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Kellogg School of Management

Northwestern University

Investment Management Primer:


Stock Pitching for Success

Investment Management Club


November 8, 2007

Pitching a Stock
_____________________________________________________________________________________________________________________________

• What are the “types” of stock pitches?


– Job interview
– Classroom
– Professional (e.g., to portfolio manager)
– Your money
• What are the respective goals?
– Get the job
– Get the ‘A’
– Get the investment

– Need I articulate??
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©2007 Linda Vincent 1


Pitching a Stock
_____________________________________________________________________________________________________________________________

• What are the recommendations?


– Buy the stock
• Stock is underpriced
• Target price and estimated time frame
– Hold the stock
• Stock fairly priced
• Expect continued “market” returns
– Sell the stock
• Stock overpriced
– Short the stock
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Pitching a Stock
_____________________________________________________________________________________________________________________________

• What is shorting a stock?


– Sell a stock that you do not own
– Betting the share price will go down
– “Borrow” the stock from the broker
– Collateralize the position (50%)
– Maximum gain on trade?
– Maximum loss on trade?
• Target price and time frame
• Stop loss
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©2007 Linda Vincent 2


Pitching a Stock
_____________________________________________________________________________________________________________________________

• How to find a stock to pitch


– Read
– Read
– Read
• Personal interest / experience
– Something you know
– Something you have learned about

Pitching a Stock
_____________________________________________________________________________________________________________________________

• Pitching a stock for a job interview


– The story is key
• Growth
• Asset play
• Turnaround
• Other……
– Make the pitch a buy or a sell (short)
• Why?
– Keep it simple and short

©2007 Linda Vincent 3


Pitching a Stock
_____________________________________________________________________________________________________________________________

• Pitching a stock for a class or


professionally
– Both story and analysis are key
– More in depth analysis reviewed
• By professor or portfolio manager
– Most stocks are fairly priced
• Why?
Î Most stocks are a hold

Pitching a Stock
_____________________________________________________________________________________________________________________________

• “Pitching a stock” for your own


portfolio (your money)
– The analysis is key (driven by the
story)
– Most stocks are fairly priced
– Key is to understand the risks (and
your risk preferences)
– Target prices for buys and shorts
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©2007 Linda Vincent 4


Pitching a Stock – The Analysis
_____________________________________________________________________________________________________________________________

• Types of valuation analysis


– Technical
– Fundamental
– Relative
– Comparable transactions

Technical Analysis
_____________________________________________________________________________________________________________________________

Technical Analysis – Example

June 23

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©2007 Linda Vincent 5


Fundamental Analysis
___________________________________________________________________________________________________________________________________________

Five steps:
1) Overview of firm and its strategies
2) Evaluate structure of industry
3) Evaluate firm’s economic position
4) Predict future course of firm
5) Valuation of firm

Goal: Estimate intrinsic value of the firm.

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Fundamental Analysis
___________________________________________________________________________________________________________________________________________

What is intrinsic value of the firm?


Per Warren Buffett of Berkshire Hathaway:
Intrinsic value is an all-important concept
that offers the only logical approach to
evaluating investments: it is simply the
discounted value of the cash that can be
taken out of a business during its
remaining life.

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©2007 Linda Vincent 6


1) Overview of Firm and its Strategies
___________________________________________________________________________________________________________________________________________

A) Key lines of business


- Number of lines of business?
- Is the firm diversified?
B) Major products/services
- Characteristics of products/services
• Commodity?
• Specialized, quality?
C) Primary markets
- Number of major customers?
- Dependence on a few customers?
- Diversified markets?
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1) Overview of Firm and its Strategies


___________________________________________________________________________________________________________________________________________

D) Age of firm
- Firm’s economic life cycle
[Start up, emerging growth, established
growth, maturity, decline]
E) Current operating strategy
- Growth (organic or via acquisition)
- Restructuring
- Downsizing
- Diversifying
- Steady state
F) Management (quality, strengths, experience,
reputation)
G) Corporate governance (quality, red flags)

