Costco Wholesale Corp Business Model and Strategy - DOC by ajf58208


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									Costco Wholesale Corp. (COST)                                                               Omar Khalil
Date:                          April 12, 2006          Consensus Estimate     08/05       08/06     08/07
Sector:                       Consumer Cyclical        EPS                    $2.16       $2.33      $2.67
Industry:                          Retail              P/E                    25.14       23.40      20.42
Current Price:                     $54.53              Long Term Growth Rate:                  12.94%
52 Wk Price Range:              $39.48-57.37           Ratio Analysis    Co.    Indus.     Sector SP500
Ave. Daily Vol:                  2,785,000             P/E (TTM)        25.14   31.33       28.00     22.10
Beta:                               0.69               P/S (TTM)        0.49     3.60        2.91      3.02
Market Cap ($million):            $25,700              P/B (MRQ)        2.89     4.32        3.65      3.98
Shares Out (million):              471.2               ROA (TTM)        6.39     9.45        6.26      8.23
Inst. Hold %:                      77.2%               EBO Valuation                                 $56.72
Div Yld:                            0.80               Recommendation:                                 Hold
Total Debt/Equity:                  0.07               Stop-loss Price:                              $43.70
Member S&P 500?                     Yes                                  Price      6-mo prob     12-mo prob
                                                       Target Price       $60         32%            43%

               Investment Thesis                                              Summary
                                                         Fundamental Valuation:
      Costco have steadily been increasing market          Neutral/Positive: Based on a discount rate of
       share from traditional grocers, making it the        7.78%, Costco’s EBO valuation of $56.72 is
       largest warehouse club retailer in the US.           slightly above the current price.

      Costco could still maintain its competitive       Relative Valuation:
       advantage due to well located stores and a           Neutral/Positive: Based on forward indicators
       large and loyal customer base.                       (P/E, PEG), Costco could be overvalued. The
                                                            historical indicator (P/B, P/S) conversely appear
      Through expansions, adding new products              bullish.
       and services and gaining regular customers,       Technical Analysis:
       Costco has been able to compete                      Negative/Neutral: Most of the technical
       successfully by averaging 11% growth in              indicators, with the exception of Stochastics,
       sales.                                               indicate a continuation of downward price trend.

                                                         Earnings Analysis:
      With rising gas prices consumer’s behavior
                                                            Positive: Slight positive earning surprises with
       could change leading people to start buying
                                                            earnings expected to increase over the next year.
       by bulk, which in turn would increase
                                                            There were substantially more positive revisions
       Costco’s sales.
                                                            and negative revision in the last four weeks.
      Costco’s success draw threats to the              Analyst Recommendations:
       company; Sam’s Club for example changed              Negative: The mean recommendation is a
       its strategy to narrow the performance gap           “Hold.” Ratings have been slowly decreasing.
       between the two competitors.
                                                         Institutional Ownership:
      Costco is planning to increase its annual             Negative: The number of institutional owners
       non-executive memberships fees in May,                and the fraction of shares held by institutions are
       which raised fiscal year 2007 earnings-per-           decreasing.
       share estimate by 10 cents.
                                                         Piotroski Analysis:
                                                             Positive: Second quintile with a score of seven.

Company Summary

Costco Wholesale, Inc. is headquartered in Washington and was established in 1976. The company later
changed its name to Costco Wholesale Corporation in 1999. Costco Wholesale Corporation manages
membership warehouses, which offer members a wide range of branded and private label products at low
prices. Costco offers memberships to two primary types of members; business and Gold Star (individual)
members. It also offers an Executive Memberships to categories.

The company offers goods in a no-frills, self-service environment. The company’s products include a range
of nationally branded and selected private-label intended for businesses and consumer, according to the
company summary from yahoo, “Its product category includes candy, snack foods, health and beauty aids,
tobacco, alcoholic beverages, soft drinks, and cleaning and institutional supplies; dry and fresh foods, and
institutionally packaged foods; appliances, electronics, hardware, office supplies, garden and patio, sporting
goods, furniture, and automotive supplies; apparel, domestics, cameras, jewelry, house wares, media, home
furnishings, and small appliances; and pharmacy, optical, one-hour photo, print shop, food court, hearing aid,
and gas stations.” In addition, the company operates regional cross-docking facilities and operates various
processing, packaging facilities to other subsidiaries and other businesses.

Costco Wholesale operates 471 warehouses; most of them are located in the United States and Puerto Rico,
the rest in Canada, United Kingdom, Korea, Taiwan, Japan and in Mexico. Moreover, Costco not only
operates physical locations but also operates Costco Online.

The following table shows the approximate percentage of net sales for Costco’s each major category of items
sold during fiscal 2005, 2004 and 2003:2

                                                                        2005 2004 2003

                                                                        ---- ---- ----
Food (including dry and fresh foods and institutionally packaged         31% 31% 30%
Sundries (including candy, snack foods, health and beauty aids,          29%   29%   30%
tobacco, alcoholic beverages, soft drinks and cleaning and
institutional supplies)
Hardlines (including major appliances, electronics, hardware,            16%   16%   16%
office supplies, garden and patio, sporting goods, furniture,
cameras and automotive supplies)
Softlines (including apparel, domestics, jewelry, housewares,            12%   13%   14%
media, home furnishings and small appliances)
Other (including gas stations, pharmacy, food court, optical,            12%   11%   10%
one-hour photo, hearing aid and print shop)

