Company Analysis and Stock

Valuation
After you read this chapter, you should be able to answer the following questions:
• Why is it important to differentiate between company analysis and stock valuation?
• What is the difference between a true growth company and a growth stock?
• How do we apply the two valuation approaches and the several valuation techniques to
Walgreens?
• What techniques are useful when estimating the inputs to alternative valuation models?
• What techniques are useful when estimating company sales?
• How do we estimate the profit margins and earnings per share for a company?
• What factors are considered 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?
• In addition to the earnings multiplier, what insights can be gained from other relative valuation
ratios?
• How do we apply the several present value of cash flow models to the valuation of a company?
• What value-added measures are available to evaluate the performance of a firm?
• How do we compute economic value added (EVA) and market value added (MVA)?
• How do these value-added measures relate to changes in the market value of firms?
• What is the relationship between positive EVA and a true growth company?
• Why is it inappropriate to use the standard dividend discount model (DDM) to value a true
growth company?
• What is the difference between no growth, simple growth, and dynamic growth?
• What is the growth duration model, and what information does it provide?
• Once you compute a stock’s growth duration, how do you make an investment decision?
• How can we use the growth duration model to estimate the P/E for a growth company?
• How can site visits and interviews provide unique insights (discovery) not generally available?
• What factors should lead you to sell a stock?
• What additional factors should be considered when analyzing a company on a global basis?
At this point, you have made two decisions about your investment in equity
markets.
First, after analyzing the economy and stock markets for several countries, you
have decided
what percent of your portfolio should be invested in common stocks and your
allocation to alternative countries (i.e., overweight, market weight, or underweight).
Second,
after analyzing various industries, you have identified those that appear to offer
above-average risk-adjusted performance over your investment horizon. The final
questions
in the fundamental analysis procedure are: (1) Which are the best companies
within these desirable industries? and (2) What is the intrinsic value of the firm’s
stock?
Specifically, is the intrinsic value of the stock above its market value, or is the
expected
rate of return on the stock equal to or greater than its required rate of return?
We begin with a discussion of the difference between company analysis and stock
valuation. Company analysis should occur in the context of the prevailing economic
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and industry conditions. We discuss some competitive strategies that can help firms
maximize returns in an industry’s competitive environment. Most of the chapter
demonstrates cash flow models and relative valuation ratios used to determine a
stock’s intrinsic value and whether it is an undervalued or overvalued stock. This
includes
several models that specifically relate to the valuation of growth companies.
This is followed by a review of factors that will help you determine when to sell a
stock that you own. Also, we discuss the pressures and influences that affect
professional
stock analysts. Finally, we discuss important factors to consider when analyzing
foreign stocks.

14.1 COMPANY ANALYSIS VERSUS STOCK VALUATION

This chapter is titled “Company Analysis and Stock Valuation” to convey the idea that the
common stocks of good companies are not necessarily good investments. The point is, after
analyzing a company and deriving an understanding of its strengths and risks, you need to
compute the intrinsic value of the firm’s stock and compare this to its market value to
determine
if the company’s stock should be purchased. The stock of a wonderful firm with superior
management and strong performance measured by current and future sales and earnings
growth can be priced so high that the intrinsic value of the stock is below its current market
price (i.e., the stock is overvalued) and it should not be acquired. In contrast, the stock of a
company with lower sales and earnings growth may have a market price that is below its
intrinsic
value. In this case, although the company is not as good, its stock could be the better
investment.
The classic confusion concerns growth companies versus growth stocks. The stock of a
growth company is not necessarily a growth stock! Recognition of this difference is
absolutely
essential for successful investing.
14.1.1 Growth Companies and Growth Stocks
Observers have historically defined growth companies as those that consistently experience
above-average increases in sales and earnings. This definition has some limitations because
many firms could qualify due to certain accounting procedures, mergers, or other external
events.
In contrast, financial theorists such as Salomon (1963) and Miller and Modigliani (1961)
define a growth company as a firm with the management ability and the opportunities to
consistently
make investments that yield rates of return greater than the firm’s required rate of
return. This required rate of return is the firm’s weighted average cost of capital (WACC). As
an example, a growth company might be able to acquire capital at an average cost of 10
percent
and yet have the management ability and the opportunity to invest those funds at rates of
return of 15 to 20 percent. As a result of these superior investment opportunities, the firm’s
sales and earnings grow faster than those of similar risk firms and the overall economy. In
addition,
a growth company that has above-average investment opportunities should, and typically
does, retain a large portion of its earnings to fund these superior investment projects
(i.e., they have low or zero dividend-payout ratios).
Growth stocks are not necessarily shares in growth companies. A growth stock is a stock
with a higher expected rate of return than other stocks in the market with similar risk
characteristics.
The stock achieves this expected superior risk-adjusted rate of return because the market
has undervalued it compared to other stocks. In the language introduced in Chapter 11 and
used
subsequently, an undervalued stock has an intrinsic value (estimated by alternative
valuation
models) that is greater than its current market price. Although the stock market adjusts
stock

