Company

analysis and
stock valuation
ch14
Company Analysis vs. Stock
Valuation
 Good companies are not necessarily good investments.
Why?

 Compare the intrinsic value of a stock to its market

value
 Stock of a great company may be overpriced (market
value is higher than intrinsic value)
 Which means its not a good stock to invest in although
the company’s performance is extremely well.
Growth companies and growth stocks
Growth company is a:
 company that has a rate of return that is higher than the
required rate of return (WACC).
 Has the potential for future earning growth.
 The firm’s sales and earnings grow faster than those of a
similar risk firms and the overall economy.
 Younger companies that has above average investment
opportunities.
 These companies retain a large portion of its earning to
fund these investment projects.
 Low dividend payout ratio. Or no dividend sometimes.
Growth companies and growth stocks

 Growth stock is :
 Stock with higher expected rate of return than
other stocks in the market with similar risk
characteristics
 Achieves this superior risk-adjusted rate of return
because the market has undervalued it compared
to other stocks.
Growth companies and growth stocks
 Although stock market adjusts stock prices relatively quickly and
accurately to reflect new information, available information are not
always perfect or complete.
 Therefore, incomplete information may cause a stock to be
undervalued or overvalued at a point in time.
 If the stock is undervalued, its price should eventually reflect the
true fundamental value when the correct information becomes
available.
 During this period of price adjustment, it will be a growth stock.
Growth companies and growth stocks
 Growth stock are not necessarily limited to growth
companies.
 It can be the stock of any type of company as long
as this stock is undervalued by the market.
Growth companies and growth stocks
 Example,

if an overeager investor tend to overestimate the

expected growth rate of earnings and cash flows for
a growth company and inflate the price of a growth
company stock.
Then investors who paid the inflated stock price will
earn a rate of return below the risk adjusted required
rate of return.
Defensive companies vs defensive stock

 Defensive Company:
 Whose future earnings are likely to resist an
economic downturn
 Normally have low business risk and not excessive
financial risk
 Supply basic consumer necessities such as Public
utilities or grocery stores.
Defensive companies vs defensive
stock
Defensive stock:
 Rate of return is not expected to decline during an
overall market decline or decline less than the
overall market.
 Stock with low or negative systematic risk
 Or in other words, a stock that has a low positive
or negative beta (the expected return of an asset
based on its expected market returns is low)
Cyclical companies and cyclical stocks
Cyclical companies:
 Sales and earnings will be heavily influenced by
aggregate business activity
 Outperform other firms during economic
expansion
 Underperform during economic contractions
 High volatility in sales (high business risk and
financial risk)
 Example steel, auto or heavy machinery industries
Cyclical companies and cyclical stocks
Cyclical stock:
 Experiences changes in rates of return greater than
changes in overall market rates of return
 Stocks with high betas
Speculative companies vs speculative
stocks
Speculative companies
 Whose assets involve greater risk but that also has
a possibility of greater gain
Speculative stock
Possesses a high probability of low or negative rates
of return
Speculative stocks
 One that is overpriced, leading to a high probability
that during the future period when the market adjusts
the stock price to its true value,

 Will experience either low or possibly negative rates

of return

 Might be the case for an excellent growth stock that

is substantially overvalued
Firm’s Overall Strategic Approach
 Porter suggests two major strategies:
 Low-Cost Strategy
 The firm seeks to be the low-cost producer, and hence the cost
leader in its industry
 Cost advantages vary by industry and might include economies
of scale, proprietary technology,

Differentiation Strategy
 Firm positions itself as unique in the industry in an area that is
important to buyers
 A company can attempt to differentiate itself based
 on its distribution system or some unique marketing approach
Company Analysis
 SWOT analysis
 Strengths
 Weaknesses
 Opportunities
 Threats
SWOT Analysis
 Internal Analysis
 Strengths
 Give the firm a comparative advantage in the
marketplace
 Perceived strengths can include good customer service,
high-quality products, strong brand
 image, customer loyalty, innovative R&D, market
leadership, or strong financial resources
 Weaknesses
 Weaknesses result when competitors have potentially
advantages over the firm
SWOT Analysis

 External Analysis
 Opportunities
 These are environmental factors that favor the firm
 They may include a growing market for the firm’s
products (domestic and international), shrinking
competition, favorable exchange rate shifts
 Threats
 They are environmental factors that can hinder the firm in
achieving its goals
 Examples would include a slowing domestic economy,
additional government regulation, an increase in industry
competition, threats of entry,
Some Lessons from Peter Lynch
 Favorable Attributesof Firms may result in
favorable stock market performance
 Firm’s product should not be faddish
 Firm should have some long-run comparative
advantage over its rivals
 Firm’s industry or product has market stability
 Firm can benefit from cost reductions
Estimating Intrinsic value
 Present value of cash flows (PVCF)
 Present value of dividends (DDM)
 Present value of free cash flow to equity (FCFE)
 Present value of free cash flow (FCFF)
 Relative valuation techniques
 Price earnings ratio (P/E)
 Price cash flow ratios (P/CF)
 Price book value ratios (P/BV)
 Price sales ratio (P/S)
Present Value of Dividends

 Dividend discount model (DDM).

