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**Firm Valuation and Analysis**

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**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

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**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

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**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

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**Speculative Companies and Stocks**

Speculative companies invest in assets involving great risk, but with the possibility of great gain Very high business risk, likely no current cash flows Example: biotech Speculative stocks have the potential for great percentage gains and losses Often characterized by high P/E ratios

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**Value versus Growth Investing**

Growth stocks will have positive earnings surprises and above-average risk adjusted rates of return So long as they continue to grow and surprise to the upside) Value stocks appear to be undervalued, may have disappointed investors in the past and are now forgotten, left for dead, despised Value stocks usually have low P/E ratio or low ratios of price to book value Are housing stocks value stocks or value traps?

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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

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**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

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**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

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**Approaches to Common Stock Valuation**

Discounted Cash Flow Techniques Present value of Dividends (DDM) 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) Used most often for banks and other capital-intensive businesses Not appropriate for many “asset-light” businesses

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**Dividend Discount Models**

Constant Growth Model: Assumes dividends started at D0 (current 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 = D1/(k-g) where D1= D0(1+g)

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**Dividend Discount Models**

Example 10.1 Consider a situation in which we are valuing a share of common stock that we plan to hold for only one year. What will be the value of the stock today if it pays a dividend of $2.00, is expected to have a price of $75 and the investor’s required rate of return is 12%? FIN3000, Liuren Wu

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**Dividend Discount Models**

Value of Common stock = Present Value of future cash flows = Present Value of (dividend + expected selling price) = ($2+$75) ÷ (1.12)1 = $68.75 FIN3000, Liuren Wu

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**Dividend Discount Models**

Example Continue example What will be the value of common stock if you hold the stock for two years and sell it for $82? Assume the dividend payment is fixed at $2 per year. Value of Common stock = Present Value of future cash flows = Present Value of (dividends + expected selling price) = {($2) ÷ (1.12)1 } + {($2+$82) ÷ (1.12)2 } = $71.14 FIN3000, Liuren Wu

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**Determinants of Growth Rate of Future Dividends**

Firm’s growth opportunities relate to: The rate of return the firm expects to earn when they reinvest earnings (the return on equity, ROE), and The proportion of firm’s earnings that they reinvest. This is known as the retention ratio, b, = 1- dividend payout ratio. The growth rate can be formally expressed as follows: g = the expected rate of growth of dividends D1/E1 = the dividend payout ratio ROE = the return on equity earned when the firm reinvests a portion of its earning back into the firm. FIN3000, Liuren Wu

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**Discounted Cash Flow Model**

Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm’s free cash flows. A firm generates free cash flows for its stock holders and debt holders, so: Market value of a firm=Market value of stocks + market value of debt

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**DCF Continued Find the Enterprise Value (EV) of the firm.**

PV of firm’s future FCFs FCF = cash providing by operating activities, less capital expenditures (capex) Subtract market value of firm’s debt (and preferred stock, if any) to get total value of common stock (equity). Value of equity = EV of firm – MV of debt Divide value of equity by the number of shares outstanding. Value per share = value of equity / # of shares of common stock

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DCF Continued The value of a business is usually computed as the discounted value of FCF out to a valuation horizon (H). The value after H is sometimes called the terminal value or horizon value.

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DCF Continued PV (free cash flows) PV (terminal value)

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Given the long-run gFCF = 6%, and firm discount rate of 10%, use the corporate value model to find the firm’s value. 21.20 1 2 3 4 ... g = 6% r = 10% -4.545 8.264 15.026 21.20 530 = = TV3 0.10 0.06 -

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If the firm has $40 million in debt and has 10 million shares of stock, what is the firm’s stock value per share? MV of equity = MV of firm – MV of debt = $416.94m - $40m = $ million Value per share = MV of equity / # of shares = $376.94m / 10m = $37.69

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**When to use the DCF vs. DDM**

When firms don’t pay dividends or when dividends are hard to forecast, use the DCF model if possible Projecting free cash flows might give us more accurate estimates of a firm’s value A lot of accounting information to predict free cash flow (FCF).

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**P/E Ratio Valuation Model**

Price/Earnings ratio (P/E ratio) is a popular measure of stock valuation. P/E ratio is a relative value model because it tells the investor how many dollars investors are willing to pay for each dollar of the company’s earnings. Vcs = the value of common stock of the firm. P/E1 = the price earnings ratio for the firm based on the current price per share divided by earnings for end of year 1. E1 = estimated earnings per share of common stock for the end of year 1. FIN3000, Liuren Wu

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P/E Ratio Factors The ratio is the earnings multiplier, and is a measure of the prevailing attitude of investors regarding a stock’s value P/E is determined by CASH FLOW, not vice versa What causes the growth rate in dividends (and earnings) and the investor’s required rate of return to go up and down? These are the real determinants of the P/E ratio. Firm factors impacting the investor’s required rate of return (increase in perceived risk) Economic or macro factors impacting the investor’s required rate of return (growth outlook, interest rates/inflation) Firm factors impacting the earnings/dividend growth rate – dividend policy and firm investment opportunities.

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**Price-Earnings 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)

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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 =CF1x(P/CF)

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**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

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**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

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**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

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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

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**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

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**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

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**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

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**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

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**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

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**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

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**Categorizing Companies**

Lynch further recommends the following categorization of firms: Slow growers Stalwart Fast growers Cyclicals Turnarounds Asset plays

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**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

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Chapter 13 Equity Valuation

Chapter 13 Equity Valuation

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