Company Analysis and Stock Valuation: Techniques and Insights

1. Chapter 15 COMPANY ANALYSIS AND STOCK VALUATION

2. Chapter 15 Questions • Why is it important to differentiate between company analysis and stock analysis? • What is the difference between a growth company and a growth stock? • What are the two primary approaches to the valuation of common stock? • How do we apply the discounted cash flow valuation approach? • What are the major discounted cash flow valuation techniques?

3. Chapter 15 Questions • How do we apply the relative valuation approach? • What are the major relative valuation techniques (ratios)? • What are some economic, industry, and structural links that should be considered in company analysis? • What insights regarding a firm can be derived from analyzing its competitive strategy and from a SWOT analysis?

4. Chapter 15 Questions • How do we apply the two valuation approaches and several valuation techniques? • What techniques can be used to estimate 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?

5. Chapter 15 Questions • What factors do we consider 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? • When should we consider selling a stock?

6. Company Analysis and Stock Selection • Good companies are not necessarily good investments • In the end, we want to compare the intrinsic value of a stock to its market value • Stock of a great company may be overpriced • Stock of a lesser company may be a superior investment since it is undervalued

7. Growth Companies and Growth Stocks • Companies that consistently experience above-average increases in sales and earnings have traditionally been thought of as growth companies • Limitations to this definition • 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

8. Growth Companies and 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 under-valuation compared to other stocks • Studies indicate that growth companies have generally not been growth stocks

9. Defensive Companies and Stocks • Defensive companies’ future earnings are more likely to withstand an economic downturn • Low business risk • Not excessive financial risk • Defensive stocks’ returns are not as susceptible to changes in the market • Stocks with low systematic risk

10. Cyclical Companies and Stocks • Sales and earnings heavily influenced by aggregate business activity • High business risk • Sometimes high financial risk as well • Cyclical stocks experience high returns is up markets, low returns in down markets • Stocks with high betas

11. Speculative Companies and Stocks • Speculative companies invest in sssets involving great risk, but with the possibility of great gain • Very high business risk • Speculative stocks have the potential for great percentage gains and losses • May be firms whose current price-earnings ratios are very high

12. 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

13. The Search for True Growth Stocks • To find undervalued stocks, we must understand the theory of valuation itself

14. Theory of Valuation • The value of a financial asset is the present value of its expected future cash flows • Required inputs: • The stream of expected future returns, or cash flows • The required rate of return on the investment

15. Stream of Expected Returns (Cash Flows) From of returns • Depending on the investment, returns can be in the form of: • Earnings • Dividends • Interest payments • Capital gains Time period and growth rate of returns • When will the cash flows be received from the investment?

16. Required Rate of Return • Determined by the risk of an investment and available returns in the market • Determined by: • The real risk-free rate of return, plus • The expected rate of inflation, plus • A risk premium to compensate for the uncertainty of returns • Sources of uncertainty, and therefore risk premiums, vary by the type of investment

17. Investment Decision Process • Once expected (intrinsic) value is calculated, the investment decision is rather straightforward and intuitive: • If Estimated Value > Market Price, buy • If Estimated Value < Market Price, do not buy

18. 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

19. 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

20. 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

21. Company Analysis • Competitive forces necessitate competitive strategies. • Competitive Forces: • Current rivalry • Threat of new entrants • Potential substitutes • Bargaining power of suppliers • Bargaining power of buyers • SWOT analysis is another useful tool

22. Firm Competitive Strategies • Defensive or offensive • Defensive strategy deflects competitive forces in the industry • Offensive competitive strategy affects competitive force in the industry to improve the firm’s relative position • Porter suggests two major strategies: low-cost leadership and differentiation

23. Low-Cost Strategy • Seeks to be the low cost leader in its industry • Must still command prices near industry average, so still must differentiate • Discounting too much erodes superior rates of return

24. Differentiation Strategy • Seeks to be identified as unique in its industry in an area that is important to buyers • Above average rate of return only comes if the price premium exceeds the extra cost of being unique

25. Focusing a Strategy • Firms with focused strategies: • Select segments in the industry • Tailor the strategy to serve those specific groups • Determine which strategy a firm is pursuing and its success • Evaluate the firm’s competitive strategy over time

26. SWOT Analysis • Examination of a firm’s: • Strengths • Competitive advantages in the marketplace • Weaknesses • Competitors have exploitable advantages of some kind • Opportunities • External factors that make favor firm growth over time • Threats • External factors that hinder the firm’s success

