Securities Analysis, Section IV Security Valuation & EIC Analysis (Part 2)

Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapters 11,14,15, & 18

Copyright © 2000 by Harcourt, Inc. All rights reserved Top-Down Approach, Step Three Company and Stock Analysis

Copyright © 2000 by Harcourt, Inc. All rights reserved Company Analysis and Stock Selection After analyzing the economy and stock markets 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?

Copyright © 2000 by Harcourt, Inc. All rights reserved Company Analysis and Stock Selection Good companies are not necessarily good investments 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

Copyright © 2000 by Harcourt, Inc. All rights reserved Types of Companies and Stocks Growth Defensive Cyclical Speculative

Copyright © 2000 by Harcourt, Inc. All rights reserved Growth companies have historically been defined 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 firm’s required rate of return Growth Companies

Copyright © 2000 by Harcourt, Inc. All rights reserved Growth Stocks Growth stocks are not necessarily shares in growth 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

Copyright © 2000 by Harcourt, Inc. All rights reserved 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

Copyright © 2000 by Harcourt, Inc. All rights reserved Value versus Growth Investing Buffett’s view: –Growth is a key determinant of value for any stock, so it is always a component of determining whether or not a stock is undervalued –Furthermore, so long as the market is under- valuing a stock, then he would categorize it as a “value” stock –Finally, he considers all investing to be “value” investing –Thus, he considers “value” vs. “growth” investing to be a false dichotomy

Copyright © 2000 by Harcourt, Inc. All rights reserved Defensive Companies and Stocks Defensive companies’ future earnings are more likely to withstand an economic downturn Low business risk Not excessive financial risk Stocks with low or negative systematic risk

Copyright © 2000 by Harcourt, Inc. All rights reserved Cyclical Companies and Stocks Sales and earnings heavily influenced by aggregate business activity Stocks with high betas

Copyright © 2000 by Harcourt, Inc. All rights reserved Speculative Companies and Stocks Assets involve great risk –e.g., biotechs, bankruptcies, etc. Can be viewed as a gamble –Possible great gain –Stock may be overpriced

Copyright © 2000 by Harcourt, Inc. All rights reserved 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

Copyright © 2000 by Harcourt, Inc. All rights reserved 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

Copyright © 2000 by Harcourt, Inc. All rights reserved 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 that followers may imitate and benefit from Politics and regulatory events can create opportunities even when economic influences are weak

Copyright © 2000 by Harcourt, Inc. All rights reserved Company Analysis Industry competitive environment SWOT analysis Present value of cash flows Relative valuation ratio techniques

Copyright © 2000 by Harcourt, Inc. All rights reserved Firm Competitive Strategies Current rivalry Threat of new entrants Potential substitutes Bargaining power of suppliers Bargaining power of buyers

Copyright © 2000 by Harcourt, Inc. All rights reserved Firm Competitive Strategies Defensive or offensive Defensive strategy deflects competitive forces in the industry Offensive competitive strategy affects competitive force in the industry to improve the firm’s relative position Porter suggests two major strategies: low- cost leadership and differentiation

Copyright © 2000 by Harcourt, Inc. All rights reserved Low-Cost Strategy Seeks to be the low cost leader in its industry –Through economies of scale (in production or marketing), better logistics, etc. Must still command prices near industry average, so still must differentiate Discounting too much erodes superior rates of return

Copyright © 2000 by Harcourt, Inc. All rights reserved Differentiation Strategy Identify as unique in its industry in an area that is important to buyers Above average rate of return only comes if the price premium exceeds the extra cost of being unique

Copyright © 2000 by Harcourt, Inc. All rights reserved 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

Copyright © 2000 by Harcourt, Inc. All rights reserved SWOT Analysis Examination of a firm’s: –S trengths –W eaknesses –O pportunities –T hreats

Copyright © 2000 by Harcourt, Inc. All rights reserved SWOT Analysis Examination of a firm’s: –S trengths –W eaknesses –O pportunities –T hreats INTERNAL ANALYSIS

Copyright © 2000 by Harcourt, Inc. All rights reserved SWOT Analysis Examination of a firm’s: –S trengths –W eaknesses –O pportunities –T hreats EXTERNAL ANALYSIS

Copyright © 2000 by Harcourt, Inc. All rights reserved Lynch’s Favorable Attributes 1. Firm’s product is not faddish 2. Company has competitive advantage over rivals 3. Industry or product has potential for market stability 4. Firm can benefit from cost reductions 5. Firm is buying back its own shares or managers (insiders) are buying