prices relatively quickly and accurately to reflect new information, available information is
not
always perfect or complete. Therefore, imperfect or incomplete information may cause a
given
stock to be undervalued or overvalued at a point in time.1
If the stock is undervalued, its price should eventually increase to reflect its true
fundamental
(intrinsic) value when the correct information becomes available. During this period of
price adjustment, the stock’s realized return will exceed the required return for a stock with
its risk, and during this period of adjustment, it will be a growth stock. Growth stocks are
not necessarily limited to growth companies. A future growth stock can be the stock of any
type of company; the stock need only be undervalued by the market.
The fact is, if investors recognize a growth company and discount its future earnings stream
properly, the current market price of the growth company’s stock will reflect its future
earnings
stream. Those who acquire the stock of a growth company at this correct market price
will receive a rate of return consistent with the risk of the stock, even when the superior
earnings
growth is attained. In many instances, overeager investors tend to overestimate the
expected
growth rate of earnings and cash flows for the growth company and, therefore, inflate
the price of a growth company’s stock. Investors who pay the inflated stock price (compared
to its true intrinsic value) will earn a rate of return below the risk-adjusted required rate of
return, despite the fact that the growth company experiences above-average growth of
sales
and earnings. Studies by Solt and Statman (1989), Shefrin and Statman (1995), and
Clayman
(1987) have examined the stock price performance for samples of growth companies and
found that their stocks performed poorly—that is, the stocks of growth companies have
generally
not been growth stocks.
14.1.2 Defensive Companies and Stocks
Defensive companies are those whose future earnings are likely to withstand an economic
downturn. One would expect them to have relatively low business risk and not excessive
financial
risk. Typical examples are fast food chains or grocery stores—firms that supply basic
consumer
necessities.
There are two closely related concepts of a defensive stock. First, a defensive stock’s rate of
return is not expected to decline during an overall market decline, or decline less than the
overall market. Second, our CAPM discussion indicated that an asset’s relevant risk is its
covariance
with the market portfolio of risky assets—that is, an asset’s systematic risk. A stock
with low or negative systematic risk (a small positive or negative beta) may be considered a
defensive stock according to this theory because its returns are unlikely to be harmed
significantly
in a bear market.
14.1.3 Cyclical Companies and Stocks
A cyclical company’s sales and earnings will be heavily influenced by aggregate business
activity.
Examples would be firms in the steel, auto, or heavy machinery industries. Such companies
will outperform other firms during economic expansions and seriously underperform during
economic contractions. This volatile earnings pattern is typically a function of the firm’s
business risk (both sales volatility and operating leverage) and can be compounded by
financial
risk.
A cyclical stock will experience changes in its rates of return greater than changes in overall
market rates of return. In terms of the CAPM, these would be stocks that have high betas.
The stock of a cyclical company, however, is not necessarily cyclical. A cyclical stock is the
1An analyst is more likely to find such stocks outside the top tier of companies that are scrutinized by numerous
analysts;
in other words, look for neglected stocks.
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stock of any company that has returns that are more volatile than the overall market—that
is,
high-beta stocks that have high correlation with the aggregate market and greater volatility.
14.1.4 Speculative Companies and Stocks
A speculative company is one whose assets involve great risk but that also has a possibility
of
great gain. A good example of a speculative firm is one involved in oil exploration.
A speculative stock possesses a high probability of low or negative rates of return and a
low probability of normal or high rates of return. Specifically, a speculative stock is one that
is overpriced, leading to a high probability that during the future period when the market
adjusts
the stock price to its true value, it will experience either low or possibly negative rates of
return. Such an expectation might be the case for an excellent growth company whose stock
is
selling at an extremely high price/earnings ratio—that is, it is substantially overvalued.
14.1.5 Value versus Growth Investing
Some analysts also divide stocks into growth stocks and value stocks. As we have discussed,
growth stocks are companies that will experience above-average risk-adjusted rates of
return
because the stocks are undervalued. If the analyst does a good job in identifying such
companies,
investors in these stocks will reap the benefits of seeing their stock prices rise after other
investors identify their earnings growth potential. Value stocks are those that appear to be
undervalued
for reasons other than earnings growth potential. Value stocks are usually identified
by analysts as having low price-earning or price-book value ratios. Notably, in these
comparisons
between growth and value stocks, the specification of a growth stock is not consistent
with our preceding discussion. In these discussions, a growth stock is generally specified as
a
stock of a company that is experiencing rapid growth of sales and earnings (e.g., Google,
Apple, and Microsoft). As a result of this company performance, the stock typically has a
high P/E and price-book-value ratio. Unfortunately, the specification does not consider the
critical comparison we advocate between intrinsic value and market price. Therefore, these
specifications will not be used in subsequent discussions of valuation.
The major point of this section is that you must initially examine a company in detail to
determine its fundamental characteristics and subsequently use this information to derive
an
estimate of the intrinsic value of its stock. When you compare this intrinsic value of the
stock
to its current market price, you decide whether you should acquire it—that is, will it be a
growth stock that provides a rate of return greater than what is consistent with its risk?

