Investment Analysis and Portfolio Management First Canadian Edition By Reilly, Brown, Hedges, Chang

1. Investment Analysis and Portfolio Management First Canadian Edition By Reilly, Brown, Hedges, Chang 9

2. Chapter 9Company Analysis & Stock Valuation • Company Analysis versus Stock Valuation • Economic, Industry, and Structural Links to Company Analysis • Company Analysis • Estimating Intrinsic Value • Estimating Company Earnings per Share • Shoppers’ Competitive Strategies • Estimating Company Earnings Multipliers Continued…

3. Chapter 9Company Analysis & Stock Valuation • Additional Measures of Value Added • Analysis of Growth Companies • Measures of Value Added • Site Visits and the Art of the Interview • When to Sell • Influences on Analysts • Global Company and Stock Analysis

4. Company Analysis & Stock Valuation • After analyzing the economy and stock markets for several countries, you have decided to invest some portion of your portfolio in common stocks • After analyzing various industries, you have identified those industries that appear to offer above-average risk-adjusted performance over your investment horizon

5. Company Analysis & Stock Valuation • Which are the best companies? • Are they overpriced? • 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

6. 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 firm’s required rate of return

7. 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

8. Defensive Companies and Stocks • Defensive Companies • The firms whose future earnings are more likely to withstand an economic downturn • Low business risk • No excessive financial risk • Typical examples are public utilities or grocery chains—firms that supply basic consumer necessities

9. Defensive Companies and Stocks • Defense Stocks • The rate of return is not expected to decline or decline less than the overall market decline • Stocks with low or negative systematic risk

10. Cyclical Companies and Stocks • Cyclical Companies • They are the companies whose sales and earnings will be heavily influenced by aggregate business activity • Examples would be firms in the steel, auto, or heavy machinery industries.

11. Cyclical Companies and Stocks • Cyclical Stocks • They will have greater changes in rates of return than the overall market rates of return • They would be stocks that have high betas.

12. Speculative Companies and Stocks • Speculative Companies • They are the firms whose assets involve great risk but those that also have a possibility of great gain • A good example of a speculative firm is one involved in oil exploration

13. Speculative Companies and Stocks • Speculative Stocks • Stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return • For example, an excellent growth company whose stock is selling at an extremely high P/E ratio

14. 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

15. 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

16. Economic and Industry Influences • If trends are favourable 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

17. Structural Influences • Social trends, technology, political, and regulatory influences can have significant influence on firms • Firms can grow and succeed despite unfavourable industry or economic conditions due to demographic changes or shifts in consumer tastes and lifestyles Continued…

18. Structural Influences • 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

19. Company AnalysisFirm Competitive Strategies • Defensive strategy involves positioning firm so that it its capabilities provide the best means to deflect the effect of competitive forces in the industry

20. Company AnalysisFirm Competitive Strategies • Offensive strategy involves using the company’s strength to affect the competitive industry forces, thus improving the firm’s relative industry position

21. Focusing a Strategy: Low Cost Strategy • The firm seeks to be the low-cost producer, and hence the cost leader in its industry • Cost advantages vary by industry and might include economies of scale, proprietary technology, or preferential access to raw materials

22. Focusing a Strategy: Differentiation Strategy • Firm positions itself as unique in the industry in an area that is important to buyers • A company can attempt to differentiate itself based • on its distribution system or some unique marketing approach

23. Focusing a Strategy: Differentiation Strategy

24. 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

25. SWOT Analysis Strengths Weaknesses Weaknesses result when competitors have potentially exploitable advantages over the firm • Give the firm a comparative advantage in the marketplace • Perceived strengths can include good customer service, high-quality products, strong brand • image, customer loyalty, innovative R&D, market leadership, or strong financial resources

26. SWOT Analysis Opportunities Threats They are environmental factors that can hinder the firm in achieving its goals Examples would include a slowing domestic economy, additional government regulation, an increase in industry competition, threats of entry, etc • These are environmental factors that favour the firm • They may include a growing market for the firm’s products (domestic and international), shrinking competition, favourable exchange rate shifts, or identification of a new market or product segment

27. Lessons Learned from Peter Lynch • Favourable Attributes of Firms • Firm’s product should not be faddish • Firm should have some long-run comparative advantage over its rivals • Firm’s industry or product has market stability

28. Lessons Learned from Peter Lynch • Favourable Attributes of Firms • Firm can benefit from cost reductions • Firms that buy back shares show there are putting money into the firm

29. Warren Buffet’s Investment Tenets Business Tenets Managerial Tenets Is management rational? Is management candid with its shareholders? Does management resist the institutional imperative? • Is the business simple and understandable? • Does the business have a consistent operating history? • Does the business have favourable long-term prospects?

