Company Analysis and Stock

Valuation • 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

• 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

Growth Companies

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

Defensive Companies and Stocks

• Defensive companies’ future earnings are

more likely to withstand an economic

downturn

• Low business risk

• Not excessive financial risk

• Stocks with low or negative systematic risk

Cyclical Companies and Stocks

• Cyclical companies are those whose sales

and earnings will be heavily influenced by

aggregate business activity

• Cyclical stocks are those that will

experience changes in their rates of return

greater than changes in overall market rates

of return

Speculative Companies and Stocks

• Speculative companies are those whose

assets involve great risk but those that also

have a possibility of great gain

• Speculative stocks possess a high

probability of low or negative rates of return

and a low probability of normal or high

rates of return

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

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

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

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

Company Analysis

• Industry competitive environment

• SWOT analysis

• Present value of cash flows

• Relative valuation ratio techniques

Competitive Forces

• Current rivalry

• Threat of new entrants

• Potential substitutes

• Bargaining power of suppliers

• Bargaining power of buyers

Firm 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

• Offensive strategy involves using the company’s strength to affect the competitive industry forces, thus improving the firm’s relative industry position

• Porter suggests two major strategies: low-cost leadership and differentiation

Porter's Competitive Strategies

• Low-Cost Strategy

– The firm seeks to be the low-cost producer, and hence the cost leader in its industry

• 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 firm’s competitive

strategy over time

SWOT Analysis

• Examination of a firm’s:

– Strengths

– Weaknesses

– Opportunities

– Threats

SWOT Analysis

• Examination of a firm’s:

– Strengths

– Weaknesses

– Opportunities

– Threats

INTERNAL ANALYSIS

SWOT Analysis

• Examination of a firm’s:

– Strengths

– Weaknesses

– Opportunities

– Threats

EXTERNAL ANALYSIS

Estimating Intrinsic Value 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 techniques

– 1. Price earnings ratio (P/E)

– 2. Price cash flow ratios (P/CF)

– 3. Price book value ratios (P/BV)

– 4. Price sales ratio (P/S)

Present Value of Dividends

• Simplifying assumptions help in estimating

present value of future dividends

• Assumption of constant growth rate

Intrinsic Value = D1/(k-g)

D1= D0(1+g)

Growth Rate Estimates

• Average Dividend Growth Rate

1D

Dn

0

n

Growth Rate Estimates

• Average Dividend Growth Rate

• Sustainable Growth Rate = RR X ROE

1D

Dn

0

n

Required Rate of Return Estimate

• Nominal risk-free interest rate

• Risk premium

• Market-based risk estimated from the firm’s

characteristic line using regression

Required Rate of Return Estimate

• Nominal risk-free interest rate

• Risk premium

• Market-based risk estimated from the firm’s

characteristic line using regression

E(RFR)])E(R[E(RFR)R marketstockstock

The Present Value of

Dividends Model (DDM)

• Model requires k>g

• With g>k, analyst must use multi-stage

model

Present Value of

Free Cash Flow to Equity FCFE =

Net Income

+ Depreciation Expense

- Capital Expenditures

- D in Working Capital

- Principal Debt Repayments

+ New Debt Issues

Present Value of

Free Cash Flow to Equity

FCFE =

Net Income

+ Depreciation Expense

- Capital Expenditures

- D in Working Capital

- Principal Debt Repayments

+ New Debt Issues

FCFEgk

FCFEValue

1

Present Value of

Free Cash Flow to Equity

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

FCFEgk

FCFEValue

1

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) rather than

its cost of equity

FCFF = EBIT (1-Tax Rate)

+ Depreciation Expense - Capital Spending

- D in Working Capital - D in other assets

Present Value of

Operating Free Cash Flow

OFCF

FCFF

gWACC

FCFOperor

gWACC

FCFFValueFirm

1

1

.

Present Value of

Operating Free Cash Flow

Where: FCFF1 = the free cash flow in period 1

Oper. FCF1 = the firm’s operating free cash flow in period 1

WACC = the firm’s weighted average cost of capital

gFCFF = the firm’s constant infinite growth rate of free cash flow

gOFCF = the constant infinite growth rate of operating free cash flow

OFCF

FCFF

gWACC

FCFOperor

gWACC

FCFFValueFirm

1

1

.

An Alternate Measure of Growth

g = (RR)(ROIC)

where:

– RR = the average retention rate

– ROIC = EBIT (1-Tax Rate)/Total Capital

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

Relative Valuation Ratio

Techniques

• Price Earnings Ratio gk

EDEP

11

1

//

Estimating Company Earnings

Per Share

• Function of

– Sales forecast

– Estimated profit margin

Walgreens Competitive Strategies

The Internal Performance

• Industry Factors

• Company Performance

• Net Profit Margin Estimate

• Computing Earnings per Share

Importance of Quarterly Estimates

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

– Estimate of the Future Value for Walgreens

Additional Measures of Relative

Value

• Price/Book Value Ratio

• Price/Cash Flow Ratio

• Price-to-Sales Ratio