Chapter 06 –

Company Analysis and

Stock Valuation
 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
• 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 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
 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
 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
 SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– Threats
 SWOT Analysis
• Examination of a firm’s:
– Strengths INTERNAL ANALYSIS
– Weaknesses
– Opportunities
– Threats
 SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
EXTERNAL ANALYSIS
– Threats
 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)
 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)
 Example
• You will recall that the model also required that k > g (the
required rate of return is larger than the expected growth
rate), which is not true in this case because k = 9.0 percent
and g = 13 percent
• Therefore, the analyst must employ a two- or three-stage
growth model. Because of the fairly large difference
between the current growth rate of 13 percent and the
long-run constant growth rate of 8 percent,
• It seems reasonable to use a three-stage growth model,
which includes a gradual transition period.
• Therefore, beginning with 2002 when
dividends were expected to be $0.15, the
future dividend payments will be as follows
(the growth rate is in parentheses):
YEAR HIGH-GROWTH YEAR DECLINING-
PERIOD GROWTH PERIOD

2003 (13%) 0.17 2010 (12%) 0.39

2004 (13%) 0.19 2011 (11%) 0.43
2005 (13%) 0.21 2012 (10%) 0.47
2006 (13%) 0.24 2013 (9%) 0.51
2007 (13%) 0.27 2014 (8%) 0.55
2008 (13%) 0.31
2009 (13%) 0.35
Constant Growth Period:
•P 2014 = 0.55 (1.08) = $59
0.9-0.8
1. Present value of high-growth
period dividends $1.20
2. Present value of declining-growth
period dividends 1.00
3. Present value of constant-growth
period dividends 20.91
Total present value of dividends $23.11
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

R s to ck  E(RFR)   sto ck [ E(R mark et )  E(RFR)]

 EXAMPLE
• Given Hitech’s beta of 1.75 and a risk-free
rate of 7 percent, what is the expected rate
of return assuming
a. a 15 percent market return?
b. a 10 percent market return?
 Present Value of
Free Cash Flow to Equity
FCFE =
Net Income
+ Depreciation Expense
- Capital Expenditures
-  in Working Capital
- Principal Debt Repayments
+ New Debt Issues
 Present Value of
Free Cash Flow to Equity
FCFE = FCFE1
Net Income Value 
+ Depreciation Expense k  g FCFE
- Capital Expenditures
-  in Working Capital
- Principal Debt Repayments
+ New Debt Issues
 Present Value of
Free Cash Flow to Equity
FCFE1
Value 
k  g FCFE
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
 Example
• it is estimated that in 2003 the FCFE will be about $200 million
and the FCFF (free cash flow to the firm) will be about $250
million. Such volatility makes it appropriate to use the
conservative 13 percent growth rate going forward after 2003.
Therefore, the following example again uses a three-stage
growth model with characteristics similar to the dividend
growth model.
• g1 = 13 percent for the six years after 2003
• g2 = a constantly declining growth rate to 8 percent over five
years
• K = 9 percent cost of equity
• The specific estimates of annual FCFE, beginning with the
actual estimated value of $200 million in 2003, are as follows:
 HIGH-GROWTH PERIOD DECLINING-GROWTH PERIOD
YEAR GROWTH YEAR GROWTH
$ MILLION PV @ 9% $ MILLION PV @ 9%
2003 — 200 183 2010 (12%) 465 233
2004 (13%) 226 190 2011 (11%) 517 238
2005 (13%) 255 197 2012 (10%) 568 240
2006 (13%) 288 204 2013 (9%) 619 240
2007 (13%) 325 211 2014 (8%) 669 238
2008 (13%) 368 219 Total 1,189
2009 (13%) 416 228
Total 1,432

Price 2014 = 669(1.08)/ 0.09-.08 = 72,300

Price at 2003 at 9% = $25,703

 The total value of the stock is the sum of
the three present value streams discounted
at 9 percent:
$ MILLION
1. Present value of high-growth cash flows 1,432
2. Present value of declining-growth cash flows 1,189
3. Present value of constant-growth cash flows 25,703
Total present value of FCFE $28,324
 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
-  in Working Capital -  in other assets
 Present Value of
Operating Free Cash Flow
FCFF1
Firm Value 
WACC  g FCFF
Oper . FCF1
or
WACC  g OFCF
 Present Value of
Operating Free Cash Flow
FCFF1
Firm Value 
WACC  g FCFF
Oper . FCF1
or
WACC  g OFCF
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
 Example
• Therefore, the following demonstration will employ the
three-stage growth model with growth duration
assumptions similar to the prior examples. Given these
inputs for recent growth and the firm’s WACC, the growth
estimates for a three stage growth model are
• g1 = 13 percent for six years
• g2 = a constantly declining rate to 7 percent over six
years.
The specific estimates for future OFCF (or FCFF) are as
follows, beginning from the 2003 value of $250 million.
HIGH-GROWTH PERIOD DECLINING-GROWTH PERIOD
GROWTH PV @ GROWTH PV @
YEAR RATE FCFF 8% YEAR RATE FCFF 8%
2003 — 250 231 2010 (12%) 583 315
2004 (13%) 282 242 2011 (11%) 647 324
2005 (13%) 319 253 2012 (10%) 712 330
2006 (13%) 361 265 2013 (9%) 776 333
2007 (13%) 408 278 2014 (8%) 838 333
2008 (13%) 461 291 2015 (7%) 897 330
2009 (13%) 520 303 Total $1,965
Total $1,863

