CHAPTER 20: COMPANY ANALYSIS AND STOCK SELECTION

After our sojourn into bonds, we return to stocks for the remainder of the course.

Unlike all the previous chapters, this is a chapter that teaches the techniques of

analysis that can make you one a good stock-picker. These are some good, sound

techniques that can help us understand a company in the context of its industry and

the economy.

Will the knowledge of these techniques make you an ace stock-picker overnight?

Most probably not. There are two reasons for this:

- First, like any art or science, stock picking is learned by experience. Many, many

years have to be spent before one becomes an ace at anything.

- All these techniques are fairly standard and everyone on Wall Street knows them.

It is unlikely then, that they will be any source of competitive advantage.

However, they are a necessary prerequisite for any analysis of stocks, and we

shall consider some of these techniques.

I shall follow the text very closely in this chapter.

Different types of companies and stocks

- Growth Companies are those that have consistently experienced above-average

increases in sales and earnings. Growth Stocks need not be stocks in growth

companies. Any stock that has a higher rate of return compares or other stocks of

similar risk is a growth stock. A company might be a great growth company, but

as long as it is not selling cheaper relative to its intrinsic value, it does not

represent the potential to be a growth stock.

- Defensive Companies are those, whose future earnings are most likely to

withstand an economic downturn. Examples are utilities or grocery chains, in the

business of providing basic necessities. A defensive stock is any stock whose

value declines by less than one-for-one compared to a market decline. i.e. a stock

with a low or negative systematic risk, or beta can be called defensive.

- A cyclical company is one whose earnings will more or less move with the level

of economic activity. Classic examples are autos, and heavy manufacturing

industry, which are right now at a low point. A cyclical stock, on the other hand is

any high-beta stock, which means it follows the overall stock market quite

closely.

- A speculative company is one whose business involves great risk, with the

possibility of great return. A good example is oil exploration. A speculative stock,

is any stock, which has a possibility of very negative returns.

The top-down method of investment analysis

The traditional approach to investing consists of three levels.

1) Economic analysis: Analysis of the macroeconomic trends that affect every

industry and company. This involves taking a view about prospects for the

economy, interest rates etc.

2) Industry analysis: Analysis of specific industries, and how prospects for

profitability for each look in the short run and in the long run.

3) Company analysis: This is the final step in this approach. Having decided on

the economy, and the industry for investment, one needs to analyze specific

companies and evaluate the prospects for investment. This is the step we will

learn in this chapter.

Company Analysis

Strategic Analysis

In analyzing a company, we first need to understand the strategic aspects of the

company. For this, we need a framework to understand the context within which a

firm operates. It is useful to describe two frameworks here.

2

Porter’s five forces model

This model is presented in Figure 19.8 of your text. Prof. Michael Porter of Harvard

University came up it, in describing the forces influencing competitive rivalry within

an industry. According to Porter, the five basic forces influencing industry structure

are:

1) Competitive structure within an industry.

2) Threat of potential entrants

3) Threat of substitute products or services

4) Bargaining power of suppliers

5) Bargaining power of buyers

SWOT Analysis

SWOT stands for Strengths, Weaknesses, Opportunities, and Threats analysis. The

SW are internal components of the analysis, where a firm identifies its own strengths

and weaknesses. The OT are external components of the analysis, the opportunities

and threats to the company; opportunities to be exploited and threats to be avoided.

Such is the stuff of strategic analysis of firms. But, that’s not our principal focus. We

shall concentrate on the financial aspects of company analysis. The financing

approach to investment consists of the following steps:

1. Compute the intrinsic value of the stock.

2. If the current market price of the stock is less than the intrinsic value, the stock is

underpriced i.e. it is selling at a bargain price, and one should buy the stock. If the

converse is true, i.e. if the current market price of the stock is greater than the

intrinsic value, then the stock is overpriced, meaning it is too expensive relative to

what we think it should be selling for. We would sell this stock.

This approach is straightforward, but the problem clearly is to try and find the

intrinsic value of the stock.

We shall discuss several ways to do this next.

3

Estimating intrinsic value

I shall follow the Walgreen example presented in your text. The idea is to find the

intrinsic value of Walgreen stock in the year 1999. The market price of Walgreen at

the time was around $30. Be sure to read these notes along with the tables etc. from

Chapter 20 pertaining to Walgreen, in your text.

