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### Chapter 15

COMPANY ANALYSIS AND STOCK VALUATION

Chapter 15 Questions

- Why is it important to differentiate between company analysis and stock analysis?
- What is the difference between a growth company and a growth stock?
- When valuing an asset, what are the required inputs?
- After an investor has valued an asset, what is the investment decision process?
- How is the value of bonds determined?

Chapter 15 Questions

- What are the two primary approaches to the valuation of common stock?
- How do we apply the discounted cash flow valuation approach, and what are the major discounted cash flow valuation techniques?
- What is the dividend discount model (DDM), and what is its logic?
- What is the effect of the assumptions of the DDM when valuing a growth company?

Chapter 15 Questions

- How do we apply the DDM to the valuation of a firm that is expected to experience temporary supernormal growth?
- How do we apply the relative valuation approach to valuation, and what are the major relative valuation techniques (ratios)?
- How can the DDM be used to develop an earnings multiplier model?
- What does the DDM model imply are the factors that determine a stock’s P/E ratio?

Chapter 15 Questions

- What are some economic, industry, and structural links that should be considered in company analysis?
- What insights regarding a firm can be derived from analyzing its competitive strategy and from a SWOT analysis?
- What techniques can be used to estimate the inputs to alternative valuation models?
- What techniques aid estimating company sales?

Chapter 15 Questions

- How do we estimate the profit margins and earnings per share for a company?
- What procedures and factors do we consider 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?
- When should we consider selling a stock?

Company Analysis and Stock Selection

- Good companies are not necessarily good investments
- In the end, we want to compare the intrinsic value of a stock to its market value
- Stock of a great company may be overpriced
- Stock of a lesser company may be a superior investment since it is undervalued

Growth Companies and Growth Stocks

- Companies that consistently experience above-average increases in sales and earnings have traditionally been thought of as growth companies
- Limitations to this definition

- Financial theorists define a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return

Growth Companies and 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 under-valuation compared to other stocks

- Studies indicate that growth companies have generally not been growth stocks

Defensive Companies and Stocks

- Defensive companies’ future earnings are more likely to withstand an economic downturn
- Low business risk
- Not excessive financial risk

- Defensive stocks’ returns are not as susceptible to changes in the market
- Stocks with low systematic risk

Cyclical Companies and Stocks

- Sales and earnings heavily influenced by aggregate business activity
- High business risk
- Sometimes high financial risk as well

- Cyclical stocks experience high returns is up markets, low returns in down markets
- Stocks with high betas

Speculative Companies and Stocks

- Speculative companies invest in sssets involving great risk, but with the possibility of great gain
- Very high business risk

- Speculative stocks have the potential for great percentage gains and losses
- May be firms whose current price-earnings ratios are very high

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

The Search for True Growth Stocks

- To find undervalued stocks, we must understand the theory of valuation itself

Theory of Valuation

- The value of a financial asset is the present value of its expected future cash flows
- Required inputs:
- The stream of expected future returns, or cash flows
- The required rate of return on the investment

Stream of Expected Returns (Cash Flows)

From of returns

- Depending on the investment, returns can be in the form of:
- Earnings
- Dividends
- Interest payments
- Capital gains
Time period and growth rate of returns

- When will the cash flows be received from the investment?

Required Rate of Return

- Determined by the risk of an investment and available returns in the market
- Determined by:
- The real risk-free rate of return, plus
- The expected rate of inflation, plus
- A risk premium to compensate for the uncertainty of returns
- Sources of uncertainty, and therefore risk premiums, vary by the type of investment

Investment Decision Process

- Once expected (intrinsic) value is calculated, the investment decision is rather straightforward and intuitive:
- If Estimated Value > Market Price, buy
- If Estimated Value < Market Price, do not buy

- The particulars of the valuation process vary by type of investment

Valuation of Alternative Investments

We will consider the valuation of two important types of investments:

- The valuation of bonds
- The valuation of common stock

Valuation of Bonds

What are the cash flows?

