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Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 15
Chapter 15 - Company
Analysis and Stock Valuation
Questions to be answered:
• Why is it important to differentiate between
company analysis and stock valuation?
• What is the difference between a growth
company and a growth stock?
• How do we apply the two valuation
approaches and the several valuation
techniques to Walgreen?
Chapter 15 - Company
Analysis and Stock Valuation
• What techniques are useful when
estimating 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 - Company
Analysis and Stock Valuation
• What factors are considered 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?
Chapter 15 - Company
Analysis and Stock Valuation
• In addition to the earnings multiplier,
what are some other relative valuation
ratios?
• How do you apply the several present
value of cash models to the valuation of a
company?
• What value-added measures are available
to evaluate the performance of a firm?
Chapter 15 - Company
Analysis and Stock Valuation
• How do we compute economic valueadded (EVA), market value-added
(MVA), and the franchise value for a
firm?
• What is the relationship between these
value-added measures and changes in the
market value of firms?
Chapter 15 - Company
Analysis and Stock Valuation
• When should we consider selling a stock?
• What is meant by a true growth company?
• What is the relationship between positive
EVA and a growth company?
Chapter 15 - Company
Analysis and Stock Valuation
• Why is it inappropriate to use the
standard dividend discount model to
value a true growth company?
• What is the difference between no
growth, simple growth, and dynamic
growth?
• What is the growth duration model and
what information does it provide when
analyzing a true growth company and
evaluating its stock?
Chapter 15 - Company
Analysis and Stock Valuation
• How can you use the growth duration
model to derive an estimate of the P/E for
Walgreens?
• What are some additional factors that
should be considered when analyzing a
company on a global basis?
Company Analysis and Stock Valuation
• 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?
Company Analysis and Stock Valuation
• 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
Growth Companies
• 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 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
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
Cyclical Companies and Stocks
• Cyclical companies are those whose sales
and earnings will be heavily influenced by
aggregate business activity
• Cyclical stocks are those that will
experience changes in their rates of return
greater than changes in overall market rates
of return
Speculative Companies and Stocks
• Speculative companies are those whose
assets involve great risk but those that also
have a possibility of great gain
• Speculative stocks possess a high
probability of low or negative rates of return
and a low probability of normal or high
rates of return
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
Economic, Industry, and Structural
Links to Company Analysis
• Company analysis is the final step in the topdown 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
•
•
•
•
Industry competitive environment
SWOT analysis
Present value of cash flows
Relative valuation ratio techniques
Firm Competitive Strategies
•
•
•
•
•
Current rivalry
Threat of new entrants
Potential substitutes
Bargaining power of suppliers
Bargaining power of buyers
Firm Competitive Strategies
• Defensive strategy involves positioning firm so
that it its capabilities provide the best means to
deflect the effect of competitive forces in the
industry
• Offensive strategy involves using the company’s
strength to affect the competitive industry
forces, thus improving the firm’s relative
industry position
• Porter suggests two major strategies: low-cost
leadership and differentiation
Porter's Competitive Strategies
• Low-Cost Strategy
– The firm seeks to be the low-cost
producer, and hence the cost leader in its
industry
• Differentiation Strategy
– firm positions itself as unique in the
industry
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
SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– Threats
SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– Threats
INTERNAL ANALYSIS
SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– Threats
EXTERNAL ANALYSIS
Some Lessons from Peter Lynch
Favorable Attributes of Firms
1. Firm’s product should not be faddish
2. Firm should have some long-run comparative
advantage over its rivals
3. Firm’s industry or product has market stability
4. Firm can benefit from cost reductions
5. Firms that buy back shares show there are putting
money into the firm
Tenets of Warren Buffet
•
•
•
•
Business Tenets
Management Tenets
Financial Tenets
Market Tenets
Business Tenets
