6-Slides - Fundamental Analysis-3 and Private Company Valuation Size)

8/3/2019 6-Slides - Fundamental Analysis-3 and Private Company Valuation Size)

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11

Third Stage ofThird Stage ofFundamentalFundamentalAnalysisAnalysis

Company UsingCompany Using

Market BasedMarket BasedMethodsMethods


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FUNDAMENTAL ANALYSISFUNDAMENTAL ANALYSISPart IIIPart III

SA: Fundamental AnalysisSA: Fundamental Analysis (3) (3) 22


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3. Company Analysis3. Company Analysis

SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 33


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Why Company Analysis?Why Company Analysis?

The questions are:

Which are the best companies within desirableindustries?

Are their stocks over or under priced?


Are some stocks more valuable than others?


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Company Analysis vs. Stock ValuationCompany Analysis vs. Stock ValuationGrowth Companies vs. Growth StocksGrowth Companies vs. Growth Stocks

Growth company generates returns higher thanGrowth company generates returns higher thanits cost of capital.its cost of capital.

Growth stocks have returns higher than otherGrowth stocks have returns higher than other


..

Stocks of good companies are not necessarily goodStocks of good companies are not necessarily goodinvestments.investments.


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Company Analysis vs. Stock ValuationCompany Analysis vs. Stock Valuation

Defensive Companies and Defensive Stocks:Defensive Companies and Defensive Stocks:

Earnings of defensive companies are unlikely toEarnings of defensive companies are unlikely tosuffer from economic downturns such as firms withsuffer from economic downturns such as firms withlow business and financial risks.low business and financial risks.


Defensive stocks are likely to have small or negativeDefensive stocks are likely to have small or negativebeta beta ..


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Cyclical Companies and Cyclical StocksCyclical Companies and Cyclical Stocks

Cyclical companys revenue move with businessCyclical companys revenue move with businesscycles.cycles.

C clical stocks have hi herC clical stocks have hi her beta beta ..



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Speculative Companies and Speculative StocksSpeculative Companies and Speculative Stocks

Speculative companies have greater risk withSpeculative companies have greater risk withgreater returns.greater returns.

S eculativeS eculative stocksstocks have low chances of eneratinhave low chances of eneratin


higher returns.higher returns.


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Firm competitive strategiesFirm competitive strategiesDefensive strategy

Offensive strategyLow cost strategy

Differentiation strategy


Focusing on a strategy


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SWOT AnalysisSWOT AnalysisExamination of Firms: Examination of Firms:

Strengths,Weaknesses,

Opportunities, and


Threats.


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Estimating IV:Estimating IV: Discounted cash flow model

IV of a stock is equal to the PV of its expected cash flows. If Cis cash flow and k is required rate of return then:

1 1

(1 ) (1 )t t

t

C IV IV

k k + += +

+ +Similarly: 2 21 (1 ) (1 )

t t t

C IV IV

k k + +

+ = ++ +


By substitution: 1 2 22 2(1 ) (1 ) (1 )t t t

t C C IV IV

k k k + + += + +

+ + +

and so on

Thus, IV is the PV of all future cash flows and terminal price.

What are the possible forms of cash flows available toshareholders?


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Discounted CashDiscounted Cash- -flow: An exampleflow: An example 11

SP Plc paid a dividend of 2.93 per share today. 4 years ago itSP Plc paid a dividend of 2.93 per share today. 4 years ago itwas only 2. It is expected that the companys dividends wouldwas only 2. It is expected that the companys dividends wouldgrow at this rate for next 3 years. Thereafter the growth ingrow at this rate for next 3 years. Thereafter the growth individend is expected to be only 5% per year. The required rate of dividend is expected to be only 5% per year. The required rate of return is 20% and the current market price per share is 24.return is 20% and the current market price per share is 24.


u v y - w vshareholders).

Ms Salford approached you for your advice with the aboveMs Salford approached you for your advice with the aboveinformation. Should Ms Salford be buying these shares at theinformation. Should Ms Salford be buying these shares at thecurrent market price of 24.current market price of 24.


