CHAPTER SEVEN

FUNDAMENTAL STOCK ANALYSIS

A
1 3

Practical Investment Management

Robert A. Strong
 Outline
 Valuation Philosophies
 Investors’ Understanding of Risk Premiums
 The Time Value of Money

 The Importance of Cash Flows

 The Tax Factor

 EIC Analysis

 Value vs. Growth Investing

 The Value Approach to Investing
 The Growth Approach to Investing

 How Price Relates to Value

 Value Stocks and Growth Stocks:

How to Tell by Looking
South-Western / Thomson Learning © 2004 7-2
 Outline

 The Price-to-Book Ratio

 The Price-Earnings Ratio
 Differences between Industries

South-Western / Thomson Learning © 2004 7-3

 Outline
 Some Analytical Factors
 Growth Rates
 The Dividend Discount Model

 The Importance of Hitting the Earnings Estimate

 The Multistage DDM

 Caveats about the DDM

 False Growth

 A Firm’s Cash Flows

 Small-Cap, Mid-Cap, and Large-Cap Stocks

 Ratio Analysis

 Cooking the Books

South-Western / Thomson Learning © 2004 7-4

 Valuation Philosophies

 Fundamental analysts believe

securities are priced according to
fundamental economic data.

 Technical analysts think investor behavior

and supply and demand factors play the
most important role.

South-Western / Thomson Learning © 2004 7-5

 Valuation Philosophies
 Investors’ understanding of risk premiums:
Investors are almost always risk-averse.
 The time value of money:
Everyone agrees on this basic principle.
 The importance of cash flows:
Most investment research deals with
predicting future corporate earnings.
 The tax factor:
The tax code is complicated and not all
investments are taxed equally.

South-Western / Thomson Learning © 2004 7-6

 Valuation Philosophies
 Economy, Industry and Company (EIC)
analysis:
 The analyst first considers conditions in
the overall economy (market risk),
 then determines which industries are the
most attractive in light of the economic
conditions (using Porter’s competitive
strategy analysis framework, for example),
 and finally identifies the most attractive
companies within the attractive
industries.
South-Western / Thomson Learning © 2004 7-7
 Valuation Philosophies

Insert Figure 7-1 here.

South-Western / Thomson Learning © 2004 7-8

 Value vs. Growth Investing

The Value Approach to Investing

 A value investor believes that securities
should be purchased only when the
underlying fundamentals (macroeconomic
information, industry news, and a firm’s
financial statements) justify the purchase.
 Value investors believe in a regression
to the mean.

South-Western / Thomson Learning © 2004 7-9

 Regression to the Mean
+ Overvalued stock: Sell
Most of the time a
security’s long-
term return is
x xx consistent with its
Cumulative Return

x x risk.
xx x x x
x x Undervalued stock:
x x x Buy

0
Over the long run, a security
cannot survive with a cumulative
return that is negative.
-
Time in the Long Term

South-Western / Thomson Learning © 2004 7 - 10

 Value vs. Growth Investing

The Growth Approach to Investing

 Growth investors seek steadily growing
companies. There are two factions:
 Information traders are in a hurry; they
believe information differentials in the
marketplace can be profitably exploited.
 True growth investors are more willing to
wait, but they share the belief that good
investment managers can earn above-
average returns for their clients.

South-Western / Thomson Learning © 2004 7 - 11

 Value vs. Growth Investing

How Price Relates to Value

 In the early days of the market, before the
Great Crash of 1929, price played a minor
role: “A stock with good long-term
prospects is always a good investment.”
 The modern perspective is that
$8 value is inextricably intertwined
with price.

South-Western / Thomson Learning © 2004 7 - 12

 Value vs. Growth Investing

Value Stocks and Growth Stocks:

How to Tell by Looking
 No precise definition exists.
 Classification by Morningstar Mutual Funds:

relative relative  < 1.75 - value

price-to-book + price-earnings  > 2.25 - growth
ratio ratio  otherwise - blend

South-Western / Thomson Learning © 2004 7 - 13

 The Price-to-Book Ratio

 Book value per share is an accounting

concept synonymous with equity per share
or net asset value.
 Share price is not normally equal to book
value because of
 depreciation, uncollectible debts, goodwill, etc.
 economic obsolescence
 intangible assets

South-Western / Thomson Learning © 2004 7 - 14

 The Price-to-Book Ratio

 The price-earnings ratio (PE) is computed

by dividing the current stock price by the
firm’s earnings per share.
 Because of differences among industries,
relative ratios are commonly computed.

