Investment Analysis and Portfolio Management: Lecture Presentation Software

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Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 20
Copyright 2000 by Harcourt, Inc. All rights reserved
Company Analysis and Stock Selection
After analyzing the economy and stock markets
for several countries you have decided to invest
some portion of your portfolio in common stocks
After analyzing various industries, you have
identified those industries that appear to offer
above-average risk-adjusted performance over
your investment horizon
Which are the best companies?
Are they overpriced?
Company Analysis and Stock Selection
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
Types of Companies and Stocks
Growth
Defensive
Cyclical
Speculative
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 Companies
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
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
Value versus Growth Investing
Buffetts view:
Growth is a key determinant of value for any
stock, so it is always a component of determining
whether or not a stock is undervalued
Furthermore, so long as the market is under-
valuing a stock, then he would categorize it as a
value stock
Finally, he considers all investing to be value
investing
Thus, he considers value vs. growth investing
to be a false dichotomy
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
Sales and earnings heavily influenced by
aggregate business activity
Stocks with high betas
Speculative Companies and Stocks
Assets involve great risk
e.g., biotechs, bankruptcies, etc.
Possible great gain
Stock may be overpriced
Economic, Industry, and Structural
Links to Company Analysis
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 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 that 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
Firm Competitive Strategies
Current rivalry
Threat of new entrants
Potential substitutes
Bargaining power of suppliers
Bargaining power of buyers
Firm Competitive Strategies
Defensive or offensive
Defensive strategy deflects competitive
forces in the industry
Offensive competitive strategy affects
competitive force in the industry to
improve the firms relative position
Porter suggests two major strategies: low-
cost leadership and differentiation
Low-Cost Strategy
Seeks to be the low cost leader in its
industry
Through economies of scale (in production or
marketing), better logistics, etc.
Must still command prices near industry
average, so still must differentiate
Discounting too much erodes superior
rates of return
Differentiation Strategy
Identify as unique in its industry in
an area that is important to buyers
Above average rate of return only
comes if the price premium
exceeds the extra cost of being
unique
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
Strengths
Weaknesses
Opportunities
Threats
INTERNAL ANALYSIS
SWOT Analysis
Strengths
Weaknesses
Opportunities
Threats
EXTERNAL ANALYSIS
Lynchs Favorable Attributes
1. Firms 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
Lynchs Categories of Companies
1. Slow growers
2. Stalwart
3. Fast growers
4. Cyclicals
5. Turnarounds
6. Asset plays
Buffetts Favorable Attributes
Examines three categories:
1. Business tenets
2. Financial tenets
3. Market tenets
Buffetts Business Tenets
Business that is easy to understand & analyze
Is the business simple and understandable? How does it make money?
Also must have ability to adjust prices for inflation
Does the business have a consistent operating history? Do
earnings exhibit a stable upward trend?
Does the business have favorable long-term prospects?
Is the business a consumer monopoly or a commodity-type business?
see next slide
Is management candid with its shareholders?
Does management resist the institutional imperative?
Consumer Monopoly vs.
Commodity
Consumer monopoly:
Repeat business, plus one or more of following:
Strong brand or other barrier (Nike, McDonalds, Amgen
(patents), rock quarries (transportation costs))
Necessary gateway for mfrs. to reach customers (worldwide
advertising agencies, newspapers)
Provide necessary services (tax preparers, insurance)
Commodity-based business:
Low profit margins, low ROE, absence of brand
loyalty, presence of multiple producers, existence of
substantial excess capacity, erratic profits that depend
on managements ability to optimize the use of tangible
assets
Buffetts Financial Tenets
Conservative financing
Consistently high return on S/Hs equity
Focus on return on equity (ROE & ROIC), not earnings per share.
Calculate owner earnings.
NI + (D + A) (necessary capital expenditures)
Low level of spending needed to maintain economic position
Look for companies with high profit margins.
Learned from Philip Fisher
One indication of having an economic moat around the business
Profitable use of retained earnings
For every dollar retained, make sure the company has created at least
one dollar of market value.
Basically, Market-Value Added (MVA)
Buffetts Market Tenets
What is the value of the business?
Discounted cash flow (DCF) approach
Compare investment in bonds (value with no growth):
relative value = EPS / Long-Term T-bond yield
What value can growth add to this?
Key questions:
What is the value of growth within the franchise?
How long will the companys economic moat last, and to
what extent can the company increase its size and grow within
it?
What future price would such growth allow the stock to reach?
Will this future price allow >15% return?
Can the business be purchased with a margin of safety or
margin of protection from its underlying business value?
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 = D
1
/(k-g)
D
1
= D
0
(1+g)
Growth Rate Estimates
Average Dividend Growth Rate
1
D
D
n
0
n
=
Growth Rate Estimates
Average Dividend Growth Rate

