Chapter 15 COMPANY ANALYSIS AND STOCK VALUATION

Chapter 15 Questions Why is it important to differentiate between company analysis and stock analysis? What is the difference between a growth company and a growth stock? When valuing an asset, what are the required inputs? After an investor has valued an asset, what is the investment decision process? How is the value of bonds determined?

Chapter 15 Questions What are the two primary approaches to the valuation of common stock? How do we apply the discounted cash flow valuation approach, and what are the major discounted cash flow valuation techniques? What is the dividend discount model (DDM), and what is its logic? What is the effect of the assumptions of the DDM when valuing a growth company?

Chapter 15 Questions How do we apply the DDM to the valuation of a firm that is expected to experience temporary supernormal growth? How do we apply the relative valuation approach to valuation, and what are the major relative valuation techniques (ratios)? How can the DDM be used to develop an earnings multiplier model? What does the DDM model imply are the factors that determine a stock’s P/E ratio?

Chapter 15 Questions What are some economic, industry, and structural links that should be considered in company analysis? What insights regarding a firm can be derived from analyzing its competitive strategy and from a SWOT analysis? What techniques can be used to estimate the inputs to alternative valuation models? What techniques aid estimating company sales?

Chapter 15 Questions How do we estimate the profit margins and earnings per share for a company? What procedures and factors do we consider 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? When should we consider selling a stock?

Company Analysis and Stock Selection Good companies are not necessarily good investments In the end, we want to compare the intrinsic value of a stock to its market value Stock of a great company may be overpriced Stock of a lesser company may be a superior investment since it is undervalued

Companies that consistently experience above-average increases in sales and earnings have traditionally been thought of as growth companies Limitations to this definition 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 and 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 under-valuation compared to other stocks Studies indicate that growth companies have generally not been growth stocks

Defensive Companies and Stocks Defensive companies’ future earnings are more likely to withstand an economic downturn Low business risk Not excessive financial risk Defensive stocks’ returns are not as susceptible to changes in the market Stocks with low systematic risk

Cyclical Companies and Stocks Sales and earnings heavily influenced by aggregate business activity High business risk Sometimes high financial risk as well Cyclical stocks experience high returns is up markets, low returns in down markets Stocks with high betas

Speculative Companies and Stocks Speculative companies invest in sssets involving great risk, but with the possibility of great gain Very high business risk Speculative stocks have the potential for great percentage gains and losses May be firms whose current price-earnings ratios are very high

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

The Search for True Growth Stocks To find undervalued stocks, we must understand the theory of valuation itself

Theory of Valuation The value of a financial asset is the present value of its expected future cash flows Required inputs: The stream of expected future returns, or cash flows The required rate of return on the investment

Stream of Expected Returns (Cash Flows) From of returns Depending on the investment, returns can be in the form of: Earnings Dividends Interest payments Capital gains Time period and growth rate of returns When will the cash flows be received from the investment?

Required Rate of Return Determined by the risk of an investment and available returns in the market Determined by: 1. The real risk-free rate of return, plus 2. The expected rate of inflation, plus 3. A risk premium to compensate for the uncertainty of returns Sources of uncertainty, and therefore risk premiums, vary by the type of investment

Investment Decision Process Once expected (intrinsic) value is calculated, the investment decision is rather straightforward and intuitive: If Estimated Value > Market Price, buy If Estimated Value < Market Price, do not buy The particulars of the valuation process vary by type of investment

Valuation of Alternative Investments We will consider the valuation of two important types of investments: The valuation of bonds The valuation of common stock

Valuation of Bonds What are the cash flows? Bond cash flows (typically fixed) Interest payments every six months equal to one- half of: (Coupon rate x Face value) The payment of principal (Face or par value) at maturity Discount at the required rate of return to find the bond’s value Process made relatively easy with a financial calculator or spreadsheet software

Approaches to Common Stock Valuation Discounted Cash Flow Techniques Present value of Dividends (DDM) Present value of Operating Cash Flow Present value of Free Cash Flow 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)

Discounted Cash Flow Techniques Based on the basic valuation model: the value of a financial asset is the present value of its expected future cash flows V j =  CF t /(1+k) t The different discounted cash flow techniques consider different cash flows and also different appropriate discount rates

Dividend Discount Models Simplifying assumptions help in estimating present value of future dividends V j =  D t /(1+k) t Can also assume various dividends for a finite period of time with a reselling price, and simply calculate the combined present value of the dividends

Dividend Discount Models Alternative dividend assumptions Constant Growth Model: Assumes dividends started at D 0 (last year’s dividend) and will grow at a constant growth rate Growth will continue for an infinite period of time The required return (k) is greater than the constant rate of growth (g) V = D 1 /(k-g) where D 1 = D 0 (I+g)

Dividend Discount Models Constant Growth Model Growth rate Can be estimated from past growth in earnings and dividends Can be estimated using the sustainable growth model Discount rate Would consider the systematic risk of the investment (beta) Capital Asset Pricing Model

Dividend Discount Models Valuation with Temporary Supernormal Growth If you expect a company to experience rapid growth for some period of time 1. Find the present value of each dividend during the supernormal growth period separately 2. Find the present value of the remaining dividends when constant growth can be assumed. 3. Find the present value of the remaining dividends by finding the present value of the estimate obtained in step 2.