 This model has a typical assumption that the
dividend will grow at a constant rate over time.
 Although this assumption is not realistic for fast
growing or cyclical firms, this assumption may be
appropriate for many mature firms
 DDM
 More complex DDM exist for more complicated
growth forecast including two stage growth
models (a period of fast growth followed by a
period of a constant growth)
 Or three stage growth model ( a period of a fast
growth followed by a period of diminishing
growth followed by period of constant growth)
 DDM
 Constant Growth DDM
Intrinsic Value = D1/(k-g) and D1= D0(1+g)
 Growth Rate Estimates
 Average Dividend Growth Rate

 Sustainable Growth Rate

g = RR X ROE
 DDM
 Required Rate of Return Estimate
 Nominal risk-free interest rate
 Risk premium (expected return on the market – risk free rate)
 Beta is estimated by regressing market return on the stock
return. And the slope of this regression line is the stock
measure of systematic risk.

E(Rstock) = RFR+ βstock [E(Rmarket) – RFR]

DDM
 The Present Value of Dividends Model (DDM)
 Model requires k>g
 With g>k, analyst must use multi-stage model
Present Value of
Operating Free Cash Flow
 Discountthe firm’s operating free cash flow to the firm
(FCFF) at the firm’s weighted average cost of capital
(WACC)
 Computing FCFF
FCFF =EBIT (1-Tax Rate)
+ Depreciation Expense
- Capital Spending
-  in Working Capital
Present Value of
Operating Free Cash Flow
 An alternative measure of long-run growth
g = (RR)(ROIC)
where:
RR = the average retention rate
ROIC = EBIT (1-Tax Rate)/Total Capital (return on invested capital)
 Computation of WACC
WACC=WE k + WD i
where:
WE = the proportion of equity in total capital
k = the after-tax cost of equity (from the SML)
WD = the proportion of debt in total capital
i = the after-tax cost of debt
Analysis of Growth Companies

 Generating rates of return greater than the firm’s

cost of capital is considered to be temporary why?
because in a competitive economy, if the rate of
return for a given company exceed the rate of return
expected based on the risk involved, then other
companies will inter the industry, increase the supply
, and eventually drive prices down until the rate of
return earned on a capital invested are consistent
with the risk involved.
Analysis of Growth Companies
 Earnings higher the required rate of return are pure
profits
 How long can they earn these excess profits?
 Is the stock properly valued?
 Type of firms in term of growth( we assumed in the
following slides that the company is all equity firm)
 No growth firms
 Long-run growth models
No-Growth Firm

 Generate a constant stream of cash flows, E

 r = rate of return on assets
 E = r × Assets
 Since b, the rate of retention is 0
 E = r × Assets = Dividends

V =
 Required Rate of Return
Long-Run Growth Models

 Assume some of the earnings are reinvested then the value of an all equity firm
is the value of the following components:
1. E = the level of constant net earnings expected from existing assets, without
further net investments

2. G = the growth component that equals to the present value of capital gains
expected from reinvested funds
 The return on invested fund = r = mk
 m = rate of return on funds retained (r/k)
 If m=1, then r =k
 If m>1, then r > k
 If m<1, then r<k

3.bE = the proportion of earning that is reinvested, where b is the percent of

retention.
Long Run Growth
Simple growth model:
 This model assumes the firm has growth opportunities
that provides rates of return equal to r (where r is
greater than k or m>1)
 Also, it assumes that the firm can invest $R at that rate
of return where R =bE, R is constant dollar amount
because E is constant.
 The value of this firm:

V= E/k + bE (m-1)/k
The first part of the equation is the present value of a
constant earning and the second part of the equation is the
present value of excess earning from growth investment
Long Run Growth
 Negative Growth Model
 Firm retains earnings, but reinvestment returns rate
are below the firm’s cost of capital. That is, r<k or
m<1
 Since growth will be positive (r>0) but slower than it
should be (r<k), the value will decline when the
investors discount the reinvestment stream at the
cost of capital
Capital Gain components
 The three factors that influence the capital gain
component:
 The amount of capital invested in growth investments
(b)
 The relative rate of return earned on the funds retained
(m)
 The time period for these growth investments
Long Run Growth
 Dynamic True Growth Model
 Firm invests a constant percentage of current
earnings in projects that generate rates of return
above the firm’s required rate of return
 In this case, r>k and m>1
 In this model the amount invested is growing each
ear as earning increase.
 Firm value for the dynamic growth model for an
infinite time period
D1
V=
k-g
Growth Duration Model

 No company can grow indefinitely at a rate

substantially above normal.
 The purpose is to evaluate the high P/E ratio for
the stock of a growth company by relating its P/E
ratio to the firm’s rate of growth and duration of
growth
 A stock’s P/E is function of
 expected rate of growth of earnings per share
 stock’s required rate of return
 firm’s dividend-payout ratio
Growth Duration Model
 The growth estimate must consider both the rate of
growth and how long this growth rate can be
sustained—that is, the duration of the expected
growth rate
 In order to apply the growth duration model we
have to assume:
1. Equal risk in both firms we are comparing. (beta
close to 1)
2. No significant difference in the payout ratio for
these firms
Factors to consider
Inconsistency between the expected growth and the
P/E ratio could be attributed to one of the four
reasons:
 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
Computation of Growth Duration
 Example on board in class
When to sell?
 Many times holding the stock for too long leads to a return
below expectations or less than what was available earlier.
 Analysis of the stock doesn’t end when intrinsic value is
computed.
 If the key value drivers of the stock weakened or if there's a
huge change in the management, it is time to revaluate and
possibly sell the stock.
 The stock should also be closely evaluated when the current
value approaches its intrinsic value estimate.
 When the stock becomes fairly prices then it may be time to sell
the stock.