Problem highly dependent upon specific dividends used
in estimation
Three alternatives:
1. Sustainable Growth Rate = RR X ROE
2. Regression-based estimates of growth rates
3. Back out growth rate from estimated size of future market
1
D
D
n
0
n
=
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
E(RFR)] ) E(R [ E(RFR) R
market stock stock
+ = |
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
- A in Working Capital
- Principal Debt Repayments
+ New Debt Issues
Present Value of
FCFE =
Net Income
+ Depreciation Expense
- Capital Expenditures
- A in Working Capital
- Principal Debt Repayments
+ New Debt Issues
FCFE
g k
FCFE
Value
=
1
Present Value of
FCFE = the expected free cash flow in period 1
k = the required rate of return on equity for the firm
g
FCFE
= the expected constant growth rate of free cash
flow to equity for the firm
FCFE
g k
FCFE
Value
=
1
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
- A in Working Capital - A in other assets
Present Value of
OFCF
FCFF
g WACC
FCF Oper
or
g WACC
FCFF
Value Firm
=
1
1
.

Present Value of
Where: FCFF
1
= the free cash flow in period 1
Oper. FCF
1
= the firms operating free cash flow in period 1
WACC = the firms weighted average cost of capital
g
FCFF
= the firms constant infinite growth rate of free cash flow
g
OFCF
= the constant infinite growth rate of operating free cash flow
OFCF
FCFF
g WACC
FCF Oper
or
g WACC
FCFF
Value Firm
=
1
1
.

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 = W
E
k + W
d
i
Calculation of WACC
WACC = W
E
k + W
d
i
where:
W
E
= the proportion of equity in total capital
k = the after-tax cost of equity (from the SML)
W
D
= the proportion of debt in total capital
i = the after-tax cost of debt
Relative Valuation Techniques
Price Earnings Ratio
g k
E D
E P
=
1 1
1
/
/
Affected by two variables:
1. Required rate of return on its equity (k)
2. Expected growth rate of dividends (g)
g k
E D
E P
=
1 1
1
/
/
Price/Cash Flow Ratio
g k
E D
E P
=
1 1
1
/
/
Price/Book Value Ratio
g k
E D
E P
=
1 1
1
/
/
Price-to-Sales Ratio
g k
E D
E P
=
1 1
1
/
/
Price-to-Sales Ratio
g k
E D
E P
=
1 1
1
/
/
Analyze the differences in the various ratio techniques
Analysis of Growth Companies
Generating rates of return greater than the firms
cost of capital is considered to be temporary
Earnings higher than the required rate of return are
pure profits
How long can they earn these excess profits?
How long are they likely to earn these excess
profits?
How long does the market expect them to earn
these excess profits?
Is the stock properly valued?
Alternative Growth Models
Growth companies and the DDM
Constant growth model not appropriate
No growth firms:
All earnings paid out as dividends g = 0
V = D / k = E / k
Long-run / Simple growth model:
Assume some earnings are reinvested
Value = PV(constant dividend) + PV(growth investment)

where m = r / k; b = ret. rate

( )
k
bEm
k
b E
V +
=
1
Expansion model:
Firm retains earnings to reinvest, but receives a
rate of return on its investment equal to its cost of
capital
m = 1 so r = k

( )
k
E
k
bE
k
b E
V = +
=
1
Negative growth model:
Firm retains earnings, but reinvestment returns are below
the firms cost of capital
Since growth will be positive, but slower than it should
be, the value will decline when the investors discount the
reinvestment stream at the cost of capital
Key lesson = not all growth is value-adding
If company retains earnings but m < 1, then company is
destroying shareholder wealth even though it is growing!
Note: m < 1 r < k NPV < 0
I.e., if a company goes for growth by investing in negative NPV
projects, the shareholders will be worse off, not better!
Dynamic True Growth Model
Firm invests a constant percentage of
current earnings in projects that generate
rates of return above the firms required rate
of return
g k
D
V
=
1
Measures of Value-Added
Economic Value-Added (EVA)
Compare net operating profit less adjusted taxes
(NOPLAT) to the firms total cost of capital in
dollar terms, including the cost of equity
EVA return on capital
EVA/Capital
Alternative measure of EVA
Compare return on capital to cost of capital
Market Value-Added (MVA)
Measure of external performance
How the market has evaluated the firms
performance in terms of market value of debt
and market value of equity compared to the
capital invested in the firm
Relationships between EVA and MVA
mixed results
The Franchise Factor
Breaks P/E into two components
P/E based on ongoing business (base P/E)
Franchise P/E the market assigns to the expected value of
new and profitable business opportunities
Franchise P/E = Observed P/E - Base P/E
Incremental Franchise P/E = Franchise Factor X Growth Factor
G
rk
k R
=
Growth Duration
Evaluate the high P/E ratio by relating P/E ratio to
the firms rate and duration of growth
P/E is function of
expected rate of growth of earnings per share
stocks required rate of return
firms dividend-payout ratio
Use the ratio of P/Es, related to growth and
dividend rates, to infer the markets implied
growth duration:
Growth Duration
( )
|
|
.
|
\
|
+ +
+ +
~
|
|
.
|
\
|
T
a a
T
g g
a d
g g
) D G (1
) D G (1