                                                                        ---- ---- ----
                                                                        100% 100% 100%

2 (10K)

Competition and Strategy

Costco’s competitors include Wal-Mart Stores Inc., Target Corporation, and BJ’s Wholesale Corporation
Club, Best Buy Corporation. Costco purchase most of its products directly from manufacturers and have
them shipped either directly to their selling warehouses or to a depot where they combine different shipments
in order to lower shipping and handling costs. Costco provide more cost-effective way of distributing goods,
thus meeting the needs of business customers who otherwise would pay a premium from small purchases and
for customers who cannot otherwise get the whole range of products they need from any single source.
Costco try to carry a limited number of certain items in each product to fast selling models, sizes and colors.
The company carries very low active stockkeeping units per warehouse in their core warehouse business,
compared to its competitors. A large percentage of the inventory is financed by payment terms provided by
vendors rather than by working capital, when sales in a certain warehouse increase and inventory turnover
increase at a fast pace. Costco’s warehouse formats are designed for economy and efficiency in the use of
space. To support the company strategy they do not locate their stores in prime locations and they do not
focus on elaborate facilities. Costco’s strategy is to offer a wide range of high quality merchandise at low
prices. An important key factor that allows them to offer low prices is that they carry only products that offer
their customers with low-priced products.3

Furthermore, Costco emphasize on providing upscale customer base with quality, name-branded products at
low prices. The average Costco store makes $144 million in sales a year compared to $64 million for Sam’s
and $44 million for BJ wholesale. Costco is by far more efficient than Sam’s which made Costco ahead of
about $6 million more than Sam’s last year; although Sam’s has more stores than Costco. In addition, Costco
continue to grow its per-store sales at a faster rate compared to the competition. Costco is also different that
the competition by laying out the store in a way to encourage impulse buying. In addition, while Costco
books come in a pile style, Sam’s Club provides books in a more organized fashion. Costco also offers their
customers a sense of shopping as adventure on the top of low priced items. Another way, Costco is different
that the competition is that they rotate their products every week, and people appear to like looking at items
in different places each time they go shop at the store.4

Historical Revenue and Earnings:

                                 Historical Revenue                              Historical Earnings
                     FY 08/06        FY 08/05         FY 08/04          FY 08/06     FY 08/05        FY 08/04
1st Quarter           12,927.4        11,578.0         10,521.5          $0.45          $0.40         $0.34
2nd Quarter           14,054.6        12,658.1         11,549.0          $0.62          $0.62         $0.48
3rd Quarter             NA           11,996.910        10,897.2           $NA           $0.43         $0.42
4th Quarter             NA            16,702.2         15,139.3           NA            $0.73         $0.42
Total                 26,982.0        52,935.2         15,139.3          $1.07          $2.18         $1.86

Both revenues and earnings in the past few years and in the first and second quarter look encouraging, even
though earnings stayed the same during the second quarter and from 2005 to 2006. In addition, revenues and

3 (10K)


earnings continued to grow from 2004 to 2005 in both third and fourth quarter. Overall revenues and earning
have been increasing over the past few years, which is a positive indicator. It would be interesting to see if the
company can maintain its performance in the future with rising transportation costs; increase in gas prices.
On the other hand, that could be offset by the change in consumer behavior in relation to gas prices; with
high gas price people could start buying bulk to lessen trips to local stores.

I. Fundamental Valuation
Costco Wholesale       PARAMETERS                           FY1       FY2      Ltg
as of 4/12/06          EPS Forecasts                           2.33     2.67   12.94%              Model 1: 12-year forecasting horizon (T=12).
                       Book value/share (last fye)            18.79                                            and a 7-year growth period.
                       Discount Rate                         7.78%
                       Dividend Payout Ratio                20.28%
                       Next Fsc Year end                       2007
                       Current Fsc Mth (1 to 12)                  8
                       Target ROE (industry avg.)           14.35%

                       Year                                   2007      2008     2009      2010          2011       2012        2013       2014    2015    2016    2017    2018
                       Long-term EPS Growth Rate (Ltg)                         0.1294    0.1294        0.1294     0.1294      0.1294
                       Forecasted EPS                         2.33      2.67      3.02      3.41          3.85       4.34        4.91
                       Beg. of year BV/Shr                  18.790    20.647   22.776    25.180        27.895     30.961      34.424
                       Implied ROE                                     0.129    0.132     0.135         0.138      0.140       0.143

ROE                    (Beg. ROE, from EPS forecasts)         0.124    0.129    0.132     0.135         0.138       0.140      0.143       0.143   0.143   0.143   0.143   0.144
Abnormal ROE           (ROE-r)                                0.046    0.052    0.055     0.057         0.060       0.063      0.065       0.065   0.065   0.065   0.066   0.066
growth rate for B      (1-k)*(ROEt-1)                         0.000    0.099    0.103     0.106         0.108       0.110      0.112       0.114   0.114   0.114   0.114   0.114
Compounded growth                                             1.000    1.099    1.212     1.340         1.485       1.648      1.832       2.040   2.272   2.531   2.820   3.142
growth*AROE                                                   0.046    0.057    0.066     0.077         0.089       0.103      0.119       0.132   0.148   0.165   0.185   0.206
required rate (r)                                   0.078     0.078    0.078    0.078     0.078         0.078       0.078      0.078       0.078   0.078   0.078   0.078   0.078
discount rate                                                 1.078    1.162    1.252     1.349         1.454       1.568      1.690       1.821   1.963   2.115   2.280   2.457
div. payout rate (k)                                0.203
Add to P/B             PV(growth*AROE)                         0.04     0.05     0.05      0.06          0.06        0.07       0.07        0.07    0.08    0.08    0.08    0.08
Cum P/B                                                        1.04     1.09     1.14      1.20          1.26        1.33       1.40        1.47    1.55    1.63    1.71    1.79
    Add: Perpetuity
   beyond current yr   (Assume this yr's AROE forever)         0.55     0.63     0.68      0.73          0.79        0.84       0.90        0.93    0.97    1.00    1.04    1.08
Total P/B              (P/B if we stop est. this period)       1.59     1.72     1.82      1.93          2.05        2.17       2.30        2.41    2.52    2.63    2.75    2.87
Implied price                                                 31.50    33.95    36.05     38.24         40.54       42.95      45.47       47.56   49.72   51.97   54.30   56.72