Copyright © 2000 by Harcourt, Inc. All rights reserved Lynch’s Categories of Companies 1. Slow growers 2. Stalwart 3. Fast growers 4. Cyclicals 5. Turnarounds 6. Asset plays

Copyright © 2000 by Harcourt, Inc. All rights reserved Approaches to the Valuation of Common Stock Two general approaches have developed: 1.Discounted cash-flow valuation Present value of some measure of cash flow, such as dividends, operating cash flow, and free cash flow 2.Relative valuation technique Value estimated based on its price relative to significant variables, such as earnings, cash flow, book value, or sales

Copyright © 2000 by Harcourt, Inc. All rights reserved Approaches to the Valuation of Common Stock These two approaches have some factors in common Both are affected by: –Investor’s required rate of return –k  V  –Estimated growth rate of the variable used –g  V 

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation Approaches and Specific Techniques Approaches to Equity Valuation Discounted Cash Flow Techniques Relative Valuation Techniques Present Value of Dividends (DDM) Present Value of Operating Cash Flow Present Value of Free Cash Flow Price/Earnings Ratio (PE) Price/Cash flow ratio (P/CF) Price/Book Value Ratio (P/BV) Price/Sales Ratio (P/S)

Copyright © 2000 by Harcourt, Inc. All rights reserved Why and When to Use the Discounted Cash Flow Valuation Approach The measure of cash flow used –Dividends Cost of equity as the discount rate –Operating cash flow Weighted Average Cost of Capital (WACC) –Free cash flow to equity Cost of equity Dependent on growth rates and discount rate

Copyright © 2000 by Harcourt, Inc. All rights reserved Why and When to Use the Relative Valuation Techniques Provides information about how the market is currently valuing stocks –aggregate market –alternative industries –individual stocks within industries No guidance as to whether valuations are appropriate; best used when: –have comparable entities –aggregate market is not at a valuation extreme

Copyright © 2000 by Harcourt, Inc. All rights reserved Discounted Cash-Flow Valuation Techniques Where: V j = value of stock j n = life of the asset CF t = cash flow in period t k = the discount rate that is equal to the investor’s required rate of return for asset j, which is determined by the uncertainty (risk) of the stock’s cash flows

Copyright © 2000 by Harcourt, Inc. All rights reserved The Dividend Discount Model (DDM) The value of a share of common stock is the present value of all future dividends Where: V j = value of common stock j D t = dividend during time period t k = required rate of return on stock j

Copyright © 2000 by Harcourt, Inc. All rights reserved The Dividend Discount Model (DDM) If the stock is not held for an infinite period, a sale at the end of year 2 would imply:

Copyright © 2000 by Harcourt, Inc. All rights reserved The Dividend Discount Model (DDM) If the stock is not held for an infinite period, a sale at the end of year 2 would imply: Selling price at the end of year two is the value of all remaining dividend payments, which is simply an extension of the original equation

Copyright © 2000 by Harcourt, Inc. All rights reserved The Dividend Discount Model (DDM) Stocks with no dividends are expected to start paying dividends at some point else they would not have any value!

Copyright © 2000 by Harcourt, Inc. All rights reserved The Dividend Discount Model (DDM) Stocks with no dividends are expected to start paying dividends at some point, say year three... Where: D 1 = 0 D 2 = 0

Copyright © 2000 by Harcourt, Inc. All rights reserved The Dividend Discount Model (DDM) Infinite period model assumes a constant growth rate for estimating future dividends

Copyright © 2000 by Harcourt, Inc. All rights reserved The Dividend Discount Model (DDM) Infinite period model assumes a constant growth rate for estimating future dividends Where: V j = value of stock j D 0 = dividend payment in the current period g = the constant growth rate of dividends k = required rate of return on stock j n = the number of periods, which we assume to be infinite

Copyright © 2000 by Harcourt, Inc. All rights reserved The Dividend Discount Model (DDM) Infinite period model assumes a constant growth rate for estimating future dividends This can be reduced to: 1. Estimate the required rate of return (k) 2. Estimate the dividend growth rate (g)

Copyright © 2000 by Harcourt, Inc. All rights reserved Infinite Period DDM and Growth Companies Assumptions of DDM: 1. Dividends grow at a constant rate 2. The constant growth rate will continue for an infinite period 3. The required rate of return (k) is greater than the infinite growth rate (g)

