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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

a pter1

4

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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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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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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


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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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


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



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



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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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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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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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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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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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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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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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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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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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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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