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					Lecture Presentation Software
              to accompany

  Investment Analysis and
    Portfolio Management
              Seventh Edition
                   by
    Frank K. Reilly & Keith C. Brown

 Chapter 15
   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?
   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?
   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?
   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?
   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?
   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?
   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?
   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?
     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?
     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
         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
            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
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
 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
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
  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
   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
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
         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
         Company Analysis
•   Industry competitive environment
•   SWOT analysis
•   Present value of cash flows
•   Relative valuation ratio techniques
    Firm Competitive Strategies
•   Current rivalry
•   Threat of new entrants
•   Potential substitutes
•   Bargaining power of suppliers
•   Bargaining power of buyers
    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
   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
        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
          SWOT Analysis
• Examination of a firm’s:
  – Strengths
  – Weaknesses
  – Opportunities
  – Threats
          SWOT Analysis
• Examination of a firm’s:
  – Strengths        INTERNAL ANALYSIS
  – Weaknesses
  – Opportunities
  – Threats
          SWOT Analysis
• Examination of a firm’s:
  – Strengths
  – Weaknesses
  – Opportunities
                      EXTERNAL ANALYSIS
  – Threats
 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
       Tenets of Warren Buffet
•   Business Tenets
•   Management Tenets
•   Financial Tenets
•   Market Tenets
           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 with its
  shareholders?
• Does management resist the institutional
  imperative?
           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 value of the business?
• Can the business be purchased at a
  significant discount to its fundamental
  intrinsic value?
      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)
  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)
     Growth Rate Estimates
• Average Dividend Growth Rate

                  Dn
             n      1
                  D0
     Growth Rate Estimates
• Average Dividend Growth Rate

                  Dn
             n      1
                  D0

• Sustainable Growth Rate = RR X ROE
Required Rate of Return Estimate
 • Nominal risk-free interest rate
 • Risk premium
 • Market-based risk estimated from the firm’s
   characteristic line using regression
Required Rate of Return Estimate
 • Nominal risk-free interest rate
 • Risk premium
 • Market-based risk estimated from the firm’s
   characteristic line using regression

R stock  E(RFR)   stock [E(R market )  E(RFR)]
      The Present Value of
    Dividends Model (DDM)
• Model requires k>g
• With g>k, analyst must use multi-stage
  model
       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
           Present Value of
   Free Cash Flow to Equity
FCFE =                      FCFE1
                   Value 
                           k  g FCFE
    Net Income
  + Depreciation Expense
  - Capital Expenditures
  - D in Working Capital
  - Principal Debt Repayments
  + New Debt Issues
        Present Value of
    Free Cash Flow to Equity
                       FCFE1
             Value 
                      k  g FCFE
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
       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
  - D in Working Capital - D in other assets
    Present Value of
Operating Free Cash Flow
                 FCFF1
  Firm Value 
               WACC  g FCFF
      Oper . FCF1
  or
     WACC  g OFCF
          Present Value of
      Operating Free Cash Flow
                        FCFF1
         Firm Value 
                      WACC  g FCFF
             Oper . FCF1
         or
            WACC  g OFCF
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
An Alternate Measure of Growth
g = (RR)(ROIC)
where:
  – RR = the average retention rate
  – ROIC = EBIT (1-Tax Rate)/Total Capital
Calculation of WACC

   WACC = WEk + Wdi
     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
Relative Valuation Techniques
                                  D1 / E1
• Price Earnings Ratio   P / E1 
                                  kg
Relative Valuation Techniques
                                             D1 / E1
• Price Earnings Ratio              P / E1 
                                             kg
  – Affected by two variables:
  – 1. Required rate of return on its equity (k)
  – 2. Expected growth rate of dividends (g)
Relative Valuation Techniques
                      D1 / E1
             P / E1 
                      kg

• 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
Relative Valuation Techniques
                      D1 / E1
             P / E1 
                      kg
• 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
Relative Valuation Techniques
                      D1 / E1
             P / E1 
                      kg
• 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
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?
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

   E 1  b E                       k
                                        E
 V 
   k     k                              v
  Analysis of Growth Companies
   • Long-run growth models
      – assumes some earnings are reinvested
   • Simple growth model
bEmk bEm
   2
                                                      s)
               (Gross Present Value of Growth Investment
 k          k
bEm bE
                                                  s)
            ( Net Present Value of Growth Investment
 k       k
    E bEm bE                 E 1  b  bEm
v                    v             
    k      k      k              k       k
    Simple Growth Model (cont.)
  E bEm bE              E 1  b  bEm
v                 v           
  k  k   k                  k       k

  D bEm         (Present value of Constant Dividend plus
v 
  k  k          the Present Value of Growth Investment)

  E bEm  1 (Present value of Constant Earnings plus
v           the Present Value of Excess Earnings
  k    k
              from Growth Investment)
          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
  E E 1  b  bE E
V              
  k     k       k   k
     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
 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
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
                    D1
                V
                   kg
   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
   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
      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

                      Rk
                         G
                       rk
          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
                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
    E(t)  E (0) (1  G  D) t
 Pg (0)   E g (0) (1  G g  D g ) T 
        
 P 0   E (0) (1  G  D ) T 
                                        
 d   a                   a     a     
              Growth Duration
 Pg (0)   E g (0) (1  G g  D g ) T 
        
 P 0   E (0) (1  G  D ) T 
                                        
 d   a                   a     a     

   Pg (0)/Eg (0)   (1 G g  D g ) T 
                 
   P 0 / E (0)   (1 G  D ) T 
                                        
   d        a            a     a     

    Pg (0)/Eg (0)          (1 G g  Dg ) 
ln                  T ln 
    P 0 / E (0)          (1 G  D )   
    d        a                   a    a 
        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
        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
                 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
           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
     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
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
         The Internet
      Investments Online
www.better-investing.com
www.fool.com
www.cfonews.com
www.ibes.com
www.zacks.com
www.valueline.com
www.financialweb.com
investor.msn.com
www.marketedge.com
www.nyssa.org
End of Chapter 20
 –Company Analysis and
  Stock Selection
       Future topics
        Chapter 16
Technical Analysis
• Assumptions and Advantage
• Technical Trading Rules and
  Indicators
• Techniques and Charts

				
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