Beg. BV/Shr                                                   18.79    20.65    22.78     25.18         27.89       30.96      34.42       38.34   42.70   47.56   52.99   59.04
Implied EPS                                                    2.33     2.67     3.02      3.41          3.85        4.34       4.91        5.47    6.10    6.81    7.59    8.47
Implied EPS growth                                                     0.146    0.129     0.129         0.129       0.129      0.129       0.115   0.115   0.115   0.116   0.116


       1. EPS Forecasts and long-term growth rate (LTG) are from Reuters Investors (04/12/06).
       2. Book value per share derived from 08/28/05 balance sheet. Total equity = 8,881.1 M, common
          stock outstanding = 472.48 M. Therefore, BVPS= 8,881.1/472.48=$18.79.
       3. Discount rate: Used current 20 year t-bond rate of 5.08% for the risk free rate, an expected return on
          the market of 9% and Costco’s beta of 0.69 (from Reuters) yielding a CAPM discount rate of 7.78%
       4. Dividend payout ratio reflects the trailing 12 months as reported by Reuters.
       5. Next fiscal year-end 2006.
       6. Current fiscal month is 8 (April).
       7. Target ROE= 14.35%, the lagging five year Retail industry ROE reported by Reuters.

Output and Sensitivity Analysis:
   1. Based on these parameters, a 12 year forecasting horizon and a 7 year growth period, the EBO
       valuation is $56.72.
   2. Changing the discount rate to 10.00% (+2%), the EBO valuation is $37.45. Thus, if the expectations
       in the model are realized, we should expect to earn a return of approximately 10%/year.
   3. Changing the growth rate to 6.94% (-6%), the EBO valuation is $50.64.
   4. Changing the industry ROE 10% (-4.35), the EBO valuation is $38.91.

       Given the current price of $54.53 the EBO valuation model yields a slightly attractive valuation at 7.78%
       discount rate. Increasing the discount rate to 10% yields a value considerably lower than the current

   II. Relative Valuation
                                                                        Mean FY2
                                                                     Earnings Estimate    Forward    Mean LT      PEG       P/B      ROE        Value
    Ticker    Name                         Mkt Cap   Current Price   (next fiscal year)    P/E      Growth Rate            (MRQ)     5 yr ave   Ratio     P/S
    WMT       Wal-Mart Stores Inc.          190.70       45.77             3.34            13.70      13.14%       1.04     3.59     21.14%      0.17     0.61
    BJ        BJ's Wholesale Club, Inc.      2.03        30.06             2.12            14.18      10.72%       1.32     1.99     14.43%      0.14     0.26
    TGT       Target Corporation            44.84        51.48             3.57            14.42      14.93%       0.97     3.17     16.79%      0.19     0.87
    BBY       Best Buy Co, Inc.             28.18        57.51             3.19            18.03      17.14%       1.05     5.34     24.63%      0.22     0.94

    COST      Costco Wholesale Corp.        25.49        54.09             2.67            20.26      12.94%      1.57      2.80     12.71%     0.22      0.47

              Implied Price based on:                                                      P/E                    PEG       P/B                 Value     P/S
    WMT       Wal-Mart Stores Inc.                                                        $36.59                  $36.03   $69.35               $41.70   $70.20
    BJ        BJ's Wholesale Club, Inc.                                                   $37.86                  $45.70   $38.44               $33.86   $29.92
    TGT       Target Corporation                                                          $38.50                  $33.37   $61.24               $46.36   $100.12
    BBY       Best Buy Co, Inc.                                                           $48.14                  $36.34   $103.16              $53.23   $108.18

              High                                                                         $48.14                 $45.70   $103.16              $53.23   $108.18
              Low                                                                          $36.59                 $33.37   $38.44               $33.86   $29.92
              Median                                                                       $38.18                 $36.19   $65.29               $44.03   $85.16

   Indicator                                                                    Interpretation
   P/E                                    Bearish: Costco has the highest P/E ratio when compared with its competitors. This
                                          implies that they either have a high growth rate or they are overvalued or less risky.
   PEG (P/E/G)                            Bearish: Costco’s PEG is higher than all of its competitors, which could indicate it is
                                          expensive given its competitors growth rate.
   P/B                                    Bullish: Costco has one of the lowest P/B relative to its competitors, indicating that
                                          Costco is undervalued, has high risk, or a low ROE.
   Value (P/B/ROE)                        Bearish: Costco has one of the highest value ration (tied with Best Buy). Thus the
                                          market must expect higher future ROEs from Costco relative to the competition.
   P/S                                    Bullish: Costco’s P/S is one of the lowest among its competitors. This might indicate
                                          that Costco has a low profit margin, low growth rate, or high risk.
   Summary                                After comparing Costco with the competition the forward indicators (P/E, PEG) of
                                          the company indicate that the company could be overvalued or less risky. While the
                                          historical indicators (Value, P/B, and P/S) suggest that the company has low profit
                                          margin and investors expect this stock to grow in the future.