Method 1: Present Value of Cash Flows

This method says that investors can calculate the intrinsic value of any stock by

estimating future cash flows and discounting them at appropriate discount rates.

Specifically, we have three methods under this broad framework.

1. PV(Dividends) or Dividend Discount Model (DDM)

Here the idea is that the price of a stock is the present value of all future dividends.

The model itself is very intuitive, but in order to use it, we need to estimate all future

dividends. Obviously, it is not possible to estimate all future dividends. A way out is

to make some assumptions regarding dividend growth. For example, the simplest

assumption one might make is that dividends are going to remain a constant number

for the rest of the firm’s life. i.e. we are assuming D1=D2=…=Dn=….= D. According

to this model, the price of a firm’s stock can be found as the present value of a

perpetuity of D dollars per period, which is, given by: P0=D/k. The assumption of

constant, perpetual dividends is great for preferred stock, but not a great one for

common stock. It is typical to assume some growth.

The simplest model with growth is to assume that dividends will grow at a constant

growth rate g forever. i.e. D1=D0(1+g); D2=D1(1+g); …;Dn= Dn-1(1+g) , which means

that dividends under this model are a growing perpetuity. Thus, the price of common

4

stock today is given by the formula for the PV of a growing perpetuity, which is:

Here, D0 and D1 are the expected dividends now and next year respectively. k is the

rate of return required by investors on this common stock, while g is the constant

growth rate at which dividends are expected to grow forever. D0 is the current

dividend, and is hence known. What about k and g? How do we set about estimating

them?

Estimating g

There are two methods to estimate g the constant growth rate expected in the future.

One is to look at past data regarding the particular stock and calculate a historical

growth rate. If the firm has had a fairly constant growth rate, this is a sensible

method. Let us say we have a series of dividend numbers from the past n periods

(usually years): D0 through Dn. Then, the average growth rate is given by the g that

solves the following: Dn = D0(1+g)n, or . In the Walgreen example, we

can take a sample of 10 years, from 1988 to 1998. D1988 is $0.04 per share, and D1998

is $0.125 per share (See Table 20.2). The average growth rate is:

Remember, this method works only if the historical growth rate is reasonably

constant. If there were big jumps in between, obviously blind plugging-in is not going

to help.

There is another method to estimate the constant growth in dividends. Under this

method, the growth rate g is given by the following formula:

g = Retention ratio Return on Equity

= (1-dividend payout ratio) Return on Equity

5

For Walgreen, the Retention Ratio is given to us as 75%, and the Return on Equity is

19%, which yields a growth rate estimate of g= 0.75 19% = 14.25%.

After calculations by both methods, we have two values of g, 12.07% and 14.25%.

So, we now have a range of 12.07% through 14.25%. The authors of your text have

placed more weight on the second method, as they feel (subjectively) that the ROE of

Walgreen is the factor driving the growth; hence they settle on a value of 14.0% for

growth.

Estimating k

One can use the good old CAPM to estimate k, the rate of return that investors require

on the firm’s stock. You will recall (from Chapter 10) that the CAPM relates the

expected return and the systematic risk of any asset.

ki = rf+i[E(rM)-rf]

At the time of this analysis, i.e. at the end of 1998, the risk free rate was 6%. There

are different numbers that analysts plug in for the market risk premium. The actual

historical market risk premium i.e. the excess returns of stocks over risk-free treasury

securities is about 8%. Academics contend that the number to plug in should be a lot

smaller, like 3%. The authors of your text have chosen to be in the middle of the road,

and picked 5%. The beta of Walgreen is found by estimating the characteristic line:

RWAG = WAG+WAG.RM +WAG

You will recall that we plotted a line like this for Coke way back in the course, during

our discussion of the CAPM. Basically, this amounts to fitting a line with the rate of

return on the market (typically, a proxy such as the S&P 500 rate of return on the X-

axis, and the rate of return on Walgreen stock on the Y-axis. The slope of the fitted

line is the estimated beta of Walgreen – 0.90 in the calculation by the authors using a

sample of data for 5 years from 1994-1998.

Plugging in these inputs, we can estimate the expected rate of return on Walgreen

stock as: kWAG = 6% + 0.90(5%) = 10.5%

6

Now, let us try plugging these inputs into our DDM formula, with D1 = $0.16:

Wait! Something is wrong here. The denominator is a negative number, which

implies a negative price for Walgreen stock, which cannot be true at all. What

happened here?