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©2007 Linda Vincent 7


2) Evaluate Structure of Industry
____________________________________________________________________________________________________________________________________________

A) Number of firms and concentration


- What percentage of industry sales captured by
industry leaders?
B) Level of competitiveness
- Barriers to entry?
- Relative market shares of firms in industry?
- Competition - domestic, foreign, both?
- Characteristics of major competitors?
• Strengths, weaknesses, strategies

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2) Evaluate Structure of Industry


____________________________________________________________________________________________________________________________________________

C) Growth profile
- Historical, current and projected rates of growth
D) Seasonal or cyclical patterns
- Sensitivity to business cycle?
E) Regulatory environment
- Established agencies
• FDA, EPA, FDIC, NRC, FAA, etc.
- SEC, Sarbanes-Oxley, the next Eliott Spitzer, etc.
F) Sensitivity to macroeconomic conditions
- Interest rates, inflation, consumer confidence

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2) Evaluate Structure of Industry
____________________________________________________________________________________________________________________________________________

G) Technological change and innovation


- Importance – history, resources
H) Production profile
- Labor or capital intensive?
- Unionized?
• History of labor relations
- Constraints on availability of raw materials,
labor, other production inputs?

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2) Evaluate Structure of Industry


____________________________________________________________________________________________________________________________________________

I) Drivers of business
- What drives success in industry?
- What drives stock price/returns of firms
in industry?

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Value drivers
______________________________________________________________________________________________________________________________________________

Share price

Value driver

Examples
Retail: Gross margin (sales less cost of goods sold)
Same store sales per square foot
Homebuilders: Interest rates
Demographics (e.g., household formation)
Credit availability
Consumer confidence
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Value drivers
______________________________________________________________________________________________________________________________________________

Operating
Margins

29%

27%

25%

23% $60 / share

21% $55 / share

19% $50 / share

17%
4% 6% 8% 10% 12%
Sales Growth

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Industry Analysis - Airlines
__________________________________________________________________________________

Industry Characteristics:
- Protracted downturn (2001 – 2005 )
- Top 10 carriers’ losses (5 consecutive years):
• 2005: $ 27 billion loss on $ 97 billion revenues
• 2004: $ 10 billion loss on $ 91 billion revenues
- Heavily regulated
- Highly unionized
• Poor labor relations common
- Major cost components
• Labor ( 25 – 32 % of total costs in 2006)
• Fuel ( 26 % of total costs in 2006)
- Capital intensive
- Highly levered

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Industry Analysis - Airlines


________________________________________________________________________

Key value drivers:


• Revenue per revenue-paying passenger mile
(RPM or yield - measure of fare levels)
▪ Revenue per available seat mile (RASM)
• Cost per available seat mile (CASM)
• Passenger load factor:
Revenue passenger miles / available seat miles
• Break-even analysis based on load factor
- Load factor in US YTD 2007 = 79.2%
- Load factor in 2006 = 77.6%
- Break-even load factor in 2007 = 76%
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©2007 Linda Vincent 11


Industry Analysis - Airlines
__________________________________________________________________________

Example of Value Drivers

Airlines: Domestic cost per available seat mile (CASM)


Domestic operating revenue per ASM (RASM)

2nd Qtr 2005


(in cents/mile) Cost/ASM Rev/ASM

US Airways 15.3 > 15.2


Northwest 15.7 > 15.0
Continental 15.7 > 14.9
United 13.8 > 13.7
American 11.5 < 11.6
America West 11.4 = 11.4
Frontier 10.7 = 10.7
Southwest 7.1 < 8.0
JetBlue 6.7 < 7.4 23

Industry Analysis - Airlines


__________________________________________________________________________

Airlines: Domestic cost per available seat mile (CASM)


Domestic operating revenue per ASM (RASM)

