Stock Fundamental
Analysis
XSIF—2010 Primer
1
Valuation Approaches
• Valuation Approaches
1. Discounted CF: Value stock based on the
PV of the expected CF: dividends, FCF,
or FCFE.
2. Relative Valuation: P/E, P/BV, P/CF, or
P/S.
• Note: Both require estimating k and g.
2
Discounted Cash Flow
• Dividends:
– Model
– Gordon:
V


D(1  g) t
t
(
1

k
)
t 1
D1
V
k g
– 2-stage or 3-stage growth model
3
Discounted Cash Flow
• Cash Flow Model:
• Free cash flow to equity: Cash flow left after meeting obligations to
capital suppliers: debt and preferred.
– Model

t
V

FCFE(1  g)
t 1
– Constant Growth:
(1  k ) t
FCFE1
V
k g
• where: g = growth in FCFE
– 2-stage or 3-stage growth model
4
Relative Valuation
• P/E or Multiplier Approach:
P
Current Market Pr ice

E Expected 12  Month EPS
P D1 / E1

E
k g
• Example: Expected D/E = .5, k = .12, g = .08,
then P/E = 12.5.
• Note: Small changes in k or g have large impact
on P/E.
• Gordon P/E:
5
Relative Valuation
• P/CF
P
Current Market Pr ice

CF Expected 12  Month CF
• Constant Growth: P/CF:
P
D1 / CF1

CF
k g
• CF = EBDITDA (typically used)
6
Relative Valuation
• P/BV
P
Current Market Pr ice

BV Expected Year  End BV
• P/S:
P
Current Market Pr ice

S Expected Sales  per  Share
7
Points on Relative Valuation
•
Comparative analysis: company to
industry (or comparable companies) and
to market
•
Comparative and time-series analysis:
compare company, industry, and market
over time.
8
•
g, k, and
eps
•
Both the Dividend Discounted
Cash Flow and Relative
Valuation Approaches depend
on estimating g and k.
Both models also need to be
compared to an estimated
earnings or eps.
9
Estimating g
•
In discounted dividend model and the P/E
model, g is the growth rate in dividends.
•
The growth rate in dividends will equal the
growth rate in EPS if the D/E is constant.
•
If D/E are increasing (decreasing) over time,
then growth rate in DPS will be greater (less)
than the growth rate in EPS.
10
Estimating g: Historical
•
•
Historical Growth Rates:
Calculate historical growth rate in
dividends or earnings.
•
Remember: More is better and recent is
relevant.
11
Estimating g: Historical
•
Historical: Geometrical:
D n  D0 (1  g) n
1/ n
D 
g n
 D0 
•
1
Example:
1 / 10
 D 2008 
g

D
 1998 
1 / 10
 $0.20 
g

 $0.05 
1
 1  14.87%
12
Estimating g: Historical
•
Linear Regression:
EPS  a  b t
–
•
where:
EPS
b
t
Log linear form:
ln EPS  a  b t
–
where:
b  Average %EPS
13
Estimating g: Sustainable Growth
•
•
Sustainable Growth Rate:
I
g fi   i
E
Estimate:
 RE 
g 
ROE

 E 
g  (RR ) ROE
14
Estimating g: Sustainable Growth
• Estimating ROE:
1. Estimate ROE directly:
•
•
Historical Average
Regression
2. Use DuPont System (or Extended
System):
 Net Income   Sales   Assets 
ROE  
 Equity 