South-Western / Thomson Learning © 2004 7 - 15

 The Price-to-Book Ratio

Insert Figure 7-3 here.

South-Western / Thomson Learning © 2004 7 - 16

 The Price-to-Book Ratio

Insert Figure 7-4 here.

South-Western / Thomson Learning © 2004 7 - 17

 Some Analytical Factors: Growth Rates
 Growth rates from historical data:
1
 ending value  n
growth rate geometric mean =   − 1
 beginning value 
where n = number of compounding periods

 Growth rates from earnings retention:

growth rate = ( 1- payout ratio ) × return on equity

using arithmetic averages

South-Western / Thomson Learning © 2004 7 - 18

 Some Analytical Factors: Growth Rates

Insert Table 7-4 here.

South-Western / Thomson Learning © 2004 7 - 19

 Some Analytical Factors: Growth Rates

Choosing a Growth Rate

 Financial analysts typically calculate a
number of growth rates using different
ways to determine a likely range for the
statistic.
 Recent data may be more reliable than data
from the more distant past.
 Company statements regarding company
targets may be considered too.

South-Western / Thomson Learning © 2004 7 - 20

 Some Analytical Factors: Growth Rates

Insert Table 7-5 here.

South-Western / Thomson Learning © 2004 7 - 21

 Some Analytical Factors: Growth Rates

Growth Rate Estimates from Other Analysts

 Another important source of growth rate
estimates is from other security analysts.
 Three popular services that monitor and
report these estimates are Zacks, First Call,
and the Institutional Brokers Estimate
System (I/B/E/S).
 The term whisper number refers to what
people really think the earnings will be,
and not what the published estimate is.

South-Western / Thomson Learning © 2004 7 - 22

 The Dividend Discount Model (DDM)
 Also called Gordon’s growth model.

D0 ( 1 + g ) D1
current price P0 = =
k −g k −g
where D0 is the current dividend
D1 is the dividend to be paid next year
g is the expected dividend growth rate
k is the discount factor according to
the riskiness of the stock

 The model assumes that the dividend

stream is perpetual and that the long-
term growth rate is constant.

South-Western / Thomson Learning © 2004 7 - 23

 The Dividend Discount Model (DDM)

 The variable k is sometimes called the

shareholders’ required rate of return.

D0 ( 1 + g )
k= +g
P0

 Note that the shareholder’s required rate of

return is the sum of the expected dividend
yield and the expected stock price
appreciation.

South-Western / Thomson Learning © 2004 7 - 24

 The Importance of Hitting the Earnings Estimate

 The market often penalizes a company’s

stock substantially when the earnings
report is disappointing.
 This is especially true when the required
rate of return and the estimated growth rate
are high.

South-Western / Thomson Learning © 2004 7 - 25

 The Multistage DDM

 Often, initial high growth levels cannot be

sustained.
 Suppose the growth rate g is expected to
persist from the third year:

D1 D2 D2 ( 1 + g ) ( k − g )
P0 = + +
( 1+ k) ( 1+ k)2 ( 1+ k)2

South-Western / Thomson Learning © 2004 7 - 26

 Some Analytical Factors
 Caveats about the DDM:
The DDM is at most a useful tool in
security analysis - it requires certain
assumptions and it has shortcomings.
 False growth:
False growth occurs when a firm acquires
another firm with a lower price-earnings
ratio - historical data should always be
scrutinized carefully when used to
determine a growth rate.

South-Western / Thomson Learning © 2004 7 - 27

 False Growth

Insert Table 7-7 here.

South-Western / Thomson Learning © 2004 7 - 28

 Some Analytical Factors
 A firm’s cash flow:
The statement of cash flows is a useful
analytical tool - the cash flow from
operations figures are widely used as a
check on a firm’s earnings quality.

South-Western / Thomson Learning © 2004 7 - 29

 Some Analytical Factors
 Small-cap, mid-cap, and large-cap stocks:
Another consideration in fundamental
stock analysis relates to the size of the
firm - for example, the small firm effect.