(0) E / 0 P
(0) (0)/E P
( )
|
|
.
|
\
|
+ +
+ +
~
|
|
.
|
\
|
) D G (1
) D G (1
ln
(0) E / 0 P
(0) (0)/E P
ln
a a
g g
a d
g g
T

) D G (1
) D G (1
ln
P/E
P/E
ln
a a
g g
a
g
|
|
.
|
\
|
+ +
+ +
|
|
.
|
\
|
~ T
Intra-Industry Analysis
Directly compare two firms in the same industry
An alternative use of T to determine a reasonable
P/E ratio
Factors to consider
A major difference in the risk involved
Inaccurate growth estimates
Stock with a low P/E relative to its growth rate
is undervalued
Stock with high P/E and a low growth rate is
overvalued
Extensions on Growth Duration
For more information and additional
extensions and applications in using market-
based information to infer the markets
assumptions about the various factors that
drive a stocks valuation, see:
www.expectationsinvesting.com
A Flexible Growth Stock
Valuation Model
Maos three-stage valuation model
dynamic growth period
simple growth period
declining growth period
Valuation Model
( )
( )
( )
+
+
|
.
|
\
|

1
1
1
1
1
n
t
t
t
k
br
bE
k
k r
(Value of Dynamic
Growth Opportunities)
( )
( )
=
+
|
.
|
\
|

1
1
1
1
n
t
t
k
bE
k
k r
(Value of Simple
( )
( )
( )
=
+
+
|
.
|
\
|

1
1
3
3
1
1
n
t
t
k n
t n
bE
k
k r
(Value of Declining
Valuation Model
Assumptions
no change in the required rate of return
same rate of return on all growth projects
same retention rate (b) during the three growth
periods
( )
( )
( )
( )
( )
(
+
+
+
+
+
+
|
.
|
\
|

+ =
+

C
k
br
B
k
br
A bE
k
k r
k
E
P
n n
n
n
n
2 1
1
1
1
1
1
1
1
1 1
Valuation Model
Very theoretical model
Key value in application comes not from filling in the numbers
in the equation,
but in using this framework to better structure the valuation
process
Provides a framework for thinking about the factors that drive
value how much value they will bring
( )
( )
( )
( )
( )
(
+
+
+
+
+
+
|
.
|
\
|

+ =
+

C
k
br
B
k
br
A bE
k
k r
k
E
P
n n
n
n
n
2 1
1
1
1
1
1
1
1
1 1
Site Visits and the
Art of the Interview
Focus on managements plans, strategies, and
concerns
Restrictions on nonpublic information
What if questions can help gauge sensitivity
of revenues, costs, and earnings
Management may indicate appropriateness of
earnings estimates
Discuss the industrys major issues
Review the planning process
Talk to more than just the top managers
When to Sell
Holding a stock too long may lead to lower returns
than expected
If stocks decline right after purchase, is that a
further buying opportunity or an indication of
incorrect analysis?
Continuously monitor key assumptions
Evaluate closely when market value approaches
estimated intrinsic value
Know why you bought it and watch for that to
change
Efficient Markets
Opportunities are mostly among less well-known
companies
To outperform the market you must find disparities
between stock values and market prices - and you must
be correct
Concentrate on identifying what is wrong with the
market consensus and what earning surprises may exist
Again, useful to examine the expectations that underlie the
current market price
Are these realistic/optimistic/pessimistic?
Forces Pulling on the Analyst
Investment bankers may push for favorable
evaluations
Corporate officers may try to convince
analysts
Analyst must maintain independence and
have confidence in his or her analysis
Global Company Analysis
Earnings per share analysis
Common stock statistics
Share price performance
Individual company analysis
The Internet
Investments Online
www.better-investing.com
www.fool.com
www.cfonews.com
www.ibes.com
www.zacks.com
www.valueline.com
www.financialweb.com
investor.msn.com
www.marketedge.com
www.nyssa.org
End of Chapter 20
Company Analysis and
Stock Selection
Future topics
Chapter 8
Portfolio management
Alternative measures of risk
Computing expected return
The risk-return efficient frontier
Future topics
Chapter 22
Equity Portfolio Management
Strategies

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