2nd Qtr 2006

(in cents/mile) Cost/ASM Rev/ASM

US Airways 16.1 < 18.4


Northwest 13.8 < 15.2
Continental 13.6 < 14.6
United 13.4 < 14.1
American 12.4 < 13.4
America West 12.7 < 13.5
Frontier 11.0 < 11.4
Southwest 8.9 < 10.7
JetBlue 7.8 < 8.5
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©2007 Linda Vincent 12


Industry Analysis - Airlines
___________________________________________________________________________

Airlines: Domestic cost per available seat mile (CASM)


Domestic operating revenue per ASM (RASM)

2nd Qtr 2007

(in cents/mile) Cost/ASM Rev/ASM

US Airways 16.3 < 19.0


Northwest 13.0 < 14.7
Continental 13.5 < 14.5
United 13.0 < 14.5
American 12.8 < 13.7
America West 13.1 > 12.8
Frontier 10.7 = 10.7
Southwest 9.0 < 10.3
JetBlue 8.0 < 9.0

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Industry Analysis - Airlines


_____________________________________________________________________________________________________________________________

Continental Airlines Nov. 2005 – Nov. 2007

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Industry Analysis - Airlines
__________________________________________________________________________________

Additional considerations for airline analysis:


• Market share (share of available seat miles)
• Barriers to entry
Gates
Take-off and landing slots
Routes
• Aircraft fleet
Average age
Standardization
Fuel efficiency
Aircraft orders and options

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3) Evaluate Firm’s Current Economic Position


_____________________________________________________________________________________________________________________________

A) Financial position
- Balance sheet analysis
• Types of assets (tangible, intangible, current, long term)
• Nature of liabilities (maturity structure, off-balance-sheet)
• Capital structure (leverage)
• Components of residual equity
B) Profitability
- Income statement analysis
• Operating revenues and expenses
• Profit margins
• Nonrecurring or unusual items

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3) Evaluate Firm’s Current Economic Position
_____________________________________________________________________________________________________________________________

C) Cash flow
- Statement of cash flows analysis
• Cash from operations
• Cash from investing activities
• Cash from financing activities
D) Time series (firm through time)
E) Cross-section (firm relative to competitors)
F) Risks
- Economic – macroeconomic risks
- Business – risk of not earning cost of capital
- Financial – risk of not meeting financial obligations

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4) Predict Future Course of Firm


____________________________________________________________________________________________________________________

Build financial model


- Project firm’s future operations
• Understand the firm’s business model
• Understand firm’s strategy
• Understand and assess sustainability of
competitive advantages
- Structure projections as pro forma financial
statements
• Income statement
• Balance sheet
• Statement of cash flows

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4) Predict Future Course of Firm
____________________________________________________________________________________________________________________

Build financial model (Cont.’)

- Carefully and completely articulate assumptions


- Do sensitivity analysis on value drivers
• Sales growth
• Cost of goods sold
• Cost of capital
• Others
- Incorporate alternative strategies
- Assess impact of risk

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5) Estimate the intrinsic value of the firm


__________________________________________________________________________________________________________________

a) Valuation model

b) Sensitivity analysis

c) Reasonable range for intrinsic value

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©2007 Linda Vincent 16


Valuation
__________________________________________________________________________________

This process is at least as much ART as


SCIENCE.

The goal is not just the “number” (the intrinsic


value) but an understanding of what drives the
value and how that value could change.

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Valuation - Free Cash Flows


______________________________________________________________________________________________

Free cash flows are the cash flows


available for distribution to all providers
of capital after providing for all short
term and long term capital needs of the
firm necessary to execute the firm’s
strategic plan. These cash flows
determine the firm’s value.

