© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Company Analysis & Stock Valuation

Company Analysis vs. 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 Compare the intrinsic value of a stock to its market value 14-2 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Growth Companies & Growth Stocks Growth Companies –Historically, consistently experience above-average increases in sales and earnings –Theoretically, yield rates of return greater than the firm’s required rate of return –The firm’s sales and earnings grow faster than those of similar risk firms and the overall economy. –Dividends pay-out ratio high or low?? 14-3 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Growth Companies & Growth Stocks Growth Stocks –Not Necessarily the stocks of growth companies –A growth stock has a higher rate of return than other stocks with similar risk characteristics. –Superior risk-adjusted rate of return occurs because of market undervaluation compared to other stocks at a point of time. –If the stock is undervalued its price should increase to reflect its true fundamental value when the correct information become available. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14-4

Growth Companies & Growth Stocks –During price adjustment period the stock is considered a growth one, because its realized returns will exceed the required rate of return for the stock. – overeager investors overestimate the expected growth rate of earnings and cash-flows for a growth company and inflate its stock price. Investors who pay the inflated price will earn a rate of return below the risk- adjusted required rate of return. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14-5

Defensive Companies and Stocks Defensive Companies –The firms whose future earnings are more likely to withstand an economic downturn –Low business risk –No excessive financial risk –Typical examples are public utilities or grocery chains—firms that supply basic consumer necessities Defense Stocks –The rate of return is not expected to decline or decline less than the overall market decline –Stocks with ……… systematic risk 14-6 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Cyclical Companies and Stocks Cyclical Companies –They are the companies whose sales and earnings will be heavily influenced by aggregate business activity –Examples would be firms in the steel, auto, or heavy machinery industries. –The volatile earnings is a functions of the firm’s business risk. Cyclical Stocks –They will have greater changes in rates of return than the overall market rates of return –They would be stocks that have high betas © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Speculative Companies and Stocks Speculative Companies –They are the firms whose assets involve great risk but those that also have a possibility of great gain –A good example of a speculative firm is one involved in oil exploration Speculative Stocks –Stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return, overpriced stock. –Experience low or negative rates of return when the market adjust the stock price to its true value. –For example, an excellent growth company whose stock is selling at an extremely high P/E ratio 14-8 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Company Analysis Firm’s Overall Strategic Approach –Industry competitive environment –SWOT analysis  Strengths  Weaknesses  Opportunities  Threats Firm’s Valuation Approaches –Present value of cash flows –Relative valuation ratio techniques 14-9 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Some Lessons from Peter Lynch Favorable Attributes of Firms –Firm’s product should not be faddish –Firm should have some long-run comparative advantage over its rivals –Firm’s industry or product has market stability –Firm can benefit from cost reductions –Firms that buy back shares show there are putting money into the firm © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Tenets of Warren Buffet 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 its shareholders? © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Tenets of Warren Buffet 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 intrinsic value of the business? –Can the business be purchased at a significant discount to its fundamental intrinsic value? © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Relative Valuation Ratio Techniques –Price earnings ratio (P/E) –Price cash flow ratios (P/CF) –Price book value ratios (P/BV) –Price sales ratio (P/S) © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Relative Valuation Ratio Techniques Price earnings ratio (P/E)  The P/E is more than a measure of a company's past performance. It also takes into account market expectations for a company's growth.  If a company has a P/E ratio higher than the market or industry average, this means that the market is expecting good performance for the company over the next few months or years. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Relative Valuation Ratio Techniques A company with a high P/E ratio should generate high earnings to live up to the high rating and expectations by the market, or the stock price will need to drop. For example, if a company’s P/E ratio is 42 and the average ratios in the market is between 15 and 20, then the company should generate higher earnings to reflect the high expectations by the market, or the stock price should drop. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Relative Valuation Ratio Techniques Price/Book Value Ratio –Book value is a reasonable measure of value for firms that have consistent accounting practice –It can be applied to firms with negative earnings or cash flows –Should not attempt to use this ratio to compare firms with different levels of hard assets—for example, a heavy industrial firm and a service firm © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Relative Valuation Ratio Techniques Price/Cash Flow Ratio –The price/cash flow ratio has grown in prominence and use because many observers contend that a firm’s cash flow is less subject to manipulation Price-to-Sales Ratio –Sales growth drives the growth of all subsequent earnings and cash flow and sales is one of the purest numbers available © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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, if key value drivers are weakened or a change occur in management it might be better to sell © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

When to Sell Evaluate closely when market value approaches estimated intrinsic value. When the stock become fairly priced (the undervaluation is corrected) it might be better to sell and reinvest the funds in other underpriced stocks. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

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