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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?

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Chapter 15 l.jpg

Chapter 15

COMPANY ANALYSIS AND STOCK VALUATION


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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?


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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?


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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?


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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?


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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?


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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


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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


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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


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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


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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


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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


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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


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The Search for True Growth Stocks

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


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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


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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?


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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


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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


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Valuation of Alternative Investments

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

  • The valuation of bonds

  • The valuation of common stock


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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


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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)


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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


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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


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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)


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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


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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.


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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


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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)


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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


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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)


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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


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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)


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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


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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


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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)


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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)


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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)


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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)


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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Categorizing Companies

  • Lynch further recommends the following categorization of firms:

    • Slow growers

    • Stalwart

    • Fast growers

    • Cyclicals

    • Turnarounds

    • Asset plays


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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


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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


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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


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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


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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


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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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