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©2007 Linda Vincent 17


Calculating free cash flows
______________________________________________________________________________________________

START WITH STATEMENT OF CASH FLOWS


Cash Flow from Operations
Net income
+ expenses not using cash
- revenues not providing cash
- increase in working capital** -OR-
+ decrease in working capital**
___________________________________________________________________________________________________

Cash Flow from Operations (from St. of Cash Flows)**

** Includes changes in working capital except for:


cash
notes payable
current portion of long term debt
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Calculating free cash flows


_________________________________________________________________________________________________

Cash Flow from Operations (from St. of Cash Flows)


+ interest paid in cash
- interest tax shield (tax shelter from financing charges)
_______________________________________________________
Cash Flow from Operations of the Unlevered Firm
- capital investment (including, but not limited to, capital
expenditures or “CAPEX”)
_______________________________________________________
Free Cash Flows of the Unlevered Firm (FCFU)
====================================================

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Step 5 of Fundamental Analysis -
Valuation
_________________________________________________________________________________

Discounted cash flow model:


• The numerator contains the free cash flows
• Estimate annual free cash flows until firm reaches
steady state – the horizon or terminal date (T)
• Estimate the value of the firm from the terminal date

E(FCFt ) E(TVT )
T
V0 = ∑ (1 + k )t
+
(1 + k )T
t =1

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Step 5 of Fundamental Analysis


_________________________________________________________________________________

Discounted cash flow model (continued):


• Terminal or continuing value:

E(FCFt ) E(TVT )
T
V0 = ∑ (1 + k )t
+
(1 + k )T
t =1
– Often estimated as a perpetuity, usually with growth
– Terminal values are often filled with heroic
assumptions
– Terminal value may dominate calculation of firm
value
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©2007 Linda Vincent 19


Step 5 of Fundamental Analysis
_________________________________________________________________________________

Discounted cash flow model (continued):


• Terminal or continuing value:

E(FCFT )(1 + g )
E(TVT ) =
(k − g )
– Perpetuity with growth
– g is growth rate of FCF in perpetuity

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Step 5 of Fundamental Analysis


_________________________________________________________________________________

Discounted cash flow model (continued):


• Discount rate k: E(FCFt ) E(TVT )
T
V0 = ∑ (1 + k )t
+
(1 + k )T
t =1

• Weighted average cost of capital

⎛E ⎞ ⎛D ⎞
k = WACC t = k E,t ⎜⎜ t ⎟ + k D,t ⎜ t
⎟ ⎜V


⎝ Vt ⎠ ⎝ t ⎠
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©2007 Linda Vincent 20


Step 5 of Fundamental Analysis
_________________________________________________________________________________

Discounted cash flow model (continued):


• Weighted average cost of capital

⎛E ⎞ ⎛D ⎞
WACC t = k E,t ⎜⎜ t ⎟ + k D,t ⎜ t
⎟ ⎜V


⎝ Vt ⎠ ⎝ t ⎠
Where:
kEt = cost of equity capital at time t
kDt = after tax cost of debt capital at time t
Et = market value of equity at time t
Dt = market value of debt at time t
Vt = market value of the levered firm at time t = Et + Dt
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Step 5 of Fundamental Analysis


_________________________________________________________________________________

Discounted cash flow model (continued):

V0 = total value of firm (debt + equity)

V0 less market value of debt =


intrinsic value of equity

Value of equity / # shares = Price / share

Compare intrinsic value to market price Î

RECOMMENDATION
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©2007 Linda Vincent 21


Multiples Analysis – An Alternative
______________________________________________________________________________

• Also referred to as relative valuation


• Ubiquitous
• Generally not motivated by first
principles
• What does relative valuation assume
about market prices?

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Multiples Analysis
___________________________________________________________________________________

• Procedure (to value a firm):


– Select comparable firms
• Identify key characteristics of comparable
firms
– What are these key characteristics?
» Industry
» Firm size
» Growth rate
» Capital structure
» Profitability
• How many sample firms?
– Are more firms “better”?
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©2007 Linda Vincent 22


Multiples Analysis
__________________________________________________________________________________________________

– Choose an appropriate comparison metric


• What are the criteria for choice?
– Value driver?
• Examples
– Earnings per share or EPS
– Earnings before interest, taxes, depreciation and
amortization or EBITDA
– Book value of equity (BVE or BV)
– Sales
• Industry specific
– CASM, RASM, load factor (airlines)
– Gross margin and same store sales (retail)
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Multiples Analysis
____________________________________________________________________________________________________________________

