# final - company analysis and stock valuation

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Company Analysis and Stock Valuation

Shazia Farooq 18 July 2009

Learning Objectives

Differentiate between company analysis and stock valuation Explain 3 step approach to fundamental analysis Understand qualitative and quantitative approach to company analysis Determine intrinsic value of the stock using various valuation techniques Understand value-added measures available to evaluate the performance of a firm Describe the passive and active strategies in managing an equity portfolio

Company Analysis and Stock Valuation

Growth Company vs Growth Stock

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

Company Analysis and Stock Valuation

Growth Company

Historically been defined as companies that consistently experience above-average increase in sales and earnings Financial theorists define a growth company as one with management and opportunities that yield rates of return greater than the firms required rate of return

This required rate of return is weighted average cost of capital (WACC)

Company Analysis and Stock Valuation

Growth Stock

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

Company Analysis and Stock Valuation

Intrinsic Value of the Stock

Present value of all expected future cash flows to the stock investor Cash flows are discounted at the appropriate required rate of return, k Expected future cash flows consist of:1. 2.

cash dividends sale price: proceeds from the ultimate sale of the stock

Company Analysis and Stock Valuation

Intrinsic Value of the Stock

Intrinsic value is the analysts estimate of what a stock is really worth Intrinsic value (IV) can differ from the current market price (MP)

If IV > MP: stock is underpriced => buy If IV < MP: stock is overpriced => sell or do not buy

Company Analysis and Stock Valuation

Market EquilibriumIn market equilibrium,

Everyone has the same intrinsic value. So, intrinsic value equals market price, i.e., IV0 = P0. Everyone also demands the same required rate of return from the stock. So everyone has the same k. In addition, expected HPR = k

Fundamental Analysis

Method of evaluating a security by attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors Researchers have found that stock price changes can be attributed to the following:

Understanding of macroeconomic environment and developments

Analyzing industry prospects to which the firm belongs

Economy-wide factors: (30-35%) Industry factors: (15-20%) Company factors: (30-35%) Other factors: (15-25%) Assessing projected company performance and intrinsic share value

Fundamental Analysis

Economic and Industry Influences

Macroeconomic analysis identifies industries likely to offer attractive returns in the expected future environment

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

Analysis of firms in selected industries concentrates on a stocks intrinsic value based on cash flow, growth and risk

Fundamental Analysis

Structural Influences

Social trends, technology, political, and regulatory influences can have significant influence on firms Early stages in an industrys 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

Qualitative and Quantitative Approach to Company Analysis

Industry competitive environment Present value of cash flows

SWOT analysis

Relative valuation ratio techniques

Qualitative Approach

Competitive Forces

Current rivalry Threat of new entrants Potential substitutes Bargaining power of suppliers Bargaining power of buyers

Qualitative Approach

Firm Competitive Strategies

Defensive Strategy Positioning firm so that it its capabilities provide the best means to deflect the effect of competitive forces in the industry Examples include investing in fixed assets and technology or creating a strong brand image Offensive Strategy Using the companys strength to affect the competitive industry forces, thus improving the firms relative industry position Examples include preempting by obtaining price concessions from suppliers

Qualitative Approach

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 firms competitive strategy over time

Qualitative Approach

SWOT Analysis

Examination of a firms:

Strengths Weaknesses Opportunities Threats

Qualitative Approach

SWOT Analysis

Examination of a firms:

Strengths Weaknesses Opportunities Threats

INTERNAL ANALYSIS

Qualitative Approach

SWOT Analysis

Examination of a firms:

Strengths Weaknesses Opportunities Threats

EXTERNAL ANALYSIS

Intrinsic Value of the Stock

Stock Valuation TechniquesA. 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 Techniques1. 2. 3. 4. Price earnings ratio (P/E) Price cash flow ratio (P/CF) Price book value ratio (P/BV) Price sales ratio (P/S)

Present Value of Dividends

Constant Dividend Growth

Simplifying assumptions help in estimating present value of future dividends Most applicable to stable, mature firms where the assumption of relatively constant growth for the long term is appropriate

Intrinsic Value = D1/(k-g)

D1= D0(1+g)where D1 is next years dividend, k is required rate of return and g is the dividend growth rate

Present Value of Dividends

Constant Growth Model

Model requires k>g With g>k, analyst must use multi-stage model All other things unchanged,

If D1 increases (decreases), IV increases (decreases). If g increases (decreases), IV increases (decreases). If k increases (decreases), IV decreases (increases).

Present Value of Dividends

Constant Growth Model - ExampleBig Oil Inc. just paid a dividend of $10 (i.e. D0 = 10.00). Its dividends are expected to grow at a 4% annual rate forever. The required rate of return is 15%. What is the price of Big Oils common stock? (to 2 decimal places) Intrinsic Value = D1/(k-g) =10(1.04)/(0.15-0.04) = $94.55

Present Value of Dividends

Required Rate of Return Estimate

Nominal risk-free interest rate Risk premium Market-based risk estimated from the firms characteristic line using regression

R stock ! E(RFR) F stock [E(R market ) E(RFR)]where RFR is the risk free rate,stock

is beta of the stock and

E(Rm) is the expected market return

Present Value of Dividends

Expected HPR and k

Suppose the market is in equilibrium. This means that stock price is equal to intrinsic value, i.e., P0 = IV0. Then, expected HPR, E(r) is,

D1 P1 - P 0 E (r ) = + P0 P0 D1 = + g P0Dividend yield Capital gains yield

Present Value of Dividends

Expected HPR and k

If stock is selling at intrinsic value, P0 = IV0 . Then required rate of return, k, must equal the expected HPR. Therefore,

When everyone agrees on the same k (in equilibrium), we can use the above formula to compute required rate of return

D1 k = + g P0

Present Value of Dividends

Growth Rate Estimates

Average Dividend Growth Rate

!n

Dn 1 D0

Sustainable Growth Rate = b X ROEwhere b is the retention ratio and ROE is the return on equity Retention ratio is also called the plowback ratio

Present Value of Dividends

ROE Determinants

ROE

Operating Efficiency (Profit Margin)

Asset Use Efficiency (Total Asset Turnover)

Financial Leverage (Equity Multiplier)

Present Value of Dividends

ROE DeterminantsROE = = ROE = =

Profit Margin * Total Asset Turnover * Equity Multiplier (Profit/Sales) * (Sales/Assets) * (Assets/Equity)

Tax Burden * Interest Burden * Operating Profit Margin * Asset Turnover * Equity Multiplier (Net Profit/Pretax Profit)* (Pretax Profit/EBIT)* (EBIT/Sales)* (Sales/Assets) * (Assets/Equity)

Present Value of Dividends

Retention Ratio and GrowthSuppose ROE > 0 Earnings retention ratio, b Growth rate, g Growth policy b>0 g>0 No-growth policy b=0 g=0

Bottomline: If a company reinvests some portion of earnings back into the business (b > 0), future earnings and dividends will grow (i.e., g > 0). Otherwise, earnings and dividends will not grow

Present Value of Dividends

Is Growth Always Beneficial?

Does positive growth always increase stock price?

No. It depends on the attractiveness of the firms investment opportunities, ROE. If ROE > k, then retaining earnings (i.e., b > 0) will increase stock price If ROE < k, then retaining earnings will decrease stock price

Compared to a no-growth policy,

Present Value of Dividends

Consider two companiesGrowth Prospects,

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