Lecture Presentation Software to accompanyInvestment Analysis and Portfolio ManagementSeventh Editionby Frank K. Reilly & Keith C. Brown

Chapter 15

Chapter 15 - Company Analysis and Stock ValuationQuestions to be answered:Why is it important to differentiate between company analysis and stock valuation?What is the difference between a growth company and a growth stock?How do we apply the two valuation approaches and the several valuation techniques to Walgreen?

Chapter 15 - Company Analysis and Stock ValuationWhat techniques are useful when estimating the inputs to alternative valuation models?What techniques aid estimating company sales?How do we estimate the profit margins and earnings per share for a company?

Chapter 15 - Company Analysis and Stock ValuationWhat factors are considered 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?

Chapter 15 - Company Analysis and Stock ValuationIn addition to the earnings multiplier, what are some other relative valuation ratios?How do you apply the several present value of cash models to the valuation of a company?What value-added measures are available to evaluate the performance of a firm?

Chapter 15 - Company Analysis and Stock ValuationHow do we compute economic value-added (EVA), market value-added (MVA), and the franchise value for a firm?What is the relationship between these value-added measures and changes in the market value of firms?

Chapter 15 - Company Analysis and Stock ValuationWhen should we consider selling a stock?What is meant by a true growth company?What is the relationship between positive EVA and a growth company?

Chapter 15 - Company Analysis and Stock ValuationWhy is it inappropriate to use the standard dividend discount model to value a true growth company?What is the difference between no growth, simple growth, and dynamic growth?What is the growth duration model and what information does it provide when analyzing a true growth company and evaluating its stock?

Chapter 15 - Company Analysis and Stock ValuationHow can you use the growth duration model to derive an estimate of the P/E for Walgreens?What are some additional factors that should be considered when analyzing a company on a global basis?

Company Analysis and Stock ValuationAfter analyzing the economy and stock markets for several countries, you have decided to invest some portion of your portfolio in common stocksAfter analyzing various industries, you have identified those industries that appear to offer above-average risk-adjusted performance over your investment horizonWhich are the best companies?Are they overpriced?

Company Analysis and Stock ValuationGood companies are not necessarily good investmentsCompare the intrinsic value of a stock to its market valueStock of a great company may be overpricedStock of a growth company may not be growth stock

Growth Companies Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earningsFinancial 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 StocksGrowth stocks are not necessarily shares in growth companiesA growth stock has a higher rate of return than other stocks with similar riskSuperior risk-adjusted rate of return occurs because of market undervaluation compared to other stocks

Defensive Companies and StocksDefensive companies future earnings are more likely to withstand an economic downturnLow business riskNot excessive financial riskStocks with low or negative systematic risk

Cyclical Companies and StocksCyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall market rates of return

Speculative Companies and StocksSpeculative companies are those whose assets involve great risk but those that also have a possibility of great gainSpeculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return

Value versus Growth InvestingGrowth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervaluedValue stocks appear to be undervalued for reasons besides earnings growth potentialValue stocks usually have low P/E ratio or low ratios of price to book value

Economic, Industry, and Structural Links to Company AnalysisCompany analysis is the final step in the top-down approach to investingMacroeconomic analysis identifies industries expected to offer attractive returns in the expected future environmentAnalysis of firms in selected industries concentrates on a stocks intrinsic value based on growth and risk

Economic and Industry InfluencesIf trends are favorable for an industry, the company analysis should focus on firms in that industry that are positioned to benefit from the economic trendsFirms with sales or earnings particularly sensitive to macroeconomic variables should also be consideredResearch analysts need to be familiar with the cash flow and risk of the firms

Structural InfluencesSocial trends, technology, political, and regulatory influences can have significant influence on firmsEarly stages in an industrys life cycle see changes in technology which followers may imitate and benefit fromPolitics and regulatory events can create opportunities even when economic influences are weak

Company AnalysisIndustry competitive environmentSWOT analysisPresent value of cash flowsRelative valuation ratio techniques

Firm Competitive StrategiesCurrent rivalryThreat of new entrantsPotential substitutesBargaining power of suppliersBargaining power of buyers

Firm Competitive StrategiesDefensive strategy involves positioning firm so that 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 Porter suggests two major strategies: low-cost leadership and differentiation

Porter's Competitive Strategies Low-Cost StrategyThe firm seeks to be the low-cost producer, and hence the cost leader in its industry Differentiation Strategyfirm positions itself as unique in the industry

Focusing a StrategySelect segments in the industryTailor strategy to serve those specific groupsDetermine which strategy a firm is pursuing and its successEvaluate the firms competitive strategy over time

