Investment Analysis and Portfolio Management Frank K' Reilly

1
Investment Analysis and Portfolio
ManagementFrank K. Reilly Keith C. Brown
CHAPTER 15
BADM 744 Portfolio Management and Security
AnalysisAli Nejadmalayeri
2
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

3
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

4
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

5
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

6
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

7
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

8
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

9
Company Analysis

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

10
Firm Competitive Strategies

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

11
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
13
SWOT Analysis

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

EXTERNAL ANALYSIS
14
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?

17
Management Tenets

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

18
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

19
Market Tenets

• What is the value of the business?
• FCF discounted at Gov Bond rate
• Can the business be purchased at a significant
  discount to its fundamental intrinsic value?
• MV of all components gt MV of stocks
• Cash A/R Inv. MV (Fixed Assets) - MV Debt
  should exceed MV Equity!

20
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)

21
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)

22
Growth Rate Estimates

• Average Dividend Growth Rate

23
Growth Rate Estimates

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

24
Required Rate of Return Estimate

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

25
Required Rate of Return Estimate

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

26
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

29
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
32
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

34
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

36
Relative Valuation Techniques

• Price Earnings Ratio

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Relative 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)

38
Relative 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

39
Relative 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

40
Relative 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

41
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?

42
NO Growth Companies

• Growth companies and the DDM
• constant growth model not appropriate
• Alternative growth models
• no growth firm ? no retention
• E r X Assets Dividends

43
Long-run Growth Companies

• Long-run growth models
• assumes some earnings are reinvested
• Return relative return ? Cost r m ? k
• Simple growth model
• Expansion Model

44
Simple Growth Model

• (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)
45
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

46
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

47
The Capital Gain Component

• 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

48
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

49
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

50
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

51
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

52
Growth Duration

• 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

53
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

54
Growth Duration
Use to back out the appropriate P/E and price
How long the high P/E stock has to grow at rapid
rate before it falls down to low growth
55
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

56
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

57
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

58
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

59
Influences 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

60
Global Stock Analysis

• Factors to Consider
• Availability of Data
• Differential Accounting Conventions
• Currency Differences (Exchange Rate Risk)
• Political (Country) Risk
• Transaction Costs
• Valuation Differences