1. COMPANY ANALYSIS AND STOCK VALUATION
Chapter 12
COMPANY ANALYSIS AND STOCK VALUATION

2. 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?

3. Chapter 12 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?

4. Chapter 12 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?

5. Chapter 12 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?

6. 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

7. 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

8. 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

9. 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

10. 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

11. Speculative Companies and Stocks
Speculative companies invest in assets 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

12. 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

13. The Search for True Growth Stocks
To find undervalued stocks, we must understand the theory of valuation itself

14. 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

15. 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?

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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)

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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