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Discounted CashDiscounted Cash- -flow: An exampleflow: An example22

D(t-4) = 2.00 Dividend 4 years agoD

t= 2.93 Dividend today

G 1 = 10.0% Dividend growth rate during the past 4years and expected for the next 3 years

=


1 14 4

01

4

2.931 1 0.10 10%

2.00t

DG

D

= = = =

Calculation of growth rate (G 1):

.R = 20.0% Required rate of return


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1 1

(1 ) (1 )t t

t

C IV IV

k k + += +

+ +

The calculation process can be simplified as follows:

Recall:

Year Dividend Growth rate DF at 20% Present Value


. . . .2 3.55 10.0% 0.6944 2.46

3 3.90 10.0% 0.5787 2.264 4.10 5.0%

The sum of the PV the next 3 years dividend is 7.41


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Discounted CashDiscounted Cash- -flow: An exampleflow: An example 33In year 4, the dividend per share is expected to be 4.10.Now, estimate the price of the share at the end of year 3based on the dividend of year 4 and a constant growth rateof 5%. This is estimated as:

4 4.10 27.33 DP = = =


. .

r - g The price per share at the end of year 3 should be 27.33.

Discount 27.33 by 20% per annum (required rate of return)to estimate its present value.The PV is 15.82 (27.31*0.5787).


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Finally, to get the current intrinsic value of the share addthe PV of dividend receivable during the next 3 years(7.41) and the PV of the price at the end of year-3(15.82) together.

Thus, IV is 23.23 , (7.41+15.82).


The current market price (24.00) of this share is higherthan its intrinsic ( IV < MV). It is overpriced! Ms Salfordshould not buy these shares.


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Implementing theImplementing theImplementing theImplementing theImplementing theImplementing theImplementing theImplementing the modelmodelmodelmodelmodelmodelmodelmodel 11111111

Sources of growth rates:Sources of growth rates:

(a)(a) Analysts forecastsAnalysts forecasts(b)(b) Investment plans of companiesInvestment plans of companies

SA:SA: Fundamental Analysis (3)Fundamental Analysis (3) 1717

a na ys s orecas s:a na ys s orecas s:( ) ( )

( )2 1

1

t t t

t

E EPS E EPSg

E EPS+ +

+

=


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(b) Investment plans:(b) Investment plans:E = ROE * Investment

= ROE * retentions= ROE * (retention ratio * earnings)= *

Implementing theImplementing theImplementing theImplementing theImplementing theImplementing theImplementing theImplementing the modelmodelmodelmodelmodelmodelmodelmodel 22222222


**

E ROE bE g ROE b

E E

= = =


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Cost of capital estimated using dividend growth modelis sensitive to the choice of growth rate in dividends.

Discounted cash flow, Growth rateDiscounted cash flow, Growth rateand the Cost of capitaland the Cost of capital

Davies et al (1999):Davies et al (1999):


Boots BP MKS ULVRH= 0 5.85 5.90 5.40 5.14

H= 5 6.76 7.13 6.39 5.74

H= 10 7.67 8.36 7.36 6.34


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Discounted Cash Flow Model:An Appraisal

Simple to useEstimate of IV is sensitive to gIt cannot be applied:

-


if g k (in a constant growth model)

Definition and measurement of cash-flow

Overall, discounted cash-flow method of stock valuationoffers simplicity but suffers from some limitations.


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Summary: Fundamental AnalysisSummary: Fundamental Analysis

Stock Mkt. Value Intrinsic Value Strategy

A 20 24 buy

B 23 23 hold

C 45 40 sell

Consider the following:


se

E 18 22 buy

F 32 32 hold

Overall, the challenge to security analysts is to estimate IV.

Analysts should consider global & domestic macroeconomic,industry, and firm specific factors in valuing the common stocks.


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Essential ReadingsEssential Readings

Bodie, Z., A. Kane and A. J. Marcus, (2008), Investments ,Irwin (BKN). Chapter 18

Davies, R., P. Draper, S. Unni and K. Paudyal (1999), The Cost of Equity Capital, The Chartered Institute of Management Accountants.


Reilly, F. K., and K. C. Brown (2006), Investment Analysis and Portfolio Management , Thomson South-Western, Chapter14.

See Supplementary Reading list for further references.


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Seminar questionsSeminar questions

1.1. The discounted cashThe discounted cash- -flow method sounds logical in valuingflow method sounds logical in valuingshares. However, it is not free from limitations. Comment.shares. However, it is not free from limitations. Comment.

