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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?
Chapter 14 - Company
Analysis and Stock Valuation
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?
Chapter 14 - Company
Analysis and Stock Valuation
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?
Chapter 14 - Company
Analysis and Stock Valuation
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?
Chapter 14 - Company
Analysis and Stock Valuation
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?
Chapter 14 - Company
Analysis and Stock Valuation
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?
Chapter 14 - Company
Analysis and Stock Valuation
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?
Chapter 14 - Company
Analysis and Stock Valuation
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
firms 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 stocks 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 industrys 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
companys strength to affect the competitive
industry forces, thus improving the firms
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 firms competitive
strategy over time
SWOT Analysis
Examination of a firms:
Strengths
Weaknesses
Opportunities
Threats
SWOT Analysis
Examination of a firms:
Strengths
Weaknesses
Opportunities
Threats
INTERNAL ANALYSIS
SWOT Analysis
Examination of a firms:
Strengths
Weaknesses
Opportunities
Threats
EXTERNAL ANALYSIS
Some Lessons from Peter Lynch
Favorable Attributes of Firms
1. Firms product should not be faddish
2. Firm should have some long-run comparative
advantage over its rivals
3. Firms 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 = D
1
/(k-g)
D
1
= D
0
(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 firms
characteristic line using regression
Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the firms
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
- A in Working Capital
- Principal Debt Repayments
+ New Debt Issues
Present Value of
Free Cash Flow to Equity
FCFE =
Net Income
+ Depreciation Expense
- Capital Expenditures
- A in Working Capital
- Principal Debt Repayments
+ New Debt Issues
FCFE
g k
FCFE
Value

=
1
Present Value of
Free Cash Flow to Equity
FCFE = the expected free cash flow in period 1
k = the required rate of return on equity for the firm
g
FCFE
= 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 firms operating free cash flow
to the firm (FCFF) at the firms weighted
average cost of capital (WACC) rather than
its cost of equity
FCFF = EBIT (1-Tax Rate)
+ Depreciation Expense - Capital Spending
- A in Working Capital - A in other assets
Present Value of
Operating Free Cash Flow
OFCF
FCFF
g WACC
FCF Oper
or
g WACC
FCFF
Value Firm

=
1
1
.

Present Value of
Operating Free Cash Flow
Where: FCFF
1
= the free cash flow in period 1
Oper. FCF
1
= the firms operating free cash flow in period 1
WACC = the firms weighted average cost of capital
g
FCFF
= the firms constant infinite growth rate of free cash flow
g
OFCF
= 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 = W
E
k + W
d
i
Calculation of WACC
WACC = W
E
k + W
d
i
where:
W
E
= the proportion of equity in total capital
k = the after-tax cost of equity (from the SML)
W
D
= 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
firms 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?
Analysis of Growth Companies
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 =
Analysis of Growth Companies
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 firms 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 firms rate of return on investments and
the firms 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 firms 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 firms 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
Measures of Value-Added
Market Value-Added (MVA)
Measure of external performance
How the market has evaluated the firms
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
Measures of Value-Added
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 firms rate and duration of
growth
P/E is function of
expected rate of growth of earnings per share
stocks required rate of return
firms 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 managements 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 industrys 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