1. CHAPTER SEVEN Practical Investment Management Robert A. Strong A 1 3 FUNDAMENTAL STOCK ANALYSIS

2. South-Western / Thomson Learning © 2004 7 - 2 Outline  Valuation Philosophies  Investors’ Understanding of Risk Premiums  The Time Value of Money  The Importance of Cash Flows  The Tax Factor  EIC Analysis  Value vs. Growth Investing  The Value Approach to Investing  The Growth Approach to Investing  How Price Relates to Value  Value Stocks and Growth Stocks: How to Tell by Looking

3. South-Western / Thomson Learning © 2004 7 - 3  The Price-to-Book Ratio  The Price-Earnings Ratio  Differences between Industries Outline

4. South-Western / Thomson Learning © 2004 7 - 4 Outline  Some Analytical Factors  Growth Rates  The Dividend Discount Model  The Importance of Hitting the Earnings Estimate  The Multistage DDM  Caveats about the DDM  False Growth  A Firm’s Cash Flows  Small-Cap, Mid-Cap, and Large-Cap Stocks  Ratio Analysis  Cooking the Books

5. South-Western / Thomson Learning © 2004 7 - 5 Valuation Philosophies  Fundamental analysts believe securities are priced according to fundamental economic data.  Technical analysts think investor behavior and supply and demand factors play the most important role.

6. South-Western / Thomson Learning © 2004 7 - 6 Valuation Philosophies  Investors’ understanding of risk premiums: Investors are almost always risk-averse.  The time value of money: Everyone agrees on this basic principle.  The importance of cash flows: Most investment research deals with predicting future corporate earnings.  The tax factor: The tax code is complicated and not all investments are taxed equally.

7. South-Western / Thomson Learning © 2004 7 - 7 Valuation Philosophies  Economy, Industry and Company (EIC) analysis:  The analyst first considers conditions in the overall economy (market risk),  then determines which industries are the most attractive in light of the economic conditions (using Porter’s competitive strategy analysis framework, for example),  and finally identifies the most attractive companies within the attractive industries.

8. South-Western / Thomson Learning © 2004 7 - 8 Valuation Philosophies Insert Figure 7-1 here.

9. South-Western / Thomson Learning © 2004 7 - 9 Value vs. Growth Investing  A value investor believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm’s financial statements) justify the purchase.  Value investors believe in a regression to the mean. The Value Approach to Investing

10. South-Western / Thomson Learning © 2004 7 - 10 Regression to the Mean Most of the time a security’s long- term return is consistent with its risk. Over the long run, a security cannot survive with a cumulative return that is negative. Cumulative Return Time in the Long Term 0 + - x x x x x x x x x x x x x x x Undervalued stock: Buy Overvalued stock: Sell

11. South-Western / Thomson Learning © 2004 7 - 11 Value vs. Growth Investing  Growth investors seek steadily growing companies. There are two factions:  Information traders are in a hurry; they believe information differentials in the marketplace can be profitably exploited.  True growth investors are more willing to wait, but they share the belief that good investment managers can earn above- average returns for their clients. The Growth Approach to Investing

12. South-Western / Thomson Learning © 2004 7 - 12 Value vs. Growth Investing  In the early days of the market, before the Great Crash of 1929, price played a minor role: “A stock with good long-term prospects is always a good investment.” How Price Relates to Value  The modern perspective is that value is inextricably intertwined with price. $ 8

13. South-Western / Thomson Learning © 2004 7 - 13 Value vs. Growth Investing  No precise definition exists.  Classification by Morningstar Mutual Funds: Value Stocks and Growth Stocks: How to Tell by Looking relative price-to-book ratio relative price-earnings ratio +

14. South-Western / Thomson Learning © 2004 7 - 14 The Price-to-Book Ratio  Book value per share is an accounting concept synonymous with equity per share or net asset value.  Share price is not normally equal to book value because of  depreciation, uncollectible debts, goodwill, etc.  economic obsolescence  intangible assets

15. South-Western / Thomson Learning © 2004 7 - 15 The Price-to-Book Ratio  The price-earnings ratio (PE) is computed by dividing the current stock price by the firm’s earnings per share.  Because of differences among industries, relative ratios are commonly computed.

16. South-Western / Thomson Learning © 2004 7 - 16 The Price-to-Book Ratio Insert Figure 7-3 here.

17. South-Western / Thomson Learning © 2004 7 - 17 The Price-to-Book Ratio Insert Figure 7-4 here.

18. South-Western / Thomson Learning © 2004 7 - 18 Some Analytical Factors: Growth Rates  Growth rates from historical data:  Growth rates from earnings retention:

19. South-Western / Thomson Learning © 2004 7 - 19 Some Analytical Factors: Growth Rates Insert Table 7-4 here.

20. South-Western / Thomson Learning © 2004 7 - 20 Some Analytical Factors: Growth Rates  Financial analysts typically calculate a number of growth rates using different ways to determine a likely range for the statistic.  Recent data may be more reliable than data from the more distant past.  Company statements regarding company targets may be considered too. Choosing a Growth Rate

21. South-Western / Thomson Learning © 2004 7 - 21 Some Analytical Factors: Growth Rates Insert Table 7-5 here.

22. South-Western / Thomson Learning © 2004 7 - 22 Some Analytical Factors: Growth Rates  Another important source of growth rate estimates is from other security analysts.  Three popular services that monitor and report these estimates are Zacks, First Call, and the Institutional Brokers Estimate System (I/B/E/S).  The term whisper number refers to what people really think the earnings will be, and not what the published estimate is. Growth Rate Estimates from Other Analysts

23. South-Western / Thomson Learning © 2004 7 - 23 The Dividend Discount Model (DDM)  Also called Gordon’s growth model.  The model assumes that the dividend stream is perpetual and that the long- term growth rate is constant.

