1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown
Chapter 15

2. 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?

3. 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?

4. 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?

5. 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?

6. Chapter 15 - Company Analysis and Stock Valuation
How do we compute economic value-added (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?

7. 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?

8. 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?

9. 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?

10. 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?

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

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 Industry competitive environment SWOT analysis
Present value of cash flows
Relative valuation ratio techniques

22. Firm Competitive Strategies
Current rivalry
Threat of new entrants
Potential substitutes
Bargaining power of suppliers
Bargaining power of buyers

23. 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

24. 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

25. 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

26. SWOT Analysis Strengths Weaknesses Opportunities Threats
Examination of a firm’s:
Strengths
Weaknesses
Opportunities
Threats

27. SWOT Analysis Strengths Weaknesses Opportunities Threats
Examination of a firm’s:
Strengths
Weaknesses
Opportunities
Threats
INTERNAL ANALYSIS

28. SWOT Analysis Strengths Weaknesses Opportunities Threats
Examination of a firm’s:
Strengths
Weaknesses
Opportunities
Threats
EXTERNAL ANALYSIS

29. 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

30. Tenets of Warren Buffet
Business Tenets
Management Tenets
Financial Tenets
Market Tenets

31. Business Tenets Is the business simple and understandable?
Does the business have a consistent operating history?
Does the business have favorable long-term prospects?

32. Management Tenets Is management rational?
Is management candid with with its shareholders?
Does management resist the institutional imperative?

33. 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

34. Market Tenets What is the value of the business?
Can the business be purchased at a significant discount to its fundamental intrinsic value?

35. 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)

36. 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)

37. Growth Rate Estimates
Average Dividend Growth Rate

38. Growth Rate Estimates Average Dividend Growth Rate
Sustainable Growth Rate = RR X ROE

39. Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the firm’s characteristic line using regression

40. Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the firm’s characteristic line using regression

41. The Present Value of Dividends Model (DDM)
Model requires k>g
With g>k, analyst must use multi-stage model

42. 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

43. 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

44. Present Value of Free Cash Flow to Equity
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

45. 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
-  in Working Capital -  in other assets

46. Present Value of Operating Free Cash Flow

47. Present Value of Operating Free Cash Flow
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

48. An Alternate Measure of Growth
g = (RR)(ROIC)
where:
RR = the average retention rate
ROIC = EBIT (1-Tax Rate)/Total Capital

49. Calculation of WACC
WACC = WEk + Wdi

50. 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

51. Relative Valuation Techniques
Price Earnings Ratio

52. Relative Valuation Techniques
Price Earnings Ratio
Affected by two variables:
1. Required rate of return on its equity (k)
2. Expected growth rate of dividends (g)

53. Relative Valuation Techniques
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

54. Relative Valuation Techniques
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

55. Relative Valuation Techniques
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

56. 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?

57. 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

58. Analysis of Growth Companies
Long-run growth models
assumes some earnings are reinvested
Simple growth model

59. Simple Growth Model (cont.)
(Present value of Constant Dividend plus the Present Value of Growth Investment)
(Present value of Constant Earnings plus the Present Value of Excess Earnings from Growth Investment)

60. 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

61. 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

62. 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

63. 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

64. 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

65. 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

66. 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

67. 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

68. 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

69. Growth Duration

70. 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

71. 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

72. 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

73. 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

74. 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

75. 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

76. The Internet Investments Online
investor.msn.com

77. End of Chapter 20
Company Analysis and Stock Selection

78. Future topics Chapter 16 Technical Analysis Assumptions and Advantage
Technical Trading Rules and Indicators
Techniques and Charts