COMPANY ANALYSIS AND STOCK VALUATION 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? What are the two primary approaches to the valuation of common stock? How do we apply the discounted cash flow valuation approach? What are the major discounted cash flow valuation techniques?

Chapter 15 Questions How do we apply the relative valuation approach? What are the major relative valuation techniques (ratios)? 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?

Chapter 15 Questions How do we apply the two valuation approaches and several valuation techniques? What techniques can be used to estimate the inputs to alternative valuation models? What techniques aid estimating company sales? How do we estimate the profit margins and earnings per share for a company?

Chapter 15 Questions What 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

Growth Companies and Growth Stocks 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: The real risk-free rate of return, plus The expected rate of inflation, plus 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

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 Competitive forces necessitate competitive strategies. Competitive Forces: Current rivalry Threat of new entrants Potential substitutes Bargaining power of suppliers 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 Strengths Weaknesses Opportunities Threats Examination of a firm’s: Strengths Competitive advantages in the marketplace Weaknesses Competitors have exploitable advantages of some kind Opportunities External factors that make favor firm growth over time Threats External factors that hinder the firm’s success

Favorable Attributes of Firms Peter Lynch’s list of favorable attributes: Firm’s product is not faddish Company has competitive advantage over rivals Industry or product has potential for market stability Firm can benefit from cost reductions Firm is buying back its own shares or managers (insiders) are buying

Applying the Valuation Models (From Chapter 11) 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 Vj = SCFt/(1+k)t The different discounted cash flow techniques consider different cash flows and also different appropriate discount rates

Applying the Valuation Models to Walgreens DDM Valuation with Temporary Supernormal Growth Value Estimate $27.05 (See page 491) Implied P/E of 21 times expected earnings Market Price $35.65 (mid 2004) Prevailing Market P/E of about 18 times current earnings

Applying the Valuation Models to Walgreens Present Value of Free Cash Flow to Equity Value Estimate $35.99 (see page 493) Implied P/E of about 25 times expected earnings Market Price $35.65 (mid 2004) Prevailing Market P/E of about 17 times expected earnings Higher P/E justified by higher growth rate and lower beta

Applying the Valuation Models to Walgreens Present Value of Operating Free Cash Flows Value Estimate $33.13 (see page 496) Implied P/E of 26 times current earnings Market Price $35.65 (mid 2004) Prevailing Market P/E of about 18 times

Applying the Valuation Models (From Chapter 11) 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

Applying the Valuation Models to Walgreens All four relative valuation ratios increasing over time for Walgreens, its industry, and the market Suggests that changes are caused by aggregate economic variables Walgreens experienced a larger increase than its industry in all ratios, while lagging the market in terms of the P/E ratio in several years

Specific Valuation with the P/E Ratio Using the P/E approach to valuation: Estimate earnings for next year Estimate the P/E ratio (Earnings Multiplier) Multiply expected earnings by the expected P/E ratio to get expected price V =E1x(P/E)

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

Ranking Undervalued Stocks How do we rank if we have a budget constraint? Best to rank on the basis of the excess return ratio Intrinsic Value/Market Price

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