Income Statement (for the X month period


ending on date)

Operating revenues (sales)


less: (Operating expenses)
Earnings before interest and taxes (EBIT)
Plus: Depreciation and amortization
Earnings before interest, taxes, depreciation,
and amortization or EBITDA

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©2007 Linda Vincent 23


Multiples Analysis
__________________________________________________________________________________________________

– Determine “representative” multiple from


the distribution of comparable firms
• Analyze distribution – understand what
is high, low, “normal”
• Mean, median
– Apply multiple to firm being valued to get
an implied “price”
• Choose appropriate numerator

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Multiples Analysis
__________________________________________________________________________________________________

• Choice of performance metric


– Share price to earnings (P / E)
• Most popular, most commonly used
• “Not meaningful” for firms that report
losses
– Share price to book value of equity
• Used when balance sheet reflects
approximate fair value of assets in place
• Used more widely in recent years after
academic research on importance of book
values in predicting returns
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©2007 Linda Vincent 24


Multiples Analysis
__________________________________________________________________________________________________

• Choice of performance metric


– Enterprise Value (EV) to EBITDA
• Enterprise value = debt + equity
• Used for firms with significant non-cash
expenditures
– Enterprise Value (EV) to sales
• Used for young firms or firms with negative
net income
• Why share price vs enterprise value in
numerator?
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Brinker International (NYSE: EAT)


__________________________________________________________________________________________________

Example – Determine appropriate price for Brinker


International (a restaurant) using multiples.

Data for Brinker


Price (MVE / share) = $ 26.90
EPS = $ 1.46
EBITDA / share = $ 3.35
Debt / share = $ 2.32
Sales / share = $ 24.86
BVE / share = $ 9.05

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©2007 Linda Vincent 25


Brinker International (NYSE: EAT)
______________________________________________________________________________________________

68 publicly traded comparable restaurants:

P/E EV / EBITDA EV / Sales P / BVE


Mean 18.75 7.67 0.75 2.16
Median 15.73 6.75 0.55 1.44

Brinker Implied Price (vs. $26.90 actual price)

Mean $ 27.38 $ 23.37 $ 16.33 $ 19.55


Median $ 22.97 $ 20.29 $ 11.35 $ 13.03

(computations on next slide)

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Brinker International (NYSE: EAT)


______________________________________________________________________________________________

Computations (Means):

P/E $ 1.46 x 18.75 = $ 27.38


EV/EBITDA $ 3.35 x 7.67 = $ 25.69 - $ 2.32 = $ 23.37
EV/Sales $ 24.86 x 0.75 = $ 18.65 - $ 2.32 = $ 16.33
P / BVE $ 9.05 x 2.16 = $ 19.55

(recall that EV = enterprise value = total value of firm both


debt and equity)

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©2007 Linda Vincent 26


Brinker International (NYSE: EAT)
______________________________________________________________________________________________

What do you conclude about Brinker’s trading


price?

Too high, too low, or about “right”?

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Stock Picking/Pitching
___________________________________________________________________________________________________________________________________________

• What does the “street” say about your


stock?

• Why are you better than the “street”?

• What is going to make the street see things


your way and move the price of the stock
appropriately (what are the catalysts)?

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©2007 Linda Vincent 27


Stock Picking/Pitching
___________________________________________________________________________________________________________________________________________

Why are you better than the “street”?


• Rely on three competitive advantages:
– Better information Î dig deeper
• Industry reports, primary diligence
– Better, more robust analysis
• Accounting adjustments, business
cycles, secular shifts
– Objectivity
• Take advantage of market
psychology when it is wrong
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Stock Picking/Pitching
__________________________________________________________________________________

• Quick overview
• Importance of understanding the firm’s
story
• Importance of understanding the
industry and its key value drivers
• Importance of in-depth financial analysis
• No quick, back of the envelope answers
• Peter Lynch estimates that the top stock
pickers are right 60% of the time

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©2007 Linda Vincent 28