|


 



 

r 
 
!

þ Differentiate between company analysis and stock valuation

þ Explain 3 step approach to fundamental analysis
þ Understand qualitative and quantitative approach to company analysis
þ Determine intrinsic value of the stock using various valuation
techniques
þ Understand value-added measures available to evaluate the
performance of a firm
þ Describe the passive and active strategies in managing an equity
portfolio
|

 

" # |
! " #  

þ ºood companies are not necessarily good

investments
þ Compare the intrinsic value of a stock to its market
value
þ Stock of a great company may be overpriced
þ Stock of a growth company may not be growth stock
|

 

" # |


þ Ñistorically been defined as companies that consistently

experience above-average increase in sales and
earnings
þ 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
± This required rate of return is weighted average cost
of capital (WACC)
|

 

" #  

þ ºrowth stocks are not necessarily shares in growth

companies
þ A growth stock has a higher rate of return than other
stocks with similar risk
þ Superior risk-adjusted rate of return occurs because
of market undervaluation compared to other stocks
|

 

$ 

  %   

þ ‰resent value of all expected future cash flows to the

stock investor
þ Cash flows are discounted at the appropriate
required rate of return, 2
þ Expected future cash flows consist of:
&  
!
 
&  

proceeds from the ultimate sale of the stock
|

 

$ 

  %   

þ rntrinsic value is the analyst¶s estimate of what a

stock is really worth
þ rntrinsic value (r ) can differ from the current market
price (M‰)
± rf r > M‰: stock is underpriced => buy
± rf r < M‰: stock is overpriced => sell or do not buy
|

 

' (




rn market equilibrium,
þ Everyone has the same intrinsic value. So, intrinsic
value equals market price, i.e.,
r
= ‰
.
þ Everyone also demands the same required rate of
return from the stock. So everyone has the same 2.
rn addition, expected щ = 2

 

þ Method of evaluating a security by Understanding of macro-

attempting to measure its intrinsic economic environment and
value by examining related economic, developments
financial and other qualitative and
quantitative factors
þ esearchers have found that stock Analyzing industry prospects
price changes can be attributed to the to which the firm belongs
following:
± Economy-wide factors: (3
-35%)
± rndustry factors: (15-2
%) Assessing projected
± Company factors: (3
-35%) company performance and
intrinsic share value
± Other factors: (15-25%)

 

( 

$ $% 

þ Macroeconomic analysis identifies industries likely to offer

attractive returns in the expected future environment

þ rf 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

þ Analysis of firms in selected industries concentrates on a

stock¶s intrinsic value based on cash flow, growth and risk

 

  $% 

þ Social trends, technology, political, and regulatory

influences can have significant influence on firms
þ Early stages in an industry¶s life cycle see
changes in technology which followers may imitate
and benefit from
þ ‰olitics and regulatory events can create
opportunities even when economic influences are
weak


! 

!  
|


$ 


! 
)*

!
 


+  !  , 
! !

% % # 
 



!  
|


!  

|  
!

*   % #  

+ 
 


-

 #  % 


-

 #  % 


!  


|


!   

þ . % 
!   
± ‰ositioning firm so that it its capabilities provide the best
means to deflect the effect of competitive forces in the
industry
± Examples include investing in fixed assets and technology
or creating a strong brand image
þ %% 
!   
± Using the company¶s strength to affect the competitive
industry forces, thus improving the firm¶s relative industry
position
± Examples include preempting by obtaining price
concessions from suppliers


!  
 
  

þ Select segments in the industry

þ Tailor strategy to serve those specific groups
þ Determine which strategy a firm is pursuing and its
success
þ Evaluate the firm¶s competitive strategy over time


!  
)*

þ Examination of a firm¶s:
± trengths
± )eaknesses
± pportunities
± *hreats


!  
)*

þ Examination of a firm¶s:
± trengths rTEAL AALYSrS
± )eaknesses
± pportunities
± *hreats


!  
)*

þ Examination of a firm¶s:
± trengths
± )eaknesses
± pportunities
EXTEAL AALYSrS
± *hreats
$ 