South-Western / Thomson Learning © 2004 7 - 30

 Some Analytical Factors: Ratio Analysis
 The fundamental analyst is necessarily
interested in the firm’s accounting
statements and in the prevailing general
economic conditions.
 To assist in the analysis, several
organizations publish comparative
statistics for industry groups.
e.g. Dun and Bradstreet’s Industry Norms
& Key Business Ratios, which
includes solvency, efficiency and
profitability ratios.

South-Western / Thomson Learning © 2004 7 - 31

 Some Analytical Factors: Ratio Analysis
Dun & Bradstreet’s 14 Key Business Ratios
Solvency Ratios
1. Quick Ratio = (Cash + Accounts Receivable)/Current Liabilities
Measures ability to raise cash quickly, ignores inventory
2. Current Ratio = Current Assets/Current Liabilities
General measure of liquidity
3. Current Liabilities to Net Worth = Current Liabilities/Net Worth
Compares short-term liabilities to permanent invested capital
4. Current Liabilities to Inventory = Current Liabilities/Inventory
Measures extent to which payment of current debts relies on sale of
inventory
5. Total Liabilities to Net Worth = Total Liabilities/Net Worth
Measures firm’s reliance on debt financing
6. Fixed Assets to Net Worth = Fixed Assets/Net Worth
Measures proportion of firm’s equity tied up in long-term assets
South-Western / Thomson Learning © 2004 7 - 32
 Some Analytical Factors: Ratio Analysis
Dun & Bradstreet’s 14 Key Business Ratios
Efficiency Ratios
7. Collection Period = Accounts Receivable/Credit Sales per Day
Measures firm’s efficiency in turning credit sales into cash
8. Sales to Inventory = Annual Net Sales/Inventory
Measures speed that inventory moves from shelf to customer
9. Assets to Sales = Total Assets/Net Sales
Measures efficiency with which assets are used to produce sales
10. Sales to Net Working Capital = Sales/Net Working Capital
Measures aggressiveness or conservatism in financing sales
11. Accounts Payable to Sales = Accounts Payable/Annual Net Sales
Measures how rapidly company pays its suppliers

South-Western / Thomson Learning © 2004 7 - 33

 Some Analytical Factors: Ratio Analysis
Dun & Bradstreet’s 14 Key Business Ratios
Profitability Ratios
12. Return on Sales (Profit Margin) = Net Profit after Taxes/Annual Net
Sales
Measures profit per dollar of net sales
13. Return on Assets = Net Profit after Taxes/Total Assets
Measures company’s efficiency in using assets to produce operating profit
14. Return on New Worth (Return on Equity) = Net Profit after Taxes/Net
Worth
Measures return to the suppliers of equity capital

South-Western / Thomson Learning © 2004 7 - 34

 Some Analytical Factors: Cooking the Books

 All publicly traded firms in the United States

must have their financial statements
audited to ensure they fairly present the
company’s financial position.
 Still, every year, there is at least one story of
accounting fraud at a major firm.
Unfortunately, there is not much the analyst
can do about fraud.

South-Western / Thomson Learning © 2004 7 - 35

 Review
 Valuation Philosophies
 Investors’ Understanding of Risk Premiums
 The Time Value of Money

 The Importance of Cash Flows

 The Tax Factor

 EIC Analysis

 Value vs. Growth Investing

 The Value Approach to Investing
 The Growth Approach to Investing

 How Price Relates to Value

 Value Stocks and Growth Stocks:

How to Tell by Looking
South-Western / Thomson Learning © 2004 7 - 36
 Review

 The Price-to-Book Ratio

 The Price-Earnings Ratio
 Differences between Industries

South-Western / Thomson Learning © 2004 7 - 37

 Review
 Some Analytical Factors
 Growth Rates
 The Dividend Discount Model

 The Importance of Hitting the Earnings Estimate

 The Multistage DDM

 Caveats about the DDM

 False Growth

 A Firm’s Cash Flows

 Small-Cap, Mid-Cap, and Large-Cap Stocks

 Ratio Analysis

 Cooking the Books

South-Western / Thomson Learning © 2004 7 - 38