Post on 05-Apr-2018
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Analysis of Investments and
Management of Portfolios
by Keith C. Brown & Frank K. Reilly
Analysis of Investments and
Management of Portfolios
by Keith C. Brown & Frank K. Reilly
Ch
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Company Analysis &
Stock Valuation
Company Analysis &
Stock ValuationCompany Analysis versus Stock Valuation
Economic, Industry, and Structural Links
to Company Analysis
Company AnalysisEstimating Intrinsic Value
Analysis of Growth Companies
Measures of Value Added
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Company Analysis and Stock ValuationCompany Analysis and Stock Valuation
After analyzing the economy and stockmarkets 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?
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Company Analysis and Stock ValuationCompany Analysis and Stock Valuation
Good companies are not necessarily goodinvestments
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
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Growth companies have historically beendefined 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 CompaniesGrowth Companies
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Growth StocksGrowth Stocks
Growth stocks are not necessarily shares ingrowth 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
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Defensive Companies and StocksDefensive Companies and Stocks
Defensive Companies The firms whose future earnings are more likely to
withstand an economic downturn
Low business risk
No excessive financial risk
Typical examples are public utilities or grocery
chainsfirms that supply basic consumer
necessities
Defense Stocks
The rate of return is not expected to decline or
decline less than the overall market decline
Stocks with low or negative systematic risk
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Cyclical Companies and StocksCyclical Companies and Stocks
Cyclical Companies They are the companies whose sales and earnings
will be heavily influenced by aggregate business
activity
Examples would be firms in the steel, auto, or heavymachinery industries.
Cyclical Stocks
They will have greater changes in rates of return
than the overall market rates of return
They would be stocks that have high betas.
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Speculative Companies and StocksSpeculative Companies and Stocks
Speculative Companies They are the firms whose assets involve great risk
but those that also have a possibility of great gain
A good example of a speculative firm is one
involved in oil exploration
Speculative Stocks
Stocks possess a high probability of low or negative
rates of return and a low probability of normal or
high rates of return
For example, an excellent growth company whose
stock is selling at an extremely high P/E ratio
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Value versus Growth InvestingValue versus Growth Investing
Growth stocks will have positive earningssurprises and above-average risk adjusted
rates of return because the stocks are
undervalued
Value stocks appear to be undervalued forreasons besides earnings growth potential
Value stocks usually have low P/E ratio or low
ratios of price to book value
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Economic, Industry, and Structural Links to
Company Analysis
Economic, Industry, and Structural Links to
Company Analysis
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 stocks intrinsic value based
on growth and risk
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Economic and Industry InfluencesEconomic and Industry Influences
If trends are favorable for an industry, thecompany analysis should focus on firms in
that industry that are positioned to benefit
from the economic trends
Firms with sales or earnings particularlysensitive to macroeconomic variables should
also be considered
Research analysts need to be familiar withthe cash flow and risk of the firms
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Structural InfluencesStructural Influences
Social trends, technology, political, and regulatoryinfluences can have significant influence on firms
Firms can grow and succeed despite unfavorable
industry or economic conditions due to demographic
changes or shifts in consumer tastes and lifestyles Early stages in an industrys life cycle see changes
in technology which followers may imitate and
benefit from
Politics and regulatory events can createopportunities even when economic influences are
weak
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Company AnalysisCompany Analysis
Firms Overall Strategic Approach Industry competitive environment
SWOT analysis Strengths
Weaknesses
Opportunities
Threats
Firms Valuation Approaches Present value of cash flows
Relative valuation ratio techniques
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Firm Competitive StrategiesFirm Competitive Strategies
Defensive strategy involves positioning firm sothat 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