III. Technical Analysis

Indicator                                                 Interpretation
Bollinger Bands     Neutral: The price is not near either of the bands, indicating neither bullish nor bearish.
Stochastics         Bearish: %K=25, %D=73. Because %K is below %D and both lines appear to be
                    dropping lower.
Moving Averages     Neutral: Price is between long-run and short-run moving averages.
MACD                Neutral: MACD is below the signal line, which indicates a bearish indicator. MACD is
                    greater than zero, which is a bullish indicator.
Regression          Neutral: Price is downtrend, which indicates a bearish sing. Some divergence the price
                    moves downward and below the trend line, which indicates a bullish sing.
PriceROC            Neutral: Roc is higher than zero, a bullish indicator. The slope is decreasing, which is a
                    bearish indicator.

IV. Earnings Analysis
                                              Earnings Surprises
                        02/06:            11/05:            08/05:              05/05:             02/05:
                       (Last qtr)      (2 qtrs prior)    (3 qtrs prior)      (4 qtrs prior)     (5 qtrs prior)
Estimate                 0.60               0.45              0.65                0.42               0.55
Actual                   0.62               0.46              0.66                0.43               0.54
Difference               0.02               0.01              0.01                0.01              -0.01
                                          Mean Earnings Estimates
                      05/06:              08/06:            08/06:          08/07:         LT Growth
                    This Quarter       Next Quarter     This Fiscal Year Next Fiscal           Rate
Earnings                 0.50              0.77             2.33             2.67             12.94
# Estimates               21                20               24               20                16
                              Earnings Per Share Estimates Revisions Summary
                                                 Last Week                        Last 4 Weeks
                                       Revised Up      Revised Down      Revised Up       Revised Down
Quarter ending 05/06                         0                2                1                 2
Quarter ending 08/06                         6                0                7                 0
Year ending 08/06                            7                2                8                 2
Year ending 08/07                            9                0               11                 0

Costco experienced positive earnings surprises over the past four quarters, but not over the past fifth one.
Even though there was a negative earning surprise over the fifth quarter, we could say that analysts have been
accurate in their predications about the company due to slight difference between the estimates and the actual

Costco plans to increase its annual non-executive memberships fees by $5 for renewal starting in May.
Analysts expect those fees to result in earnings profit of 10 cents per share, which raised fiscal year 2007
earnings-per-share estimate on Costco from $2.60 to $2.70. As a result analysts also increased the 12-month
target price from $60 to $63.5

Earnings revisions over the past four weeks reveal only four negative revisions and 27 positive revisions.
Earnings revisions over the last week reveal the same number of negative revisions as the last four weeks, but
reveal 22 positive revisions. Analysts continue to believe by majority that the company earnings will increase.


V. Analysts’ Recommendations
                       Current                 1 Month Ago           2 Months Ago            1 Year Ago
Buy                       1                         1                      1                      2
Outperform                1                         1                      1                      5
Hold                     21                        22                     21                     19
Underperform              1                         1                      1                      2
Sell                      1                         0                      0                      0
No Opinion                0                         0                      0                      0
Mean Rating             3.00                      2.92                   2.92                   2.75

Compared to Analyst recommendations a year ago there has been a slight change over the past year, although
there was a decrease of four Outperform recommendations and an increase of one Sell recommendation. The
decrease of Outperfrom recommendation and the increase of one Sell recommendation could mean that
analysts still think this company is a good investment, but perhaps it is a good time to sell the stock while
everything looks good.

VI. Institutional Ownership

                                     # of Holders      % Beg. Holders          Shares              % Shares
Shares Outstanding                                                           673,126,104           100.00%
Total Positions                          612               96.99%            363,488,096           54.00%

New Positions                            78                12.36%            10,460,366              1.55%
Soldout Positions                        35                 5.55%             -4,706,497            -0.70%
Buyers                                   271               42.95%            31,095,668              4.62%
Sellers                                  290               45.96%            -31,415,740            -4.67%
Beg. Total Inst. Positions               631               100.00%           363,808,168            54.05%

# Net Buyers/3 Mo. Net Chg.               -19               -3.01%             -320,072             -0.05%

The net number of buyers for Costco Wholesale had decreased by 19, a bearish indicator. There has also
been a -0.05 decrease in number of shares held by institutions, a slight bearish indicator. This indicates that
investors still think that the company is a good investment, but it might be the right time to sell while stock
price is high.