Copyright © 2000 by Harcourt, Inc. All rights reserved Infinite Period DDM and Growth Companies Growth companies have opportunities to earn return on investments greater than their required rates of return To exploit these opportunities, these firms generally retain a high percentage of earnings for reinvestment, and their earnings grow faster than those of a typical firm This is inconsistent with the infinite period DDM assumptions

Copyright © 2000 by Harcourt, Inc. All rights reserved Infinite Period DDM and Growth Companies The infinite period DDM assumes constant growth for an infinite period, but abnormally high growth usually cannot be maintained indefinitely Risk and growth are not necessarily related Temporary conditions of high growth cannot be valued using the CGR-DDM

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation with Temporary Supernormal Growth Combine the models to evaluate the years of supernormal growth and then use DDM to compute the remaining years at a sustainable rate

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation with Temporary Supernormal Growth Combine the models to evaluate the years of supernormal growth and then use DDM to compute the remaining years at a sustainable rate For example: With a 14 percent required rate of return, a most recently paid dividend of $2.00 per share, and dividend growth of:

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation with Temporary Supernormal Growth Dividend Year Growth Rate 1-3: 25% 4-6: 20% 7-9: 15% 10 on: 9%

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation with Temporary Supernormal Growth The value equation becomes

Copyright © 2000 by Harcourt, Inc. All rights reserved Computation of Value for Stock of Company with Temporary Supernormal Growth

Copyright © 2000 by Harcourt, Inc. All rights reserved Present Value of Operating Cash Flows 2 nd DCF method Derive the value of the total firm by discounting the total operating cash flows prior to the payment of interest to the debt- holders Then subtract the value of debt to arrive at an estimate of the value of the equity

Copyright © 2000 by Harcourt, Inc. All rights reserved Present Value of Operating Cash Flows Where: V j = value of firm j n = number of periods; assumed to be infinite OCF t = the firms operating cash flow in period t WACC = firm j’s weighted average cost of capital (OCF and WACC to be discussed in Chapter 20)

Copyright © 2000 by Harcourt, Inc. All rights reserved Present Value of Operating Cash Flows Similar to DDM, this model can be used to estimate an infinite period Where growth has matured to a stable rate, the adaptation is Where: OCF 1 = operating cash flow in period 1 g OCF = long-term constant growth of operating cash flow

Copyright © 2000 by Harcourt, Inc. All rights reserved Present Value of Operating Cash Flows Assuming several different rates of growth for OCF, these estimates can be divided into stages as with the supernormal dividend growth model Estimate the rate of growth and the duration of growth for each period This will be demonstrated later

Copyright © 2000 by Harcourt, Inc. All rights reserved Present Value of Free Cash Flows to Equity 3 rd DCF method “Free” cash flows to equity are derived after operating cash flows have been adjusted for debt payments (interest and principle) The discount rate used is the firm’s cost of equity (k) rather than WACC

Copyright © 2000 by Harcourt, Inc. All rights reserved Volume Pricing Expenses Leases Tax Provision Deferred Taxes Tax Shield Sales Operating Margin Cash Taxes Free Cash Flow Cash available for distribution to all claimholders Cash Earnings Investment minus Free cash flow to equity defined Working Capital Expenditures Acquisitions/ Divestitures  A/R Inventories A/P Net PP&E Operating Leases Follow the Cash

Copyright © 2000 by Harcourt, Inc. All rights reserved Present Value of Free Cash Flows to Equity Where: V j = Value of the stock of firm j n = number of periods assumed to be infinite FCF t = the firm’s free cash flow in period t

Copyright © 2000 by Harcourt, Inc. All rights reserved Relative Valuation Techniques Value can be determined by comparing to similar stocks based on relative ratios Relevant variables include earnings, cash flow, book value, and sales Multiply this variable by some “capitalization factor” The most popular relative valuation technique is based on price to earnings (the P/E approach)

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model This values the stock based on expected annual earnings The price earnings (P/E) ratio, or Earnings Multiplier

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model The infinite-period dividend discount model indicates the variables that should determine the value of the P/E ratio

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model The infinite-period dividend discount model indicates the variables that should determine the value of the P/E ratio Dividing both sides by expected earnings during the next 12 months (E 1 )

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model Thus, the P/E ratio is determined by –1. Expected dividend payout ratio –2. Required rate of return on the stock (k) –3. Expected growth rate of dividends (g)