24. South-Western / Thomson Learning © 2004 7 - 24 The Dividend Discount Model (DDM)  The variable k is sometimes called the shareholders’ required rate of return.  Note that the shareholder’s required rate of return is the sum of the expected dividend yield and the expected stock price appreciation.

25. South-Western / Thomson Learning © 2004 7 - 25 The Importance of Hitting the Earnings Estimate  The market often penalizes a company’s stock substantially when the earnings report is disappointing.  This is especially true when the required rate of return and the estimated growth rate are high.

26. South-Western / Thomson Learning © 2004 7 - 26 The Multistage DDM  Often, initial high growth levels cannot be sustained.  Suppose the growth rate g is expected to persist from the third year:

27. South-Western / Thomson Learning © 2004 7 - 27 Some Analytical Factors  Caveats about the DDM: The DDM is at most a useful tool in security analysis - it requires certain assumptions and it has shortcomings.  False growth: False growth occurs when a firm acquires another firm with a lower price-earnings ratio - historical data should always be scrutinized carefully when used to determine a growth rate.

28. South-Western / Thomson Learning © 2004 7 - 28 False Growth Insert Table 7-7 here.

29. South-Western / Thomson Learning © 2004 7 - 29 Some Analytical Factors  A firm’s cash flow: The statement of cash flows is a useful analytical tool - the cash flow from operations figures are widely used as a check on a firm’s earnings quality.

30. South-Western / Thomson Learning © 2004 7 - 30 Some Analytical Factors  Small-cap, mid-cap, and large-cap stocks: Another consideration in fundamental stock analysis relates to the size of the firm - for example, the small firm effect.

31. South-Western / Thomson Learning © 2004 7 - 31 Some Analytical Factors: Ratio Analysis  The fundamental analyst is necessarily interested in the firm’s accounting statements and in the prevailing general economic conditions.  To assist in the analysis, several organizations publish comparative statistics for industry groups. e.g. Dun and Bradstreet’s Industry Norms & Key Business Ratios, which includes solvency, efficiency and profitability ratios.

32. South-Western / Thomson Learning © 2004 7 - 32 Some Analytical Factors: Ratio Analysis Dun & Bradstreet’s 14 Key Business Ratios Solvency Ratios 1.Quick Ratio = (Cash + Accounts Receivable)/Current Liabilities Measures ability to raise cash quickly, ignores inventory 2.Current Ratio = Current Assets/Current Liabilities General measure of liquidity 3.Current Liabilities to Net Worth = Current Liabilities/Net Worth Compares short-term liabilities to permanent invested capital 4.Current Liabilities to Inventory = Current Liabilities/Inventory Measures extent to which payment of current debts relies on sale of inventory 5.Total Liabilities to Net Worth = Total Liabilities/Net Worth Measures firm’s reliance on debt financing 6.Fixed Assets to Net Worth = Fixed Assets/Net Worth Measures proportion of firm’s equity tied up in long-term assets

33. South-Western / Thomson Learning © 2004 7 - 33 Some Analytical Factors: Ratio Analysis Dun & Bradstreet’s 14 Key Business Ratios Efficiency Ratios 7.Collection Period = Accounts Receivable/Credit Sales per Day Measures firm’s efficiency in turning credit sales into cash 8.Sales to Inventory = Annual Net Sales/Inventory Measures speed that inventory moves from shelf to customer 9.Assets to Sales = Total Assets/Net Sales Measures efficiency with which assets are used to produce sales 10.Sales to Net Working Capital = Sales/Net Working Capital Measures aggressiveness or conservatism in financing sales 11.Accounts Payable to Sales = Accounts Payable/Annual Net Sales Measures how rapidly company pays its suppliers

34. South-Western / Thomson Learning © 2004 7 - 34 Some Analytical Factors: Ratio Analysis Dun & Bradstreet’s 14 Key Business Ratios Profitability Ratios 12.Return on Sales (Profit Margin) = Net Profit after Taxes/Annual Net Sales Measures profit per dollar of net sales 13.Return on Assets = Net Profit after Taxes/Total Assets Measures company’s efficiency in using assets to produce operating profit 14.Return on New Worth (Return on Equity) = Net Profit after Taxes/Net Worth Measures return to the suppliers of equity capital

35. South-Western / Thomson Learning © 2004 7 - 35 Some Analytical Factors: Cooking the Books  All publicly traded firms in the United States must have their financial statements audited to ensure they fairly present the company’s financial position.  Still, every year, there is at least one story of accounting fraud at a major firm. Unfortunately, there is not much the analyst can do about fraud.

36. South-Western / Thomson Learning © 2004 7 - 36 Review  Valuation Philosophies  Investors’ Understanding of Risk Premiums  The Time Value of Money  The Importance of Cash Flows  The Tax Factor  EIC Analysis  Value vs. Growth Investing  The Value Approach to Investing  The Growth Approach to Investing  How Price Relates to Value  Value Stocks and Growth Stocks: How to Tell by Looking

37. South-Western / Thomson Learning © 2004 7 - 37  The Price-to-Book Ratio  The Price-Earnings Ratio  Differences between Industries Review

38. South-Western / Thomson Learning © 2004 7 - 38  Some Analytical Factors  Growth Rates  The Dividend Discount Model  The Importance of Hitting the Earnings Estimate  The Multistage DDM  Caveats about the DDM  False Growth  A Firm’s Cash Flows  Small-Cap, Mid-Cap, and Large-Cap Stocks  Ratio Analysis  Cooking the Books Review