changes in overall market rates
of return

Speculative Companies and Stocks
• Speculative companies are those whose
assets involve great risk but those that also
have a possibility of great gain
• Speculative stocks possess a high
probability of low or negative rates of return
and a low probability of normal or high
rates of return

Value versus Growth Investing
• Growth stocks will have positive
earnings surprises and above-average
risk adjusted rates of return because the
stocks are undervalued
• Value stocks appear to be undervalued
for reasons besides earnings growth
potential
• Value stocks usually have low P/E ratio
or low ratios of price to book value

Economic, Industry, and Structural
Links to Company Analysis
• Company analysis is the final step in the top-
down approach to investing
• Macroeconomic analysis identifies industries
expected to offer attractive returns in the
expected future environment
• Analysis of firms in selected industries
concentrates on a stock’s intrinsic value
based on growth and risk

Economic and Industry Influences
• If trends are favorable for an industry, the
company analysis should focus on firms in
that industry that are positioned to benefit
from the economic trends
• Firms with sales or earnings particularly
sensitive to macroeconomic variables
should also be considered
• Research analysts need to be familiar with
the cash flow and risk of the firms

Structural Influences
• Social trends, technology, political, and
regulatory influences can have significant
influence on firms
• Early stages in an industry’s life cycle see
changes in technology which followers may
imitate and benefit from
• Politics and regulatory events can create
opportunities even when economic influences are
weak

Company Analysis
• Industry competitive environment
• SWOT analysis
• Present value of cash flows
• Relative valuation ratio techniques

Competitive Forces
• Current rivalry
• Threat of new entrants
• Potential substitutes
• Bargaining power of suppliers
• Bargaining power of buyers

Firm Competitive Strategies
• Defensive strategy involves positioning firm so
that it its capabilities provide the best means to
deflect the effect of competitive forces in the
industry
• Offensive strategy involves using the company’s
strength to affect the competitive industry
forces, thus improving the firm’s relative
industry position
• Porter suggests two major strategies: low-cost
leadership and differentiation

Porter's Competitive Strategies
• Low-Cost Strategy
–The firm seeks to be the low-cost
producer, and hence the cost leader in its
industry
• Differentiation Strategy
–firm positions itself as unique in the
industry

Focusing a Strategy
• Select segments in the industry
• Tailor strategy to serve those specific
groups
• Determine which strategy a firm is
pursuing and its success
• Evaluate the firm’s competitive
strategy over time

SWOT Analysis
• Examination of a firm’s:
–Strengths
–Weaknesses
–Opportunities
–Threats

SWOT Analysis
–Strengths
–Weaknesses
–Opportunities
–Threats
INTERNAL ANALYSIS

SWOT Analysis
–Strengths
–Weaknesses
–Opportunities
–Threats
EXTERNAL ANALYSIS

Some Lessons from Peter Lynch
Favorable Attributes of Firms
1. Firm’s product should not be faddish
2. Firm should have some long-run comparative
advantage over its rivals
3. Firm’s industry or product has market stability
4. Firm can benefit from cost reductions
5. Firms that buy back shares show there are putting
money into the firm

Tenets of Warren Buffet
• Business Tenets
• Management Tenets
• Financial Tenets
• Market Tenets

Business Tenets
• Is the business simple and understandable?
• Does the business have a consistent
operating history?
• Does the business have favorable long-term
prospects?

Management Tenets
• Is management rational?
• Is management candid with with its
shareholders?
• Does management resist the institutional
imperative?

Financial Tenets
• Focus on return on equity, not earnings per
share
• Calculate “owner earnings”
• Look for companies with high profit
margins
• For every dollar retained, make sure the
company has created at least one dollar of
market value

Market Tenets
• What is the value of the business?
• Can the business be purchased at a
significant discount to its fundamental
intrinsic value?

Estimating Intrinsic Value
A. Present value of cash flows (PVCF)
– 1. Present value of dividends (DDM)
– 2. Present value of free cash flow to equity (FCFE)
– 3. Present value of free cash flow (FCFF)
B. Relative valuation techniques
– 1. Price earnings ratio (P/E)
– 2. Price cash flow ratios (P/CF)
– 3. Price book value ratios (P/BV)
– 4. Price sales ratio (P/S)

Present Value of Dividends
• Simplifying assumptions help in estimating
present value of future dividends
• Assumption of constant growth rate
Intrinsic Value = D1/(k-g)
D1= D0(1+g)

Growth Rate Estimates
• Average Dividend Growth Rate
1
D
D
n
0
n



Growth Rate Estimates
• Average Dividend Growth Rate
• Sustainable Growth Rate = RR X ROE
1
D
D
n
0
n



Required Rate of Return Estimate
• Nominal risk-free interest rate
• Risk premium
• Market-based risk estimated from the firm’s
characteristic line using regression

