1 Research term paper Five major sections: Company background / introduction Competitive strengths Financial analysis (focus section) Stock valuation analysis Investment summary & recommendations

Company Competitive strengths Cost / price leadership Differentiated products Industry positioning: market share, brand & reputation, corporate culture, management track record, etc.

An Economic moat An economic moat is a barrier that protects a firm's margin and profits from competing firms, thus better able to sustain its high margin and profitability. An economic moat comes from a firm’s sustainable competitive advantages over similar companies. Example: Wal-Mart's buying power, economy scale and distribution infrastructure create a wide and sustainable economic moat.

Economic moats A cost advantage A size advantage: economic scale Intangible assets: patents, brand recognition, government licenses, etc. High switching cost Network effect: a firm's value increases as number of users increase Soft moats: exceptional management, unique corporate culture.

Example: Intel Corporation Competitive strengths: Low cost producer / economy of scale Generally superior products Dominant market share Well capitalized balance sheet Manufacturing expertise / vertical integration Brand recognition: Intel Inside

Intel: economic moats Sustainable advantages: Dominant market share position well capitalized balance sheet Strong technology and R&D expertise Deep manufacturing knowhow

Financial analysis Sales / growth analysis Profitability and margin analysis Asset turn over analysis Liquidity analysis Financial leverage ROE analysis (DuPont formula) WACC analysis and Enterprise value Free cash flow projections

Sales / growth analysis Sales by business segments and by regions Historic sales growth rate (last 5 years) Estimating growth rate next 5 years based on the historic sales growth

Ratio analysis Profitability and margin analysis: EBIT margin and net margin Asset turn over analysis: Total asset turnover Inventory turnover Liquidity analysis Quick ratio Financial leverage Debt/equity ratio EBIT/interest coverage

ROE analysis The DuPont Identity: ROE = Net margin * total asset turnover * equity multiplier

Free cash flow projections Using the % of sales approach: Look up 2015 year sales, EBITDA, taxes, capex and working capital change Estimate sales growth rate for next 3 years; estimate growth rates for other income statement items: EBIT, Taxes, capex and working capital change Estimate free cash flows for next 3 years (see FCF forecast template)

WACC analysis Market value of debt Market value of equity Total enterprise value Cost of debt estimate Cost of equity estimate using CAPM WACC calculation

Financial analysis example: Apple Inc. Company Competitive strengths: 1.Integrated products and services (one eco-system): hardware, software, apps store, iclouds, Pay, etc 2.Brand 3.Customer loyalty 4.Financial strength and profitability 5.Ability to leverage current platform: Apple Pay, Watch 6.Management

Apple Inc. Competitive strategies: 1.Differentiated products 2.Product quality and innovations 3.Integrated offerings: hardware, software and services 4.Third party developer contents and apps 5.Company-own distribution network: retail stores 6.New products/ services: Pay

Apple: Free cash flow projections From Yahoo/finance: For FY2015: EBIT: $71.2 b D&A: $11.2 b Taxes: 19.1 b Capex: 11.2 b w/capital increase: $4 b

Apple FCF forecast (see template) 16

Apple: WACC analysis Market value of debt: use book value of debt at $64.5 b Cost of debt: average about 1.5% Market value of equity Market capitalization at $528 b Total enterprise value Debt + equity = = $592.5 b Debt % = 64.5 / = 11% Equity % = 528 / = 89%

Apple: stock data (from yahoo/finance) Stock Price: $95 (as of 2/24/2016) Current dividend: $2.08 per share Beta: 1.35 (will use 1.1) Growth rate (next 5-year): 12.7% Total shares outstanding: 5.5 billion Stock Market assumptions: Market beta: 1.0 Long term risk free rate: 4.5% Long term risk premium: 6%

Apple: WACC analysis Cost of equity estimate using CAPM: Re = 4.5% risk free rate beta* 6% risk premium = 11.1% WACC calculation: WACC = Re * (E%) + Rd *D% (1 – t) = 11.1% * 89% + 1.5%*11% (1 -35%) = 10% 19

Stock valuation analysis Estimate the stock beta Estimate stock discount rate using CAPM Estimate dividend growth rate stock valuations model: Dividend Growth Model Discount Free Cash Flow model Set weighted price target Use the investment criteria to make buy /sell decision

Investment buy criteria To buy a stock: Strong competitive strengths Strong financial conditions Free cash flow generation Stock price target from DGM and DCF models: upside potential from current price at least 20%

Apple: stock data (from yahoo/finance) Stock Price: $95 (as of 2/24/2016) Current dividend: $2.08 per share Beta: 1.35 (will use 1.1) Growth rate (next 5-year): 12.7% Long term growth rate: Total shares outstanding: 5.5 billion Market assumptions: Market beta: 1.0 Long term risk free rate: 4.5% Long term risk premium: 6%

Apple: discount rate & growth rate Apple Beta = 1.1 Discount rate using CAPM: k = 4.5% *6% = 11.1% 5-year growth rate estimate: 11.9% (yahoo/finance) For my models, I will use 9% 5-year growth rate.

Apple Inc: Perpetual DDM model Current dividend: $2.08 per share dividend growth rate: 9% (assumption) Equity discount rate: 11.1% Fair value = $2.08 (1+9%) / (11.1% - 9%) = $108

Apple: DCF Model From the DCF spread sheet: 3-year growth rate: 9.55% Discount rate: WACC = 10% Equity fair value = $133 25

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Apple: Setting price target DDM fair value : $108 DCF fair value: $133 Weighted average price target: $120.5 Current price: $95 Stock upside potential: 26.8% Investment recommendation: buy

Apple: Investment summary & recommendation Investment summary: Strong competitive positions with leading market share, integrated products and services (one eco-system), strong brand and customer loyalty Strong financial strength and profitability Stock fair value: over 20% upside from current price Recommendation: buy

Team discussions items: What are the company’s competitive strengths? How are the company’s financial conditions? What are reasonable estimates for company beta and growth rate and discount rate? What is the fair value from the DDM and DCF models? Does the price target from the stock valuation models provide 20% upside? What’s the investment recommendation based on the buy criteria?