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model As an example, assume: –Dividend payout = 50% –Required return = 12% –Expected growth = 8% –D/E =.50; k =.12; g=.08

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model As an example, assume: –Dividend payout = 50% –Required return = 12% –Expected growth = 8% –D/E =.50; k =.12; g=.08

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model A small change in either or both k or g can have a large impact on the multiplier

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model A small change in either or both k or g can have a large impact on the multiplier D/E =.50; k=.13; g=.08

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model A small change in either or both k or g can have a large impact on the multiplier D/E =.50; k=.13; g=.08 P/E =.50/(.13-/.08) =.50/.05 = 10

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model A small change in either or both k or g can have a large impact on the multiplier D/E =.50; k=.13; g=.08 P/E = 10

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model A small change in either or both k or g can have a large impact on the multiplier D/E =.50; k=.13; g=.08 P/E = 10 D/E =.50; k=.12; g=.09 P/E = 16.7 D/E =.50; k=.11; g=.09 P/E = 25

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings Multiplier Model small change in either or both k or g can have a large impact on the multiplier D/E =.50; k=.12; g=.09 P/E = 16.7

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation Using the Earnings Multiplier Model Given current earnings of $2.00 and growth of 9% You would expect E 1 to be $2.18 D/E =.50; k=.12; g=.09 P/E = 16.7

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation Using the Earnings Multiplier Model Given current earnings of $2.00 and growth of 9% You would expect E 1 to be $2.18 D/E =.50; k=.12; g=.09 P/E = 16.7 V = 16.7 x $2.18 = $36.41 Compare this estimated value to market price to decide if you should invest in it

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Cash Flow Ratio 2 nd relative valuation approach Companies can manipulate earnings Cash-flow is less prone to manipulation Cash-flow is important for fundamental valuation and in credit analysis

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Cash Flow Ratio Companies can manipulate earnings Cash-flow is less prone to manipulation Cash-flow is important for fundamental valuation and in credit analysis

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Cash Flow Ratio Companies can manipulate earnings Cash-flow is less prone to manipulation Cash-flow is important for fundamental valuation and in credit analysis Where: P/CF j = the price/cash flow ratio for firm j P t = the price of the stock in period t CF t+1 = expected cash low per share for firm j

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Book Value Ratio 3 rd relative valuation approach Widely used to measure bank values (most bank assets are liquid (bonds and commercial loans) Fama and French study indicated inverse relationship between P/BV ratios and excess return for a cross section of stocks

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Book Value Ratio

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Book Value Ratio Where: P/BV j = the price/book value for firm j P t = the end of year stock price for firm j BV t+1 = the estimated end of year book value per share for firm j

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Book Value Ratio Be sure to match the price with either a recent book value number, or estimate the book value for the subsequent year Can derive an estimate based upon historical growth rate for the series or use the growth rate implied by the (ROE) X (Ret. Rate) analysis

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Sales Ratio 4 th relative valuation approach Strong, consistent growth rate is a requirement of a growth company Sales is less subject to manipulation than other financial data Popularized by Ken Fisher

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Sales Ratio

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Sales Ratio Where:

Copyright © 2000 by Harcourt, Inc. All rights reserved The Price-Sales Ratio Match the stock price with recent annual sales, or future sales per share This ratio varies dramatically by industry Profit margins also vary by industry Relative comparisons using P/S ratio should be between firms in similar industries

Copyright © 2000 by Harcourt, Inc. All rights reserved Estimating the Inputs: The Required Rate of Return and The Expected Growth Rate of Valuation Variables Valuation procedure is the same for securities around the world, but the required rate of return (k) and expected growth rate of earnings and other valuation variables (g) such as book value, cash flow, and dividends differ among countries

Copyright © 2000 by Harcourt, Inc. All rights reserved Required Rate of Return (k) Required rate of return on equity (k e ) affects valuation, regardless of approach: –k  V , and vice versa This required rate of return will be used as the discount rate and also affects relative-valuation Although k e is not directly used in the present value of operating cash flow approach, it is nonetheless a component of WACC

Copyright © 2000 by Harcourt, Inc. All rights reserved Required Rate of Return (k) But, what is the proper approach for deriving k e ? –CAPM? –APT? –Haugen’s ad hoc expected return factor model? Still an open question –CAPM most widely used in practice –Even then, questions can remain in terms of how to apply the model