The answer is: The numbers are telling us that this is not an appropriate method to

use. The company is growing way too fast for it to maintain the same growth rate

forever. Thus, we need to improve upon this method. One method, known as the non-

constant growth dividend discount model, is as follows:

Pick a time period during which one expects abnormal or above-normal growth of 14% in dividends.

Here, let’s pick the above-normal growth rate period as extending from 2000 through 2004. Then,

assume that the growth rate tapers off over the next few years, until the growth steadies in 2010 to 8%

forever. The following presents the dividends of Walgreen with these assumptions.

Walgreen Company PV @ Year Growth Dividends 10.50%

1999 - 0.140High growth period

2000 14% 0.160 $0.144 2001 14% 0.182 $0.149 2002 14% 0.207 $0.154 2003 14% 0.236 $0.159 2004 14% 0.270 $0.164

$0.769 Declining growth period

2005 13% 0.305 $0.167 2006 12% 0.341 $0.170 2007 11% 0.379 $0.170 2008 10% 0.417 $0.170 2009 9% 0.454 $0.167

$0.844 Steady growth period

2010 8% 0.490 Price at the end of 2009 19.614 $7.227 Total present value- Price per stock $8.840

7

Starting with a 1999 value of $0.14 per share, we have dividends growing at 14%

until 2004, for five years. The present value of the first five dividends during this

above-normal phase is $0.769. From 2005 through 2009, the growth rate declines

until it reaches 9% in 2009. As can be seen from the above table, the present value of

dividends during this phase is $0.844. Finally, from 2010 onwards, the dividends

grow at 8% forever. That is, dividends are a growing perpetuity from 2010 onwards.

This is shown as below:

The present value of this series can be found by the growing perpetuity formula,

which means that the P2009 is estimated to be:

. The present value of this is estimated as:

.

Thus, the total price of Walgreen stock is found as: $(0.769+0.844+7.227) = $8.84

Notice that this method results in a price of $8.84, compared to the then market price

of about $30. This method says that Walgreen stock is very much overpriced

compared to its intrinsic value.

What about a company that does not pay any dividends, e.g. Microsoft? Obviously,

the DDM is not going to work. We need another method to deal with this and other

such tricky cases.

2. PV(FCFE): PV(Free Cash Flow to Equity) method

Here the idea is that the total value of a company’s equity is the present value of all

the free cash flows that are expected to flow to equity holders (shareholders) of the

firm.

8

2009 2010 2011 2012 2013 ….

0.49 0.49(1.08) 0.49(1.082) 0.49(1.083)

The definition of FCFE is:

FCFE = Net Income + Depreciation Expense – Capital Expenditures

- in working capital – Principal repayments on debt +New debt issues

Let us apply a non-constant growth model to FCFE. Again, the algorithm is similar to

that for dividends. Pick a time period during which one expects abnormal or above-

normal growth in FCFE. If one looks at Table 20.2, we can see that FCFE has had a

growth of about 20 percent over the 15-year period, but this growth is highly volatile.

So, the authors decided on 16% as a conservative value for the above normal growth.

Again, let’s pick the above-normal growth rate period as extending from 2000

through 2004. Then, assume that the growth rate tapers off over the next few years,

until the growth steadies in 2012 to 8% forever. The following presents the FCFE and

the valuation of Walgreen with these assumptions.

Walgreen Company   PV @ Year Growth FCFE ($ M) 10.50%1999 - 204High growth period2000 16% 237 2142001 16% 275 2252002 16% 318 2362003 16% 369 2482004 16% 428 260      1,183Declining growth period  2005 15% 493 2712006 14% 562 2792007 13% 635 2862008 12% 711 2892009 11% 789 2912010 10% 868 2892011 9% 946 286      1,991Steady growth period    2012 8% 1022 Value at the end of 2011 40874 12,334Total present value of FCFE 15,507Number of shares 1,003Value per share   15.46

9

This method results in a price of $15.46, compared to the then market price of about

$30. This method again says that Walgreen stock is very much overpriced compared

to its intrinsic value.

3. PV(FCFF): PV(Free Cash Flow to Firm) method

Here the idea is that to find the entire firm, and then subtract from that value, the

value of debt, to arrive at the value of equity. The total value of a company’s equity is

the present value of all the free cash flows that are expected to flow to the firm (note:

the firm, not just the shareholders of the firm).