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Firm Competitive StrategiesFirm Competitive Strategies
Porter suggests two major strategies: Low-Cost Strategy
The firm seeks to be the low-cost producer, and hence
the cost leader in its industry
Cost advantages vary by industry and might includeeconomies of scale, proprietary technology, or
preferential access to raw materials
Differentiation Strategy
Firm positions itself as unique in the industry in anarea that is important to buyers
A company can attempt to differentiate itself based
on its distribution system or some unique marketing
approach
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Focusing a StrategyFocusing 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
See Exhibit 14.1
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Exhibit 14.1Exhibit 14.1
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SWOT AnalysisSWOT Analysis
Internal Analysis Strengths
Give the firm a comparative advantage in the
marketplace
Perceived strengths can include good customerservice, high-quality products, strong brand
image, customer loyalty, innovative R&D, market
leadership, or strong financial resources
Weaknesses
Weaknesses result when competitors have potentially
exploitable advantages over the firm
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SWOT AnalysisSWOT Analysis
External Analysis Opportunities
These are environmental factors that favor the firm
They may include a growing market for the firms
products (domestic and international), shrinkingcompetition, favorable exchange rate shifts, or
identification of a new market or product segment
Threats
They are environmental factors that can hinder the
firm in achieving its goals
Examples would include a slowing domestic economy,
additional government regulation, an increase in
industry competition, threats of entry, etc
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Some Lessons from Peter LynchSome Lessons from Peter Lynch
Favorable Attributes of Firms Firms product should not be faddish
Firm should have some long-run comparative
advantage over its rivals
Firms industry or product has market stability
Firm can benefit from cost reductions
Firms that buy back shares show there are putting
money into the firm
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Tenets of Warren BuffetTenets of Warren Buffet
Business Tenets Is the business simple and understandable?
Does the business have a consistent operating
history?
Does the business have favorable long-termprospects?
Management Tenets
Is management rational?
Is management candid with its shareholders?
Does management resist the institutional
imperative?
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Tenets of Warren BuffetTenets of Warren Buffet
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?
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Estimating Intrinsic ValueEstimating Intrinsic Value
Present value of cash flows (PVCF) Present value of dividends (DDM)
Present value of free cash flow to equity (FCFE)
Present value of free cash flow (FCFF)
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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Present Value of DividendsPresent Value of Dividends
Simplifying assumptions help in estimatingpresent value of future dividends
Constant Growth DDM
Intrinsic Value = D1
/(k-g) and D1
= D0
(1+g)
Growth Rate Estimates
Average Dividend Growth Rate
Sustainable Growth Rate
g = RR X ROE
1n
D
D
0
n=
g
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Present Value of DividendsPresent Value of Dividends
Required Rate of Return Estimate Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the firms
characteristic line using regression
E(RFR)])E(R[E(RFR)R marketstockstock +=
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Present Value of DividendsPresent Value of Dividends
The Present Value of Dividends Model (DDM) Model requires k>g
With g>k, analyst must use multi-stage model
The three-stage model example of the DDM
approach in the book illustrates how to estimate the
stock price experiences (1) high growth at 13% (2)
declining growth (3) a constant perpetual growth of 7
percent
fP t V l f
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Present Value ofFree Cash Flow to Equity
Present Value ofFree Cash Flow to Equity
Computing the FCFEFCFE =Net Income
+ Depreciation Expense
- Capital Expenditures- in Working Capital
- Principal Debt Repayments
+ New Debt Issues
P V l fP t V l f
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Present Value ofFree Cash Flow to Equity
Present Value ofFree Cash Flow to Equity
The Constant Growth Formula
where:
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
A multi-stage model similar to DDM can also
be applied
FCFEgk
FCFEValue
=1
fP t V l f
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Present Value ofOperating Free Cash Flow
Present Value ofOperating Free Cash Flow
Discount the firms operating free cash flow tothe firm (FCFF) at the firms weighted average
cost of capital (WACC)
Computing FCFF
FCFF =EBIT (1-Tax Rate)