  %   
 
* 


&+    %|  # /+|0

1. ‰resent value of dividends (DDM)
2. ‰resent value of free cash flow to equity (FCFE)
3. ‰resent value of free cash flow (FCFF)
-&, 
! 
* 

1. ‰rice earnings ratio (‰E)
2. ‰rice cash flow ratio (‰CF)
3. ‰rice book value ratio (‰ )
4. ‰rice sales ratio (‰S)
+    %.
!
 
|   .
!
 " # 

þ Simplifying assumptions help in estimating present

value of future dividends
þ Most applicable to stable, mature firms where the
assumption of relatively constant growth for the long
term is appropriate
± rntrinsic alue = D1(k-g)
D1= D
(1+g)
0




 

2









0



+    %.
!
 
|   " # '  

þ Model requires k>g

þ With g>k, analyst must use multi-stage model
þ All other things unchanged,
‡ rf D1 increases (decreases), r increases (decreases).
‡ rf g increases (decreases), r increases (decreases).
‡ rf k increases (decreases), r decreases (increases).
+    %.
!
 
|   " # '  1 (2


ig Oil rnc. just paid a dividend of $1
(i.e. D
= 1
.

).

rts dividends are expected to grow at a 4% annual rate
forever. The required rate of return is 15%. What is the
price of ig Oil¶s common stock? (to 2 decimal places)

rntrinsic alue = D1(k-g)

=1
(1.
4)(
.15-
.
4)
= $94.55
+    %.
!
 
, 
 ,  %, (



þ ominal risk-free interest rate

þ isk premium
þ Market-based risk estimated from the firm¶s characteristic line
using regression

 
G

    G

  G


0



2





2 




2






2




+    %.
!
 
(2  3+,2

þ Suppose the market is in equilibrium. This means that stock

price is equal to intrinsic value, i.e., ‰
= r
. Then, expected
щ, E(r) is,
D! P!  P
E
r   
P P
D!
  g
P
.
!
 
 |

 

+    %.
!
 
(2  3+,2

þ rf stock is selling at intrinsic value, ‰
= r
.

þ Then required rate of return, k, must equal the
expected щ. Therefore,
D!
k   g
P
þ When everyone agrees on the same k (in
equilibrium), we can use the above formula to
compute required rate of return
+    %.
!
 
" # , (



þ Average Dividend ºrowth ate

!

þ Sustainable ºrowth ate = b X OE
0








 











!!!


!02

+    %.
!
 
,(. 



,(

 
  4 


r !  
(%%

 (%%


/(
'

0
/+ %
'
0 /*  
* ! 0
+    %.
!
 
,(. 



,(
= ‰rofit Margin * Total Asset Turnover * Equity
Multiplier
= (‰rofitSales) * (SalesAssets) * (AssetsEquity)

,(
= Tax urden * rnterest urden * Operating ‰rofit
Margin * Asset Turnover * Equity Multiplier
= (et ‰rofit‰retax ‰rofit)* (‰retax ‰rofitErT)*
(ErTSales)* (SalesAssets) * (AssetsEquity)
+    %.
!
 
, 
,
" # 

 ,(5 " #  

 6 1 # 
 

Earnings retention ratio, b b>
b=

ºrowth rate, g g>
g=

-


rf a company reinvests some portion of earnings back
into the business (b >
), future earnings and dividends will grow
(i.e., g >
). Otherwise, earnings and dividends will not grow
+    %.
!
 
$ " # # -  %

7

þ Does positive growth always increase stock price?

± o. rt depends on the attractiveness of the firm¶s
investment opportunities, OE.
þ Compared to a no-growth policy,
± rf OE > k, then retaining earnings (i.e., b >
) will
increase stock price
± rf OE < k, then retaining earnings will decrease stock
price
+    %.
!
 
| 
  # 


" #  . -  8
+   8$ $/.-0
/"+0

o-growth earnings per share $5 $5

equired rate of return, k 12.5% 12.5%

o-growth price per share 5
.125 = 4
5
.125 = 4

OE 15% 1
%

u
+    %.
!
  