Copyright © 2000 by Harcourt, Inc. All rights reserved Estimating Growth Rates Three general approaches: 1.Reinvestment-rate approaches –Sustainable Growth Rate = RR X ROE 2.Historical estimates –Point estimates of growth rates –Regression-based estimates of growth rates 3.Back out growth rates from estimated size of future market –Compare company to industry (Ch. 20) and industry to economy as a whole (Ch. 19)

Copyright © 2000 by Harcourt, Inc. All rights reserved Expected Growth Rate of Dividends Determined by –the growth of earnings –the proportion of earnings paid in dividends In the short run, dividends can grow at a different rate than earnings due to changes in the payout ratio Earnings growth is also affected by compounding of earnings retention g = (Retention Rate) x (Return on Equity) = RR x ROE

Copyright © 2000 by Harcourt, Inc. All rights reserved DuPont Breakdown of ROE Profit Total Asset Financial Margin Turnover Leverage = xx

Copyright © 2000 by Harcourt, Inc. All rights reserved Estimating Growth Based on History Alternative to reinvestment rate approach Historical growth rates of sales, earnings, cash flow, and dividends Two general techniques 1.arithmetic or geometric average of annual percentage changes (point estimates) 2.linear or log-linear regression models Both use time-series plot of data

Copyright © 2000 by Harcourt, Inc. All rights reserved Checking Your Figures: Three Alternative Measures of Value (cf., Value Investing) 1.Value of Company’s Assets –Graham & Dodd net-net approach –Book Value of Assets – P/BV for valuation –Market value / replacement value of assets 2.Earnings Power Value –Value company’s current earnings, adjusted for seasonality / cyclicality – DCF value assuming growth = 0 or = long-run growth in economy –Greater than value of company’s underlying assets iff company holds competitive advantage or benefits from barriers to entry –Understanding value requires knowledge of industry

Copyright © 2000 by Harcourt, Inc. All rights reserved Checking Your Figures: Three Alternative Measures of Value (cf., Value Investing) 3.What is Growth Worth? –Adds value only if growth occurs “within the franchise” Potential problem - firm retains earnings, but reinvestment returns are below the firm’s cost of capital (i.e., project NPV is negative) Taking on more projects means that sales and earnings will grow, but not by enough to cover additional costs of capital, so growth will actually destroy value held by current shareholders Key lesson = not all growth is “value-adding” Only projects with positive NPV’s will create value, and projects will only have positive NPV if they exploit or occur within the firm’s realm of competitive advantage, i.e., within the firm’s franchise

Copyright © 2000 by Harcourt, Inc. All rights reserved 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 canHow long can they earn these excess profits? are they likely toHow long are they likely to earn these excess profits? does the market expect them toHow long does the market expect them to earn these excess profits? Is the stock properly valued?

Copyright © 2000 by Harcourt, Inc. All rights reserved 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

Copyright © 2000 by Harcourt, Inc. All rights reserved Growth Duration Evaluate the high P/E ratio by relating P/E ratio to the firm’s rate and duration of growth P/E is function of –expected rate of growth of earnings per share –stock’s required rate of return –firm’s dividend-payout ratio Use the ratio of P/E’s, related to growth and dividend rates, to infer the market’s implied growth duration:

Copyright © 2000 by Harcourt, Inc. All rights reserved Intra-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

Copyright © 2000 by Harcourt, Inc. All rights reserved Growth Duration

Copyright © 2000 by Harcourt, Inc. All rights reserved Growth Duration Alternatively, the equation can be rearranged to determine a justified P/E ratio for a firm, given its expected dividend yield and growth rate and the expected length of time over which the firm will continue to experience above-average growth, relative to its benchmark (B).

Copyright © 2000 by Harcourt, Inc. All rights reserved Extensions on Growth Duration For more information and additional extensions and applications in using market- based information to infer the market’s assumptions about the various factors that drive a stock’s valuation, see: –

Copyright © 2000 by Harcourt, Inc. All rights reserved When to Sell Knowing when to sell is an even harder decision than knowing when to buy –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 –Always need a “sell discipline”

Copyright © 2000 by Harcourt, Inc. All rights reserved 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 –Again, useful to examine the expectations that underlie the current market price –Are these realistic/optimistic/pessimistic?

Copyright © 2000 by Harcourt, Inc. All rights reserved Next Up: Final Topics Bond Portfolio Management Are the Markets Rational?

Copyright © 2000 by Harcourt, Inc. All rights reserved