VII. Piotroski Analysis

A. P/B ratio and quintile (1=growth, high P/B; 5=value, low P/B): _Quintile 2_______________

B. Piotroski Score: _____7___________

         Piotroski Item             Variable needed to compute                Value            Points
1. Positive net income          TTM net income                          1,085.8          1

2. Positive cash flow           TTM cash flow                           1,876.2          1

3. Earnings Quality                                                                      1

4. Decreasing Debt              Debt/assets most recent ann figure      1.86
                                Debt/assets previous ann figure         1.98             1

5. Increasing working capital   Current ratio most recent ann figure    1.22
                                Current ratio previous ann figure       1.18             1

6. Improving Productivity       Asset turnover most recent ann figure   3.4
                                Asset turnover previous ann figure      3.4

7. Growing Profitability        ROA most recent ann figure              6.73%
                                ROA previous ann figure                 6.24%            1

8. Issuing Stock                Shares outstanding most recent ann      492
                                Shares outstanding previous ann         482              1

9. Competitive Position         Gross margin most recent ann            12.4%
                                Gross margin previous ann               12.5%

Total                                                                                    7


   1. General:
         You first report should entail approximately 40 hours of work. Subsequent reports are likely to
         entail 30 hours of work. You need to decide which company to evaluate, closely examine the
         company’s strategy and competition and determine what will drive the stock price in the future
         (your “investment thesis”). In addition, you should carefully proofread your reports to ensure a
         professional presentation.

           All the information needed for the analysis can be found on our web site or at specific web sites
           discussed below. Our userid is “cougfund” (or and password is
           “gocougs” at all websites.

           Highlighted sections indicate you need to set dates as appropriate (e.g., if the current fiscal year-
           end is December 2004, then FY1 should be FY 12/04).

   2. Narrowing your Stock Selection

           a.   Enter the site:
                Select your sector, select United States of America, select minimum market capitalization ($5
                bil). You will be given a list of stocks in your sector with a minimum capitalization of $5 bil.
                Print out this list.

           b. Narrowing your sector-eligible stock list. Once you have a list of stocks in your sector with
              at least $5b capitalization, you may be able to narrow down the list by focusing on one
              industry within your sector. Take a look at the current portfolio spreadsheet (handed out in
              class each week), and see if there are industries that account for a substantial portion of the
              sector, but that we hold few stocks. For example, in the financial sector, banks make up
              about 40% of the sector. Do we currently hold any banking stocks?

                It is up to you to decide which stock to evaluate. One possible way to further narrow the list
                is to select msn’s top ranked stocks at
       This link allows you to see
                the stocks msn ranks highest within each sector. (Note, however, that msn sector
                definitions do match perfectly with DJ sector definitions.)

                If you do not want to screen stocks according to some criteria, you can skip to #3.

                In addition, you can go to a number of different “stock screening sites” to further refine
                your security selection. Several screening sites allow you to restrict screens to certain sectors.
                (e.g., Kimberly Clark is defined as a “Basic Industry Sector” by Reuters, but “Consumer
                Non-cyclicals” by Dow Jones, and “Consumer Staples” by Zacks).

                Here are some suggestions for screening sites (that include a “sector” screen):

           c. If you want to screen on fundamental data such as P/B, Analysts’ forecasts, Changes in
              Institutional ownership, etc., I recommend you use Zacks. Begin by clicking this link:
     Then select “Go to the Custom Screener
              now.” Note also, that by clicking on this link, Zack gives you the option of viewing a
              number of predefined screens e.g., low fundamentals (value stocks).

                 i. Begin by setting “Select Category” to “Company Descriptors.” Then on the right-
                    hand side, select the sector (you may have to run a couple of sectors in different
                    screens to get the DJ sectors). Also select “Market Cap” “>=” and enter 5000 (i.e.,
                    5,000 million is 5 bil).

                ii. Hit the “Click to Screen” button. On the left hand side, you will see the number of
                    companies that are in the sector and greater than $5b cap (i.e., the number of
                    companies that meet the screen). Under that you will see the criteria you’ve
                    selected. For example, if you pick the “Basic Materials” sector and min cap of $5b,
                    it will tell you 33 companies meet the criteria (on 8/21/03).

                iii. Select another category (on the drop down menu right above “# of companies”)
                     and choose your criteria. Hit “Click to Screen” again. For example, I picked EPS
                     Surprises and set “Average EPS Surprise (Last 4 Quarters)” to “>=” 10. If you are
                     not sure what a variable means (e.g., Average EPS Surprise), click on it for a
                     definition. After hitting click to screen, the # of companies moves from 33 to five.
                     Thus, there are only five companies that meet all three criteria (Basic Industries,
                     $5b, EPS surprise greater than 10%).

                iv. Now click “Run Report.” Zacks will give you a list of information you can request
                    for these five companies. Select the items you want and click “Submit Query” at the
                    bottom of the report. Zacks will return the companies and any information you

3. Page 1 (summary page)

       a.   Top left-hand box
                i. Sector/Industry: If you printed out the list from 1a (above), then you can pull sector
                    and industry off the list. If you did not print out the results, then determine sector
                    and industry from
                    Select your sector, select United States of America, select minimum market
                    capitalization ($5 bil). You will be given a list of stocks in your sector with a
                    minimum capitalization of $5 bil. In addition, the sector and industry will be given.