Present Value of Operating Cash Flows Another discounted cash flow approach is to discount operating cash flows Operating cash flows are pre-interest cash flows, so the required rate of return would be adjusted to incorporate the required returns of all investors (use the WACC) V Fj =  OCF t /(1+WACC j ) t

Present Value of Operating Cash Flows If we further assume a growth rate of g OCF for operating cash flows, we can value the firm as: V Fj = OCF t /(WACC j – g OCF )

Present Value of Free Cash Flow to Equity A third discounted cash flow technique is to consider the free cash flows of a firm available to equity as the cash flow stream to be discounted. Since this is an equity stream, the appropriate discount rate is the required return on equity V Sj =  FCF t /(1+k j ) t

Present Value of Free Cash Flow to Equity Once again, if we constant growth in free cash flows, this expression reduces to the following V Sj = FCF t /(k j – g FCF )

Relative Valuation Techniques These techniques assume that prices should have stable and consistent relationships to various firm variables across groups of firms Price-Earnings Ratio Price-Cash Flow Ratio Price-Book Value Ratio Price-Sales Ratio

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

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

Price-Earnings Ratio Look at the relationship between the current market price and expected earnings per share over the next year The ratio is the earnings multiplier, and is a measure of the prevailing attitude of investors regarding a stock’s value P/E factors Expected growth in dividends and earnings Required rate of return on the stock

Price-Earnings Ratio Using the P/E approach to valuation: 1. Estimate earnings for next year 2. Estimate the P/E ratio (Earnings Multiplier) 3. Multiply expected earnings by the expected P/E ratio to get expected price V =E 1 x(P/E)

Price-Cash Flow Ratio Cash flows can also be used in this approach, and are often considered less susceptible to manipulation by management. The steps are similar to using the P/E ratio V =CF 1 x(P/CF)

Price-Book Value Ratio Book values can also be used as a measure of relative value The steps to obtaining valuation estimates are again similar to using the P/E ratio V =BV 1 x(P/BV)

Price-Sales Ratio Finally, sales can be used in relation to stock price. Some drawbacks, in that sales do not necessarily produce profit and positive cash flows Advantage is that sales are also less susceptible to manipulation The steps are similar to using the P/E ratio V =S 1 x(P/S)

Company Analysis: Examining Influences 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 Competitive forces necessitate competitive strategies. Competitive Forces: 1. Current rivalry 2. Threat of new entrants 3. Potential substitutes 4. Bargaining power of suppliers 5. Bargaining power of buyers SWOT analysis is another useful tool

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

Low-Cost Strategy Seeks to be the low cost leader in its industry Must still command prices near industry average, so still must differentiate Discounting too much erodes superior rates of return

Differentiation Strategy Seeks to be identified 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

Focusing a Strategy Firms with focused strategies: Select segments in the industry Tailor the 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: S trengths Competitive advantages in the marketplace W eaknesses Competitors have exploitable advantages of some kind O pportunities External factors that make favor firm growth over time T hreats External factors that hinder the firm’s success

Favorable Attributes of Firms Peter Lynch’s list of 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

Categorizing Companies Lynch further recommends the following categorization of firms: 1. Slow growers 2. Stalwart 3. Fast growers 4. Cyclicals 5. Turnarounds 6. Asset plays

Specific Valuation with the P/E Ratio Earnings per share estimates Time series – use statistical analysis Sales - profit margin approach EPS = (Sales Forecast x Profit Margin)/ Number of Shares Outstanding Judgmental approaches to estimating earnings Last year’s income plus judgmental evaluations Using the consensus of analysts’ earnings estimates Once annual estimates are obtained, do quarterly estimates and interpret announcements accordingly

Site Visits, Interviews, and Fair Disclosure Fair Disclosure (FD) requires that all disclosure of material information be made public to all interested parties at the same time Many firms will not allow interviews with individuals, only provide information during large public presentations Analysts now talk to people other than top managers Customers, suppliers

Making the Investment Decision If the estimate of the stock’s intrinsic value is greater than or equal to the current market price, buy the stock If your estimate of the stock’s future intrinsic value would yield a return greater than your required rate of return (based on current investment price), then buy the stock If the value is less than its current price, or its return would be less than your required rate of return, do not buy the stock

When to Sell Hold on or move on? If stocks decline right after purchase, is that a further buying opportunity or a signal of a mistaken investment? Continuously monitor key assumptions that led to the purchase of the investment Know why you bought, and see if conditions have changed Evaluate when market value approaches estimated intrinsic value

Influences on Analysts Several factors make it difficult for analysts to outperform the market Efficient Markets Markets tend to price securities correctly, so opportunities are rare Most opportunities are likely in small, less followed companies Paralysis of Analysis Must see the forest (the appropriate recommendation) despite all of the trees (data) that complicate the decision

Influences on Analysts Investment bankers may push for favorable evaluations of securities when the same firm does (or wants to do) underwriting business with the firm in question Are analysts independent and unbiased in their recommendations? Ideally, analysts will remain independent and show confidence in their analyses