Securities Analysis, Section IV Security Valuation & EIC Analysis (Part 2)

Securities Analysis, Section IV

Security Valuation

&

EIC Analysis

(Part 2)

Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Sixth Editionby

Frank K. Reilly & Keith C. Brown

Chapters 11,14,15, & 18

Copyright © 2000 by Harcourt, Inc. All rights reserved

Top-Down Approach, Step Three

• Company and Stock Analysis


Company Analysis and Stock Selection• 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

• Which are the best companies?

• Are they overpriced?


Company Analysis and Stock Selection

• 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


Types of Companies and Stocks

• Growth

• Defensive

• Cyclical

• Speculative


• 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


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


Value versus Growth Investing• Buffett’s view:

– Growth is a key determinant of value for any stock, so it is always a component of determining whether or not a stock is undervalued

– Furthermore, so long as the market is under-valuing a stock, then he would categorize it as a “value” stock

– Finally, he considers all investing to be “value” investing

– Thus, he considers “value” vs. “growth” investing to be a false dichotomy


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

• Sales and earnings heavily influenced by aggregate business activity

• Stocks with high betas


Speculative Companies and Stocks

• Assets involve great risk– e.g., biotechs, bankruptcies, etc.

• Can be viewed as a gamble– Possible great gain

– Stock may be overpriced


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 that 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


Firm Competitive Strategies

• Current rivalry

• Threat of new entrants

• Potential substitutes

• Bargaining power of suppliers

• Bargaining power of buyers


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


Low-Cost Strategy

• Seeks to be the low cost leader in its industry– Through economies of scale (in production or

marketing), better logistics, etc.

• Must still command prices near industry average, so still must differentiate

• Discounting too much erodes superior rates of return


Differentiation Strategy

• Identify 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


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


– Strengths

– Weaknesses

– Opportunities

– Threats

INTERNAL ANALYSIS


SWOT Analysis


– Strengths

– Weaknesses

– Opportunities

– ThreatsEXTERNAL ANALYSIS


Lynch’s Favorable Attributes

1. Firm’s product is not faddish2. Company has competitive advantage over

rivals3. Industry or product has potential for market

stability4. Firm can benefit from cost reductions5. Firm is buying back its own shares or

managers (insiders) are buying


Lynch’s Categories of Companies

1. Slow growers2. Stalwart3. Fast growers4. Cyclicals5. Turnarounds6. Asset plays


Approaches to the Valuation of Common Stock

Two general approaches have developed:1. Discounted cash-flow valuation

• Present value of some measure of cash flow, such as dividends, operating cash flow, and free cash flow

2. Relative valuation technique• Value estimated based on its price relative to

significant variables, such as earnings, cash flow, book value, or sales


Approaches to the Valuation of Common Stock

These two approaches have some factors in common

• Both are affected by:– Investor’s required rate of return– kV– Estimated growth rate of the variable used– gV


Valuation Approaches and Specific Techniques

Approaches to Equity Valuation

Discounted Cash Flow Techniques

Relative Valuation Techniques

• Present Value of Dividends (DDM)

•Present Value of Operating Cash Flow

•Present Value of Free Cash Flow

• Price/Earnings Ratio (PE)

•Price/Cash flow ratio (P/CF)

•Price/Book Value Ratio (P/BV)

•Price/Sales Ratio (P/S)


Why and When to Use the Discounted Cash Flow Valuation Approach

• The measure of cash flow used– Dividends

• Cost of equity as the discount rate

– Operating cash flow• Weighted Average Cost of Capital (WACC)

– Free cash flow to equity• Cost of equity

• Dependent on growth rates and discount rate


Why and When to Use the Relative Valuation Techniques

• Provides information about how the market is currently valuing stocks– aggregate market

– alternative industries

– individual stocks within industries

• No guidance as to whether valuations are appropriate; best used when:– have comparable entities

– aggregate market is not at a valuation extreme


Discounted Cash-Flow Valuation Techniques

1 )1(tt

tj k

CFV

Where:

Vj = value of stock j

n = life of the asset

CFt = cash flow in period t

k = the discount rate that is equal to the investor’s required rate of return for asset j, which is determined by the uncertainty (risk) of the stock’s cash flows


The Dividend Discount Model (DDM)

The value of a share of common stock is the present value of all future dividends

1

33

221

)1(

)1(...