                    As noted above, different sites use different sector and industry definitions. If you
                    use the dowjones site, you can ensure you get the right (i.e., the DJ-TMI) sector and

                ii. Download an alphabetical list of the companies that make up the S&P 500 at
           to determine if the
                    stock is a member of the S&P 500.

                iii. All other variables in top LH table can be found at
            Enter ticker, then
                     hit “company report” under “Research” on left hand side of screen.

       b. Top right-hand box
              i. TTM refers to trailing 12 months, FY1 is next fiscal year, FY2 is the following fiscal
                  year. Replace this notation with calendar notation (e.g., 12/04A, 12/05E, 12/06E
                  for December 2004 actual, December 2005 estimated, etc.).

        ii. Put in appropriate EPS figures. All data for this section is available from
   Enter ticker in box and hit “Go.” (Note – even
            though they ask for an email address, just sign in as cougfund, with password,
                  1. Get TTM P/E from “Ratios” (on left-hand side under Financial Info).
                     Determine TTM earnings by dividing current price by TTM P/E. Date for
                     TTM will be quarter prior to next earnings forecast. For example, Boeing’s
                     next forecast is for qtr 9/04, therefore, TTM ends 6/04.
                  2. Select “estimates” (under “Analysis” on left-hand side) to get FY1 and FY2
                     EPS estimates. Be sure to use annual, not quarterly estimates. Compute
                     FY1 and FY2 P/E as current price/FY1 and current price/FY2. Use mean
       iii. Forecasted long-term growth rate can be pulled directly from
   “estimates” (under “Analysis”).
       iv. All other ratios on top right-hand box can be pulled directly from
   “Ratios.” Note, however, that “valuation ratios”
            are the default (which includes P/E, P/S, and P/B). To get ROA, you must select
            “Mgt Effectiveness” in the box titled, “Ratios” on the left-hand side of the screen.
        v. EBO valuation is from your fundamental valuation (“Lee spreadsheet”).
       vi. YOUR Recommendation can be Strong Buy, Buy, Hold, Moderate Sell, or Strong
      vii. Stop-loss price is the price at which you think we should sell if the stock starts to
            tank. Historically, we’ve used about 20 percent below the current price.
      viii. The target price is up to you (where do you think the stock is going?). Zacks reports
            the “target price consensus” which, I think it the median target price by analysts.
            Click on this link (, enter the ticker in top left-hand corner, hit
            enter. The consensus target price should be reported in the box on the left-hand
       ix. Use the Price Acceptability Tester (reality check) at
   to compute the probability (based
            on the stocks’ historical return distribution) of reaching the target price in the next
            six months and next year.

            To use the price acceptability tester (PAT), put in the symbol, the target price and
            the period, hit calculate. The likelihood will show up in the graph.

            PAT is based on historical risk and return data. Specifically, the expected return is
            the industry return over the past 7 years. The firm’s volatility is estimated as a
            decaying average of its historical volatility.

            FYI, the “riskgrade” of a stock is relative to a score of 100 for a well-diversified
            international index.

c. Bottom left-hand box
          Investment thesis – Why do you make the recommendation you do? Make a list of
          what you believe are the key determinants (or “value drivers”) as to the future value
          of this stock.

            This is one of the hardest, and most important, parts of the report. You should do
            this section only after you have evaluated the company’s strategy and competition.
            Focus on why you think the price will rise or fall in the future. For example,
            reporting that the company is the largest in its industry does not tell us anything

                    about what you think will happen to the stock price. Alternatively, reporting that
                    the company will spin-off unprofitable divisions over the next year will likely
                    influence what will happen to the stock price. Make sure this section is well
                    thought-out. In addition, be sure to incorporate market expectations. For
                    example, if a company recently announced good news and you believe the
                    market overreacted, then you would forecast a price decline. Alternatively, if
                    the market underreacted to the good news, then you would forecast a price
                    increase. If you believe the market reacted correctly to the good information
                    (i.e., efficient markets), then it really tells you nothing about how the price
                    should move in the future.

        d. Bottom right-hand box
                  Summarize your analyses. Begin each with sign of indicator (i.e., positive, negative,
                  or neutral – see example reports).

4. Page 2/3 – Company Summary/Competition and Strategy/Historical Revenue and Earnings
   (maximum of two pages):
       a. Company Summary – provide a brief description of the company including a list of major
          divisions. Reuters (, provides a nice business description
          (enter ticker, select “Go,” select “Company Profile,” then select “Full Description”).

            Be sure to include divisional breakdown of revenue and earnings. These numbers are usually
            available from the company’s quarterly reports (10Qs or 10Ks). These reports are usually
            available from their corporate websites. Alternatively, you can get the data from
   (enter ticker, click “Go”,
            select “SEC Filings,” then select the most recent 10Q or 10K). FYI, 10Q is the company’s
            quarterly report (filed three time a year), and 10K is the company’s annual report.

        b. Competition and Strategy – Who are the company’s major competitors? How does the
           company differentiate itself from other companies?, e.g., How is their strategy unique?
           Focus on the company’s strategy and how they differentiate themselves in the industry. For
           example, how does Ford differ from other automakers? This is one of the hardest and most
           important parts of the report. Spend some time looking around (on the web) to learn about
           the company, the competition, and the industry.

            There are no easy answers to these questions. You may also determine the competitors at
   Enter the ticker, select “competitors” from menu on left-hand-
            side. Also, select “industry” from menu on left-hand-side, then select “industry summary”
            from about three-quarters down the page.

            I also recommend the company’s own website and competitors’ websites.

        c. Historical revenue and earnings. The information for this table (earnings history) is available
           from MSN money (, enter the ticker, select “Go,”
           hit “Financial Results”). Discuss any patterns in revenue and earnings.

5. Page 4 – Fundamental (EBO) Analysis
       Use the spreadsheet provided by Professor Charles Lee to value the security.
       Click here to get the EBO Valuation Spreadsheet (excel file).


To copy the spreadsheet into your word document – select the cells you want to copy and hit
“edit copy” (or CTRL C), in Word, hit “edit” “paste special” and choose “picture.”

Note to “see” the picture, make sure Word’s view (view menu) is on “Print Layout.”

