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

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

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

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

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

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

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

Economic, Industry, and Structural

Links to Company Analysis
Company analysis is the final step in the topdown 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

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 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

Company Analysis

Industry competitive environment

SWOT analysis
Present value of cash flows
Relative valuation ratio techniques

Competitive Forces

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

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

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

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

SWOT Analysis
Examination of a firms:

Strengths
Weaknesses
Opportunities
Threats

SWOT Analysis
Examination of a firms:

Strengths
Weaknesses
Opportunities
Threats

INTERNAL ANALYSIS

SWOT Analysis
Examination of a firms:

Strengths
Weaknesses
Opportunities
Threats

EXTERNAL ANALYSIS

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)

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(1+g)

Growth Rate Estimates

Average Dividend Growth Rate

Dn
1
D0

Growth Rate Estimates

Average Dividend Growth Rate

Dn
1
D0

Sustainable Growth Rate = RR X ROE

Required Rate of Return Estimate

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

Required Rate of Return Estimate

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

R stock E(RFR) stock [E(R market ) E(RFR)]

The Present Value of

Dividends Model (DDM)
Model requires k>g
With g>k, analyst must use multi-stage
model

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

Present Value of
Free Cash Flow to Equity
FCFE =
FCFE1
Value
Net Income
k g FCFE
+ Depreciation Expense
- Capital Expenditures
- D in Working Capital
- Principal Debt Repayments
+ New Debt Issues

Present Value of
Free Cash Flow to Equity

FCFE1
Value
k g FCFE
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

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
- D in Working Capital - D in other assets

Present Value of
Operating Free Cash Flow
FCFF1
Firm Value
WACC g FCFF
Oper . FCF1
or
WACC g OFCF

Present Value of
Operating Free Cash Flow
FCFF1
Firm Value
WACC g FCFF
Oper . FCF1
or
WACC g OFCF
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

An Alternate Measure of Growth

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

Calculation of WACC
WACC = WEk + Wdi

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

Relative Valuation Ratio

Techniques
Price Earnings Ratio

D1 / E1
P / E1
kg

Estimating Company Earnings

Per Share
Function of
Sales forecast
Estimated profit margin

Walgreens Competitive Strategies

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

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

Additional Measures of Relative

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