)1()1()1(

tt

t

j

k

D

k

D

k

D

k

D

k

DV

Where:

Vj = value of common stock j

Dt = dividend during time period t

k = required rate of return on stock j



If the stock is not held for an infinite period, a sale at the end of year 2 would imply:

2

2

221

)1()1()1( k

SP

k

D

k

DV j

j



If the stock is not held for an infinite period, a sale at the end of year 2 would imply:

Selling price at the end of year two is the value of all remaining dividend payments, which is simply an extension of the original equation

2

2

221

)1()1()1( k

SP

k

D

k

DV j

j



Stocks with no dividends are expected to start paying dividends at some point else they would not have any value!



Stocks with no dividends are expected to start paying dividends at some point, say year three...

Where:

D1 = 0

D2 = 0

)1(...

)1()1()1( 33

221

k

D

k

D

k

D

k

DV j



Infinite period model assumes a constant growth rate for estimating future dividends




Where:

Vj = value of stock j

D0 = dividend payment in the current period

g = the constant growth rate of dividends

k = required rate of return on stock j

n = the number of periods, which we assume to be infinite

n

n

j k

gD

k

gD

k

gDV

)1(

)1(...

)1(

)1(

)1(

)1( 02

200




This can be reduced to:

1. Estimate the required rate of return (k)

2. Estimate the dividend growth rate (g)

n

n

j k

gD

k

gD

k

gDV

)1(

)1(...

)1(

)1(

)1(

)1( 02

200

gk

DV j

1


Infinite Period DDM and Growth Companies

Assumptions of DDM:

1. Dividends grow at a constant rate

2. The constant growth rate will continue for an infinite period

3. The required rate of return (k) is greater than the infinite growth rate (g)



Growth companies have opportunities to earn return on investments greater than their required rates of return

To exploit these opportunities, these firms generally retain a high percentage of earnings for reinvestment, and their earnings grow faster than those of a typical firm

This is inconsistent with the infinite period DDM assumptions



The infinite period DDM assumes constant growth for an infinite period, but abnormally high growth usually cannot be maintained indefinitely

Risk and growth are not necessarily related

Temporary conditions of high growth cannot be valued using the CGR-DDM


Valuation with Temporary Supernormal Growth

Combine the models to evaluate the years of supernormal growth and then use DDM to compute the remaining years at a sustainable rate



Combine the models to evaluate the years of supernormal growth and then use DDM to compute the remaining years at a sustainable rate

For example:With a 14 percent required rate of return, a most recently paid dividend of $2.00 per share, and dividend growth of:



Dividend Year Growth Rate 1-3: 25% 4-6: 20% 7-9: 15% 10 on: 9%



The value equation becomes

9

333

9

333

8

233

7

33

6

33

5

23

4

3

3

3

2

2

)14.1(

)09.14(.

)09.1()15.1()20.1()25.1(00.2

14.1

)15.1()20.1()25.1(00.2

14.1

)15.1()20.1()25.1(00.2

14.1

)15.1()20.1()25.1(00.2

14.1

)20.1()25.1(00.2

14.1

)20.1()25.1(00.2

14.1

)20.1()25.1(00.2

14.1

)25.1(00.2

14.1

)25.1(00.2

14.1

)25.1(00.2

iV


Computation of Value for Stock of Company with Temporary Supernormal Growth

Discount Present Growth

Year Dividend Factor Value Rate

1 2.50$ 0.8772 2.193$ 25%2 3.13 0.7695 2.408$ 25%3 3.91 0.6750 2.639$ 25%4 4.69 0.5921 2.777$ 20%5 5.63 0.5194 2.924$ 20%6 6.76 0.4556 3.080$ 20%7 7.77 0.3996 3.105$ 15%8 8.94 0.3506 3.134$ 15%9 10.28 0.3075 3.161$ 15%

10 11.21 9%

224.20$ a 0.3075 b 68.943$

94.365$

aValue of dividend stream for year 10 and all future dividends, that is$11.21/(0.14 - 0.09) = $224.20bThe discount factor is the ninth-year factor because the valuation of theremaining stream is made at the end of Year 9 to reflect the dividend inYear 10 and all future dividends.