Sales
Assets




ESA
ROE 
SAE
15
Estimating g: Sustainable Growth
•
•
•
Year
Estimating ROE:
Comparative Analysis: Compare the ratios of the
company, industry (or comparable companies), and
market.
Set up Bloomberg table:
Firm
E/S S/A A/E ROE
Industry
E/S S/A A/E ROE
Market
E/S S/A A/E ROE
1980
:
2007
Mean
σ
16
Estimating g: Sustainable Growth
•
From your comparison, you can determine
ROE to be above or below the industry or
market.
•
By comparing ratio, you may get some insight
on explain relative ROE.
•
Note: Bloomberg provides sustainable growth
rates.
17
Estimating k
•
Estimate k by examining fundamental
risk factors
k  R f  RP
•
Fundamental risk factors:
–
–
–
–
–
Liquidity (Internal) Risk = LR
Business Risk = BR
Financial Risk = FR
Exchange-Rate Risk = ER
Market or External Liquidity Risk = ELR
18
Estimating k
• Methodology:
1. Conduct a relative analysis of each risk:
Company, industry, and market.
2. Compare historical RP of company,
industry, and market.
3. Based on analysis, determine if the
company’s RP should be greater, equal
or less than the industry and market.
19
Liquidity Risk
•
•
Do a comparative analysis of liquidity
ratios:
Liquidity Ratios:
CA
Current Ratio 
CL
Cash  Mkt.Sec.  Re ceivables
Quick Ratio 
CL
Cash  Mkt. Sec.
Cash Ratio 
CL
20
Liquidity Risk
•
Liquidity Ratios:
Re ceivable Turnovers 
Net Annual Sale
Average Accounts Re ceivables
365
Average Collection Period 
Av. Re ceiver Turnover
Cost of Goods Sold
Inventory Turnovers 
Average Inventory
365
Av. Inventory Pr ocessin g Time 
Av. Annual Inventory Turnover
21
Liquidity Risk
•
•
•
Year
Comparative Analysis: Compare the ratios of the company,
industry (or comparable companies), and market.
Set up Bloomberg Table.
Determine if the company has more or less liquidity risk than
industry, and market.
Firm
CR QR CR RT CP IT IP
Industry
CR QR CR RT CP IT IP
Market
CR QR CR RT CP IT IP
1980
:
2007
Mean
σ
22
Business Risk
•
•
Measure:
Profitability Ratios:
–
–
–
•
•
Gross Profit Margin = Gross Profit/Sales
Operating Profit Margin = Operating Profit/Sales
Net Profit Margins = Net Income/Sales
Do a comparative analysis
Look at the variability of the margins.
23
Business Risk
• Measure
1. Coefficient of Variation (CV) in operating income:
–
CV = σ(operating income)/μ(operating income)
2. Coefficient of Variation (CV) in operating income:
–
CV = σ(Sales)/μ(Sales)
24
Business Risk
•
1.
2.
3.
4.
5.
Analysis of Business Risk – Points
Companies with a high operating leverage have high
operating profit margins. As a result, their earnings vary
more with sales – implies high unlevered beta.
High operating leverage companies tend to have higher
earnings in economic expansion and lower in economic
slowdowns.
Steel Companies have high operating leverages and
operating margins. They should have higher CV
Retail Companies tend to have lower operating leverages
and margins and therefore should have lower CV.
Sales of cyclical sectors – auto or steel – will be more
volatile than noncyclicals – hospital services.
25
