Chapter 15 COMPANY ANALYSIS AND STOCK VALUATION. Chapter 15 Questions Why is it important to differentiate between company analysis and stock analysis?

Chapter 15

COMPANY ANALYSIS AND STOCK VALUATION

Chapter 15 Questions

Why is it important to differentiate between company analysis and stock analysis?What is the difference between a growth company and a growth stock?When valuing an asset, what are the required inputs?After an investor has valued an asset, what is the investment decision process?How is the value of bonds determined?


What are the two primary approaches to the valuation of common stock?How do we apply the discounted cash flow valuation approach, and what are the major discounted cash flow valuation techniques?What is the dividend discount model (DDM), and what is its logic?What is the effect of the assumptions of the DDM when valuing a growth company?


How do we apply the DDM to the valuation of a firm that is expected to experience temporary supernormal growth?How do we apply the relative valuation approach to valuation, and what are the major relative valuation techniques (ratios)?How can the DDM be used to develop an earnings multiplier model?What does the DDM model imply are the factors that determine a stock’s P/E ratio?


What are some economic, industry, and structural links that should be considered in company analysis?What insights regarding a firm can be derived from analyzing its competitive strategy and from a SWOT analysis?What techniques can be used to estimate 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?What procedures and factors do we consider 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?When should we consider selling a stock?

Company Analysis and Stock Selection

Good companies are not necessarily good investmentsIn the end, we want to compare the intrinsic value of a stock to its market valueStock of a great company may be

overpricedStock of a lesser company may be a

superior investment since it is undervalued

Companies that consistently experience above-average increases in sales and earnings have traditionally been thought of as growth companies Limitations to this definition

Financial theorists define a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return

Growth Companies and Growth Stocks

Growth Companies and Growth Stocks

Growth stocks are not necessarily shares in growth companiesA growth stock has a higher rate of return

than other stocks with similar riskSuperior risk-adjusted rate of return occurs

because of market under-valuation compared to other stocks

Studies indicate that growth companies have generally not been growth stocks

Defensive Companies and Stocks

Defensive companies’ future earnings are more likely to withstand an economic downturnLow business riskNot excessive financial risk

Defensive stocks’ returns are not as susceptible to changes in the marketStocks with low systematic risk

Cyclical Companies and Stocks

Sales and earnings heavily influenced by aggregate business activityHigh business riskSometimes high financial risk as well

Cyclical stocks experience high returns is up markets, low returns in down marketsStocks with high betas

Speculative Companies and Stocks

Speculative companies invest in sssets involving great risk, but with the possibility of great gainVery high business risk

Speculative stocks have the potential for great percentage gains and lossesMay be firms whose current price-earnings

ratios are very high

Value versus Growth Investing

Growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervaluedValue stocks appear to be undervalued for reasons besides earnings growth potentialValue stocks usually have low P/E ratio or

low ratios of price to book value

The Search for True Growth Stocks

To find undervalued stocks, we must understand the theory of valuation itself

Theory of Valuation

The value of a financial asset is the present value of its expected future cash flows

Required inputs:The stream of expected future returns, or

cash flowsThe required rate of return on the

investment

Stream of Expected Returns (Cash Flows)

From of returnsDepending on the investment, returns can be in the form of: Earnings Dividends Interest payments Capital gains

Time period and growth rate of returnsWhen will the cash flows be received from the investment?

Required Rate of Return

Determined by the risk of an investment and available returns in the market

Determined by:1. The real risk-free rate of return, plus

2. The expected rate of inflation, plus

3. A risk premium to compensate for the uncertainty of returns

Sources of uncertainty, and therefore risk premiums, vary by the type of investment

Investment Decision Process

Once expected (intrinsic) value is calculated, the investment decision is rather straightforward and intuitive: If Estimated Value > Market Price, buy If Estimated Value < Market Price, do not

buy

The particulars of the valuation process vary by type of investment

Valuation of Alternative Investments

We will consider the valuation of two important types of investments:

The valuation of bonds

The valuation of common stock

Valuation of Bonds

What are the cash flows?Bond cash flows (typically fixed) Interest payments every six months equal to one-

half of: (Coupon rate x Face value) The payment of principal (Face or par value) at

maturity

Discount at the required rate of return to find the bond’s valueProcess made relatively easy with a financial calculator or spreadsheet software