27. Favorable Attributes of Firms • Peter Lynch’s list of favorable attributes: • Firm’s product is not faddish • Company has competitive advantage over rivals • Industry or product has potential for market stability • Firm can benefit from cost reductions • Firm is buying back its own shares or managers (insiders) are buying

28. Applying the Valuation Models (From Chapter 11) • Discounted Cash Flow Techniques • Based on the basic valuation model: the value of a financial asset is the present value of its expected future cash flows Vj = SCFt/(1+k)t • The different discounted cash flow techniques consider different cash flows and also different appropriate discount rates

29. Applying the Valuation Models to Walgreens • DDM Valuation with Temporary Supernormal Growth • Value Estimate $27.05 (See page 491) • Implied P/E of 21 times expected earnings • Market Price $35.65 (mid 2004) • Prevailing Market P/E of about 18 times current earnings

30. Applying the Valuation Models to Walgreens • Present Value of Free Cash Flow to Equity • Value Estimate $35.99 (see page 493) • Implied P/E of about 25 times expected earnings • Market Price $35.65 (mid 2004) • Prevailing Market P/E of about 17 times expected earnings • Higher P/E justified by higher growth rate and lower beta

31. Applying the Valuation Models to Walgreens • Present Value of Operating Free Cash Flows • Value Estimate $33.13 (see page 496) • Implied P/E of 26 times current earnings • Market Price $35.65 (mid 2004) • Prevailing Market P/E of about 18 times

32. Applying the Valuation Models (From Chapter 11) • Relative Valuation Techniques • These techniques assume that prices should have stable and consistent relationships to various firm variables across groups of firms • Price-Earnings Ratio • Price-Cash Flow Ratio • Price-Book Value Ratio • Price-Sales Ratio

33. Applying the Valuation Models to Walgreens • All four relative valuation ratios increasing over time for Walgreens, its industry, and the market • Suggests that changes are caused by aggregate economic variables • Walgreens experienced a larger increase than its industry in all ratios, while lagging the market in terms of the P/E ratio in several years

34. Specific Valuation with the P/E Ratio • Using the P/E approach to valuation: • Estimate earnings for next year • Estimate the P/E ratio (Earnings Multiplier) • Multiply expected earnings by the expected P/E ratio to get expected price V =E1x(P/E)

35. Specific Valuation with the P/E Ratio • Earnings per share estimates • Time series – use statistical analysis • Sales - profit margin approach • EPS = (Sales Forecast x Profit Margin)/ Number of Shares Outstanding • Judgmental approaches to estimating earnings • Last year’s income plus judgmental evaluations • Using the consensus of analysts’ earnings estimates • Once annual estimates are obtained, do quarterly estimates and interpret announcements accordingly

36. Site Visits, Interviews, and Fair Disclosure • Fair Disclosure (FD) requires that all disclosure of material information be made public to all interested parties at the same time • Many firms will not allow interviews with individuals, only provide information during large public presentations • Analysts now talk to people other than top managers • Customers, suppliers

37. Making the Investment Decision • If the estimate of the stock’s intrinsic value is greater than or equal to the current market price, buy the stock • If your estimate of the stock’s future intrinsic value would yield a return greater than your required rate of return (based on current investment price), then buy the stock • If the value is less than its current price, or its return would be less than your required rate of return, do not buy the stock

38. Ranking Undervalued Stocks • How do we rank if we have a budget constraint? • Best to rank on the basis of the excess return ratio • Intrinsic Value/Market Price

39. When to Sell • Hold on or move on? • If stocks decline right after purchase, is that a further buying opportunity or a signal of a mistaken investment? • Continuously monitor key assumptions that led to the purchase of the investment • Know why you bought, and see if conditions have changed • Evaluate when market value approaches estimated intrinsic value

40. Influences on Analysts Several factors make it difficult for analysts to outperform the market • Efficient Markets • Markets tend to price securities correctly, so opportunities are rare • Most opportunities are likely in small, less followed companies • Paralysis of Analysis • Must see the forest (the appropriate recommendation) despite all of the trees (data) that complicate the decision

41. Influences on Analysts • Investment bankers may push for favorable evaluations of securities when the same firm does (or wants to do) underwriting business with the firm in question • Are analysts independent and unbiased in their recommendations? • Ideally, analysts will remain independent and show confidence in their analyses