final - company analysis and stock valuation

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


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


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 firm’s required rate of return

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


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


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. cash dividends

2. sale price: proceeds from the ultimate sale of the stock



Intrinsic value is the analyst’s 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


Market Equilibrium

In 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:

– Economy-wide factors: (30-35%)

– Industry factors: (15-20%)

– Company factors: (30-35%)

– Other factors: (15-25%)

Understanding of macroeconomic environment and

developments

Analyzing industry prospects to which the firm belongs

Assessing projected company performance and

intrinsic share value


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

stock’s intrinsic value based on cash flow, growth and risk


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

Qualitative and Quantitative Approach to Company Analysis

Industry competitive

environmentSWOT analysis

Present value

of cash flowsRelative valuation

ratio techniques

Qualitative Approach

Competitive Forces

Current rivalry

Threat of new entrants

Potential substitutes

Bargaining power of suppliers

Bargaining power of buyers


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 company’s strength to affect the competitive

industry forces, thus improving the firm’s relative industry position

– Examples include preempting by obtaining price concessions from suppliers


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


– Strengths

– Weaknesses

– Opportunities

– Threats

INTERNAL ANALYSIS


SWOT Analysis


– Strengths

– Weaknesses

– Opportunities

– ThreatsEXTERNAL ANALYSIS


Stock Valuation Techniques

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 Techniques1. Price earnings ratio (P/E)

2. Price cash flow ratio (P/CF)

3. Price book value ratio (P/BV)

4. 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 year’s dividend,

k is required rate of return and g is the dividend growth rate


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).


Constant Growth Model - Example

Big 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 Oil’s common stock? (to 2 decimal places)

Intrinsic Value = D1/(k-g)=10(1.04)/(0.15-0.04)= $94.55


Required Rate of Return Estimate

Nominal risk-free interest rate

Risk premium

Market-based risk estimated from the firm’s characteristic line

using regression

where RFR is the risk free rate,

βstock is beta of the stock and

E(Rm) is the expected market return

E(RFR)])E(R[E(RFR)R marketstockstock

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,

1 1 0

0 0

1

0

( )D P P

E rP PD

gP

-= +

= +

Dividend 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

1

0

Dk g

P= +


Growth Rate Estimates

Average Dividend Growth Rate

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

1D

Dn

0

n


ROE Determinants

ROE

Operating Efficiency

(Profit Margin)

Asset Use Efficiency

(Total Asset Turnover)

Financial Leverage (Equity Multiplier)


ROE Determinants

ROE

= Tax Burden * Interest Burden * Operating Profit Margin * Asset Turnover * Equity Multiplier

= (Net Profit/Pretax Profit)* (Pretax Profit/EBIT)* (EBIT/Sales)* (Sales/Assets) * (Assets/Equity)

ROE = Profit Margin * Total Asset Turnover * Equity

Multiplier = (Profit/Sales) * (Sales/Assets) * (Assets/Equity)


Retention Ratio and Growth

Suppose ROE > 0 Growth policy No-growth policy

Earnings retention ratio, b b > 0 b = 0

Growth rate, g g > 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


Is Growth Always Beneficial?

Does positive growth always increase stock price?– No. It depends on the attractiveness of the firm’s

investment opportunities, ROE. Compared to a no-growth policy,

– If ROE > k, then retaining earnings (i.e., b > 0) will increase stock price

– If ROE < k, then retaining earnings will decrease stock price

31

Present Value of Dividends Consider two companies

Growth Prospects, Inc

(GP)

Dead Beat, Inc (DB)

No-growth earnings per share $5 $5

Required rate of return, k 12.5% 12.5%

No-growth price per share 5/0.125 = 40 5/0.125 = 40

ROE 15% 10%

Present Value of Dividends Suppose both companies reinvest 60% of next year’s earnings…


(GP)

Dead Beat, Inc (DB)

Earnings retention ratio, b 0.6 0.6

Next year’s dividend per share, D1 = (1 – b) x 5

$2 $2

Dividend growth rate, g

= ROE x b

9% 6%

Constant dividend growth model share price

2/(0.125 – 0.09) = 57.14

2/(0.125 – 0.06) = 30.77

Present Value of Dividends Compare GP and DB


(GP)

Dead Beat, Inc (DB)

ROE 15% 10%

Required rate of return, k 12.5% 12.5%

No-growth price per share (1) 40 40

Constant div. growth price (2) 57.14 30.77

Present value of growth opportunities, PVGO = (2) – (1)

17.14 -9.23

PVGO = Price per share – no-growth price per share

34


Multi Stage Dividend Growth

With this assumption, dividends grow at different rates for different periods of time. Eventually, dividends will grow at a constant rate forever

Time line is very useful for valuing this type of stocks To value such stocks, also need the constant growth

formula Best way to learn is through an example


Multi Stage Dividend Growth - Example

Example: ABC Co. is expected to pay dividends at the end of the next three years of $2, $3, $3.50, respectively. After three years, the dividend is expected to grow at 5% constant annual rate forever. If the market capitalization rate for this stock is 15%, what is the current stock price?