The definition of FCFF is:

FCFF = EBIT(1-Tax rate) + Depreciation Expense – Capital Expenditures

- in working capital – in other assets

Notice that the above formula says we should discount the FCFFs at not k, but the

WACC. This is the Weighted Average Cost of Capital, and is the appropriate rate to

discount cash flows to the firm. You should have seen the WACC in a corporate

finance course. The definition of WACC is:

WACC = wE.ke+wD.kd(1-t), i.e. the WACC is a weighted average of the

costs of equity and debt, with the weights being the proportions of debt and equity in

the firm’s capital structure. Think of this as a rate of return on a portfolio (firm)

with two assets (debt and equity) in its portfolio. The weights on the two assets have

to add up to 1.

Calculation of WACC: The WACC calculation needs wE and wD, the proportions of

debt and equity in the firm’s capital. It is important that we realize that these

proportions must be based on the market values of debt and equity, not the book

values from the accounting statements. In your text, it is given that wE=0.90, and

wD=0.10, based on market values. This means that Walgreen uses very little debt.

10

It is also given that kd(1-t) = 7%(1-0.39) =4.3%. Earlier, we estimated ke=10.5%.

Let’s plug these values into the WACC equation:

WACC = wE.ke+wD.kd(1-t) = 0.90.(10.5%)+0.10.(7%).(1-0.39)=9.88%

We should use this rate now to discount the free cash flows to the firm, or the FCFF.

Again, we shall use a non-constant growth model to value the FCFFs. Once again, the

algorithm is identical. Let’s pick a time period during which one expects abnormal or

above-normal growth in FCFF. The authors decided on 14% as a value for the above

normal growth, during the period from 2000 through 2004. Then, assume that the

growth rate tapers off over the next few years, until the growth steadies in 2011 to 7%

forever. The following presents the FCFF and the valuation of Walgreen with these

assumptions.

Walgreen Company   PV @ Year Growth FCFF ($ M) 9.88%1999 - 202 High growth period 2000 14% 230 2102001 14% 263 2172002 14% 299 2262003 14% 341 2342004 14% 389 243      1,129Declining growth period  2005 13% 439 2502006 12% 492 2552007 11% 546 2572008 10% 601 2572009 9% 655 2552010 8% 708 251      1,525Steady growth period    2011 7% 757 Value at the end of 2011 26286 9,324Total present value of FCFF 11,979Minus: Value of debt 4250Value of equity 7,729Number of common shares 1003Value per share   7.71

This method results in a price of $7.71, that is once again substantially lower than the

market price of about $30. Again, our analysis suggests that Walgreen stock is very

much overpriced compared to its intrinsic value.

Method 2: Relative Valuation ratio Techniques

11

Here, we try to estimate the earnings of a company, and multiply that by the

appropriate Price/Earnings (P/E) ratio for the company, and arrive at a stock price.

The various steps of this method are explained below for Walgreen.

Step 1: Forecasting Sales for Walgreen

Here, the analyst tries to get at a “best guess” forecast of sales based on several

factors. On alternative is to use some measure of consumer spending and relate it to

the company in hand. After all, consumers have to buy the products that this company

offers. As we know, Walgreen is primarily a pharmacy, hence personal spending on

medical care might be especially important. Table 20.5 tries to compare Walgreen

sales over the past 20 years (1977-1998) to various measures. Figure 20.2 plots the

relationship between Walgreen sales and the Personal Consumption Expenditure –

Medical (PCE-Medical), and finds a strong relationship between the two. This

suggests that is we know how PCE-Medical is going to grow, we can try to get an

estimate for Walgreen sales.

Economists are forecasting the PCE will grow at 6.3% in 1999 which will result in a

dollar figure for PCE of $6,177 billion. Of this, 15.3% is expected to be expenditure

on medical care, which says that PCE-Medical care will be about (15.3%

6,177)=$945 billion, which is a growth rate of 6.5% from 1998. Using the

relationship between PCE-Medical care and Walgreen Sales, such as the one in

Figure 20.2, we can forecast Walgreen sales growth in 1999 as 11%.