  


! 9: %
 2  ;  
 <

" #  . -  8$
+   8$ /.-0
/"+0
Earnings retention ratio, b
.6
.6
ext year¶s dividend per $2 $2
share, D1 = (1 ± b) x 5
Dividend growth rate, g 9% 6%
= OE x b
Constant dividend growth 2(
.125 ±
.
9) 2(
.125 ±
.
6)
model share price = 57.14 = 3
.77
+    %.
!
 
|
 "+.-

" #  . -  8
+   8$ $/.-0
/"+0
OE 15% 1
%
equired rate of return, k 12.5% 12.5%
o-growth price per share (1) 4
4

Constant div. growth price (2) 57.14 3
.77

‰resent value of growth 17.14 -9.23

opportunities, ‰ ºO = (2) ± (1)

+"=+
    >  1 # 
   
+    %.
!
 
'
  .
!
 " # 

þ With this assumption, dividends grow at different

rates for different periods of time. Eventually,
dividends will grow at a constant rate forever
þ Time line is very useful for valuing this type of stocks
þ To value such stocks, also need the constant growth
formula
þ est way to learn is through an example

u

+    %.
!
 
'
  .
!
 " # 1 (2


(2

AC Co. is expected to pay dividends at the end of the

next three years of $2, $3, $3.5
, respectively. After three
years, the dividend is expected to grow at 5% constant annual
rate forever. rf the market capitalization rate for this stock is
15%, what is the current stock price?
1. ‰lace yourself at t = 3 and use the constant growth
formula to find ‰ of dividend stream after year 3. Call
this ‰3
2. Find the ‰ of ‰3
3. Find ‰ of dividends at t=1, t=2 and t=3
4. Current stock price = sum of 2 and 3
+    %.
!
 
'
  .
!
 " # 1 (2


1. ‰lace yourself at t = 3 and use the constant growth

formula to find ‰ of dividend stream after year 3.
Call this ‰3
2. Find the ‰ of ‰3
3. Find ‰ of dividends at t=1, t=2 and t=3
4. Current stock price = sum of 2, 3 and 4

$2.

$3.

$3.5
Dividends grow

at 5% forever

T=
T =1 T=2 T=3 T=4

+    %.
!
 
'
  .
!
 " # 1 (2


þ ‰3 = (3.5 x (1.
5))(
.15 ±
.
5) = 36.75

Current stock price, ‰

   

P     
 
!!
!! 
!! 
!! 
    

    
!!
!! 
!! 
   
+    %| % #
+  !  % |  #

þ Dividend discount models do not work for companies

which do not pay dividends
þ For non-dividend paying companies, we can use free
cash flow valuation approach
þ There are two versions:
± Free cash flow to equity holders (FCFE)
± Free cash flow to the firm (FCFF)
+    %| % #
+  !  % |  # 
(


i i
!

  i i

FCFE = the expected free cash flow in period 1

= et rncome + Depreciation Expense - Capital Expenditures

- - in Working Capital - ‰rincipal Debt epayments + ew Debt rssues

k = the required rate of return on equity

gFCFE = the expected constant growth rate of free cash flow to equity
+    %| % # 
+  !  % |  # 


!






°

!



 °

FCFE = the operating free cash flow to the firm in period 1
= ErT (1-Tax ate) + Depreciation Expense - Capital Spending
- - in Working Capital
WACC = the firm¶s weighted average cost of capital
gFCFF = the firm¶s constant infinite growth rate of free cash flow
+    %| % # 
+  !  % |  # 


g = ()(OrC)
where:
±  = the average retention rate
± OrC = ErT (1-Tax ate)Total Capital

WACC = D2"D
where:
D = the proportion of equity in total capital
2 = the after-tax cost of equity (from the SML)
D = the proportion of debt in total capital
 = the after-tax cost of debt
, 
! 
* 

+
  (
 ,

þ atio of current price per share (‰
) to next year¶s

expected earnings per share (E‰S)
þ Ñow do we use ‰E ratio to value a stock?
1. Forecast next year¶s E‰S, E1
2. Forecast ‰E ratio, ‰
E1
3. Multiple ‰E by E‰S to get current estimate of
price.
(‰
E1) x E1 = ‰

+
  (
 ,

+?(,
|   " # '  

þ rf a company has a constant dividend growth rate

and the market is in equilibrium (i.e., r
=‰
), then
we have an explicit formula for the ‰E ratio!