Required Rate of Return Estimate
• Nominal risk-free interest rate
• Risk premium
• Market-based risk estimated from the firm’s
characteristic line using regression
E(RFR)]
)
E(R
[
E(RFR)
R market
stock
stock 

 

The Present Value of
Dividends Model (DDM)
• Model requires k>g
• With g>k, analyst must use multi-stage
model

Present Value of
Free Cash Flow to Equity
FCFE =
Net Income
+ Depreciation Expense
- Capital Expenditures
- D in Working Capital
- Principal Debt Repayments
+ New Debt Issues

Present Value of
FCFE =
Net Income
+ Depreciation Expense
- Capital Expenditures
- D in Working Capital
- Principal Debt Repayments
+ New Debt Issues
FCFE
g
k
FCFE
Value

 1

Present Value of
FCFE = the expected free cash flow in period 1
k = the required rate of return on equity for the firm
gFCFE = the expected constant growth rate of free cash
flow to equity for the firm
FCFE
g
k
FCFE
Value

 1

Present Value of
Operating Free Cash Flow
Discount the firm’s operating free cash flow
to the firm (FCFF) at the firm’s weighted
average cost of capital (WACC) rather than
its cost of equity
FCFF = EBIT (1-Tax Rate)
+ Depreciation Expense - Capital Spending
- D in Working Capital - D in other assets

Present Value of
OFCF
FCFF
g
WACC
FCF
Oper
or
g
WACC
FCFF
Value
Firm



1
1
.

Present Value of
Where: FCFF1 = the free cash flow in period 1
Oper. FCF1 = the firm’s operating free cash flow in period 1
WACC = the firm’s weighted average cost of capital
gFCFF = the firm’s constant infinite growth rate of free cash flow
gOFCF = the constant infinite growth rate of operating free cash flow
OFCF
FCFF
g
WACC
FCF
Oper
or
g
WACC
FCFF
Value
Firm



1
1
.

An Alternate Measure of Growth
g = (RR)(ROIC)
where:
– RR = the average retention rate
– ROIC = EBIT (1-Tax Rate)/Total Capital

Calculation of WACC
WACC = WEk + Wdi

Calculation of WACC
WACC = WEk + Wdi
where:
WE = the proportion of equity in total capital
k = the after-tax cost of equity (from the SML)
WD = the proportion of debt in total capital
i = the after-tax cost of debt

Relative Valuation Ratio
Techniques
• Price Earnings Ratio g
k
E
D
E
P

 1
1
1
/
/

Estimating Company Earnings
Per Share
• Function of
– Sales forecast
– Estimated profit margin

Walgreens Competitive Strategies
The Internal Performance
• Industry Factors
• Company Performance
• Net Profit Margin Estimate
• Computing Earnings per Share
Importance of Quarterly Estimates

Estimating Company Earnings
Multipliers
• Macroanalysis of the Earnings Multiplier
• Microanalysis of the Earnings Multiplier
– Comparing Dividend-Payout Ratios
– Estimating the Required Rate of Return
– Estimating the Expected Growth Rate
– Computing the Earnings Multiplier
– Estimate of the Future Value for Walgreens

Additional Measures of Relative
Value
• Price/Book Value Ratio
• Price/Cash Flow Ratio
• Price-to-Sales Ratio

Analysis of Growth Companies
• Generating rates of return greater than the
firm’s cost of capital is considered to be
temporary
• Earnings higher the required rate of return
are pure profits
• How long can they earn these excess
profits?
• Is the stock properly valued?

• Growth companies and the DDM
– constant growth model not appropriate
• Alternative growth models
– no growth firm
E = r x Assets = Dividends
 
k
E
b
k
E
V



1
v
E
k 

• Long-run growth models
– assumes some earnings are reinvested
• Simple growth model
s)
Investment
Growth
of
Value
Present
Gross
(
2
k
bEm
k
bEmk

s)
Investment
Growth
of
Value
Present
Net
(
k
bE
k
bEm

k
bE
k
bEm
k
E
v 


 
k
bEm
k
b
E
v 


1

Simple Growth Model (cont.)
(Present value of Constant Dividend plus
the Present Value of Growth Investment)
k
bE
k
bEm
k
E
v 


 
k
bEm
k
b
E
v 


1
k
bEm
k
D
v 

 
k
m
bE
k
E
v
1



(Present value of Constant Earnings plus
the Present Value of Excess Earnings
from Growth Investment)

Expansion Model
• Firm retains earnings to reinvest, but
receives a rate of return on its investment
equal to its cost of capital
m = 1 so r = k
k
E
V 
 
k
E
k
bE
k
b
E




1

Negative Growth Model
• Firm retains earnings, but reinvestment
returns are below the firm’s cost of capital
• Since growth will be positive, but slower
than it should be, the value will decline
when the investors discount the
reinvestment stream at the cost of capital