SWOT AnalysisExamination of a firms:StrengthsWeaknessesOpportunitiesThreats

SWOT AnalysisExamination of a firms:StrengthsWeaknessesOpportunitiesThreatsINTERNAL ANALYSIS

SWOT AnalysisExamination of a firms:StrengthsWeaknessesOpportunitiesThreatsEXTERNAL ANALYSIS

Some Lessons from Peter Lynch Favorable Attributes of Firms1. Firms product should not be faddish2. Firm should have some long-run comparative advantage over its rivals 3. Firms industry or product has market stability 4. Firm can benefit from cost reductions 5. Firms that buy back shares show there are putting money into the firm

Tenets of Warren BuffetBusiness Tenets Management TenetsFinancial TenetsMarket Tenets

Business TenetsIs the business simple and understandable?Does the business have a consistent operating history?Does the business have favorable long-term prospects?

Management TenetsIs management rational?Is management candid with with its shareholders?Does management resist the institutional imperative?

Financial TenetsFocus on return on equity, not earnings per shareCalculate owner earningsLook for companies with high profit marginsFor every dollar retained, make sure the company has created at least one dollar of market value

Market TenetsWhat is the value of the business?Can the business be purchased at a significant discount to its fundamental intrinsic value?

Estimating Intrinsic ValueA. Present value of cash flows (PVCF)1. Present value of dividends (DDM)2. Present value of free cash flow to equity (FCFE)3. Present value of free cash flow (FCFF)B. Relative valuation techniques1. Price earnings ratio (P/E)2. Price cash flow ratios (P/CF)3. Price book value ratios (P/BV)4. Price sales ratio (P/S)

Present Value of DividendsSimplifying assumptions help in estimating present value of future dividendsAssumption of constant growth rateIntrinsic Value = D1/(k-g)D1= D0(1+g)

Growth Rate EstimatesAverage Dividend Growth Rate

Growth Rate EstimatesAverage Dividend Growth Rate

Sustainable Growth Rate = RR X ROE

Required Rate of Return EstimateNominal risk-free interest rateRisk premiumMarket-based risk estimated from the firms characteristic line using regression

Required Rate of Return EstimateNominal risk-free interest rateRisk premiumMarket-based risk estimated from the firms characteristic line using regression

The Present Value of Dividends Model (DDM)Model requires k>gWith g>k, analyst must use multi-stage model

Present Value of Free Cash Flow to EquityFCFE = Net Income + Depreciation Expense - Capital Expenditures - D in Working Capital - Principal Debt Repayments + New Debt Issues

Present Value of Free Cash Flow to EquityFCFE = Net Income + Depreciation Expense - Capital Expenditures - D in Working Capital - Principal Debt Repayments + New Debt Issues

Present Value of Free Cash Flow to EquityFCFE = the expected free cash flow in period 1 k = the required rate of return on equity for the firmgFCFE = the expected constant growth rate of free cash flow to equity for the firm

Present Value of Operating Free Cash FlowDiscount the firms operating free cash flow to the firm (FCFF) at the firms weighted average cost of capital (WACC) rather than its cost of equityFCFF = EBIT (1-Tax Rate)+ Depreciation Expense - Capital Spending- in Working Capital - in other assets

Present Value of Operating Free Cash Flow

Present Value of Operating Free Cash FlowWhere: FCFF1 = the free cash flow in period 1Oper. FCF1 = the firms operating free cash flow in period 1WACC = the firms weighted average cost of capitalgFCFF = the firms constant infinite growth rate of free cash flowgOFCF = the constant infinite growth rate of operating free cash flow

An Alternate Measure of Growthg = (RR)(ROIC)where:RR = the average retention rateROIC = EBIT (1-Tax Rate)/Total Capital

Calculation of WACCWACC = WEk + Wdi

Calculation of WACCWACC = WEk + Wdiwhere:WE = the proportion of equity in total capitalk = the after-tax cost of equity (from the SML)WD = the proportion of debt in total capitali = the after-tax cost of debt

Relative Valuation TechniquesPrice Earnings Ratio

Relative Valuation TechniquesPrice Earnings RatioAffected by two variables:1. Required rate of return on its equity (k)2. Expected growth rate of dividends (g)

Relative Valuation TechniquesPrice Earnings RatioAffected by two variables:1. Required rate of return on its equity (k)2. Expected growth rate of dividends (g)Price/Cash Flow Ratio

Relative Valuation TechniquesPrice Earnings RatioAffected by two variables:1. Required rate of return on its equity (k)2. Expected growth rate of dividends (g)Price/Cash Flow RatioPrice/Book Value Ratio

Relative Valuation TechniquesPrice Earnings RatioAffected by two variables:1. Required rate of return on its equity (k)2. Expected growth rate of dividends (g)Price/Cash Flow RatioPrice/Book Value RatioPrice-to-Sales Ratio

Analysis of Growth CompaniesGenerating rates of return greater than the firms cost of capital is considered to be temporaryEarnings higher the required rate of return are pure profitsHow long can they earn these excess profits?Is the stock properly valued?