Instructions for the spreadsheet:

a. Fill in all Yellow cells
b. EPS forecasts: Take FY1, FY2 and LTG (fiscal year 1, fiscal year 2, and long-term growth
   rates) from the top right-hand box on summary sheet (first page)
c. Book value/share (last fye): Use - enter ticker, select
   “Go,” select “Financial Statements.” The default is the income statement, thus, you next
   need to select “Balance Sheet,” from the “in Financial Statements” (in the top right corner).
   Use “Total Equity” (book value of equity) and “Total Common Shares Outstanding” for the
   SHEET). Divide “Total Equity” by “Total Common Shares Outstanding” to get book
d. Discount Rate: Use the CAPM to estimate the discount rate (r=rf+(E(rm)-rf)). Assume the
   appropriate risk-free rate is the 20 year t-bond rate. The current 20 year T-bond rate is
   available from the Fed at Select the most recent H.15 release. Pull
   the rate from the most recent “20-year” under “U.S. government securities.” Note, a rate of
   5.4 means 5.4% in the CAPM (i.e., rf=0.054). You recorded beta in the top LH box. The
   historical market return is around 12%. Many argue, however, that, high current valuations
   suggest the expected future market risk premium is lower. I recommend an estimate of the
   expected return on the market (E(rm)) of 9 to 10%. Assuming, for example, an expected
   market return of 9.5%, I estimate Boeing’s required rate of return as 0.054+0.54(0.095-
e. Dividend Payout Ratio: Use (enter ticker, select “Go,” select
   “Ratios,” select “Dividends” from “in Ratios” box) for dividend payout rate (TTM for
   company). In the case of negative earnings, divide DPS by (6% X total assets per share).
f. Next fiscal year-end: The year corresponding to the next fiscal year-end.
g. Current fiscal month: The month of the current fiscal year. For example, if the firm’s fiscal
   year ends in June, then July would be “1” and May would be “11.”
h. Target ROE (industry avg.): Use (enter ticker, select “Go,” select
   “Ratios,” select “Management Effectiveness” from “Ratios” box) – Return on Equity (5 yr.
   Avg.) for INDUSTRY.
i. Implied Price: This is the present value (TODAY) of future cash flows to shareholders (i.e.,
   the firm’s fundamental value). EACH number in this row is an estimate of the price
   TODAY. The number varies based on how many periods we specifically forecast.
   Professor Lee’s spreadsheet goes out 12 years. Thus, the best estimate of price is the last
   price forecast (i.e., cell P29).

Discuss the inputs, i.e., how did you get the values you used (see example reports)?
Discuss the output and sensitivity analysis. For the sensitivity analysis, try a few different
discount rates, growth rates and industry ROE to see how sensitive the EBO valuation is to
changes in these parameters.

Holding everything else equal, find the discount rate that gets you the current market price. If all
your expectations are realized, this is the rate you should earn on the stock. See the Boeing

6. Page 5 – Relative Valuation
       Click here for the relative valuation spreadsheet.

        SAVE the spreadsheet to your disk before you begin editing. After you complete the
        spreadsheet (instructions are given below), copy the spreadsheet into your document and discuss
        the relative valuation of your company.

        To copy the spreadsheet into your word document– select the cells you want to copy and hit
        “edit copy” (or CTRL C), in Word, hit “edit” “paste special” and choose “picture.”

        Note to “see” the picture, make sure Word’s view (view menu) is on “Print Layout.”

        Relative valuation spreadsheet instructions
        a. Go to Enter the ticker, select “competitors” from menu on
            left-hand-side. Record the tickers and market capitalizations for the US-based competitors.


        b. Fill in ticker, company name, and market capitalization fields in spreadsheet.
        c. Go to and enter the first comparison ticker, select “Go.” Enter
           the current price in the spreadsheet.
        d. Click on “Estimates” and enter:
                  i. mean FY2 earnings estimate
                 ii. mean LT growth rate
        e. Click on “Ratios” and enter the data for:
                  i. P/B (MRQ)
                 ii. P/S (TTM)
                iii. ROE (5 yr average, under “Management Effectiveness” in “Ratios”).
        f. Repeat steps for a total of five stocks (the four comparables and “your” stock).

7. Page 6 – Technical Analysis
       Insert three charts here.
       All Charts are from

        Click on the above link, enter your ticker in the “Symbol” box, and select “Get Chart.”
        Next select the following options:
            Then click “Go”

        Next change the “Chart Display” options to:
           Size: Large
           Density: High

        Chart 1:     Under the Technical Analysis Options
                     Empty the “Studies to be Applied” box (click on each indicator and then the Delete
                     Move “Bollinger Bands” from the Available Studies box to the Studies to be
                     Applied box

                    Move “Stochastics” from the Available Studies box to the Studies to be Applied box
                    Select (highlight) the Stochastics and set the parameters to 25 and 25 (i.e., %k is
                    over past 25 days and %d is 25 day moving average of %k).

                    Select (highlight) Bollinger Bands and set parameters to 50 and 2.5 (i.e., moving
                    average price over past 50 days and 2.5 standard deviations of moving average
                    volatility over past 50 days)

                    Once a chart is shown, right-click on the chart and “save picture as” (if using
                    explorer, “save image as” if using firefox) to a directory on your computer. Then,
                    once in MS-Word, “insert picture.”