Approaches to Common Stock Valuation

Discounted Cash Flow Techniques Present value of Dividends (DDM) Present value of Operating Cash Flow Present value of Free Cash Flow

Relative valuation techniques Price-earnings ratio (P/E) Price-cash flow ratios (P/CF) Price-book value ratios (P/BV) Price-sales ratio (P/S)

Discounted Cash Flow Techniques

Based on the basic valuation model: the value of a financial asset is the present value of its expected future cash flows

Vj = CFt/(1+k)t

The different discounted cash flow techniques consider different cash flows and also different appropriate discount rates

Dividend Discount Models

Simplifying assumptions help in estimating present value of future dividends

Vj = Dt/(1+k)t

Can also assume various dividends for a finite period of time with a reselling price, and simply calculate the combined present value of the dividends


Alternative dividend assumptions

Constant Growth Model: Assumes dividends started at D0 (last year’s

dividend) and will grow at a constant growth rate Growth will continue for an infinite period of time The required return (k) is greater than the constant

rate of growth (g)

V = D1/(k-g)

where D1= D0(I+g)


Constant Growth ModelGrowth rate

Can be estimated from past growth in earnings and dividends

Can be estimated using the sustainable growth model

Discount rateWould consider the systematic risk of the

investment (beta)Capital Asset Pricing Model


Valuation with Temporary Supernormal Growth If you expect a company to experience rapid

growth for some period of time1. Find the present value of each dividend during

the supernormal growth period separately2. Find the present value of the remaining dividends

when constant growth can be assumed.3. Find the present value of the remaining dividends

by finding the present value of the estimate obtained in step 2.

Present Value of Operating Cash Flows

Another discounted cash flow approach is to discount operating cash flows Operating cash flows are pre-interest cash

flows, so the required rate of return would be adjusted to incorporate the required returns of all investors (use the WACC)

VFj = OCFt/(1+WACCj)t

Present Value of Operating Cash Flows

If we further assume a growth rate of gOCF for operating cash flows, we can value the firm as:

VFj = OCFt/(WACCj – gOCF)

Present Value of Free Cash Flow to Equity

A third discounted cash flow technique is to consider the free cash flows of a firm available to equity as the cash flow stream to be discounted.Since this is an equity stream, the appropriate discount rate is the required return on equity

VSj = FCFt/(1+kj)t

Present Value of Free Cash Flow to Equity

Once again, if we constant growth in free cash flows, this expression reduces to the following

VSj = FCFt/(kj – gFCF)

Relative Valuation Techniques

These techniques assume that prices should have stable and consistent relationships to various firm variables across groups of firmsPrice-Earnings RatioPrice-Cash Flow RatioPrice-Book Value RatioPrice-Sales Ratio


Price Earnings RatioAffected by two variables:1. Required rate of return on its equity (k)2. Expected growth rate of dividends (g)

gk

EDEP

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Price Earnings RatioAffected by two variables:1. Required rate of return on its equity (k)2. Expected growth rate of dividends (g)

Price/Cash Flow Ratio

gk

EDEP

11

1

//

Price-Earnings Ratio

Look at the relationship between the current market price and expected earnings per share over the next year The ratio is the earnings multiplier, and is a

measure of the prevailing attitude of investors regarding a stock’s value

P/E factors Expected growth in dividends and earnings Required rate of return on the stock

Price-Earnings Ratio

Using the P/E approach to valuation:1. Estimate earnings for next year2. Estimate the P/E ratio (Earnings

Multiplier)3. Multiply expected earnings by the

expected P/E ratio to get expected price

V =E1x(P/E)

Price-Cash Flow Ratio

Cash flows can also be used in this approach, and are often considered less susceptible to manipulation by management.

