practical investment management by robert.a.strong slides ch08

8/14/2019 Practical Investment Management by Robert.A.Strong slides ch08

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CHAPTER EIGHT

Practical Investment Management

Robert A. Strong

FUNDAMENTAL ANALYSIS II

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5 8


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South-Western / Thomson Learning 2004 8 - 2

Market Analysis The Major Indexes The Greenspan Model The Equity Risk Premium

Outline


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Company Analysis The Greenspan Model Growth At a Reasonable Price (GARP) Pro-Forma Earnings

EBITDA The Growing Role of Cash Flow DuPont Analysis Present Value of Growth Opportunities

Regulation Fair Disclosure

Outline


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The Major Indexes

A portfolio of securities, or equivalently, anindex like the S&P 500 or the Dow Jones

Industrial Average, can be valued using the

dividend discount model (DDM).

Recall that DDM states that the current

share price equals the discounted value of

a perpetually growing stream of dividends:

( )gk

gDP

+=

1

0

0


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We can substitute earnings fordividends, and, with a few minor

adjustments, apply the basic DDM

to indexes.

The Major Indexes


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The Equity Risk Premium

Equity risk premium is the anticipatedreturn advantage to common stock over

fixed income securities.

Equity risk premium may be presented

relative to short-term Treasury bills or to

long-term Treasury bonds.

There is growing evidence that in the future

the equity risk premium is going to be lessthan it has historically been.



Company Analysis

There are several important ways in which

analysts can dig deeper into the company.

What do you think of this company?



The Greenspan Model

The Greenspan model can be adapted for

use with individual equity securities.

Greenspan stock value

= estimated annual earnings per share10-year Treasury rate

Greenspan stock value > stock price

the stock is undervalued Greenspan stock value < stock price

the stock is overvalued



The Greenspan Model

Insert Table 8-3 here.



Growth At a Reasonable Price (GARP)

The GARP (Growth At a Reasonable Price)technique seeks to combine elements of

both growth and value investing.

Value investors like low price/earningsratios, while growth investors like high

growth rates.



The PEG ratio, which is the principal GARPyardstick, combines both perspectives.

PEG ratio =

price earnings ratio.

annual earnings per share growth rate

GARP investors like a low number, and

many seek stocks with a PEG ratio that isless than one.



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Pro-Forma Earnings

In general, pro forma earnings refer to net

income excluding the effects of write-downsor goodwill amortization.

Pro forma earnings data give the investor

more reliable information on which toassess future corporate prospects.

However, the more firms choose to exclude

from net income, the better their earnings

ratios will look. Pro forma earnings are also called cash

earnings orcore earnings.


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EBITDA

EBITDA (earnings before interest, taxes,depreciation, and amortization) is similar to

pro forma earnings in that it excludes non-

operational expenses from the earnings

figure. People involved in the valuation of

businesses often base their analysis in part

on EBITDA multiples and may call thefigure operating cash flow.


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The Growing Role of Cash Flow

Many analysts prefer to focus on cash flowrather than on earnings.

There are many legitimate choices the

firms accountants may take as they work

their way down the income statement, but

cash flow is much less subjective.

Free cash flowrepresents a firms cash

flow minus the amount required fornecessary capital expenditures.


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DuPont Analysis

DuPont analysis investigates the interplayof three aspects of corporate performance:

Profitability: Is the company selling its

products for more than it costs to provide

them?

Efficiency: Is the company making

productive use of its assets?

Leverage: To what extent does the firm rely

on bondholders and the bank?


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DuPont Analysis

Insert Figure 8-2 here.


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DuPont Analysis



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DuPont Analysis

Insert Figure 8-3 here.


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Present Value of Growth Opportunities

The present value of growth opportunities

(PVGO) comes from closer scrutiny of the

dividend discount model.

It is the difference between the stock price

and the present value of a perpetual streamof the current earnings level.

PVGOk

EPS

P +=1

0


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Present Value of Growth Opportunities

Insert Table 8-6 (PepsiCo and

Coca-Cola Stock Data) here.


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In August 2000, the Securities andExchange Commission approved

Regulation Fair Disclosure (Regulation FD).

The principal provision of the rule prevents

companies from giving material

information to security analysts, mutual

funds, or institutional investors unless the

company simultaneously issues the sameinformation to the general public.


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However, to avoid violating the rule,companies in general have begun to

provide less information between quarterly

reports.



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Market Analysis The Major Indexes The Greenspan Model The Equity Risk Premium

Review


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S th W t / Th L i 2004 8 28

Company Analysis The Greenspan Model Growth At a Reasonable Price (GARP) Pro-Forma Earnings

EBITDA The Growing Role of Cash Flow DuPont Analysis Present Value of Growth Opportunities


Review

practical investment management by robert.a.strong slides ch08

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