Chapter 12 COMPANY ANALYSIS AND STOCK VALUATION. 1.2 Investments Chapter 12 Chapter 12 Questions Why is it important to differentiate between company.

Chapter 12Chapter 12

COMPANY ANALYSIS AND STOCK VALUATION

1.2Investments Chapter 12

Chapter 12 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?



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?



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?



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 valueStock of a great company may be overpricedStock 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 companiesLimitations 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 Companies and Growth Stocks

Growth stocks are not necessarily shares in growth companiesA growth stock has a higher rate of return than other

stocks with similar riskSuperior 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 downturnLow business riskNot excessive financial risk

Defensive stocks’ returns are not as susceptible to changes in the marketStocks with low systematic risk


Cyclical Companies and Stocks

Sales and earnings heavily influenced by aggregate business activityHigh business riskSometimes high financial risk as well

Cyclical stocks experience high returns is up markets, low returns in down marketsStocks with high betas


Speculative Companies and Stocks

Speculative companies invest in assets involving great risk, but with the possibility of great gainVery high business risk

Speculative stocks have the potential for great percentage gains and lossesMay 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 potentialValue 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 flowsThe 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:

EarningsDividendsInterest paymentsCapital 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, buyIf 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 industryTailor the strategy to serve those specific groupsDetermine which strategy a firm is pursuing and its

successEvaluate the firm’s competitive strategy over time


SWOT Analysis

Examination of a firm’s:Strengths

Competitive advantages in the marketplace

WeaknessesCompetitors have exploitable advantages of some kind

OpportunitiesExternal factors that make favor firm growth over time

ThreatsExternal 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 = CFt/(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 GrowthValue Estimate $27.05 (See page 491)

Implied P/E of 21 times expected earningsMarket Price $35.65 (mid 2004)

Prevailing Market P/E of about 18 times current earnings



Present Value of Free Cash Flow to EquityValue Estimate $35.99 (see page 493)

– Implied P/E of about 25 times expected earningsMarket 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



Present Value of Operating Free Cash FlowsValue 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 firmsPrice-Earnings RatioPrice-Cash Flow RatioPrice-Book Value RatioPrice-Sales Ratio



All four relative valuation ratios increasing over time for Walgreens, its industry, and the marketSuggests 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:1. Estimate earnings for next year2. Estimate the P/E ratio (Earnings Multiplier)3. 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 estimatesTime series – use statistical analysisSales - profit margin approach

EPS = (Sales Forecast x Profit Margin)/ Number of Shares Outstanding

Judgmental approaches to estimating earningsLast year’s income plus judgmental evaluationsUsing 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 timeMany 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 investmentKnow 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 MarketsMarkets tend to price securities correctly, so opportunities

are rareMost 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 questionAre analysts independent and unbiased in their

recommendations?Ideally, analysts will remain independent and show

confidence in their analyses

Chapter 12 COMPANY ANALYSIS AND STOCK VALUATION. 1.2 Investments Chapter 12 Chapter 12 Questions Why is it important to differentiate between company.

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