2.2. In the recent past In the recent past LanchesterLanchester Plc. has been earning 3 millionPlc. has been earning 3 milliona year and its management is confident that this will bea year and its management is confident that this will bemaintained in the future from existing production facilities.maintained in the future from existing production facilities.


oug t e rm s genera po cy s to payoug t e rm s genera po cy s to pay- -out o tsout o tsearnings it plans to retain 1/3 of its earnings for the next 3earnings it plans to retain 1/3 of its earnings for the next 3years. The new investments are expected to generate 20%years. The new investments are expected to generate 20%return p.a. in perpetuity. Once these investment return p.a. in perpetuity. Once these investment

opportunities are exploited the firm will return to its policyopportunities are exploited the firm will return to its policyof 100% payof 100% pay- -out. The required rate of return is 10%. You areout. The required rate of return is 10%. You arerequired to estimate the value of the firm.required to estimate the value of the firm.


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Valuing a Division or a Private CompanyValuing a Division or a Private Company

SA: Valuing a Private CompanySA: Valuing a Private Company 2424


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Estimating cost of capital a listed firmEstimating cost of capital a listed firm

Expected rate of return and risk are directly and linearlyrelated.It concentrates on risk and expected return.

The Capital Asset Pricing Model:E(R i - Rf ) = R f + (E(R M) R f )

SA:SA: Valuing a Private CompanyValuing a Private Company 2525

It p aces particu ar emp asis on systematic ris

Recent developments in asset pricing:Fama-French 3 factor model4-factor model of Carhart And Others

The Issue:The Issue: How to estimate the value (or the Cost of Capital) when historical prices are not available?


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Valuing a Private Company or a DivisionValuing a Private Company or a Division

Estimating systematic risk when stock prices are notavailable: The market based approach

Assumption:Assumption:

Systematic risk for a particular line of business is


constant for all firms that compete in that line of business.

Methods:Methods:

a. The Pure-Play approach (Fuller and Keer, 1981)b. The Full-Information approach ( (Ehrhardt and

Bhagwat, 1991).


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TheThe PurePure- -PlayPlay approachapproach11

The concept: The concept:

Find some publicly traded firms that compete in thesame line of business as your unlisted firm

Estimate the s of those listed firms


Use these s to estimate of your private firm.


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TheThe PurePure- -PlayPlay approachapproach22

Some issues: Some issues: 1. What if s of pure-play firms are far apart?

Fuller and Keer (1981) suggest using median

-


. Bower and Jenks (1975) suggest that finding

pure-play firm is not easy.

3. Is there any alternative to pure-play approach? Use FullUse Full--Information approach.Information approach.


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FullFull--Information ApproachInformation Approach--11

The Basis:

The overall beta of a firm is the weighted averageof divisional s

of a division is constant


There should be more firms (M) than divisions (N)in the sample.


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, ,1

N

M j s j s js

W =

= +

FullFull--Information ApproachInformation Approach--22

Where:

Consider the following equation:


Market of firms is the dependent variable and weightsfor the divisions are the explanatory variables.

Mj = Over all market of firm jw js = weight of each segment in company js = of segment s (a parameter to estimate)


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Performance of FullPerformance of Full- -Information ApproachInformation Approach

Ehrhardt and Bhagwat (1991):

Main results (Using 2-digit SIC code of segment)

Adj. R2 = 0.694 of 70 estimates are not statistically significant


pure-play method.

Explains higher proportion of variation in

Is the superiority of Full-Information approach is robust?

Robust to alternative measures of segment weight, and

Robust to 3-digit SIC classification.


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SummarySummary

Lack of market value makes valuation of unlisted firmsLack of market value makes valuation of unlisted firmsor divisions difficult.or divisions difficult.

Difficulties in finding pure play firms limits theDifficulties in finding pure play firms limits theapplicability of Pureapplicability of Pure- -play approachplay approach

uu -- n orma on me o u zes n orma on con en nn orma on me o u zes n orma on con en nmutimuti--divisional firms.divisional firms.



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Essential ReadingsEssential Readings

Ehrhardt, M. C. (1994), The Search for Value: Measuringthe Companys Cost of Capital , Harvard Business School

Press. Chapter 4.Ehrhardt, M.C. and Y.N. Bhagwat (1991), A Full-Information Approach for Estimating Divisional Betas,


nanc a anagement , - .

Fuller, R. J. and H. S. Kerr (1981), Estimating theDivisional Cost of Capital: An Analysis of the Pure-PlayTechnique, Journal of Finance 36, 997-1009.

See Supplementary Reading list for further references.

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