P ! ï


E! k

E ð ï
+
  (
 ,

+?(,
, 
,

þ b appears in both numerator

and denominator
þ Depends on how OE
compares with k P ! ï
± rf OE>k, increase in b


increases ‰E increases E! k

E ð ï
± rf OE=k, increase in b
has no effect on ‰E
± rf OE<k, increase in b
decreases ‰E
+
  (
 ,

+?(,
$  ,

þ equired rate of return on equity stocks reflects

interest rate and risk
þ rncrease in interest rates results in an increase in
required rate of return, pushing down security prices
and vice versa
þ rnverse relationship between ‰E ratios and interest
rates
+
  (
 ,

+?(,
,


þ Other things being equal, riskier stocks have

higher required rate of return and lower ‰E
multiples
þ True in all cases, not just the constant growth
model
þ ‰resent value of expected earnings and dividend
stream is lower when the risk is high
+
  (
 ,

  
%   +?(,

þ Other things being equal, stocks with higher

r


 liquidity command higher ‰E multiples and
vice versa

þ Other things being equal, a larger company


 tends to command a higher ‰E multiple
due to greater investor interest

þ rf the management of a company is reputed

,  
 % for integrity and investor friendliness, it is
'
 likely to command a higher ‰E multiple
, 
! 
* 

+
  -  ,

þ atio of current price per share (‰
) to current book

value per share (
)
þ ook value is determined by economic events as
well as accounting conventions
þ rf a company has a constant dividend growth rate
and the market is in equilibrium (i.e., r
=‰
), then
the ratio could be explained as,
‰
 
= OE(1+g)(1-b)(k-g)
, 
! 
* 

+
   ,

þ atio of current price per share to revenue per share

for the most recent 12 months
þ Mitigates problems in ‰E ratio due to:
± erratic earnings
± negative earnings
± managed earnings
 1 '  
( 

  

þ Economic alue-Added (E A)
± Compare net operating profit less adjusted taxes (O‰LAT)
to the firm¶s total cost of capital in dollar terms, including the
cost of equity
± E A = O‰LAT ± (WACC x Capital)
þ E A return on capital
± E ACapital
þ Alternative measure of E A
± Compare return on capital to cost of capital
 1 '  
'   

þ Market alue-Added (M A)
± Measure of external performance
± Ñow 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
± M A = Market alue of Firm ± Capital



    %  $ !
#

þ Focus on management¶s plans, strategies, and concerns

þ estrictions on nonpublic information
þ ³What if´ questions can help gauge sensitivity of revenues,
costs, and earnings
þ Management may indicate appropriateness of earnings
estimates
þ Discuss the industry¶s major issues
þ eview the planning process
þ Talk to more than just the top managers
)   

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

 '

þ Opportunities are mostly among less well-known

companies
þ To outperform the market you must find disparities
between stock values and market prices - and you
must be correct
þ Concentrate on identifying what is wrong with the
market consensus and what earning surprises may
exist
(
+  % 
'
 
+
! !   
! '


þ +
! (
+  % 
'

± Long-term buy-and-hold strategy
± Usually tracks an index over time
± Designed to match market performance
± Manager is judged on how well they track the target
index
þ 
! (
+  % 
'

± Attempts to outperform a passive benchmark portfolio
on a risk-adjusted basis
(
+  % 
'
 
+
! '
   

þ eplicate the performance of an index

þ May slightly under perform the target index due to
fees and commissions
þ Costs of active management (1 to 2 percent) are
hard to overcome in risk-adjusted performance
þ Many different market indexes are used for tracking
portfolios
(
+  % 
'


! '
   

þ ºoal is to earn a portfolio return that exceeds the

return of a passive benchmark portfolio, net of
transaction costs, on a risk-adjusted basis
þ ‰ractical difficulties of active manager
± Transactions costs must be offset
± isk can exceed passive benchmark