P 2015 = 897 (1.07) / .08 - .07 $96,000

PV @ 8% = $ 32654
 Thus, the total value of the firm is:
$ MILLION

1. Present value of high-growth cash flows $1,863

2. Present value of declining-growth cash flows 1,965
3. Present value of constant-growth cash flows 32,654
Total present value of operating FCF (FCFF) $36,482
 Problem No.01
At year-end 1991, the Wall Street consensus was
that Philip Morris’ earnings and dividends would
grow at 20 percent for five years after which
growth would fall to a market-like 7 percent.
Analysts also projected a required rate of return of
10 percent for the U.S. equity market. a. Current
Dividend on year end is $ 65 per share
Required: Using the multistage dividend discount
model, calculate the intrinsic value of Philip Morris
stock at year-end 1991.
 Problem No.02
TABLE 14
VALUATION INFORMATION: DECEMBER 1997
QuickBrush SmileWhite
Beta 1.35 1.15
Market price $45.00 $30.00
Intrinsic value $63.00 ?
Annual dividend per share $1.72
• Notes:
• Risk-free rate 4.50%
• Expected market return 14.50%
• Janet Ludlow’s firm requires all its analysts to use a two-stage
dividend discount model (DDM) and the capital asset pricing model
(CAPM) to value stocks. Using the CAPM and DDM, Ludlow has
valued QuickBrush Company at $63 per share. She now must value
SmileWhite Corporation.
• a. Calculate the required rate of return for SmileWhite using the
information in Table 14 and the CAPM. Show your work. [6 minutes]
Ludlow estimates the following EPS and dividend growth rates for
SmileWhite:
– First 3 years: 12 percent per year
– Years thereafter: 9 percent per year
• b. Estimate the intrinsic value of SmileWhite using the data from
Table 14 and the two stage DDM. Show your work. [12 minutes]
• c. Recommend QuickBrush or SmileWhite stock for purchase by
comparing each company’s intrinsic value with its current market
price. Show your work.
 Problem No.03
End of Year
1 $ -0-
2 Lease receipts 15,000
3 Lease receipts 25,000
3 Sale proceeds $100,000
PRESENT VALUE OF $1
Period 6% 8% 10% 12%
1 0.943 0.926 0.909 0.893
2 0.890 0.857 0.826 0.797
3 0.840 0.794 0.751 0.712
4 0.792 0.735 0.683 0.636
5 0.747 0.681 0.621 0.567
• Your client is considering the purchase of $100,000 in
common stock, which pays no dividends and will
appreciate in market value by 10 percent per year. At the
same time, the client is considering an opportunity to
invest $100,000 in a lease obligation that will provide the
annual year-end cash flows listed in Table 1. Assume that
each investment will be sold at the end of three years and
that you are given no additional information.
• Required:
• Calculate the present value of each of the two investments
assuming a 10 percent discount rate, and state which one
will provide the higher return over the three-year period.
Use the data in Table 1, and show your calculations.
 Problem No.04
• Abbey Naylor, CFA, has been directed by Carroll to
determine the value of Sundanci’s stock using the free cash
flow to equity (FCFE) model. Naylor believes that Sundanci’s
FCFE will grow at 27 percent for two years and 13 percent
thereafter. Capital expenditures, depreciation, and working
capital are all expected to increase proportionately with FCFE.
a. Calculate the amount of FCFE per share for the year 2000,
using the data from Table 17. Show your work. [6 minutes]
b. Calculate the current value of a share of Sundanci stock based
on the two-stage FCFE model using required rate of return at
16%. Show your work. [8 minutes]
TABLE 17
SUNDANCI ACTUAL 1999 AND 2000 FINANCIAL STATEMENTS FOR
FISCAL YEARS ENDING MAY 31 ($ MILLION, EXCEPT PER-SHARE
DATA)
1999 2000
Income Statement
Revenue $474 $598
Depreciation 20 23
Other operating costs 368 460
Income before taxes 86 115
Taxes 26 35
Net income 60 80
Dividends 18 24
Earnings per share $0.714 $0.952
Dividend per share $0.214 $0.286
Common shares outstanding
(millions) 84.0 84.0
 Balance Sheet
Current assets $201 $326
Net property, plant and equipment 474 489
Total assets 675 815
Current liabilities 57 141
Long-term debt 0 0
Total liabilities 57 141
Shareholders’ equity 618 674
Total liabilities and equity 675 815
Capital expenditures 34 38