COMPANY ANALYSIS
This section groups various analysis components for discussion. “Firm Competitive
Strategies”
continues the Porter discussion of an industry’s competitive environment. The basic SWOT
analysis, is intended to articulate a firm’s strengths, weaknesses, opportunities, and threats.
These two analyses should provide a complete understanding of a firm’s overall strategic
approach. Given this background, we review the fundamental valuation models. In the rest
of
this chapter, we discuss estimating intrinsic value for Walgreens using the two valuation
approaches: (1) the present value of cash flows, and (2) relative valuation ratio techniques.
Following
this, we discuss the significance of site visits to companies, how to prepare for an interview
with management, and suggestions on when an investor should consider selling an asset.
This is followed by a discussion of unique considerations regarding evaluation of
international
companies and their stocks. The final section of the chapter discusses the unique features of
true
growth companies and presents and demonstrates several models that can be used to value
growth companies.

Firm Competitive
Strategies

In describing competition within industries, we identified five competitive forces that could
affect the competitive structure and profit potential of an industry. They are: (1) current
rivalry,
(2) threat of new entrants, (3) potential substitutes, (4) bargaining power of suppliers, and
(5) bargaining power of buyers. After you have determined the competitive structure of an
industry,
you should attempt to identify the specific competitive strategy employed by each firm and
evaluate these strategies in terms of the overall competitive structure of the industry.
A company’s competitive strategy can either be defensive or offensive. A defensive
competitive
strategy involves positioning the firm so that its capabilities provide the best means to
deflect the effect of the competitive forces in the industry. Examples may include investing
in
fixed assets and technology to lower production costs or creating a strong brand image with
increased advertising expenditures.
An offensive competitive strategy is one in which the firm attempts to use its strengths
to
affect the competitive forces in the industry. For example, Microsoft dominated the personal
computer software market by preempting, rivals and its early affiliation with IBM because it
became the writer of operating system software for a large portion of the PC market.
Similarly,
Wal-Mart used its buying power to obtain price concessions from its suppliers. This cost
advantage,
coupled with a superior delivery system to its stores, allowed Wal-Mart to grow against
larger competitors until it became the leading U.S. retailer.
As an investor, you must understand the alternative competitive strategies available,
determine
each firm’s strategy, judge whether the firm’s strategy is reasonable for its industry, and,
finally, evaluate how successful the firm is in implementing its strategy.
In the following sections, we discuss analyzing a firm’s competitive position and strategy.
The
analyst must decide whether the firm’s management is correctly positioning the firm to take

