to accompany
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 valueadded (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?
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
firms 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
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
Company Analysis
Current rivalry
Threat of new entrants
Potential substitutes
Bargaining power of suppliers
Bargaining power of buyers
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 firms competitive strategy
over time
SWOT Analysis
Examination of a firms:
Strengths
Weaknesses
Opportunities
Threats
SWOT Analysis
Examination of a firms:
Strengths
Weaknesses
Opportunities
Threats
INTERNAL ANALYSIS
SWOT Analysis
Examination of a firms:
Strengths
Weaknesses
Opportunities
Threats
EXTERNAL ANALYSIS
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?
Dn
1
D0
Dn
1
D0
Present Value of
Free Cash Flow to Equity
FCFE =
Net Income
+ Depreciation Expense
- Capital Expenditures
- in Working Capital
- Principal Debt Repayments
+ New Debt Issues
Present Value of
Free Cash Flow to Equity
FCFE1
FCFE =
Value
Net Income
k
g
FCFE
+ Depreciation Expense
- Capital Expenditures
- 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 firms operating free cash flow
to the firm (FCFF) at the firms weighted
average cost of capital (WACC) rather than
its cost of equity
FCFF = EBIT (1-Tax Rate)
+ Depreciation Expense - Capital Spending
- in Working Capital - 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 firms operating free cash flow in period 1
WACC = the firms weighted average cost of capital
gFCFF = the firms constant infinite growth rate of free cash flow
gOFCF = the constant infinite growth rate of operating free cash flow
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
D1 / E1
P / E1
kg
D1 / E1
P / E1
kg
E = r X Assets = Dividends
E 1 b E
V
k
k
E
k
v
k
k
k
k
k
k
k
k
D bEm
v
k
k
E 1 b bEm
v
k
k
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
D1
V
kg
Measures of Value-Added
Economic Value-Added (EVA)
Compare net operating profit less adjusted taxes
(NOPLAT) to the firms total cost of capital in
dollar terms, including the cost of equity
Measures of Value-Added
Market Value-Added (MVA)
Measure of external performance
How the market has evaluated the firms
performance in terms of market value of debt
and market value of equity compared to the
capital invested in the firm
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
Rk
G
rk
Growth Duration
Evaluate the high P/E ratio by relating P/E
ratio to the firms rate and duration of
growth
P/E is function of
expected rate of growth of earnings per share
stocks required rate of return
firms 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
T
Pg (0)
E g (0) (1 G g D g )
Pd 0 E a (0) (1 G a D a )
Growth Duration
E g (0) (1 G g D g ) T
Pg (0)
Pd 0 E a (0) (1 G a D a )
(1 G g D g ) T
Pg (0)/E g (0)
Pd 0 / E a (0) (1 G a D a )
Pg (0)/E g (0)
(1 G g D g )
T ln
ln
Pd 0 / E a (0)
(1 G a D 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
When to Sell
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
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