Company Analysis and Stock Valuation
Shazia Farooq 18 July 2009
Learning Objectives
Differentiate between company analysis and stock valuation Explain 3 step approach to fundamental analysis Understand qualitative and quantitative approach to company analysis Determine intrinsic value of the stock using various valuation techniques Understand valueadded measures available to evaluate the performance of a firm Describe the passive and active strategies in managing an equity portfolio
Company Analysis and Stock Valuation
Growth Company vs Growth Stock
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
Company Analysis and Stock Valuation
Growth Company
Historically been defined as companies that consistently experience aboveaverage increase 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
±
This required rate of return is weighted average cost of capital (WACC)
Company Analysis and Stock Valuation
Growth Stock
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 riskadjusted rate of return occurs because of market undervaluation compared to other stocks
Company Analysis and Stock Valuation
Intrinsic Value of the Stock
Present value of all expected future cash flows to the stock investor Cash flows are discounted at the appropriate required rate of return. k Expected future cash flows consist of:
1. 2.
cash dividends sale price: proceeds from the ultimate sale of the stock
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Company Analysis and Stock Valuation
Intrinsic Value of the Stock
Intrinsic value is the analyst¶s estimate of what a stock is really worth Intrinsic value (IV) can differ from the current market price (MP)
± ±
If IV > MP: stock is underpriced => buy If IV < MP: stock is overpriced => sell or do not buy
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i. In addition. So everyone has the same k. expected HPR = k
. intrinsic value equals market price..e. IV0 = P0.
Everyone has the same intrinsic value. Everyone also demands the same required rate of return from the stock.Company Analysis and Stock Valuation
Market Equilibrium
In market equilibrium. So.
financial and other qualitative and quantitative factors Researchers have found that stock price changes can be attributed to the following:
± ± ± ±
Understanding of macroeconomic environment and developments
Analyzing industry prospects to which the firm belongs
Economywide factors: (3035%) Industry factors: (1520%) Company factors: (3035%) Other factors: (1525%) Assessing projected company performance and intrinsic share value
.Fundamental Analysis
Method of evaluating a security by attempting to measure its intrinsic value by examining related economic.
the company analysis should focus on firms in that industry that are positioned to benefit from the economic trends
Analysis of firms in selected industries concentrates on a stock¶s intrinsic value based on cash flow.Fundamental Analysis
Economic and Industry Influences
Macroeconomic analysis identifies industries likely to offer attractive returns in the expected future environment
If trends are favorable for an industry. growth and risk
.
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
. technology.Fundamental Analysis
Structural Influences
Social trends. political.
Qualitative and Quantitative Approach to Company Analysis
Industry competitive environment Present value of cash flows
SWOT analysis
Relative valuation ratio techniques
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Qualitative Approach
Competitive Forces
Current rivalry Threat of new entrants Potential substitutes Bargaining power of suppliers Bargaining power of buyers
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thus improving the firm¶s relative industry position ± Examples include preempting by obtaining price concessions from suppliers
.Qualitative Approach
Firm Competitive Strategies
Defensive Strategy ± Positioning 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 Offensive Strategy ± Using the company¶s strength to affect the competitive industry forces.
Qualitative Approach
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
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Qualitative Approach
SWOT Analysis
Examination of a firm¶s:
± ± ± ±
Strengths Weaknesses Opportunities Threats
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Qualitative Approach
SWOT Analysis
Examination of a firm¶s:
± ± ± ±
Strengths Weaknesses Opportunities Threats
INTERNAL ANALYSIS
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Qualitative Approach
SWOT Analysis
Examination of a firm¶s:
± ± ± ±
Strengths Weaknesses Opportunities Threats
EXTERNAL ANALYSIS
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2. Relative Valuation Techniques
1. 4. 3. Present value of dividends (DDM) 2.Intrinsic Value of the Stock
Stock Valuation Techniques
A. Present value of free cash flow (FCFF)
B. Present Value of Cash Flows (PVCF)
1. Price earnings ratio (P/E) Price cash flow ratio (P/CF) Price book value ratio (P/BV) Price sales ratio (P/S)
. Present value of free cash flow to equity (FCFE) 3.
mature firms where the assumption of relatively constant growth for the long term is appropriate
±
Intrinsic Value = D1/(kg)
D1= D0(1+g)
where D1 is next year¶s dividend.Present Value of Dividends
Constant Dividend Growth
Simplifying assumptions help in estimating present value of future dividends Most applicable to stable. k is required rate of return and g is the dividend growth rate
.
