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to accompany

Portfolio Management

Seventh Edition

by

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?

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?

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 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 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 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

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

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

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

SWOT analysis

Present value of cash flows

Relative valuation ratio techniques

Current rivalry

Threat of new entrants

Potential substitutes

Bargaining power of suppliers

Bargaining power of buyers

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

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

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

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?

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)

2. Price cash flow ratios (P/CF)

3. Price book value ratios (P/BV)

4. Price sales ratio (P/S)

Simplifying assumptions help in estimating

present value of future dividends

Assumption of constant growth rate

Intrinsic Value = D1/(k-g)

D1= D0(1+g)

Average Dividend Growth Rate

Dn

1

D0

Average Dividend Growth Rate

Dn

1

D0

Nominal risk-free interest rate

Risk premium

Market-based risk estimated from the firms

characteristic line using regression

Nominal risk-free interest rate

Risk premium

Market-based risk estimated from the firms

characteristic line using regression

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

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

Price Earnings Ratio

D1 / E1

P / E1

kg

Price Earnings Ratio

D1 / E1

P / E1

kg

1. Required rate of return on its equity (k)

2. Expected growth rate of dividends (g)

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)

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)

Price/Book Value 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)

Price/Book Value Ratio

Price-to-Sales Ratio

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?

Growth companies and the DDM

constant growth model not appropriate

no growth firm

E = r X Assets = Dividends

E 1 b E

V

k

k

E

k

v

Long-run growth models

assumes some earnings are reinvested

bEmk bEm

2

k

k

bEm bE

k

k

E bEm bE

E 1 b bEm

v

k

k

k

k

k

E bEm bE

v

k

k

k

D bEm

v

k

k

E 1 b bEm

v

k

k

the Present Value of Growth Investment)

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

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

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

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/Capital

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

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

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

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

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

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

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