- Bond cash flows (typically fixed)
- Interest payments every six months equal to one-half of: (Coupon rate x Face value)
- The payment of principal (Face or par value) at maturity

- Discount at the required rate of return to find the bond’s value
- Process made relatively easy with a financial calculator or spreadsheet software

Approaches to Common Stock Valuation

- Discounted Cash Flow Techniques
- Present value of Dividends (DDM)
- Present value of Operating Cash Flow
- Present value of Free Cash Flow

- Relative valuation techniques
- Price-earnings ratio (P/E)
- Price-cash flow ratios (P/CF)
- Price-book value ratios (P/BV)
- Price-sales ratio (P/S)

Discounted Cash Flow Techniques

- Based on the basic valuation model: the value of a financial asset is the present value of its expected future cash flows
Vj = SCFt/(1+k)t

- The different discounted cash flow techniques consider different cash flows and also different appropriate discount rates

Dividend Discount Models

Simplifying assumptions help in estimating present value of future dividends

Vj = SDt/(1+k)t

- Can also assume various dividends for a finite period of time with a reselling price, and simply calculate the combined present value of the dividends

Dividend Discount Models

Alternative dividend assumptions

- Constant Growth Model:
- Assumes dividends started at D0 (last year’s dividend) and will grow at a constant growth rate
- Growth will continue for an infinite period of time
- The required return (k) is greater than the constant rate of growth (g)
V = D1/(k-g)

where D1= D0(I+g)

Dividend Discount Models

- Constant Growth Model
- Growth rate
- Can be estimated from past growth in earnings and dividends
- Can be estimated using the sustainable growth model

- Discount rate
- Would consider the systematic risk of the investment (beta)
- Capital Asset Pricing Model

- Growth rate

Dividend Discount Models

- Valuation with Temporary Supernormal Growth
- If you expect a company to experience rapid growth for some period of time
- Find the present value of each dividend during the supernormal growth period separately
- Find the present value of the remaining dividends when constant growth can be assumed.
- Find the present value of the remaining dividends by finding the present value of the estimate obtained in step 2.

Present Value of Operating Cash Flows

- Another discounted cash flow approach is to discount operating cash flows
- Operating cash flows are pre-interest cash flows, so the required rate of return would be adjusted to incorporate the required returns of all investors (use the WACC)
VFj = SOCFt/(1+WACCj)t

- Operating cash flows are pre-interest cash flows, so the required rate of return would be adjusted to incorporate the required returns of all investors (use the WACC)

Present Value of Operating Cash Flows

- If we further assume a growth rate of gOCF for operating cash flows, we can value the firm as:
VFj = OCFt/(WACCj – gOCF)

Present Value of Free Cash Flow to Equity

- A third discounted cash flow technique is to consider the free cash flows of a firm available to equity as the cash flow stream to be discounted.
- Since this is an equity stream, the appropriate discount rate is the required return on equity
VSj = SFCFt/(1+kj)t

Present Value of Free Cash Flow to Equity

- Once again, if we constant growth in free cash flows, this expression reduces to the following
VSj = FCFt/(kj – gFCF)

Relative Valuation Techniques

These techniques assume that prices should have stable and consistent relationships to various firm variables across groups of firms

- Price-Earnings Ratio
- Price-Cash Flow Ratio
- Price-Book Value Ratio
- Price-Sales Ratio

Relative Valuation Techniques

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

Relative Valuation Techniques

- 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-Earnings Ratio

- Look at the relationship between the current market price and expected earnings per share over the next year
- The ratio is the earnings multiplier, and is a measure of the prevailing attitude of investors regarding a stock’s value

- P/E factors
- Expected growth in dividends and earnings
- Required rate of return on the stock

Price-Earnings Ratio

- Using the P/E approach to valuation:
- Estimate earnings for next year
- Estimate the P/E ratio (Earnings Multiplier)
- Multiply expected earnings by the expected P/E ratio to get expected price
V =E1x(P/E)