1. Place yourself at t = 3 and use the constant growth formula to find PV of dividend stream after year 3. Call this P3

2. Find the PV of P3

3. Find PV of dividends at t=1, t=2 and t=3

4. Current stock price = sum of 2 and 3



1. Place yourself at t = 3 and use the constant growth formula to find PV of dividend stream after year 3. Call this P3

2. Find the PV of P3

3. Find PV of dividends at t=1, t=2 and t=3

4. Current stock price = sum of 2, 3 and 4

T = 0

$2.00 $3.00 $3.50 Dividends grow at 5% forever

T =1 T = 2 T = 3 T = 4



P3 = (3.5 x (1.05))/(0.15 – 0.05) = 36.75

Current stock price, P0

( ) ( )

( ) ( )

0 2 33

2 3

2 3 3.50 36.751.15 1.15 (1.15) 1.152 3 3.50 36.75

1.15 1.15 1.15

$30.47

P = + + +

+= + +

=

Present Value of Cash flows

Present value of Free Cash Flow

Dividend discount models do not work for companies

which do not pay dividends

For non-dividend paying companies, we can use free

cash flow valuation approach

There are two versions:

– Free cash flow to equity holders (FCFE)

– Free cash flow to the firm (FCFF)

Present Value of Cash flows

Present value of Free Cash Flow to Equity

FCFE = the expected free cash flow in period 1

= Net Income + Depreciation Expense - Capital Expenditures

- in Working Capital - Principal Debt Repayments + New Debt Issues

k = the required rate of return on equity

gFCFE = the expected constant growth rate of free cash flow to equity

FCFEgk

FCFEValue

1

Present Value of Cash flows Present value of Free Cash Flow to Firm

FCFE = the operating free cash flow to the firm in period 1

= EBIT (1-Tax Rate) + Depreciation Expense - Capital Spending

in Working Capital

WACC = the firm’s weighted average cost of capital

gFCFF = the firm’s constant infinite growth rate of free cash flow

OFCF

FCFF

gWACC

FCFOperor

gWACC

FCFFValueFirm

1

1

.

Present Value of Cash flows Present value of Free Cash Flow to Firm

g = (RR)(ROIC)

where:– RR = the average retention rate– ROIC = EBIT (1-Tax Rate)/Total Capital

WACC = WEk + Wdiwhere:

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

Price to Earnings Ratio

Ratio of current price per share (P0) to next year’s

expected earnings per share (EPS)

How do we use P/E ratio to value a stock?

1. Forecast next year’s EPS, E1

2. Forecast P/E ratio, P0/E1

3. Multiple P/E by EPS to get current estimate of

price.

(P0/E1) x E1 = P0


P/E Ratio and Constant Growth Model

If a company has a constant dividend growth rate and the market is in equilibrium (i.e., IV0=P0), then we have an explicit formula for the P/E ratio!

)(

1

1

0

bROEk

b

E

P


P/E Ratio and Retention Ratio

b appears in both numerator and denominator

Depends on how ROE compares with k

– If ROE>k, increase in b increases P/E increases

– If ROE=k, increase in b has no effect on P/E

– If ROE<k, increase in b decreases P/E

)(

1

1

0

bROEk

b

E

P

Price to Earnings Ratio P/E Ratio and Interest Rate

Required rate of return on equity stocks reflects

interest rate and risk

Increase in interest rates results in an increase in

required rate of return, pushing down security prices

and vice versa

Inverse relationship between P/E ratios and interest

rates


P/E Ratio and Risk

Other things being equal, riskier stocks have

higher required rate of return and lower P/E

multiples

True in all cases, not just the constant growth

model

Present value of expected earnings and dividend

stream is lower when the risk is high


Other influences on P/E Ratio

Other things being equal, stocks with higher liquidity command higher P/E multiples and vice versa

Liquidity

Other things being equal, a larger company tends to command a higher P/E multiple due to greater investor interest

Size

If the management of a company is reputed for integrity and investor friendliness, it is likely to command a higher P/E multiple

Reputation of Management


Price to Book Value Ratio

Ratio of current price per share (P0) to current book

value per share (BV0)

Book value is determined by economic events as well as accounting conventions

If a company has a constant dividend growth rate and the market is in equilibrium (i.e., IV0=P0), then

the ratio could be explained as,

P0 / BV0 = ROE(1+g)(1-b)/(k-g)


Price to Sales Ratio

Ratio of current price per share to revenue per share

for the most recent 12 months

Mitigates problems in P/E ratio due to:

– erratic earnings

– negative earnings

– managed earnings

Value-Added Measures

Economic 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 = NOPLAT – (WACC x Capital) EVA return on capital

– EVA/Capital Alternative measure of EVA

– Compare return on capital to cost of capital

Value-Added Measures

Market 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

– MVA = Market Value of Firm – Capital

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

Equity Portfolio Management

Passive versus Active Management

Passive Equity Portfolio Management– Long-term buy-and-hold strategy– Usually tracks an index over time– Designed to match market performance– Manager is judged on how well they track the target

index Active Equity Portfolio Management

– Attempts to outperform a passive benchmark portfolio on a risk-adjusted basis

Equity Portfolio Management

Passive Management Strategy

Replicate the performance of an index

May slightly under perform the target index due to

fees and commissions

Costs of active management (1 to 2 percent) are

hard to overcome in risk-adjusted performance

Many different market indexes are used for tracking

portfolios

Equity Portfolio Management Active Management Strategy

Goal is to earn a portfolio return that exceeds the

return of a passive benchmark portfolio, net of

transaction costs, on a risk-adjusted basis

Practical difficulties of active manager

– Transactions costs must be offset

– Risk can exceed passive benchmark

final - company analysis and stock valuation

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