       Chart 2:     Empty the “Studies to be Applied” box
                    Select “Moving Average”
                    Select “Line Oscillator” (Note: line oscillator is same as MACD – this website calls
                    the difference line oscillator for simple moving averages, and MACD for
                    exponential moving averages)

                    Set the parameters for the MA to 25 (25 day moving average), 50, 1 (the program
                    wants a third moving average, by putting in 1, you simply get the price back)
                    Set the parameters for the Line Oscillator (MACD) to 25, 50, 15 (25 day MA, 50 day
                    MA and 15 day MA of MACD for the signal line). The black line (“Osc”) will be
                    the difference between the MAs and the red line (“Ma”) will be the 15 day MA of
                    the difference.

                    Right click chart and “save picture as” to a directory on your computer.

       Chart 3:     Empty the “Studies to be Applied” box
                    Select “Least Sq. Linear Regression.” Set parameters to 25 (i.e., regression based on
                    last 25 days)
                    Select “Rate of Change.” Set parameters to 100 (i.e., the percent change in the price
                    over the past 100 trading days)

                    Right click chart and “save picture as” to a directory on your computer.

                    Chart 1:         Bollinger Bands
                                     Fast Stochastics

                    Chart 2:         Exponential Moving Average

                    Chart 3:         Linear Regression Channel
                                     Price Rate of Change (momentum)

       Briefly discuss each indicator in the table at the bottom of the page. For help in interpreting the
       indicators see:

8. Page 7 – Earnings Analysis

        Fill out the table. The information (earnings surprises, earnings estimates, and EPS revisions) is
        available at (under “estimates”). Discuss your analysis at the bottom
        of the page.

9. Page 8 – Analysts’ Recommendations
       Fill out the table. All information for earnings is available at (under
       “Recommendations”). Discuss your analysis at the bottom of the page.

10. Page 9 – Institutional Ownership
        Click here to download the “institutional ownership” spreadsheet.

        Fill out the YELLOW shaded cells based on the information at
        (, (“Ownership”). Discuss your analysis at the bottom
        of the page.

VII. Piotroski Analysis

A. P/B ratio and quintile (1=value; low P/B, 5=growth, high P/B): ________________

        Report P/B (from front page) and P/B quintile. Determine the current P/B quintile (from Ken
        French’s website 1/3/06) from the following Table:

                                P/B ratio greater than   P/B ratio less than
         1 (Growth)             3.22
         2                      2.15                     3.22
         3                      1.62                     2.15
         4                      1.14                     1.62
         5 (Value)                                       1.14

B. Piotroski Score: ________________

         Piotroski Item               Variable needed to compute                   Value         Points
1. Positive net income            TTM net income

2. Positive cash flow             TTM cash flow

3. Earnings Quality

4. Decreasing Debt                Debt/assets most recent ann figure
                                  Debt/assets previous ann figure

5. Increasing working capital     Current ratio most recent ann figure
                                  Current ratio previous ann figure

6. Improving Productivity         Asset turnover most recent ann figure
                                  Asset turnover previous ann figure

7. Growing Profitability          ROA most recent ann figure
                                  ROA previous ann figure

8. Issuing Stock                  Shares outstanding most recent ann
                                  Shares outstanding previous ann

9. Competitive Position           Gross margin most recent ann
                                  Gross margin previous ann


Fill out the above table and determine the Piotroski score. Instructions for each item are:

All nine items can be found at; enter the ticker in the “quotes” box and hit

            1. Positive net income – select “Financial Statements” from left hand side. Report the TTM
               Net Income. If positive, add one point to last column.

            2. Positive cash flow – from “Financial Statements” select the “10-Yr Cash Flows” tab. Report
               the TTM Cash from Operations. If positive, add one point to last column.

            3. Earnings quality – If TTM Cash Flow is greater than TTM earnings, add one point to last

            4. Decreasing debt – select “Key Ratios” then select “Financial Health” tab. Report Financial
               Leverage ratio (debt/assets) for most recent annual figure (e.g., 2004) and for previous
               annual figure (e.g., 2003). Add one point to last column if the most recent annual figure is
               less than the previous annual figure.

            5. Increasing working capital – select “Key Ratios” then select “Financial Health” tab. Report
               current ratio (current assets/current liabilities) for most recent annual figure (e.g., 2004) and
               for previous annual figure (e.g., 2003). Add one point to last column if the most recent
               annual figure is greater than the previous annual figure.

            6. Improving productivity – select “Key Ratios” then select “Efficiency Ratios” tab. Report
               Asset turnover ratio (revenues/total assets) for most recent annual figure (e.g., 2004) and for
               previous annual figure (e.g., 2003). Add one point to last column if the most recent annual
               figure is greater than the previous annual figure.

            7. Growing profitability – select “Key Ratios” then select “Profitability” tab. Report Return on
               Assets (NI/total assets) for most recent annual figure (e.g., 2004) and for previous annual
               figure (e.g., 2003). Add one point to last column if the most recent annual figure is greater
               than the previous annual figure.

            8. Issuing stock – select “Financial Statements” select “10-Yr Income” tab. Report shares
               outstanding (last row) for most recent annual figure and for previous annual figure. Add one
               point to last column if the most recent annual figure is no greater than the previous annual

            9. Competitive Position – select “Key Ratios” select “Profitability” tab. Report Gross Margin
               for most recent annual figure and for previous annual figure. Add one point to last column
               if the most recent annual figure is greater than the previous annual figure.

Determine the Piotroski Score by summing the last column. Higher numbers are better. See for a recent study of the Piotroski model.


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