+ Depreciation Expense
- Capital Spending
- in Working Capital
- in other assets
P t V l fP t V l f
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The Formula
where: FCFF1 = the free cash flow in period 1
OFCF1 = the firms operating free cash flow in period 1
WACC = the firms weighted average cost of capital
gFCFF = the constant growth rate of free cash flow
gOFCF = the constant growth rate of operating free cash flow
OFCF
FCFF
gWACCOFCFor
gWACC
FCFFValueFirm
=
1
1
Present Value ofOperating Free Cash Flow
Present Value ofOperating Free Cash Flow
P t V l fP t V l f
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An alternative measure of long-run growthg = (RR)(ROIC)
where:
RR = the average retention rate
ROIC = EBIT (1-Tax Rate)/Total Capital
Computation of WACC
WACC=WE k+ WD i
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
Present Value ofOperating Free Cash Flow
Present Value ofOperating Free Cash Flow
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Relative Valuation Ratio TechniquesRelative Valuation Ratio Techniques
The general relative valuation ratio techniqueshave been discussed in the previous chapters
Exhibit 14.3 contains the basic data required to
compute the relative valuation ratios
Exhibit 14.4 contains the four sets of relative
valuation ratios for Walgreens, its industry, and
the aggregate market
Due to the size, these two exhibits are notshown here
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Estimating Company Earnings Per ShareEstimating Company Earnings Per Share
A Two-Step Process Sales Forecast
It includes an analysis of the relationship of company
sales to various relevant economic series
It also includes a comparison with the industry series
Estimated Profit Margin
Identification and evaluation of the firms specific
competitive strategy
The firms internal performance
The firms relationship with its industry
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Walgreens Competitive StrategiesWalgreens Competitive Strategies
The Internal Performance Industry Factors
Company Performance
Net Profit Margin Estimate
Computing Earnings per Share
Importance of Quarterly Estimates
A way to confirm our annual estimate
If the actual quarterly results are a surprise relativeto our estimate, we will want to understand the
reason for the surprise
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Estimating Company Earnings MultipliersEstimating Company Earnings Multipliers
Macroanalysis of the Earnings Multiplier Microanalysis of the Earnings Multiplier
Comparing dividend-payout ratios
Estimating the required rate of return
Estimating the expected growth rate
Computing the earnings multiplier
Estimates of intrinsic value for Walgreens
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Additional Measures of Relative ValueAdditional Measures of Relative Value
Price/Book Value Ratio Book value is a reasonable measure of value for
firms that have consistent accounting practice
It can been applied to firms with negative earnings
or cash flows should not attempt to use this ratio to compare firms
with different levels of hard assetsfor example, a
heavy industrial firm and a service firm
See Walgreens in Exhibits 14.16 & 14.17
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Exhibit 14.16Exhibit 14.16
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Exhibit 14.17Exhibit 14.17
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Additional Measures of Relative ValueAdditional Measures of Relative Value
Price/Cash Flow Ratio The price/cash flow ratio has grown in prominence
and use because many observers contend that a
firms cash flow is less subject to manipulation
See Walgreens in Exhibits 14.18 & 14.19 Price-to-Sales Ratio
Sales growth drives the growth of all subsequent
earnings and cash flow and sales is one of the
purest numbers available See Walgreens in Exhibits 14.20 & 14.21
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Exhibit 14.18Exhibit 14.18
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Exhibit 14.19Exhibit 14.19
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Exhibit 14.20Exhibit 14.20
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Exhibit 14.21Exhibit 14.21
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Analysis of Growth CompaniesAnalysis of Growth Companies
Generating rates of return greater than thefirms 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 No growth firms
Long-run growth models
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A No-Growth Firm E = r x Assets
E = r x Assets = Dividends (Firms has retention
ratio, b, of 0)
Firm Value
Required Rate of Return
No-Growth FirmNo-Growth Firm
( )
k
Eb
k
EV
==
1
v
Ek=
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Long-Run Growth ModelsLong-Run Growth Models
Simple Growth Model It assumes the firm has growth investment
opportunities that provide rates of return equal to r,
where ris greater than k
r=mk (m is the relative rate of return operator) D=E (1-b)
Gross Present Value of Growth Investments
Net Present Value of Growth Investments
k
bEm
k
bEmk
=2
k
bE
k
bEm