If D1 increases (decreases).Present Value of Dividends
Constant Growth Model
Model requires k>g With g>k. analyst must use multistage model All other things unchanged. If k increases (decreases). If g increases (decreases). IV decreases (increases).
. IV increases (decreases). IV increases (decreases).
Present Value of Dividends
Constant Growth Model .04) = $94. The required rate of return is 15%.Example
Big Oil Inc. Its dividends are expected to grow at a 4% annual rate forever.e.150. D0 = 10. just paid a dividend of $10 (i. What is the price of Big Oil¶s common stock? (to 2 decimal places) Intrinsic Value = D1/(kg) =10(1.04)/(0.55
.00).
stock
is beta of the stock and
E(Rm) is the expected market return
.Present Value of Dividends
Required Rate of Return Estimate
Nominal riskfree interest rate Risk premium Marketbased risk estimated from the firm¶s characteristic line using regression
R stock ! E(RFR) F stock [E(R market ) E(RFR)]
where RFR is the risk free rate.
e.
D1 P1 . expected HPR. Then.P 0 E (r ) = + P0 P0 D1 = + g P0
Dividend yield Capital gains yield
. This means that stock price is equal to intrinsic value..Present Value of Dividends
Expected HPR and k
Suppose the market is in equilibrium. E(r) is. i. P0 = IV0.
Therefore. Then required rate of return. must equal the expected HPR. P0 = IV0 . k. we can use the above formula to compute required rate of return
D1 k = + g P0
.
When everyone agrees on the same k (in equilibrium).Present Value of Dividends
Expected HPR and k
If stock is selling at intrinsic value.
Present Value of Dividends
Growth Rate Estimates
Average Dividend Growth Rate
!n
Dn 1 D0
Sustainable Growth Rate = b X ROE
where b is the retention ratio and ROE is the return on equity Retention ratio is also called the plowback ratio
.
Present Value of Dividends
ROE Determinants
ROE
Operating Efficiency (Profit Margin)
Asset Use Efficiency (Total Asset Turnover)
Financial Leverage (Equity Multiplier)
.
Present Value of Dividends
ROE Determinants
ROE = = ROE = =
Profit Margin * Total Asset Turnover * Equity Multiplier (Profit/Sales) * (Sales/Assets) * (Assets/Equity)
Tax Burden * Interest Burden * Operating Profit Margin * Asset Turnover * Equity Multiplier (Net Profit/Pretax Profit)* (Pretax Profit/EBIT)* (EBIT/Sales)* (Sales/Assets) * (Assets/Equity)
.
b Growth rate.Present Value of Dividends
Retention Ratio and Growth
Suppose ROE > 0 Earnings retention ratio. earnings and dividends will not grow
. Otherwise.. g > 0). g Growth policy b>0 g>0 Nogrowth policy b=0 g=0
Bottomline: If a company reinvests some portion of earnings back into the business (b > 0). future earnings and dividends will grow (i.e.
ROE. b > 0) will increase stock price If ROE < k.Present Value of Dividends
Is Growth Always Beneficial?
Does positive growth always increase stock price?
±
No. It depends on the attractiveness of the firm¶s investment opportunities. then retaining earnings will decrease stock price
Compared to a nogrowth policy..
±
±
. If ROE > k. then retaining earnings (i.e.
k Nogrowth price per share ROE $5 12.5% 5/0.5% 5/0. Inc (DB) $5 12. Inc (GP) Nogrowth earnings per share Required rate of return.125 = 40 15% Dead Beat.125 = 40 10%
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.Present Value of Dividends
Consider two companies
Growth Prospects.