Present Value of Operating Cash Flows

• 2nd DCF method

Derive the value of the total firm by discounting the total operating cash flows prior to the payment of interest to the debt-holders

Then subtract the value of debt to arrive at an estimate of the value of the equity



n

tt

j

tj WACC

OCFV

1 )1(Where:

Vj = value of firm j

n = number of periods; assumed to be infinite

OCFt = the firms operating cash flow in period t

WACC = firm j’s weighted average cost of capital

(OCF and WACC to be discussed in Chapter 20)



Similar to DDM, this model can be used to estimate an infinite period

Where growth has matured to a stable rate, the adaptation is

OCFjj gWACC

OCFV

1

Where:

OCF1=operating cash flow in period 1

gOCF = long-term constant growth of operating cash flow



• Assuming several different rates of growth for OCF, these estimates can be divided into stages as with the supernormal dividend growth model

• Estimate the rate of growth and the duration of growth for each period

• This will be demonstrated later


Present Value of Free Cash Flows to Equity

• 3rd DCF method

• “Free” cash flows to equity are derived after operating cash flows have been adjusted for debt payments (interest and principle)

• The discount rate used is the firm’s cost of equity (k) rather than WACC


• Volume• Pricing • Expenses• Leases • Tax Provision• Deferred Taxes• Tax Shield

Sales

OperatingMargin

CashTaxes

Free Cash Flow

Cash availablefor distribution toall claimholders

CashEarnings

Investment

minus

Free cash flow to equity defined

WorkingCapital

CapitalExpenditures

Acquisitions/Divestitures

• A/R• Inventories• A/P

• Net PP&E•Operating Leases

Follow the Cash


Present Value of Free Cash Flows to Equity

Where:

Vj = Value of the stock of firm j

n = number of periods assumed to be infinite

FCFt = the firm’s free cash flow in period t

1 )1(tt

j

tj k

FCFV


Relative Valuation Techniques

• Value can be determined by comparing to similar stocks based on relative ratios

• Relevant variables include earnings, cash flow, book value, and sales

• Multiply this variable by some “capitalization factor”

• The most popular relative valuation technique is based on price to earnings (the P/E approach)


Earnings Multiplier Model

• This values the stock based on expected annual earnings

• The price earnings (P/E) ratio, or

Earnings Multiplier

EarningsMonth -Twelve Expected

PriceMarket Current


Earnings Multiplier ModelThe infinite-period dividend discount model

indicates the variables that should determine the value of the P/E ratio

gk

DPi

1


Earnings Multiplier ModelThe infinite-period dividend discount model

indicates the variables that should determine the value of the P/E ratio

Dividing both sides by expected earnings during the next 12 months (E1)

gk

DPi

1

gk

ED

E

Pi

11

1

/



Thus, the P/E ratio is determined by– 1. Expected dividend payout ratio– 2. Required rate of return on the stock (k)– 3. Expected growth rate of dividends (g)

gk

ED

E

Pi

11

1

/


Earnings Multiplier ModelAs an example, assume:

– Dividend payout = 50%

– Required return = 12%

– Expected growth = 8%

– D/E = .50; k = .12; g=.08


Earnings Multiplier ModelAs an example, assume:

– Dividend payout = 50%

– Required return = 12%

– Expected growth = 8%

– D/E = .50; k = .12; g=.08

12.5

.50/.04

.08-.12

.50P/E



A small change in either or both k or g can have a large impact on the multiplier

gk

ED

E

Pi

11

1

/




D/E = .50; k=.13; g=.08

gk

ED

E

Pi

11

1

/




D/E = .50; k=.13; g=.08

P/E = .50/(.13-/.08) = .50/.05 = 10

gk

ED

E

Pi

11

1

/




D/E = .50; k=.13; g=.08 P/E = 10

gk

ED

E

Pi

11

1

/




D/E = .50; k=.13; g=.08 P/E = 10

D/E = .50; k=.12; g=.09 P/E = 16.7

D/E = .50; k=.11; g=.09 P/E = 25

gk

ED

E

Pi

11

1

/



small change in either or both k or g can have a large impact on the multiplier

D/E = .50; k=.12; g=.09 P/E = 16.7


Valuation Using theEarnings Multiplier Model

Given current earnings of $2.00 and growth of 9%

You would expect E1 to be $2.18

D/E = .50; k=.12; g=.09 P/E = 16.7


Valuation Using theEarnings Multiplier Model

Given current earnings of $2.00 and growth of 9%

You would expect E1 to be $2.18

D/E = .50; k=.12; g=.09 P/E = 16.7

V = 16.7 x $2.18 = $36.41

Compare this estimated value to market price to decide if you should invest in it


The Price-Cash Flow Ratio

• 2nd relative valuation approach

• Companies can manipulate earnings

• Cash-flow is less prone to manipulation

• Cash-flow is important for fundamental valuation and in credit analysis






1

/

t

ti CF

PCFP






1

/

t

ti CF

PCFP

Where:P/CFj = the price/cash flow ratio for firm jPt = the price of the stock in period tCFt+1 = expected cash low per share for firm j


The Price-Book Value Ratio

• 3rd relative valuation approach

Widely used to measure bank values (most bank assets are liquid (bonds and commercial loans)

Fama and French study indicated inverse relationship between P/BV ratios and excess return for a cross section of stocks



1

/

t

tj BV

PBVP



Where:

P/BVj = the price/book value for firm j

Pt = the end of year stock price for firm j

BVt+1 = the estimated end of year book value per share for firm j

1

/

t

tj BV

PBVP



• Be sure to match the price with either a recent book value number, or estimate the book value for the subsequent year

• Can derive an estimate based upon historical growth rate for the series or use the growth rate implied by the (ROE) X (Ret. Rate) analysis


The Price-Sales Ratio

• 4th relative valuation approach

• Strong, consistent growth rate is a requirement of a growth company

• Sales is less subject to manipulation than other financial data

• Popularized by Ken Fisher



1

t

t

S

P

S

P



Where: 1

t

t

S

P

S

P

tjS

jP

jS

P

t

t

j

j

Year during firmfor shareper sales annual

firmfor pricestock year of end

firmfor ratio sales toprice

1


The Price-Sales RatioMatch the stock price with recent annual

sales, or future sales per share

This ratio varies dramatically by industry

Profit margins also vary by industry

Relative comparisons using P/S ratio should be between firms in similar industries


Estimating the Inputs: The Required Rate of Return and The Expected Growth Rate of

Valuation Variables

Valuation procedure is the same for securities around the world, but the required rate of return (k) and expected growth rate of earnings and other valuation variables (g) such as book value, cash flow, and dividends differ among countries


Required Rate of Return (k)

• Required rate of return on equity (ke) affects valuation, regardless of approach:– kV , and vice versa

• This required rate of return will be used as the discount rate and also affects relative-valuation

• Although ke is not directly used in the present value of operating cash flow approach, it is nonetheless a component of WACC


Required Rate of Return (k)

• But, what is the proper approach for deriving ke?– CAPM?– APT?– Haugen’s ad hoc expected return factor model?