Business Risk
Operating Leverage: When a project has multiple
methods of producing, the business risk of a capital
budgeting project is determined in part by the project’s
operating leverage.
•
Operating leverage relates to the mix of fixed (capital)
and variable inputs (labor) used to produce the product.
It exist whenever there are multiple methods of
producing a product. This allows the firm a choice of
spending more on fixed inputs and less on variable or
vice versa.
•
When there is more fixed inputs relative to variable,
then the project’s profit is more sensitive to sales and
vice versa.
26
Business Risk
•
Operating Leverage is characterized by the slope of profit/sales graph of the project.
Consider a small wine seller who is evaluating two alternative processes for
producing wine: Process A which would cost $120,000 to buy and install and would
have a variable cost of $0.57/bottle; Process B which would cost $30,000 to buy and
install and would have a variable cost of $0.72/bottle.
$
Total Net Re venue  Sales  TVC
m  .43
$
Total Net Re venue  Sales  TVC
m  .28
Fixed Cost
 $120,000
Fixed Cost
 $30,000
279,070
Unit Sales
107,143
Unit Sales
Pr ocess A :
Pr ocess B :
Fixed Cost  $120,000
Average Variable Cost  $0.57 / unit
Pr ice  $1.00
m  (P  AVC )  .43
Operating   m S  (.43)S
B  E Sales  $120,000 / .43  279,070
Fixed Cost  $30,000
Average Variable Cost  $0.72 / unit
Pr ice  $1.00
m  (P  AVC )  .28
Operating   m S  (.28)S
B  E Sales  $30,000 / .28  107,143
27
Financial Risk
•
Financial risk is uncertainty due to debt.
•
Because of the fixed cost on debt, companies with
high debt/equity ratios will find that in economic
expansion, the net earnings available to
shareholders will increase by a greater proportion
and in economic downturns the proportion
available will decrease by a larger proportion.
•
Plus, the higher the debt/equity ratio the greater the
possibility of default and bankruptcy.
28
Financial Risk
Financial Leverage: When a firm has some
debt financing, the debt portion of the
financing cost are fixed rather than variable.
Shareholders’ variability in realized return will
vary more, the greater the proportion of assets
financed by debt.
•
•
•
Shareholders’ return, Re, in an all equity firm is
the same as the firm’s realized return, RA.
Shareholders’ return in a leveraged firm is the
return realized after the payment to bondholders.
29
Financial Risk
Financial Leverage:
•
•
•
Consider an investment valued at $100M that could be
financed with all equity or leveraged with $50M in equity
(E) financing and $50M in debt (L) financing. Assume no
taxes and the firm pays kd = 10% on debt.
Given different possible returns from the project, RA, the Re
for leverage financing will vary more than all-equity
financing alternative.
This can be seen comparing the changes in Re for changes
in RA for the two financing alternatives.
30
Financial Risk
Financial Leverage:
RA
0
5%
10%
15%
20%
Financing : L / E  0
Re
Rd
R e
0
5%
10%
15%
20%
0
0
0
0
0
Financing : L / E  1
Re
Rd
R e