• Is the business simple and understandable?
• Does the business have a consistent
operating history?
• Does the business have favorable long-term
prospects?
Management Tenets
• Is management rational?
• Is management candid with with its
shareholders?
• Does management resist the institutional
imperative?
Financial Tenets
• Focus on return on equity, not earnings per
share
• Calculate “owner earnings”
• Look for companies with high profit
margins
• For every dollar retained, make sure the
company has created at least one dollar of
market value
Market Tenets
• What is the value of the business?
• Can the business be purchased at a
significant discount to its fundamental
intrinsic value?
Estimating Intrinsic Value
A. Present value of cash flows (PVCF)
– 1. Present value of dividends (DDM)
– 2. Present value of free cash flow to equity (FCFE)
– 3. Present value of free cash flow (FCFF)
B. Relative valuation techniques
–
–
–
–
1. Price earnings ratio (P/E)
2. Price cash flow ratios (P/CF)
3. Price book value ratios (P/BV)
4. Price sales ratio (P/S)
Present Value of Dividends
• Simplifying assumptions help in estimating
present value of future dividends
• Assumption of constant growth rate
Intrinsic Value = D1/(k-g)
D1= D0(1+g)
Growth Rate Estimates
• Average Dividend Growth Rate
n
Dn
1
D0
Growth Rate Estimates
• Average Dividend Growth Rate
n
Dn
1
D0
• Sustainable Growth Rate = RR X ROE
Required Rate of Return Estimate
• Nominal risk-free interest rate
• Risk premium
• Market-based risk estimated from the firm’s
characteristic line using regression
Required Rate of Return Estimate
• Nominal risk-free interest rate
• Risk premium
• Market-based risk estimated from the firm’s
characteristic line using regression
R stock  E(RFR)   stock [E(R market )  E(RFR)]
The Present Value of
Dividends Model (DDM)
• Model requires k>g
• With g>k, analyst must use multi-stage
model
Present Value of
Free Cash Flow to Equity
FCFE =
Net Income
+ Depreciation Expense
- Capital Expenditures
- D in Working Capital
- Principal Debt Repayments
+ New Debt Issues
Present Value of
Free Cash Flow to Equity
FCFE =
FCFE1
Value 
Net Income
k  g FCFE
+ Depreciation Expense
- Capital Expenditures
- D in Working Capital
- Principal Debt Repayments
+ New Debt Issues
Present Value of
Free Cash Flow to Equity
FCFE1
Value 
k  g FCFE
FCFE = the expected free cash flow in period 1
k = the required rate of return on equity for the firm
gFCFE = the expected constant growth rate of free cash
flow to equity for the firm
Present Value of
Operating Free Cash Flow
Discount the firm’s operating free cash flow
to the firm (FCFF) at the firm’s weighted
average cost of capital (WACC) rather than
its cost of equity
FCFF = EBIT (1-Tax Rate)
+ Depreciation Expense - Capital Spending
- D in Working Capital - D in other assets
Present Value of
Operating Free Cash Flow
FCFF1
Firm Value 
WACC  g FCFF
Oper . FCF1
or
WACC  g OFCF
Present Value of
Operating Free Cash Flow
FCFF1
Firm Value 
WACC  g FCFF
Oper . FCF1
or
WACC  g OFCF
Where: FCFF1 = the free cash flow in period 1
Oper. FCF1 = the firm’s operating free cash flow in period 1
WACC = the firm’s weighted average cost of capital
gFCFF = the firm’s constant infinite growth rate of free cash flow
gOFCF = the constant infinite growth rate of operating free cash flow
An Alternate Measure of Growth
g = (RR)(ROIC)
where:
– RR = the average retention rate
– ROIC = EBIT (1-Tax Rate)/Total Capital
Calculation of WACC
WACC = WEk + Wdi
Calculation of WACC
WACC = WEk + Wdi
where:
WE = the proportion of equity in total capital
k = the after-tax cost of equity (from the SML)
WD = the proportion of debt in total capital
i = the after-tax cost of debt
Relative Valuation Techniques
• Price Earnings Ratio
D1 / E1
P / E1 
kg
Relative Valuation Techniques
• Price Earnings Ratio
D1 / E1
P / E1 
kg
– Affected by two variables:
– 1. Required rate of return on its equity (k)
– 2. Expected growth rate of dividends (g)
Relative Valuation Techniques
D1 / E1
P / E1 
kg
• 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
Relative Valuation Techniques
D1 / E1
P / E1 
kg
• 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/Book Value Ratio
Relative Valuation Techniques
D1 / E1
P / E1 
kg
• 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/Book Value Ratio
• Price-to-Sales Ratio
Analysis of Growth Companies
• Generating rates of return greater than the
firm’s cost of capital is considered to be
temporary
• Earnings higher the required rate of return
are pure profits
• How long can they earn these excess
profits?
• Is the stock properly valued?
Analysis of Growth Companies
• Growth companies and the DDM
– constant growth model not appropriate
• Alternative growth models
– no growth firm
E = r X Assets = Dividends
E 1  b E
V 
k
k
E
k
v
Analysis of Growth Companies
• Long-run growth models
– assumes some earnings are reinvested
• Simple growth model
bEmk bEm