125 ± 0. D1 = (1 ± b) x 5 Dividend growth rate.06) = 30. g = ROE x b Constant dividend growth model share price 0. b Next year¶s dividend per share.6 $2 6% 2/(0.125 ± 0.6 $2 9% 2/(0.14
Dead Beat.Present Value of Dividends
Suppose both companies reinvest 60% of next year¶s earnings«
Growth Prospects. Inc (GP) Earnings retention ratio.77
. Inc (DB) 0.09) = 57.
Inc (DB) 10% 12.Present Value of Dividends
Compare GP and DB
Growth Prospects. k Nogrowth price per share (1) Constant div.5% 40 57.5% 40 30.23
PVGO = Price per share ± nogrowth price per share
.77 9.14 17. PVGO = (2) ± (1) 15% 12.14 Dead Beat. Inc (GP) ROE Required rate of return. growth price (2) Present value of growth opportunities.
Present Value of Dividends
Multi Stage Dividend Growth
With this assumption. dividends will grow at a constant rate forever Time line is very useful for valuing this type of stocks To value such stocks. also need the constant growth formula Best way to learn is through an example
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. dividends grow at different rates for different periods of time. Eventually.
4.
Place yourself at t = 3 and use the constant growth formula to find PV of dividend stream after year 3. Call this P3 Find the PV of P3 Find PV of dividends at t=1.Present Value of Dividends
Multi Stage Dividend Growth . 3.
. $3. $3. respectively. t=2 and t=3 Current stock price = sum of 2 and 3
2. the dividend is expected to grow at 5% constant annual rate forever. is expected to pay dividends at the end of the next three years of $2.50. After three years. what is the current stock price?
1. If the market capitalization rate for this stock is 15%.Example
Example: ABC Co.
00
T=2
$3. t=2 and t=3 Current stock price = sum of 2.50
T=3 T=4
Dividends grow at 5% forever
T=0
T =1
. 3 and 4 $2. Call this P3 Find the PV of P3 Find PV of dividends at t=1.00 $3.Present Value of Dividends
Multi Stage Dividend Growth . 4.
Place yourself at t = 3 and use the constant growth formula to find PV of dividend stream after year 3.
2. 3.Example
1.
75 P0 = + + 2 + 3 3 ( 1.15) 1.15 (1.5 x (1.75 = + 2 + 3 ( 1.15 ) (1.15) 2 3 3.15 ± 0.75
Current stock price.15) 1.50 36.15 (1.15 ) = $30. P0
2 3 3.Present Value of Dividends
Multi Stage Dividend Growth .05) = 36.05))/(0.50 + 36.47
.Example
P3 = (3.
we can use free cash flow valuation approach There are two versions:
± ±
Free cash flow to equity holders (FCFE) Free cash flow to the firm (FCFF)
.Present Value of Cash flows
Present value of Free Cash Flow
Dividend discount models do not work for companies which do not pay dividends For nondividend paying companies.
Principal Debt Repayments + New Debt Issues k = the required rate of return on equity gFCFE = the expected constant growth rate of free cash flow to equity
.Capital Expenditures .Present Value of Cash flows
Present value of Free Cash Flow to Equity
FCFE1 Value ! k g FCFE
FCFE = the expected free cash flow in period 1 = Net Income + Depreciation Expense .( in Working Capital .
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
. FCF1 or WACC g OFCF
FCFE = the operating free cash flow to the firm in period 1 = EBIT (1Tax Rate) + Depreciation Expense .Present Value of Cash flows
Present value of Free Cash Flow to Firm
FCFF 1 Firm Value ! WACC g FCFF Oper .
Present Value of Cash flows
Present value of Free Cash Flow to Firm
g = (RR)(ROIC) where: ± RR = the average retention rate ± ROIC = EBIT (1Tax Rate)/Total Capital
WACC = WEk + Wdi
where: WE = the proportion of equity in total capital k = the aftertax cost of equity (from the SML) WD = the proportion of debt in total capital i = the aftertax cost of debt
.