The Capital Gain Component
bEm/k
b Percentage of earnings retained for reinvestment
m relates the firm’s rate of return on investments and
the firm’s required rate of return (cost of capital)
1 = cost of capital
>1 is a true growth company
Time period for superior investments

Dynamic True Growth Model
• Firm invests a constant percentage of
current earnings in projects that generate
rates of return above the firm’s required rate
of return
g
k
D
V

 1

Measures of Value-Added
• Economic Value-Added (EVA)
– Compare net operating profit less adjusted taxes
(NOPLAT) to the firm’s total cost of capital in
dollar terms, including the cost of equity
• EVA return on capital
EVA/Capital
• Alternative measure of EVA
– Compare return on capital to cost of capital

• Market Value-Added (MVA)
– Measure of external performance
– How the market has evaluated the firm’s
performance in terms of market value of debt
and market value of equity compared to the
capital invested in the firm
• Relationships between EVA and MVA
– mixed results

• The Franchise Factor
– Breaks P/E into two components
• P/E based on ongoing business (base P/E)
• Franchise P/E the market assigns to the expected value of
new and profitable business opportunities
Franchise P/E = Observed P/E - Base P/E
Incremental Franchise P/E = Franchise Factor X Growth Factor
G
rk
k
R




Growth Duration Model
• Evaluate the high P/E ratio by relating P/E
ratio to the firm’s rate and duration of
growth
• P/E is function of
– expected rate of growth of earnings per share
– stock’s required rate of return
– firm’s dividend-payout ratio

Growth Duration
E’(t) = E (0) (1+G)t
N(t) = N(0)(1+D)t
E’(t) = E’(t) N(t) = E (0) [(1+G)t (1+D)]t
t
D)
G
(1
(0)
E
E(t) 



  




















T
a
a
a
T
g
g
g
d
g
)
D
G
(1
(0)
E
)
D
G
(1
(0)
E
0
P
(0)
P

Growth Duration
  




















T
a
a
a
T
g
g
g
d
g
)
D
G
(1
(0)
E
)
D
G
(1
(0)
E
0
P
(0)
P
  




















T
a
a
T
g
g
a
d
g
g
)
D
G
(1
)
D
G
(1
(0)
E
/
0
P
(0)
(0)/E
P
  




















)
D
G
(1
)
D
G
(1
ln
(0)
E
/
0
P
(0)
(0)/E
P
ln
a
a
g
g
a
d
g
g
T

Intra-Industry Analysis
• Directly compare two firms in the same industry
• An alternative use of T to determine a reasonable
P/E ratio
• Factors to consider
– A major difference in the risk involved
– Inaccurate growth estimates
– Stock with a low P/E relative to its growth rate
is undervalued
– Stock with high P/E and a low growth rate is
overvalued

Site Visits and the
Art of the Interview
• Focus on management’s plans, strategies, and
concerns
• Restrictions on nonpublic information
• “What if” questions can help gauge sensitivity
of revenues, costs, and earnings
• Management may indicate appropriateness of
earnings estimates
• Discuss the industry’s major issues
• Review the planning process
• Talk to more than just the top managers

When to Sell
• Holding a stock too long may lead to lower returns than
expected
• If stocks decline right after purchase, is that a further
buying opportunity or an indication of incorrect
analysis?
• Continuously monitor key assumptions
• Evaluate closely when market value approaches
estimated intrinsic value
• Know why you bought it and watch for that to change

Influences on Analysts
• Efficient Markets
• Paralysis of Analysis
• Analyst Conflicts of Interest

Efficient Markets
• Opportunities are mostly among less well-known
companies
• To outperform the market you must find
disparities between stock values and market
prices - and you must be correct
• Concentrate on identifying what is wrong with
the market consensus and what earning surprises
may exist

Analyst Conflicts of Interest
• Investment bankers may push for favorable
evaluations
• Corporate officers may try to convince
analysts
• Analyst must maintain independence and
have confidence in his or her analysis

Global Company and Stock
Analysis
Factors to Consider:
– Availability of Data
– Differential Accounting Conventions
– Currency Differences (Exchange Rate
Risk)
– Political (Country) Risk
– Transaction Costs
– Valuation Differences

The Internet
Investments Online
http://www.better-investing.com
http://www.fool.com
http://www.cfonews.com
http://www.zacks.com
http://www.valueline.com
http://iaschicago.org
http://moneycentral.msn.com/investor/home.asp

End of Chapter 14
–Company Analysis and
Stock Selection

Future topics
Chapter 15
Technical Analysis
• Assumptions and Advantage
• Technical Trading Rules and
Indicators
• Techniques and Charts

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