30. Warren Buffet’s Investment Tenets Financial Tenets Market Tenets What is the value of the business? Can the business be purchased at a significant discount to its fundamental intrinsic value? • 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

31. Estimating Intrinsic Value • Present value of cash flows (PVCF) • Present value of dividends (DDM) • Present value of free cash flow to equity (FCFE) • Present value of free cash flow (FCFF)

32. Estimating Intrinsic Value • Relative valuation techniques • Price earnings ratio (P/E) • Price cash flow ratios (P/CF) • Price book value ratios (P/BV) • Price sales ratio (P/S)

33. Present Value of Dividends • Simplifying assumptions help in estimating present value of future dividends • Constant Growth DDM Intrinsic Value = D1/(k-g) and D1= D0(1+g) • Growth Rate Estimates • Average Dividend Growth Rate • Sustainable Growth Rate g = RR X ROE

34. Present Value of Dividends • Required Rate of Return Estimate • Nominal risk-free interest rate • Risk premium • Market-based risk estimated from the firm’s characteristic line using regression

35. Present Value of Dividends • The Present Value of Dividends Model (DDM) • Model requires k>g • With g>k, analyst must use multi-stage model

36. Defining Free Cash Flow to Equity (FCFE) • Computing the FCFE • FCFE =Net Income • + Depreciation Expense • - Capital Expenditures • - D in Working Capital • - Principal Debt Repayments • + New Debt Issues

37. Present Value of Free Cash Flow to Equity • The Constant Growth Formula • where: • 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 • A multi-stage model similar to DDM can also be applied

38. Present Value of Operating Free Cash Flow • Discount the firm’s operating free cash flow to the firm (FCFF) at the firm’s weighted average cost of capital (WACC). FCFF =EBIT (1-Tax Rate) + Depreciation Expense - Capital Spending -  in Working Capital -  in other assets

39. Present Value of Operating Free Cash Flow where: FCFF1 = the free cash flow in period 1 OFCF1 = the firm’s operating free cash flow in period 1 WACC = the firm’s weighted average cost of capital gFCFF = the constant growth rate of free cash flow gOFCF = the constant growth rate of operating free cash flow

40. Comparing Operating Free Cash Flow & Free Cash Flow to Equity Operating Free Cash Flow Free Cash Flow to Equity FCFE =Net Income + Depreciation Exp. - Capital Expenditures - D in Working Capital - Principal Debt Repayment + New Debt Issues FCFF =EBIT (1-Tax Rate) + Depreciation Exp. - Capital Spending -  in Working Capital -  in other assets

41. Shoppers’ Competitive Strategies • The Internal Performance • Industry Factors • Company Performance • Net Profit Margin Estimate • Computing Earnings per Share • Importance of Quarterly Estimates • A way to confirm annual estimate

42. Estimating Company Earnings Multipliers • Macroanalysis of the Earnings Multiplier • Microanalysis of the Earnings Multiplier • Comparing dividend-payout ratios • Estimating the required rate of return • Estimating the expected growth rate • Computing the earnings multiplier • Estimates of intrinsic value for Shoppers

43. Additional Measures of Relative Value • Price/Book Value (PB/V) Ratio • Book value is a reasonable measure of value for firms that have consistent accounting practice • It can been applied to firms with negative earnings or cash flows • Should not attempt to use this ratio to compare firms with different levels of hard assets—for example, a heavy industrial firm and a service firm • See Exhibit 9.9

44. Additional Measures of Relative Value • Price/Cash Flow (P/CF) Ratio • The price/cash flow ratio has grown in prominence and use because many observers contend that a firm’s cash flow is less subject to manipulation • See Exhibit 9.9 • Price/Sales (P/S) Ratio • Sales growth drives the growth of all subsequent earnings and cash flow and sales is one of the purest numbers available • See Exhibit 9.9

45. Additional Measures of Relative Value

46. Analysis of Growth Companies • Generating rates of return greater than the firm’s cost of capital is considered to be temporary • Earnings higher the required rate of return are pure profits • How long can they earn these excess profits?

47. ( ) - E 1 b E = = V k k E = k V Value of No-Growth Firms • A No-Growth Firm • E = r x Assets • E = r x Assets = Dividends (Firms has retention ratio, b, of 0) • Firm Value

48. bEmk bEm = 2 k k bEm bE - k k Long-Run Growth Models • Simple Growth Model • It assumes the firm has growth investment opportunities that provide rates of return equal to r, where r is greater than k • r=mk (m is the relative rate of return operator) • D=E (1-b) • Gross Present Value of Growth Investments

49. E bEm bE = + - V k k k Long-Run Growth Models • Simple Growth Model • Firm Value

50. D bEm = + V k k Long Run-Growth Models • PV of Constant Dividend + PV of Growth Investment