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Long-Run Growth ModelsLong-Run Growth Models
Simple Growth Model (continued) Firm Value
PV of Constant Dividend + PV of Growth Investment
PV of Constant Earnings + PV of Excess Earningsfrom Growth Investment
( )
k
mbE
k
EV
1+=
k
bEm
k
DV +=
k
bE
k
bEm
k
EV +=
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Long-Run Growth ModelsLong-Run Growth Models
Expansion Model Firm retains earnings to reinvest, but receives a rate
of return on its investment equal to its cost of capital
In this case, m = 1 so r = k
Firm Value Recall the simple growth model
When m=1k
(mbE
k
EV
1)+=
k
EV=
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Long-Run Growth ModelsLong-Run Growth Models
Negative Growth Model Firm retains earnings, but reinvestment returns are
below the firms cost of capital. That is, r1
Since growth will be positive (r>0) but slower than it
should be (r
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Long-Run Growth ModelsLong-Run Growth Models
The Capital Gain Component The gross present value of growth investments
bEm / k
The three factors that influence the capital gain
component:
The amount of capital invested in growth
investments (b)
The relative rate of return earned on the funds
retained (m)
The time period for these growth investments
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Long-Run Growth ModelsLong-Run Growth Models
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
In this case, r>k and m>1
Firm value for the dynamic growth model for an
infinite time period
gk
DV
= 1
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Measures of Value-AddedMeasures of Value-Added
Economic Value-Added (EVA) It is equal to the net operating profit less adjusted
taxes (NOPLAT) minus the firms total cost of capital
in dollar terms, including the cost of equity
EVA Return on Capital EVA/Capital
This ratio can compare firms of different sizes and
determine which firm has the largest economic profit
per dollar of capita Alternative Measure of EVA
Compare return on capital to cost of capital
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Measures of Value-AddedMeasures 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 capitalinvested in the firm
Relationships between EVA and MVA
mixed results
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Measures of Value-AddedMeasures 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
where R= the expected return on the new opportunities
k=the current cost of equity
r = the current ROEon investment
G= the PV of the new growth projects relative to the
Grk
kR
=
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Growth Duration ModelGrowth Duration Model
The purpose is to evaluate the high P/E ratiofor the stock of a growth company by relatingits P/E ratio to the firms rate of growth andduration of growth
A stocks P/E is function of expected rate of growth of earnings per share stocks required rate of return firms dividend-payout ratio
The growth estimate must consider both therate of growth and how long this growth rate
can be sustainedthat is, the duration of the
expected growth rate
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Intra-Industry AnalysisIntra-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
Si Vi i d h A f h I i
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Site Visits and the Art of the InterviewSite Visits and the Art of the Interview
Focus on managements plans, strategies, andconcerns
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
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When to SellWhen to Sell
Holding a stock too long may lead to lowerreturns 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
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Influences on AnalystsInfluences on Analysts
Efficient Markets In most instances, the value estimated for a stock will
be very close to its market price, which indicates thatit is properly valued
Paralysis of Analysis To earn above-average returns, there are two
requirements: (1) the analyst must have expectationsthat differ from the consensus, and(2) the analystmust be correct
Analyst Conflicts of InterestA potential conflict can arise if communication occurs
between a firms investment banking and equityresearch division
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Efficient MarketsEfficient 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
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Analyst Conflicts of InterestAnalyst Conflicts of Interest
Investment bankers may push for favorableevaluations
Corporate officers may try to convince analysts
Analyst must maintain independence and have
confidence in his or her analysis
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Global Company and Stock AnalysisGlobal Company and Stock Analysis
Factors to ConsiderAvailability of Data
Differential Accounting Conventions
Currency Differences (Exchange Rate Risk)
Political (Country) Risk Transaction Costs and Liquidity
Valuation Differences
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