1. CHAPTER SEVEN FUNDAMENTAL STOCK ANALYSIS Practical Investment Management Robert A. Strong

2. South-Western College Publishing ©1998 2 Outline  Valuation Philosophies  Investors’ Understanding of Risk Premiums  The Time Value of Money  The Importance of Cash Flows  The Tax Factor  EIC Analysis  Value v.s. Growth Investing  The Value Approach to Investing  The Growth Approach to Investing  How Price Relates to Value  Value Stocks and Growth Stocks: How to Tell by Looking

3. South-Western College Publishing ©1998 3 Outline  Some Analytical Factors  Growth Rates  The Dividend Discount Model  The Multistage DDM  Caveats about the DDM  False Growth  A Firm’s Cash Flows  Small-Cap, Mid-Cap, and Large-Cap Stocks  Ratio Analysis

4. South-Western College Publishing ©1998 4 Valuation Philosophies  Fundamental analysts believe securities are priced according to fundamental economic data.  Technical analysts think supply and demand factors play the most important role.

5. South-Western College Publishing ©1998 5 Valuation Philosophies  Investors’ understanding of risk premiums: Investors are almost always risk-averse.  The time value of money: Everyone agrees on this basic principle.  The importance of cash flows: Most investment research deals with predicting future corporate earnings.  The tax factor: The tax code is complicated and not all investments are taxed equally.

6. South-Western College Publishing ©1998 6 Valuation Philosophies  Economy, Industry and Company (EIC) analysis:  The analyst first considers conditions in the overall economy (market risk),  then determines which industries are the most attractive in light of the economic conditions (using Porter’s competitive strategy analysis framework, for example),  and finally identifies the most attractive companies within the attractive industries.

7. South-Western College Publishing ©1998 7 Value v.s. Growth Investing  A value investor believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm’s financial statements) justify the purchase.  Value investors believe in a regression to the mean. The Value Approach to Investing

8. South-Western College Publishing ©1998 8 Regression to the Mean Most of the time a security’s long- term return is consistent with its risk. Over the long run, a security cannot survive with a cumulative return that is negative. Cumulative Return Time in the Long Term 0 + - x x x x x x x x x x x x x x x Undervalued stock: Buy Overvalued stock: Sell

9. South-Western College Publishing ©1998 9 Value v.s. Growth Investing  Growth investors seek rapidly growing companies. There are two factions:  Information traders are in a hurry; they believe information differentials in the marketplace can be profitably exploited.  True growth investors are more willing to wait, but they share the belief that good investment managers can earn above- average returns for their clients. The Growth Approach to Investing

10. South-Western College Publishing ©1998 10 Value v.s. Growth Investing  In the early days of the market, before the Great Crash of 1929, price played a minor role: “A stock with good long-term prospects is always a good investment.” How Price Relates to Value  The modern perspective is that value is inextricably intertwined with price. $ 8

11. South-Western College Publishing ©1998 11 Value v.s. Growth Investing  No precise definition exists.  Classification by Morningstar Mutual Funds: Value Stocks and Growth Stocks: How to Tell by Looking relative price to book ratio relative price-earnings ratio +

12. South-Western College Publishing ©1998 12 Value v.s. Growth Investing  The price to book ratio: book value per share is an accounting concept synonymous with equity per share.  The price-earnings ratio (PE) is computed by dividing the current stock price by the firm’s earnings per share.  Because of differences among industries, relative ratios are commonly computed for both statistics.

13. Some Analytical Factors: Growth Rates  Growth rates from historical data:  Growth rates from earnings retention: South-Western College Publishing ©1998 13

14. South-Western College Publishing ©1998 14 Some Analytical Factors: Growth Rates  Financial analysts typically calculate a number of growth rates using different ways to determine a likely range for the statistic.  Recent data may be more reliable than data from the more distant past.  Company statements regarding company targets may be considered too. Choosing a Growth Rate

15. South-Western College Publishing ©1998 15 The Dividend Discount Model (DDM)  Also called Gordon’s growth model.  The model assumes that the dividend stream is perpetual and that the long- term growth rate is constant.

16. South-Western College Publishing ©1998 16 The Dividend Discount Model (DDM)  The variable k is sometimes called the shareholders’ required rate of return.  Note that the shareholder’s required rate of return is the sum of the expected dividend yield and the expected stock price appreciation.

17. South-Western College Publishing ©1998 17 The Multistage DDM  Often, initial high growth levels cannot be sustained.  Suppose the growth rate g is expected to persist from the third year:

18. South-Western College Publishing ©1998 18 Some Analytical Factors  Caveats about the DDM: The DDM is at most a useful tool in security analysis - it requires certain assumptions and it has shortcomings.  False growth: False growth occurs when a firm acquires another firm with a lower price-earnings ratio - historical data should always be scrutinized carefully when used to determine a growth rate.

19. South-Western College Publishing ©1998 19 Some Analytical Factors  A firm’s cash flow: The statement of cash flows is a useful analytical tool - the cash flow from operations figures are widely used as a check on a firm’s earnings quality.  Small-cap, mid-cap, and large-cap stocks: Another consideration in fundamental stock analysis relates to the size of the firm - for example, the small firm effect.

20. South-Western College Publishing ©1998 20 Some Analytical Factors: Ratio Analysis  The fundamental analyst is necessarily interested in the firm’s accounting statements and in the prevailing general economic conditions.  To assist in the analysis, several organizations publish comparative statistics for industry groups. e.g. Dun and Bradstreet’s Industry Norms & Key Business Ratios, which includes solvency, efficiency and profitability ratios.

21. South-Western College Publishing ©1998 21 Review  Valuation Philosophies  Investors’ Understanding of Risk Premiums  The Time Value of Money  The Importance of Cash Flows  The Tax Factor  EIC Analysis  Value v.s. Growth Investing  The Value Approach to Investing  The Growth Approach to Investing  How Price Relates to Value  Value Stocks and Growth Stocks: How to Tell by Looking

22. South-Western College Publishing ©1998 22 Review  Some Analytical Factors  Growth Rates  The Dividend Discount Model  The Multistage DDM  Caveats about the DDM  False Growth  A Firm’s Cash Flows  Small-Cap, Mid-Cap, and Large-Cap Stocks  Ratio Analysis