Chapter 14 - Company Analysis and Stock Valuation

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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?

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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?

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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?

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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?

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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?

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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?

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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?

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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?

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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?

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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

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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 firms required
  rate of return

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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

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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

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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

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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

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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

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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

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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

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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

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Company Analysis

• Industry competitive environment
• SWOT analysis
• Present value of cash flows
• Relative valuation ratio techniques

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Competitive Forces

• Current rivalry
• Threat of new entrants
• Potential substitutes
• Bargaining power of suppliers
• Bargaining power of buyers

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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

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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

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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

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SWOT Analysis

• Examination of a firms
• Strengths
• Weaknesses
• Opportunities
• Threats

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SWOT Analysis

• Examination of a firms
• Strengths
• Weaknesses
• Opportunities
• Threats

INTERNAL ANALYSIS
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SWOT Analysis

• Examination of a firms
• Strengths
• Weaknesses
• Opportunities
• Threats

EXTERNAL ANALYSIS
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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

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Tenets of Warren Buffet

• Business Tenets
• Management Tenets
• Financial Tenets
• Market Tenets

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Business Tenets

• Is the business simple and understandable?
• Does the business have a consistent operating
  history?
• Does the business have favorable long-term
  prospects?

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Management Tenets

• Is management rational?
• Is management candid with with its shareholders?
• Does management resist the institutional
  imperative?

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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

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Market Tenets

• What is the value of the business?
• Can the business be purchased at a significant
  discount to its fundamental intrinsic value?

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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)

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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(1g)

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Growth Rate Estimates

• Average Dividend Growth Rate

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Growth Rate Estimates

• Average Dividend Growth Rate
• Sustainable Growth Rate RR X ROE

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Required Rate of Return Estimate

• Nominal risk-free interest rate
• Risk premium
• Market-based risk estimated from the firms
  characteristic line using regression

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Required Rate of Return Estimate

• Nominal risk-free interest rate
• Risk premium
• Market-based risk estimated from the firms
  characteristic line using regression

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The Present Value of Dividends Model (DDM)

• Model requires kgtg
• With ggtk, analyst must use multi-stage model

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Present Value of Free Cash Flow to Equity

• FCFE
• Net Income
• Depreciation Expense
• - Capital Expenditures
• - D in Working Capital
• - Principal Debt Repayments
• New Debt Issues

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Present Value of Free Cash Flow to Equity

• FCFE
• Net Income
• Depreciation Expense
• - Capital Expenditures
• - D in Working Capital
• - Principal Debt Repayments
• New Debt Issues

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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
• gFCFE the expected constant growth rate of free
  cash flow to equity for the firm

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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
• - ? in Working Capital - ? in other assets

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Present Value of Operating Free Cash Flow
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Present 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

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An Alternate Measure of Growth

• g (RR)(ROIC)
• where
• RR the average retention rate
• ROIC EBIT (1-Tax Rate)/Total Capital

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Calculation of WACC

• WACC WEk Wdi

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Calculation 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

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Relative Valuation Ratio Techniques

• Price Earnings Ratio

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Estimating Company Earnings Per Share

• Function of
• Sales forecast
• Estimated profit margin

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Walgreens Competitive Strategies

• The Internal Performance
• Industry Factors
• Company Performance
• Net Profit Margin Estimate
• Computing Earnings per Share
• Importance of Quarterly Estimates

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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

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Additional Measures of Relative Value

• Price/Book Value Ratio
• Price/Cash Flow Ratio
• Price-to-Sales Ratio

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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?

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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

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Analysis of Growth Companies

• Long-run growth models
• assumes some earnings are reinvested
• Simple growth model

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Simple 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)
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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

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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

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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
• gt1 is a true growth company
• Time period for superior investments

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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

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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

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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

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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

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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

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Growth Duration

• E(t) E (0) (1G)t
• N(t) N(0)(1D)t
• E(t) E(t) N(t) E (0) (1G)t (1D)t

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Growth Duration
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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

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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

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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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Influences on Analysts

• Efficient Markets
• Paralysis of Analysis
• Analyst Conflicts of Interest

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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

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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

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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

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The InternetInvestments 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

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• End of Chapter 14
• Company Analysis and Stock Selection

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Future topicsChapter 15

• Technical Analysis
• Assumptions and Advantage
• Technical Trading Rules and Indicators
• Techniques and Charts