Another way to get at the same quantity, i.e. Walgreen sales growth is based on total

square footage in all Walgreen stores in the country. This is a common measure in

retail sales. As shelf space in retail stores is very valuable, one tries to forecast the

sales per square footage, and multiply that with the total square footage. For

Walgreen, the authors assume a growth in total square footage of 1.5 million sq. ft,

which, added to the 1998 number of about 26 million sq. ft. (see Table 20.6 for this)

yields a total of about 27.5 million sq. ft. Sales per thousand sq. ft. has been steadily

climbing, as can be seen from Table 20.6, which is a good sign. The 1998 number

12

was $588.19 per 1000 sq. ft. Assuming a slight increase to $600 per 1000 sq. ft. ,

results in a total sales estimate of (60017.5 million) =$16.50 billion, which is an

increase of about 10.8% over the 1998 sales of $15.31 billion.

Yet another way could be to use the number of stores and multiply that by the sales

per store. Assuming a net increase of 160 stores during 1999 (200 new stores less 40

store closings), we can get from 2549 stores in 1998 to about 2700 stores in 1999.

Sales per store were $6.01 million in 1998. If we assume a modest increase to $6.25

million in 1999, we end up with a total 1999 sales estimate of (27006.25 million) =

$16.88 billion, which is an increase of about 10% from 1998.

Given these three estimates, the authors settle on the higher number in view of the

positive economic outlook (in 1998/99), and use 11% as their estimate of sales

growth, which results in an estimated 1999 total sales of about $17 billion. The point

of all these calculations is to tell you that there is no one magic formula that will give

the “right” answer. The idea is to try as many approaches as possible, so one can hope

to triangulate to a sensible number. That is the job of an analyst.

Step 2: Estimating profit margin for Walgreen

Figure 20.3 shows the relation between Walgreen’s Net Profit Margin and that of the

retail drugstore industry as a whole. It can be seen that industry margins have been

declining over the past two years, but Walgreen has steadily been increasing its

margins. The reason, if one dug a little deeper, is aggressive price cutting in the retail

drugstore industry. But Walgreen has been consistently improving its position by

adding more and more high-margin items on its shelves. This leads us to believe that

Walgreen is strongly positioned to increase net profit margin. The authors assume a

modest increase here of 3.50%.

Thus,

Estimated net profits of Walgreen = (Estimated Net Profit Margin)(Estimated

Sales)

= (3.50%) $17 billion = $595 million

13

Assuming there are 1003 million common shares outstanding, we can arrive at an

estimate of the Earnings per Share (EPS) as follows:

Estimated EPS = Estimated net profits/No. of common shares

= 595/1003 = $0.59 per share

Step 3: Estimating the P/E ratio for Walgreen

From Figure 20.4, we can see that Walgreen’s P/E ratio follows closely that of the

retail drug industry, as well as that of the S&P 400 index, especially since 1992.

Considering that Walgreen has been growing at a faster clip than the industry, one

can conjecture that Walgreen will, in future, have a multiple a little higher than the

industry. Assuming a multiplier of about 22 for the retail drugstore industry, we can

use some higher numbers such as 24, 26 or 28 for Walgreen. (There is nothing

sacrosanct about these numbers, we could have use 23 or 25. As it is, this is a game of

“best guesses”.) Using the three multiples, we have the following intrinsic values

implied for Walgreen:

Estimated intrinsic value = Estimated Multiplier (P/E ratio) Estimated EPS

24 $0.59 = $14.16

26 $0.59 = $15.34

28 $0.59 = $16.52

Making the Decision

The following are the values we obtained for Walgreen, from all the methods.

Method Value

Three stage DDM $8.84

Three stage FCFE $15.46

Three stage FCFF $7.71

Relative Valuation: P/E=24 $14.16

Relative Valuation: P/E=26 $15.34

Relative Valuation: P/E=28 $16.52

14

All our analysis and every method we have used us is telling us that Walgreen has a

value of less than the prevailing market price of $30 or so. Thus, we must conclude

that Walgreen is overpriced relative to its value. If you own it, we would recommend

a sell, if you don’t own it, we would not recommend a buy.

Obviously, Walgreen is a growth company, but not a growth stock at this time.

Final Word

That’s all I wanted to cover in “Company Analysis and Stock Selection”. In

particular, I want you to look at and appreciate the various kinds of data that have

been used in the analysis. Everything from economic forecasts to company data is

extensively used. This will hopefully have given you a flavor of “real-world”

analysis, where data is plenty, good information is scarce, answers are not obtained

by textbook formulas, and the analyst’s job is to guess better than the next best guess.

15