Title: Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edit
1Lecture Presentation Software to
accompanyInvestment Analysis and Portfolio
ManagementSeventh Editionby Frank K. Reilly
Keith C. Brown
Chapter 15
2Company 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?
3Company 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
4Growth 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 firms required
rate of return
5Growth 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
6Defensive 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
7Cyclical 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
8Speculative 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
9Value 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
10Economic, 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
11Economic 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
12Structural 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
13Company Analysis
- Industry competitive environment
- SWOT analysis
- Present value of cash flows
- Relative valuation ratio techniques
14Firm Competitive Strategies
- Current rivalry
- Threat of new entrants
- Potential substitutes
- Bargaining power of suppliers
- Bargaining power of buyers
15Firm 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
16Porter'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
17Focusing 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
18SWOT Analysis
- Examination of a firms
- Strengths
- Weaknesses
- Opportunities
- Threats
19SWOT Analysis
- Examination of a firms
- Strengths
- Weaknesses
- Opportunities
- Threats
INTERNAL ANALYSIS
20SWOT Analysis
- Examination of a firms
- Strengths
- Weaknesses
- Opportunities
- Threats
EXTERNAL ANALYSIS
21Some 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
22Tenets of Warren Buffet
- Business Tenets
- Management Tenets
- Financial Tenets
- Market Tenets
23Business Tenets
- Is the business simple and understandable?
- Does the business have a consistent operating
history? - Does the business have favorable long-term
prospects?
24Management Tenets
- Is management rational?
- Is management candid with with its shareholders?
- Does management resist the institutional
imperative?
25Financial 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
26Market Tenets
- What is the value of the business?
- Can the business be purchased at a significant
discount to its fundamental intrinsic value?
27Estimating 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)
28Present 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(1g)
29Growth Rate Estimates
- Average Dividend Growth Rate
30Growth Rate Estimates
- Average Dividend Growth Rate
- Sustainable Growth Rate RR X ROE
31Required Rate of Return Estimate
- Nominal risk-free interest rate
- Risk premium
- Market-based risk estimated from the firms
characteristic line using regression
32Required Rate of Return Estimate
- Nominal risk-free interest rate
- Risk premium
- Market-based risk estimated from the firms
characteristic line using regression
33The Present Value of Dividends Model (DDM)
- Model requires kgtg
- With ggtk, analyst must use multi-stage model
34Present Value of Free Cash Flow to Equity
- FCFE
- Net Income
- Depreciation Expense
- - Capital Expenditures
- - D in Working Capital
- - Principal Debt Repayments
- New Debt Issues
35Present 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 - gFCFE the expected constant growth rate of free
cash flow to equity for the firm
36Present 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
- - ? in Working Capital - ? in other assets
37Present Value of Operating Free Cash Flow
38Present Value of Operating Free Cash Flow
- Where FCFF1 the free cash flow in period 1
- Oper. FCF1 the firms operating free cash flow
in period 1 - WACC the firms weighted average cost of
capital - gFCFF the firms constant infinite growth rate
of free cash flow - gOFCF the constant infinite growth rate of
operating free cash flow
39An Alternate Measure of Growth
- g (RR)(ROIC)
- where
- RR the average retention rate
- ROIC EBIT (1-Tax Rate)/Total Capital
40Calculation of WACC
- WACC WEk Wdi
- 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
41Relative Valuation Techniques
- Price Earnings Ratio
- Affected by two variables
- 1. Required rate of return on its equity (k)
- 2. Expected growth rate of dividends (g)
- Price/Cash Flow Ratio
- Price/Book Value Ratio
- Price-to-Sales Ratio
42Analysis 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?
43Analysis of Growth Companies
- Growth companies and the DDM
- constant growth model not appropriate
- Alternative growth models
- no growth firm
- E r X Assets Dividends
44Analysis of Growth Companies
- Long-run growth models
- assumes some earnings are reinvested
- Simple growth model
45Simple Growth Model (cont.)
- (Present value of Constant Dividend plus the
Present Value of Growth Investment)
(Present value of Constant Earnings plus the
Present Value of Excess Earnings from Growth
Investment)
46Expansion 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
47Negative 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
48The 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
- gt1 is growth company
- Time period for superior investments
49Dynamic 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
50Measures 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
51Measures 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
52Measures 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
53Intra-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
54Site 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
55When 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
56Efficient 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
57Influences on Analysts
- 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
58Global 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
59The InternetInvestments Online
- www.better-investing.com
- www.fool.com
- www.cfonews.com
- www.ibes.com
- www.zacks.com
- www.valueline.com
- www.financialweb.com
- investor.msn.com
- www.marketedge.com
- www.nyssa.org