The steps are similar to using the P/E ratio

V =CF1x(P/CF)

Price-Book Value Ratio

Book values can also be used as a measure of relative value

The steps to obtaining valuation estimates are again similar to using the P/E ratio

V =BV1x(P/BV)

Price-Sales Ratio

Finally, sales can be used in relation to stock price. Some drawbacks, in that sales do not necessarily

produce profit and positive cash flows Advantage is that sales are also less susceptible

to manipulation

The steps are similar to using the P/E ratio

V =S1x(P/S)

Company Analysis: Examining Influences

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 stock’s intrinsic value based on growth and risk

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

Structural Influences

Social trends, technology, political, and regulatory influences can have significant influence on firms

Early stages in an industry’s 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

Company Analysis

Competitive forces necessitate competitive strategies. Competitive Forces:

1. Current rivalry

2. Threat of new entrants

3. Potential substitutes

4. Bargaining power of suppliers

5. Bargaining power of buyers

SWOT analysis is another useful tool

Firm Competitive Strategies

Defensive or offensiveDefensive strategy deflects competitive forces in the industryOffensive competitive strategy affects competitive force in the industry to improve the firm’s relative positionPorter suggests two major strategies: low-cost leadership and differentiation

Low-Cost Strategy

Seeks to be the low cost leader in its industry

Must still command prices near industry average, so still must differentiate

Discounting too much erodes superior rates of return

Differentiation Strategy

Seeks to be identified as unique in its industry in an area that is important to buyersAbove average rate of return only comes if the price premium exceeds the extra cost of being unique

Focusing a Strategy

Firms with focused strategies:Select segments in the industryTailor the strategy to serve those specific

groupsDetermine which strategy a firm is pursuing

and its successEvaluate the firm’s competitive strategy

over time

SWOT Analysis

Examination of a firm’s:Strengths

Competitive advantages in the marketplace

Weaknesses Competitors have exploitable advantages of some kind

Opportunities External factors that make favor firm growth over time

Threats External factors that hinder the firm’s success

Favorable Attributes of Firms

Peter Lynch’s list of favorable attributes:1. Firm’s product is not faddish

2. Company has competitive advantage over rivals

3. Industry or product has potential for market stability

4. Firm can benefit from cost reductions

5. Firm is buying back its own shares or managers (insiders) are buying

Categorizing Companies

Lynch further recommends the following categorization of firms:

1. Slow growers2. Stalwart3. Fast growers4. Cyclicals5. Turnarounds6. Asset plays

Specific Valuation with the P/E Ratio

Earnings per share estimates Time series – use statistical analysis Sales - profit margin approach

EPS = (Sales Forecast x Profit Margin)/ Number of Shares Outstanding

Judgmental approaches to estimating earnings Last year’s income plus judgmental evaluations Using the consensus of analysts’ earnings estimates

Once annual estimates are obtained, do quarterly estimates and interpret announcements accordingly

Site Visits, Interviews, and Fair Disclosure

Fair Disclosure (FD) requires that all disclosure of material information be made public to all interested parties at the same time Many firms will not allow interviews with

individuals, only provide information during large public presentations

Analysts now talk to people other than top managers Customers, suppliers

Making the Investment Decision

If the estimate of the stock’s intrinsic value is greater than or equal to the current market price, buy the stockIf your estimate of the stock’s future intrinsic value would yield a return greater than your required rate of return (based on current investment price), then buy the stockIf the value is less than its current price, or its return would be less than your required rate of return, do not buy the stock

When to Sell

Hold on or move on?If stocks decline right after purchase, is that a further buying opportunity or a signal of a mistaken investment?Continuously monitor key assumptions that led to the purchase of the investment Know why you bought, and see if conditions have

changed

Evaluate when market value approaches estimated intrinsic value

Influences on Analysts

Several factors make it difficult for analysts to outperform the marketEfficient Markets Markets tend to price securities correctly, so

opportunities are rare Most opportunities are likely in small, less followed

companies

Paralysis of Analysis Must see the forest (the appropriate

recommendation) despite all of the trees (data) that complicate the decision

Influences on Analysts

Investment bankers may push for favorable evaluations of securities when the same firm does (or wants to do) underwriting business with the firm in questionAre analysts independent and unbiased in

their recommendations? Ideally, analysts will remain independent

and show confidence in their analyses

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Chapter 15 COMPANY ANALYSIS AND STOCK VALUATION. Chapter 15 Questions Why is it important to differentiate between company analysis and stock analysis?