final - company analysis and stock valuation
TRANSCRIPT
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
Company Analysis and Stock Valuation
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
Company Analysis and Stock Valuation
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)
Company Analysis and Stock Valuation
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
Company Analysis and Stock Valuation
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
Company Analysis and Stock Valuation
Intrinsic Value 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
Company Analysis and Stock Valuation
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 macro- economic environment and
developments
Analyzing industry prospects to which the firm belongs
Assessing projected company performance and
intrinsic share value
Fundamental Analysis
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
Fundamental Analysis
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
Qualitative Approach
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
Qualitative Approach
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
Qualitative Approach
SWOT Analysis
Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– Threats
Qualitative Approach
SWOT Analysis
Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– Threats
INTERNAL ANALYSIS
Qualitative Approach
SWOT Analysis
Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– ThreatsEXTERNAL ANALYSIS
Intrinsic Value of the Stock
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
Present Value of Dividends
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).
Present Value of Dividends
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
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
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= +
Present Value of Dividends
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
Present Value of Dividends
ROE Determinants
ROE
Operating Efficiency
(Profit Margin)
Asset Use Efficiency
(Total Asset Turnover)
Financial Leverage (Equity Multiplier)
Present Value of Dividends
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)
Present Value of Dividends
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
Present Value of Dividends
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…
Growth Prospects, Inc
(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
Growth Prospects, Inc
(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
Present Value of Dividends
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
Present Value of Dividends
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
Present Value of Dividends
Multi Stage Dividend Growth - Example
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
Present Value of Dividends
Multi Stage Dividend Growth - Example
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
Price to Earnings Ratio
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
Price to Earnings Ratio
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
Price to Earnings Ratio
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
Price to Earnings Ratio
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
Relative Valuation Techniques
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)
Relative Valuation Techniques
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