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Lecture Presentation Software

to accompany

Investment Analysis and


Portfolio Management
Seventh Edition
by

Frank K. Reilly & Keith C. Brown

Chapter 15

Chapter 15 - Company
Analysis and Stock Valuation
Questions to be answered:
Why is it important to differentiate between
company analysis and stock valuation?
What is the difference between a growth
company and a growth stock?
How do we apply the two valuation
approaches and the several valuation
techniques to Walgreen?

Chapter 15 - Company
Analysis and Stock Valuation
What techniques are useful when
estimating 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?

Chapter 15 - Company
Analysis and Stock Valuation
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?

Chapter 15 - Company
Analysis and Stock Valuation
In addition to the earnings multiplier,
what are some other relative valuation
ratios?
How do you apply the several present
value of cash models to the valuation of a
company?
What value-added measures are available
to evaluate the performance of a firm?

Chapter 15 - Company
Analysis and Stock Valuation
How do we compute economic valueadded (EVA), market value-added
(MVA), and the franchise value for a
firm?
What is the relationship between these
value-added measures and changes in the
market value of firms?

Chapter 15 - Company
Analysis and Stock Valuation
When should we consider selling a stock?
What is meant by a true growth company?
What is the relationship between positive
EVA and a growth company?

Chapter 15 - Company
Analysis and Stock Valuation
Why is it inappropriate to use the
standard dividend discount model 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 when
analyzing a true growth company and
evaluating its stock?

Chapter 15 - Company
Analysis and Stock Valuation
How can you use the growth duration
model to derive an estimate of the P/E for
Walgreens?
What are some additional factors that
should be considered when analyzing a
company on a global basis?

Company Analysis and Stock Valuation


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 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

Firm Competitive Strategies

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

Some Lessons from Peter Lynch


Favorable Attributes of Firms
1. Firms product should not be faddish
2. Firm should have some long-run comparative
advantage over its rivals
3. Firms industry or product has market stability
4. Firm can benefit from cost reductions
5. Firms that buy back shares show there are putting
money into the firm

Tenets of Warren Buffet

Business Tenets
Management Tenets
Financial Tenets
Market Tenets

Business Tenets
Is the business simple and understandable?
Does the business have a consistent
operating history?
Does the business have favorable long-term
prospects?

Management Tenets
Is management rational?
Is management candid with with its
shareholders?
Does management resist the institutional
imperative?

Financial Tenets
Focus on return on equity, not earnings per
share
Calculate owner earnings
Look for companies with high profit
margins
For every dollar retained, make sure the
company has created at least one dollar of
market value

Market Tenets
What is the value of the business?
Can the business be purchased at a
significant discount to its fundamental
intrinsic 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 = 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
- in Working Capital
- Principal Debt Repayments
+ New Debt Issues

Present Value of
Free Cash Flow to Equity
FCFE1
FCFE =
Value
Net Income
k

g
FCFE
+ Depreciation Expense
- Capital Expenditures
- 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
- in Working Capital - 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 Techniques


Price Earnings Ratio

D1 / E1
P / E1
kg

Relative Valuation Techniques


Price Earnings Ratio

D1 / E1
P / E1
kg

Affected by two variables:


1. Required rate of return on its equity (k)
2. Expected growth rate of dividends (g)

Relative Valuation Techniques


D1 / E1
P / E1
kg

Price Earnings Ratio


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

Price/Cash Flow Ratio

Relative Valuation Techniques


D1 / E1
P / E1
kg

Price Earnings Ratio


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

Price/Cash Flow Ratio


Price/Book Value Ratio

Relative Valuation Techniques


D1 / E1
P / E1
kg

Price Earnings Ratio


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

Price/Cash Flow Ratio


Price/Book Value Ratio
Price-to-Sales Ratio

Analysis of Growth Companies


Generating rates of return greater than the
firms cost of capital is considered to be
temporary
Earnings higher the required rate of return
are pure profits
How long can they earn these excess profits?
Is the stock properly valued?

Analysis of Growth Companies


Growth companies and the DDM
constant growth model not appropriate

Alternative growth models


no growth firm

E = r X Assets = Dividends

E 1 b E
V
k
k

E
k
v

Analysis of Growth Companies


Long-run growth models
assumes some earnings are reinvested

Simple growth model


bEmk bEm

(Gross Present Value of Growth Investments)


2
k
k
bEm bE

( Net Present Value of Growth Investments)


k
k
E bEm bE
E 1 b bEm
v

k
k
k
k
k

Simple Growth Model (cont.)


E bEm bE
v

k
k
k
D bEm
v
k
k

E 1 b bEm
v

k
k

(Present value of Constant Dividend plus


the Present Value of Growth Investment)

E bE m 1 (Present value of Constant Earnings plus the Present


v
Value of Excess Earnings from Growth Investment)
k
k

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

E E 1 b bE E
V

k
k
k
k

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

The Capital Gain Component


bEm/k
b Percentage of earnings retained for reinvestment
m relates the firms rate of return on investments and
the firms required rate of return (cost of capital)
1 = cost of capital
>1 is growth company

Time period for superior investments

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

D1
V
kg

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

Measures of Value-Added
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

Measures of Value-Added
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

Rk

G
rk

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

Growth Duration
E(t) = E (0) (1+G)t
N(t) = N(0)(1+D)t
E(t) = E(t) N(t) = E (0) [(1+G)t (1+D)]t
E(t) E (0) (1 G D) t
T

Pg (0)
E g (0) (1 G g D g )

Pd 0 E a (0) (1 G a D a )

Growth Duration
E g (0) (1 G g D g ) T

Pg (0)

Pd 0 E a (0) (1 G a D a )
(1 G g D g ) T

Pg (0)/E g (0)

Pd 0 / E a (0) (1 G a D a )
Pg (0)/E g (0)
(1 G g D g )
T ln

ln
Pd 0 / E a (0)
(1 G a D a )

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

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

Influences on Analysts
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 and Stock


Analysis
Factors to Consider:
Availability of Data
Differential Accounting Conventions
Currency Differences (Exchange Rate Risk)
Political (Country) Risk
Transaction Costs
Valuation Differences

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 16
Technical Analysis
Assumptions and Advantage
Technical Trading Rules and
Indicators
Techniques and Charts