Company Analysis

Dr. Jitendra Mahakud 1

Company Analysis and Stock Valuation

After analyzing the economy and stockmarkets for several countries, you havedecided to invest some portion of yourportfolio in common stocks

After analyzing various industries, you haveidentified those industries that appear tooffer above-average risk-adjustedperformance over your investment horizon

Which are the best companies?

Are they overpriced?


Company Analysis and Stock Valuation

Good companies are not necessarily goodinvestments

Compare the intrinsic value of a stock to itsmarket value

Stock of a great company may be overpriced

Stock of a growth company may not begrowth stock


Growth companies have historicallybeen defined as companies thatconsistently experience above-averageincreases in sales and earnings

Financial theorists define a growthcompany as one with management andopportunities that yield rates of returngreater than the firm’s required rate ofreturn

Growth Companies


Growth Stocks

Growth stocks are not necessarilyshares in growth companies

A growth stock has a higher rate ofreturn than other stocks with similarrisk

Superior risk-adjusted rate of returnoccurs because of marketundervaluation compared to otherstocks


Defensive Companies and Stocks

Defensive companies’ future earningsare more likely to withstand aneconomic downturn

Low business risk

Not excessive financial risk

Stocks with low systematic risk


Cyclical Companies and Stocks

Cyclical 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 Stocks

Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain

Speculative 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 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


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 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

Industry competitive environment

SWOT analysis

Present value of cash flows

Relative valuation ratio techniques


Firm Competitive Strategies

Current rivalry

Threat of new entrants

Potential substitutes

Bargaining power of suppliers

Bargaining power of buyers


Firm Competitive Strategies Defensive strategy involves positioning firm

so that its capabilities provide the best means to deflect the effect of competitive forces in the industry

Offensive strategy involves using the company’s strength to affect the competitive industry forces, thus improving the firm’s relative industry position

Porter suggests two major strategies: low-cost leadership and differentiation


Porter's Competitive Strategies

Low-Cost Strategy The firm seeks to be the low-cost producer, and hence the cost leader in its industry

Differentiation Strategy

firm positions itself as unique in the industry


Focusing 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 firm’s competitive strategy over time


SWOT Analysis

Examination of a firm’s:

Strengths

Weaknesses

Opportunities

Threats


SWOT Analysis


Strengths

Weaknesses

Opportunities

Threats

INTERNAL ANALYSIS


SWOT Analysis


Strengths

Weaknesses

Opportunities

Threats

EXTERNAL ANALYSIS


Some Lessons from Peter Lynch

Favorable Attributes of Firms

1. Firm’s product should not be faddish

2. Firm should have some long-run comparative

advantage over its rivals

3. Firm’s 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 Buffet

Business Tenets

Management Tenets

Financial Tenets

Market Tenets


Business Tenets

Is the business simple and understandable?

Does the business have a consistent operating history?

Does the business have favorable long-term prospects?


Management Tenets

Is management rational?

Is management candid with its shareholders?


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?


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 techniques

1. 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)


Analysis of Growth Companies

Generating rates of return greater than the firm’s cost of capital is considered to be temporary

Earnings higher than the required rate of return are pure profits

How long can they earn these excess profits?

Is the stock properly valued?


Negative Growth Model

Firm retains earnings, but reinvestment returns are below the firm’s cost of capital

Since 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


Measures of Value-Added

Economic Value-Added (EVA)

Compare net operating profit less adjusted

taxes (NOPLAT) to the firm’s total cost of

capital in dollar terms, including the cost of

equity

EVA return on capital

EVA/Capital

Alternative measure of EVA

Compare return on capital to cost of capital


Measures of Value-Added

Market Value-Added (MVA)

Measure of external performance

How the market has evaluated the firm’s

performance in terms of market value of

debt and market value of equity compared to the capital invested in the firm

Relationships between EVA and MVA

mixed results


Measures 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

Grk

kR


Intra-Industry Analysis

Directly compare two firms in the same industry

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


Site Visits and the Art of the Interview

Focus on management’s plans, strategies, and concerns

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 industry’s major issues

Review the planning process

Talk to more than just the top managers


When to Sell

Holding a stock too long may lead to lower returns

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


Efficient 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


Global Company and Stock Analysis

Factors to Consider: Availability of Data

Differential Accounting Conventions

Currency Differences (Exchange Rate Risk)

Political (Country) Risk

Transaction Costs

Valuation Differences

Company Analysis

Economy & Finance

Transcript of Company Analysis