Forecast 2. E1 P/E ratio.
. P0/E1
P/E by EPS to get current estimate of (P0/E1) x E1 = P0
price.Relative Valuation Techniques
Price to Earnings Ratio
Ratio of current price per share (P0) to next year¶s expected earnings per share (EPS) How do we use P/E ratio to value a stock?
1. Forecast 3. Multiple
next year¶s EPS.
e.. IV0=P0). then we have an explicit formula for the P/E ratio!
1 b P0 ! E1 k ( ROE v b)
.Price to Earnings Ratio
P/E Ratio and Constant Growth Model
If a company has a constant dividend growth rate and the market is in equilibrium (i.
increase in b increases P/E increases ± If ROE=k. increase in b has no effect on P/E ± If ROE<k. increase in b decreases P/E
P0 1 b ! E1 k ( ROE v b)
.Price to Earnings Ratio
P/E Ratio and Retention Ratio
b appears in both numerator and denominator Depends on how ROE compares with k ± If ROE>k.
Price to Earnings Ratio
P/E Ratio and Interest Rate
Required rate of return on equity stocks reflects interest rate and risk Increase in interest rates results in an increase in required rate of return. pushing down security prices and vice versa Inverse relationship between P/E ratios and interest rates
.
Price to Earnings Ratio
P/E Ratio and Risk
Other things being equal. not just the constant growth model Present value of expected earnings and dividend stream is lower when the risk is high
. riskier stocks have higher required rate of return and lower P/E multiples True in all cases.
Price to Earnings Ratio
Other influences on P/E Ratio
Liquidity
Other things being equal. stocks with higher liquidity command higher P/E multiples and vice versa
Size
Other things being equal. it is likely to command a higher P/E multiple
. a larger company tends to command a higher P/E multiple due to greater investor interest
Reputation of Management
If the management of a company is reputed for integrity and investor friendliness.
IV0=P0). P0 / BV0 = ROE(1+g)(1b)/(kg)
.Relative Valuation Techniques
Price to Book Value Ratio
Ratio of current price per share (P0) to current book value per share (BV0) Book value is determined by economic events as well as accounting conventions If a company has a constant dividend growth rate and the market is in equilibrium (i.e. then the ratio could be explained as..
Relative Valuation Techniques
Price to Sales Ratio
Ratio of current price per share to revenue per share for the most recent 12 months Mitigates problems in P/E ratio due to:
± ± ±
erratic earnings negative earnings managed earnings
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ValueAdded Measures
Economic Value Added
Economic ValueAdded (EVA)
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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 = NOPLAT ± (WACC x Capital) EVA/Capital Compare return on capital to cost of capital
±
EVA return on capital
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Alternative measure of EVA
±
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ValueAdded Measures
Market Value Added
Market ValueAdded (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 MVA = Market Value of Firm ± Capital
±
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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
. costs.Site Visits and the Art of the Interview
Focus on management¶s plans. and concerns Restrictions on nonpublic information ³What if´ questions can help gauge sensitivity of revenues. strategies.
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
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Efficient Markets
Opportunities are mostly among less wellknown 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
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Equity Portfolio Management
Passive versus Active Management
Passive Equity Portfolio Management
± ± ± ±
Longterm buyandhold strategy Usually tracks an index over time Designed to match market performance Manager is judged on how well they track the target index Attempts to outperform a passive benchmark portfolio on a riskadjusted basis
Active Equity Portfolio Management
±
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Equity Portfolio Management
Passive Management Strategy
Replicate the performance of an index May slightly under perform the target index due to fees and commissions Costs of active management (1 to 2 percent) are hard to overcome in riskadjusted performance Many different market indexes are used for tracking portfolios
.
Equity Portfolio Management
Active Management Strategy
Goal is to earn a portfolio return that exceeds the return of a passive benchmark portfolio. on a riskadjusted basis Practical difficulties of active manager
± ±
Transactions costs must be offset Risk can exceed passive benchmark
. net of transaction costs.