• Still an open question– CAPM most widely used in practice– Even then, questions can remain in terms of

how to apply the model


Estimating Growth Rates

Three general approaches:1. Reinvestment-rate approaches

– Sustainable Growth Rate = RR X ROE

2. Historical estimates– Point estimates of growth rates– Regression-based estimates of growth rates

3. Back out growth rates from estimated size of future market

– Compare company to industry (Ch. 20) and industry to economy as a whole (Ch. 19)


Expected Growth Rate of Dividends• Determined by

– the growth of earnings– the proportion of earnings paid in dividends

• In the short run, dividends can grow at a different rate than earnings due to changes in the payout ratio

• Earnings growth is also affected by compounding of earnings retention

g = (Retention Rate) x (Return on Equity)

= RR x ROE


DuPont Breakdown of ROE

EquityCommon

Assets Total

Assets Total

Sales

Sales

IncomeNet

ROE

Profit Total Asset Financial

Margin Turnover Leverage= xx


Estimating Growth Based on History• Alternative to reinvestment rate approach

• Historical growth rates of sales, earnings, cash flow, and dividends

• Two general techniques1. arithmetic or geometric average of annual

percentage changes (point estimates)

2. linear or log-linear regression models

• Both use time-series plot of data


Checking Your Figures:Three Alternative Measures of Value

(cf., Value Investing)1. Value of Company’s Assets

– Graham & Dodd net-net approach– Book Value of Assets – P/BV for valuation– Market value / replacement value of assets

2. Earnings Power Value– Value company’s current earnings, adjusted for seasonality /

cyclicality – DCF value assuming growth = 0 or = long-run growth in economy

– Greater than value of company’s underlying assets iff company holds competitive advantage or benefits from barriers to entry

– Understanding value requires knowledge of industry


Checking Your Figures:Three Alternative Measures of Value

(cf., Value Investing)

3. What is Growth Worth?– Adds value only if growth occurs “within the franchise”

• Potential problem - firm retains earnings, but reinvestment returns are below the firm’s cost of capital (i.e., project NPV is negative)

• Taking on more projects means that sales and earnings will grow, but not by enough to cover additional costs of capital, so growth will actually destroy value held by current shareholders

• Key lesson = not all growth is “value-adding”

• Only projects with positive NPV’s will create value, and projects will only have positive NPV if they exploit or occur within the firm’s realm of competitive advantage, i.e., within the firm’s franchise


Analysis of Growth Companies

• Generating rates of return greater than the firm’s cost of capital is considered to be temporary

• Earnings higher than the required rate of return are pure profits

• How long cancan they earn these excess profits?• How long are they likely toare they likely to earn these excess

profits?• How long does the market expect them todoes the market expect them to earn these

excess profits?• Is the stock properly valued?


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

Franchise P/E = Observed P/E - Base P/EIncremental Franchise P/E = Franchise Factor X Growth Factor

Grk

kR


Growth Duration

• Evaluate the high P/E ratio by relating P/E ratio to the firm’s rate and duration of growth

• P/E is function of – expected rate of growth of earnings per share– stock’s required rate of return– firm’s dividend-payout ratio

• Use the ratio of P/E’s, related to growth and dividend rates, to infer the market’s implied growth duration:


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


Growth Duration

T

BB

Tgg

BB

gg

)DG(1

)DG(1

(0)E/0P

(0)(0)/EP

BB

gg

BB

gg

DG1

DG1 ln

(0)E/0P

(0)(0)/EPln T

DG1

DG1 ln

P/E

P/Eln

BB

gg

B

g

T


Growth Duration

T

BB

ggBg DG1

DG1P/E P/E

Alternatively, the equation can be rearranged to determine a justified P/E ratio for a firm, given its expected dividend yield and growth rate and the expected length of time over which the firm will continue to experience above-average growth, relative to its benchmark (B).


Extensions on Growth Duration

• For more information and additional extensions and applications in using market-based information to infer the market’s assumptions about the various factors that drive a stock’s valuation, see:– www.expectationsinvesting.com

http://www.expectationsinvesting.com/


When to Sell• Knowing when to sell is an even harder decision than

knowing when to buy– 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

– Always need a “sell discipline”


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– Again, useful to examine the expectations that underlie the

current market price

– Are these realistic/optimistic/pessimistic?


Next Up:Final Topics

• Bond Portfolio Management

• Are the Markets Rational?


Date post:	20-Dec-2015
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Securities Analysis, Section IV Security Valuation & EIC Analysis (Part 2)

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