(Gross Present Value of Growth Investment s)
2
k
k
bEm bE

( Net Present Value of Growth Investment s)
k
k
E bEm bE
E 1  b  bEm
v 

v

k
k
k
k
k
Simple Growth Model (cont.)
E bEm bE
v 

k
k
k
D bEm
v 
k
k
E 1  b  bEm
v

k
k
(Present value of Constant Dividend plus
the Present Value of Growth Investment)
E bE m  1 (Present value of Constant Earnings plus
v 
the Present Value of Excess Earnings
k
k
from Growth Investment)
Expansion Model
• Firm retains earnings to reinvest, but
receives a rate of return on its investment
equal to its cost of capital
m = 1 so r = k
E E 1  b  bE E
V 


k
k
k
k
Negative Growth Model
• Firm retains earnings, but reinvestment
returns are below the firm’s cost of capital
• Since growth will be positive, but slower
than it should be, the value will decline
when the investors discount the
reinvestment stream at the cost of capital
The Capital Gain Component
bEm/k
b Percentage of earnings retained for reinvestment
m relates the firm’s rate of return on investments and
the firm’s required rate of return (cost of capital)
1 = cost of capital
>1 is growth company
Time period for superior investments
Dynamic True Growth Model
• Firm invests a constant percentage of
current earnings in projects that generate
rates of return above the firm’s required rate
of return
D1
V
kg
Measures of Value-Added
• Economic Value-Added (EVA)
– Compare net operating profit less adjusted taxes
(NOPLAT) to the firm’s total cost of capital in
dollar terms, including the cost of equity
• EVA return on capital
EVA/Capital
• Alternative measure of EVA
– Compare return on capital to cost of capital
Measures of Value-Added
• Market Value-Added (MVA)
– Measure of external performance
– How the market has evaluated the firm’s
performance in terms of market value of debt
and market value of equity compared to the
capital invested in the firm
• Relationships between EVA and MVA
– mixed results
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
Rk

G
rk
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
Growth Duration
E’(t) = E (0) (1+G)t
N(t) = N(0)(1+D)t
E’(t) = E’(t) N(t) = E (0) [(1+G)t (1+D)]t
E(t)  E (0) (1  G  D) t
T

E g (0) (1  G g  D g ) 
 Pg (0) 


  
T 

 Pd 0    E a (0) (1  G a  D a ) 
Growth Duration
T

E g (0) (1  G g  D g ) 
 Pg (0) 


  
T 

 Pd 0    E a (0) (1  G a  D a ) 
T

(1  G g  D g ) 
 Pg (0)/E g (0) 


  
T 

 Pd 0  / E a (0)   (1  G a  D a ) 
 Pg (0)/E g (0) 
 (1  G g  Dg ) 
  T ln 

ln 
 Pd 0 / E a (0) 
 (1  G a  Da ) 
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
Site Visits and the
Art of the Interview
• Focus on management’s plans, strategies, and
concerns
• Restrictions on nonpublic information
• “What if” questions can help gauge sensitivity
of revenues, costs, and earnings
• Management may indicate appropriateness of
earnings estimates
• Discuss the industry’s major issues
• Review the planning process
• Talk to more than just the top managers
When to Sell
• 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
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
Influences on Analysts
• Investment bankers may push for favorable
evaluations
• Corporate officers may try to convince
analysts
• Analyst must maintain independence and
have confidence in his or her analysis
Global Company and Stock
Analysis
Factors to Consider:
– Availability of Data
– Differential Accounting Conventions
– Currency Differences (Exchange Rate
Risk)
– Political (Country) Risk
– Transaction Costs
– Valuation Differences
The Internet
Investments Online
www.better-investing.com
www.fool.com
www.cfonews.com
www.ibes.com
www.zacks.com
www.valueline.com
www.financialweb.com
investor.msn.com
www.marketedge.com
www.nyssa.org
End of Chapter 20
–Company Analysis and
Stock Selection
Future topics
Chapter 16
Technical Analysis
• Assumptions and Advantage
• Technical Trading Rules and
Indicators
• Techniques and Charts