Analysis of Growth CompaniesGrowth companies and the DDMconstant growth model not appropriateAlternative growth modelsno growth firmE = r X Assets = Dividends

Analysis of Growth CompaniesLong-run growth modelsassumes some earnings are reinvestedSimple growth model

Simple Growth Model (cont.) (Present value of Constant Dividend plus the Present Value of Growth Investment) (Present value of Constant Earnings plus the Present Value of Excess Earnings from Growth Investment)

Expansion ModelFirm retains earnings to reinvest, but receives a rate of return on its investment equal to its cost of capitalm = 1 so r = k

Negative Growth ModelFirm retains earnings, but reinvestment returns are below the firms cost of capitalSince growth will be positive, but slower than it should be, the value will decline when the investors discount the reinvestment stream at the cost of capital

The Capital Gain ComponentbEm/kb Percentage of earnings retained for reinvestmentm relates the firms rate of return on investments and the firms required rate of return (cost of capital)1 = cost of capital>1 is growth companyTime period for superior investments

Dynamic True Growth ModelFirm invests a constant percentage of current earnings in projects that generate rates of return above the firms required rate of return

Measures of Value-AddedEconomic Value-Added (EVA)Compare net operating profit less adjusted taxes (NOPLAT) to the firms total cost of capital in dollar terms, including the cost of equityEVA return on capitalEVA/CapitalAlternative measure of EVACompare return on capital to cost of capital

Measures of Value-AddedMarket Value-Added (MVA)Measure of external performanceHow the market has evaluated the firms performance in terms of market value of debt and market value of equity compared to the capital invested in the firmRelationships between EVA and MVAmixed results

Measures of Value-AddedThe Franchise FactorBreaks P/E into two componentsP/E based on ongoing business (base P/E)Franchise P/E the market assigns to the expected value of new and profitable business opportunitiesFranchise P/E = Observed P/E - Base P/EIncremental Franchise P/E = Franchise Factor X Growth Factor

Growth DurationEvaluate the high P/E ratio by relating P/E ratio to the firms rate and duration of growthP/E is function of expected rate of growth of earnings per sharestocks required rate of returnfirms dividend-payout ratio

Growth DurationE(t) = E (0) (1+G)tN(t) = N(0)(1+D)tE(t) = E(t) N(t) = E (0) [(1+G)t (1+D)]t

Growth Duration

Intra-Industry AnalysisDirectly compare two firms in the same industryAn alternative use of T to determine a reasonable P/E ratioFactors to considerA major difference in the risk involvedInaccurate growth estimatesStock with a low P/E relative to its growth rate is undervaluedStock with high P/E and a low growth rate is overvalued

Site Visits and the Art of the InterviewFocus on managements plans, strategies, and concernsRestrictions on nonpublic informationWhat if questions can help gauge sensitivity of revenues, costs, and earningsManagement may indicate appropriateness of earnings estimatesDiscuss the industrys major issuesReview the planning processTalk to more than just the top managers

When to SellHolding a stock too long may lead to lower returns than expectedIf stocks decline right after purchase, is that a further buying opportunity or an indication of incorrect analysis?Continuously monitor key assumptionsEvaluate closely when market value approaches estimated intrinsic valueKnow why you bought it and watch for that to change

Efficient MarketsOpportunities are mostly among less well-known companiesTo outperform the market you must find disparities between stock values and market prices - and you must be correctConcentrate on identifying what is wrong with the market consensus and what earning surprises may exist

Influences on AnalystsInvestment bankers may push for favorable evaluationsCorporate officers may try to convince analystsAnalyst must maintain independence and have confidence in his or her analysis

Global Company and Stock AnalysisFactors to Consider:Availability of DataDifferential Accounting ConventionsCurrency Differences (Exchange Rate Risk)Political (Country) RiskTransaction CostsValuation Differences

The InternetInvestments Onlinewww.better-investing.comwww.fool.comwww.cfonews.comwww.ibes.comwww.zacks.comwww.valueline.comwww.financialweb.cominvestor.msn.comwww.marketedge.comwww.nyssa.org

End of Chapter 20Company Analysis and Stock Selection

Future topicsChapter 16 Technical AnalysisAssumptions and AdvantageTechnical Trading Rules and IndicatorsTechniques and Charts