advantage of industry and economic conditions. The analyst’s opinion about management’s
decisions
should ultimately be reflected in, and be the basis for the analyst’s estimates of the firm’s
growth of cash flow and earnings.
Porter suggests two major competitive strategies: low-cost leadership and differentiation. 4
These two competitive strategies dictate how a firm has decided to cope with the five
competitive
conditions that define an industry’s environment. The strategies available and the ways of
implementing them differ within each industry.
Low-Cost Strategy The firm that pursues the low-cost strategy is determined to become the
low-cost producer and, hence, the cost leader in its industry. Cost advantages vary by
industry
and might include economies of scale, proprietary technology, or preferential access to raw
materials. In order to benefit from cost leadership, the firm must command prices near the
industry
average, which means that it must differentiate itself about as well as other firms. If the firm
discounts price too much, it could erode the superior rates of return available because of its
low
cost. During the past decade,Wal-Mart was considered a low-cost source. The firm achieved
this
by volume purchasing of merchandise and lower-cost operations. As a result, the firm
charged
less but still enjoyed higher profit margins and returns on capital than many of its
competitors.
Differentiation Strategy With the differentiation strategy, a firm seeks to identify itself as
unique in its industry in an area that is important to buyers. Again, the possibilities for
differentiation
vary widely by industry. A company can attempt to differentiate itself based on its
distribution
system (selling in stores, by mail order, or door-to-door) or some unique marketing
approach.
A firm employing the differentiation strategy will enjoy above-average rates of return only if
the
price premium attributable to its differentiation exceeds the extra cost of being unique.
Therefore,
when you analyze a firm using this strategy, you must determine whether the differentiating
factor
is truly unique, whether it is sustainable, its cost, and if the price premium derived from the
uniqueness is greater than its cost (is the firm experiencing above-average rates of return?).

Focusing a
Strategy

Whichever strategy it selects, a firm must determine where it will focus this strategy.
Specifically,
a firm must select segments in the industry and tailor its strategy to serve these specific
groups. For example, a low-cost strategy would typically exploit cost advantages for certain
segments
of the industry, such as being the low-cost producer for the expensive segment of the
market.
Similarly, a differentiation focus would target the special needs of buyers in specific
segments.
For example, in the athletic shoe market, companies have attempted to develop shoes for
unique sport segments, such as tennis, basketball, aerobics, or walkers and hikers, rather
than
offering only shoes for runners. Firms thought that participants in these activities needed
shoes
with characteristics different from those desired by joggers. Equally important, they believed
that
these athletes would be willing to pay a premium for these special shoes. Again, you must
ascertain
if special possibilities exist, if they are being served by another firm, and if they can be
priced to generate abnormal returns to the firm. Exhibit 15.2 details some of Porter’s ideas
for
the skills, resources, and company organizational requirements needed to successfully
develop a
cost leadership or differentiation strategy.
Next, you must determine which strategy the firm is pursuing and its success. Also, can the
strategy be sustained? Further, you should evaluate a firm’s competitive strategy over time,
because strategies need to change as an industry evolves; different strategies work during
differ-

SWOT Analysis
SWOT analysis involves an examination of a firm’s strengths, weaknesses, opportunities,
and
threats. It should help you evaluate a firm’s strategies to exploit its competitive advantages
or
defend against its weaknesses. Strengths and weaknesses involve identifying the firm’s
internal
abilities or lack thereof. Opportunities and threats include external situations, such as
competitive
forces, discovery and development of new technologies, government regulations, and
domestic and international economic trends.
The strengths of a company give the firm a comparative advantage in the marketplace.
Perceived
strengths can include good customer service, high-quality products, strong brand image,
customer loyalty, innovative R&D, market leadership, or strong financial resources. To
remain
strengths, they must continue to be developed, maintained, and defended through prudent
capital
investment policies.
Weaknesses result when competitors have potentially exploitable advantages over the
firm. Once weaknesses are identified, the firm can select strategies to mitigate or correct
the

weaknesses. For example, a firm that is only a domestic producer in a global market can
make
investments that will allow it to export or produce its product overseas. Another example
would be
a firm with poor financial resources that would form joint ventures with financially stronger
firms.
Opportunities, or environmental factors that favor the firm, can include a growing market for
the firm’s products (domestic and international), shrinking competition, favorable exchange
rate
shifts, a financial community that has confidence in the outlook for the industry or firm, or
identification
of a new market or product segment.
Threats are environmental factors that can hinder the firm in achieving its goals. Examples
would include a slowing domestic economy (or sluggish overseas economies for exporters),
additional government regulation, an increase in industry competition, threats of entry,
buyers or
suppliers seeking to increase their bargaining power, or new technology that can obsolete
the
industry’s product. By recognizing and understanding opportunities and threats, an investor
can
make informed decisions about how the firm can exploit opportunities and mitigate threats.