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## Chapter 15

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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**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**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**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