STEPS TO ANALYZE STOCK

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STEPS TO ANALYZE STOCK

• Think through the "story" in detail
• Why is this a potentially better stock to own
  than others? e.g. Medco Health Systems
  leader in pharmaceuticals delivered by mail at
  low cost.
• Check the financials
• Analyze ratios and quality of earnings
• Compare competitors product/ financials
• Will the story hold up under competition?

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• Consider management
• Solid record? - management turnover?
• Share ownership? - selling?
• Compute a price estimate for the stock
• Compare to market price.

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• Look at price support and resistence levels
• Try to buy at support level, sell at resistance
  -
• technical analysis - next class.
• Once you buy - keep up with new information on
  stock

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COMMON STOCK PRICING
TWO MODEL TYPES 1. Comparables models -
P/ B, P / E, P/ S, P / EBITDA, P/Marketing,
P / RD Example Price Estimate P/E E
where P stock price per share E
earnings per share 2. Discount cash flow
methods Example Price Estimate
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PRICING STOCKS USING P/E NORMAL EARNINGS

• Get industry average P/E or similar company P/E
• Estimate normal earnings per share
• - Various methods
• - Adjust for accounting gimmicks
• Multiply P/E times normal earnings
• eg. suppose normal earnings 3/share
• and P/E of industry 10
• Price estimate 3 10 30

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CYCLICAL EARNINGS
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BOOK VALUE STOCK VALUATION

• Price/Book (P/B) is the ratio of stock price per
  share (P) to book value of equity per share (B).
  P/B is are used to compare the replacement value
  of a firms equity (its book value) to the
  market's valuation of its equity (stock price).
• As P/B increases, this is a signal for firms to
  invest
• in the industry or for new firms to enter which,
  of
• course, forces P/B down.
• When P/B is very low either the industry is
  declining or firm is poor competitor.
• If neither is true then a low P/B may signal a
  buying opportunity as market value returns to at
  least book.

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• To price a stock with P/B do as we did using P/E
• A. Get industry average or comparable firm P/B
  ratio
• B. Get the firms book value per share
• C. Multiply A and B to get stock price estimate
• What if a firm has no earnings or no book value.
  (e.g. small or new firms or poorly performing
  firms)?
• - if the firm has sales then use price to sales
  (P/S) in the same way that you use P/E or P/B
  above.

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VERY NEW COMPANIES MAY NOT HAVE MUCH IF ANY
SALES Here you can use price to cost ratios or
price to research and development ratios. These
methods are much less reliable. For such
companies you must rely mostly on the value of
their share of the potential market and have
faith in management (and pray a lot).
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DISCOUNTED CASH FLOW MODELS
BASIC where V0 is the stock value (price
estimate), D dividends and k required
rate of return QUESTION Why are high growth
stocks usually riskier than low growth
stocks? ANSWER Their dividends come far into
the future - more uncertainty.
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CONSTANT GROWTH MODEL - DERIVED FROM BASIC MODEL
This model only works precisely if a. k gt
g where ggrowth in dividends b. Dividends
grow at a constant rate It is still a good
approximation EXAMPLE D0 1.80, g .055, k
.11
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You can use negative growth in the model but it
reduces value.
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HOW TO GET INPUTS

• Dividends in present year - D0
• Dividend growth - estimate from past dividends
• Or use formula if no dividends available
• g growth ROE (1 - Div. payout ratio)
• Use the industry payout ratio or the expected
  future payout ratio if the company pays no
  dividends.
• Required return
• CAPM - k Rf B(Rm - Rf)
• or k R bond equity premium.

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MORE COMPLEX GROWTH MODEL
One that allows three growth rates, an initial
rate for, say, 5 years, intermediate rate for 10
years, and an average rate for mature firms into
infinity. The more complex the model, the more
inputs you need and the more assumptions have to
be made. A manageable model is the two-stage
growth model.
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TWO-STAGE GROWTH MODEL
Two stages of growth gi initial (usually
higher) growth rate which lasts for n years
(say 5 years). g stable long-term growth at
about the economys average that is assumed
to last from the end of the initial growth
period for ever after. With two stages, the
simple model above becomes
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There are some simplifying assumptions for this
model that are not completely realistic. The
same k is used for the initial growth stage and
the stable growth stage. One might expect that
there will be more risk involved during the
initial growth stage and thus it should carry a
larger k. The model assumes that growth changes
abruptly in year n and that growth is constant at
gi for the initial stage and at g for the stable
stage. It is also unclear what n should be. We
will use n5 since it is difficult to predict
growth after 5 years.
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EXAMPLE
Redo previous example with two stage
growth. D0 1.80, gi initial growth .10, g
.05, k .11 Dn1 D6 1.80(1 gi )5 (1
g) 1.80(1 .10)5 (1 .05)
3.04
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The Two-Stage model still can not handle more
than two growth rates. To do this, one needs to
figure the actual dividends based upon various
growths over a period and then discount the
dividends along with the terminal price
calculated using the simple growth model. That
is where D1 D0(1 g1), D2 D1(1 g2),
and so forth. The problem with this approach is
that it may require many calculations depending
upon how many different growth rates are required
Spreadsheet Helpful see Amazon.
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REDO PREVIOUS EXAMPLE
D0 1.80, k .11 g1 .12, g2 .10, g3
.08 g growth .05 - long-term growth D1
1.80(1 g1 ) 1.80(1 .12) 2.02 D2 D1(1
g2 ) 2.02(1 .10) 2.22 D3 D2(1 g3 )
2.22(1 .08) 2.40 Dn1 D4 D3(1 g)
2.40(1 .05) 2.52