Price-Cash Flow Ratio

- Cash flows can also be used in this approach, and are often considered less susceptible to manipulation by management.
- The steps are similar to using the P/E ratio
V =CF1x(P/CF)

Price-Book Value Ratio

- Book values can also be used as a measure of relative value
- The steps to obtaining valuation estimates are again similar to using the P/E ratio
V =BV1x(P/BV)

Price-Sales Ratio

- Finally, sales can be used in relation to stock price.
- Some drawbacks, in that sales do not necessarily produce profit and positive cash flows
- Advantage is that sales are also less susceptible to manipulation

- The steps are similar to using the P/E ratio
V =S1x(P/S)

Company Analysis: Examining Influences

- 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 stock’s 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 industry’s 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

- Competitive forces necessitate competitive strategies.
- Competitive Forces:
- Current rivalry
- Threat of new entrants
- Potential substitutes
- Bargaining power of suppliers
- Bargaining power of buyers

- SWOT analysis is another useful tool

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 firm’s 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
- Must still command prices near industry average, so still must differentiate
- Discounting too much erodes superior rates of return

Differentiation Strategy

- Seeks to be identified 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

- Firms with focused strategies:
- Select segments in the industry
- Tailor the strategy to serve those specific groups
- Determine which strategy a firm is pursuing and its success
- Evaluate the firm’s competitive strategy over time

SWOT Analysis

- Examination of a firm’s:
- Strengths
- Competitive advantages in the marketplace

- Weaknesses
- Competitors have exploitable advantages of some kind

- Opportunities
- External factors that make favor firm growth over time

- Threats
- External factors that hinder the firm’s success

- Strengths

Favorable Attributes of Firms

- Peter Lynch’s list of favorable attributes:
- Firm’s product is not faddish
- Company has competitive advantage over rivals
- Industry or product has potential for market stability
- Firm can benefit from cost reductions
- Firm is buying back its own shares or managers (insiders) are buying

Categorizing Companies

- Lynch further recommends the following categorization of firms:
- Slow growers
- Stalwart
- Fast growers
- Cyclicals
- Turnarounds
- Asset plays

Specific Valuation with the P/E Ratio

- Earnings per share estimates
- Time series – use statistical analysis
- Sales - profit margin approach
- EPS = (Sales Forecast x Profit Margin)/ Number of Shares Outstanding

- Judgmental approaches to estimating earnings
- Last year’s income plus judgmental evaluations
- Using the consensus of analysts’ earnings estimates

- Once annual estimates are obtained, do quarterly estimates and interpret announcements accordingly

Site Visits, Interviews, and Fair Disclosure

- Fair Disclosure (FD) requires that all disclosure of material information be made public to all interested parties at the same time
- Many firms will not allow interviews with individuals, only provide information during large public presentations

- Analysts now talk to people other than top managers
- Customers, suppliers

Making the Investment Decision

- If the estimate of the stock’s intrinsic value is greater than or equal to the current market price, buy the stock
- If your estimate of the stock’s future intrinsic value would yield a return greater than your required rate of return (based on current investment price), then buy the stock
- If the value is less than its current price, or its return would be less than your required rate of return, do not buy the stock

When to Sell

- Hold on or move on?
- If stocks decline right after purchase, is that a further buying opportunity or a signal of a mistaken investment?
- Continuously monitor key assumptions that led to the purchase of the investment
- Know why you bought, and see if conditions have changed

- Evaluate when market value approaches estimated intrinsic value

Influences on Analysts

Several factors make it difficult for analysts to outperform the market

- Efficient Markets
- Markets tend to price securities correctly, so opportunities are rare
- Most opportunities are likely in small, less followed companies

- Paralysis of Analysis
- Must see the forest (the appropriate recommendation) despite all of the trees (data) that complicate the decision

Influences on Analysts

- Investment bankers may push for favorable evaluations of securities when the same firm does (or wants to do) underwriting business with the firm in question
- Are analysts independent and unbiased in their recommendations?
- Ideally, analysts will remain independent and show confidence in their analyses

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