5%
5%
5%
5%
 10%
0%
10%
20%
30%
10% 
10% 10%
10% 10%
10% 10%
10% 10%
L / E 1
R e 30%
RA A  Rd L
E
R e  R A (A / E)  R d (L / E)
Re 
L/E  
R e
  greater var iability
R A
L/ E0
20%
10%
0
5% 10% 15%
20%
RA
10%
31
Financial Risk
•
•
Measures of Financial Risk:
Balance-sheet ratio:
L  T Debt
LT D / E 
Equity
L  T Debt  Deferred Taxes  PV(Lease Obligation s)
D/E 
Common  Pr eferred Stock
L  T Debt
LT D/A 
TotalAssets
Current Liab.  L  T Debt
Total D / A 
Debt  Equity
32
Financial Risk
•
•
Measures of Financial Risk:
Coverage Ratios:
EBIT
Interest Coverage 
Debt Interest Ch arg es
EBIT  Lease Interests Earnigs
Interest Coverage 
Interest  Lease Expenses
CF
CF Coverage 
Interest
•
Note: Retail chains could have low L-T D/E, but because
of leases and payables have high total D/A.
33
Financial Risk
•
•
•
•
Bankruptcy Risk:
Determine ratio or set of ratios that
provide the best prediction of
bankruptcy.
Altman Z-Score:
Z = f(S/A, EBIT/A, Mkt. Value of
Stock/BV of Debt, RE/A)
34
Exchange-Rate Risk
•
•
ER risk depends on what proportion of
sales and earnings are generated outside
the U.S. and the variability of exchange
rates.
Study the company’s hedging policy.
35
External Liquidity Risk
•
•
•
External liquidity measure the
marketability of the company’s stock.
Marketability: Ease of speed of trading a
security with little change in price.
Measures:
1.
2.
3.
4.
Number of Shares
Market value of stock
Trading Volume
Trading Turnover
36
External Liquidity Risk
•
External Liquidity Measures:
1. Number of Shares
2. Market value of stock
•
3.
4.
[(Hi price-low Price)/2](no. of shares)
Trading Volume
Trading Turnover = Proportion of outstanding
shares traded during a period of time.
•
•
Example: 705 m shares traded in year; 1,020 shares
outstanding; Turnover = 705/1020 = .70.
70% annual turnover
5. Bid-Ask Spread
6. Institutional Ownership
37
External Liquidity Risk
• External Liquidity Points:
1. Foreign stocks may lack external
liquidity.
2. Smaller Cap companies may lack
external liquidity.
3. External liquidity information can be
found in Bloomberg.
38
Fundamental Risk Analysis
•
Compare the various ratios measuring for LR, BR, FR,
ERR, ELR for the company, industry, and market.
Determine if the ratios are higher or lower than the
norm or trend:
•
–
–
–
–
–
•
Below-Average or Above-Average LR
Below-Average or Above-Average BR
Below-Average or Above-Average FR
Below-Average or Above-Average ERR
Below-Average or Above-Average ELR
From fundamental risk comparison determine if
–
–
RP of Company >=< RP of Industry
RP of Company >=< RP of Market
39
Fundament Risk Analysis
•
•
•
•
Range of market RP = 3%-8%
The company tends to have fundamental risk
ratios that indicate it has less risk than the
market.
Estimate the company’s RP to be between 2%7%.
Note: The company’s beta should be less than
1.
40
Fundament Risk Analysis: k Estimate
•
•
•
•
•
Range of market RP = 3%-8%
The company tends to have fundamental risk ratio that
indicate it has less risk than the market.
Estimate the company’s RP to be between 2%-7%.
Note: The company’s beta should be less than 1.
If Rf = 4%, and market estimate is 5%, then the
company would have
k = Rf + RP = 4% + 4% = 8%
41
k Estimate: SML
•
Market Model, SML:
k  R f  [E(R M  R f ]
•
•
Market RP = 3%-7%
Look at Relation between:
–
–
Rf and RP
Economy or market and RP
42
k Estimate: SML
•
•
•
•
Example:
Current Market Risk Premium = 4%
Rf = 5%
Adjusted ß = .90
k  R f  [E(R M  R f ]
k  .05  [.04] (.9)  8.6%
43
k Estimate: SML
• Estimate ß
1. Historical Regression
•
k    R M
Poor regression results
2. Adjusted Beta: Vasicheck Technique
3. Adjust Beta up or down based on your
fundament risk analysis.
44
Estimating Future EPS
EBIT
1.
EBT
2.
EAT
3.
4.
Approach 1: From Bloomberg Data:
Operating Income = Rev. – Cost of Goods
Sold – SGA
Pretax Income = Operating Income – Interest
Exp. – Net Forn. EX Losses – Net Nonoperating Losses
Income Before XO Items = Pretax Income –
Income Tax
Net Income = Income before XO Item – Net
XO Loss – Net Tax Effect of XO Loss –
Minority Interest
EAT
EPS 
n
45
Estimating Future EPS
•
Approach 1: Using Bloomberg Data;
Estimation Model
Estimate the proportional changes in
revenue (sales, S), cost of goods sold,
SGA, interest expenses (Int), net FX
losses, and income taxes.
–
–
–
–
S1 = (1+g)S0
CGS1 = (1+g)CGS0
Int1 = (1+g)Int0
Etc.
46
Fundamental Stock Analysis
Forecast
Kraft
Reason
Annual Sales Growth
Rate
9.00%
Continue increasing trend
% Δ in COGS
10.00%
Significant increase based on commodity
price increases
% Δ in S,G,&A
6.00%
Maintain current percentage to sales
% Δ in Interest
10.00%
Increase due to increasing debt to asset
ratio
Foreign Exchange
Loss (G)
-
Continue trend of minimum exchange-rate
losses (gains)
Net Non-Operating
Loss (G)
539.00
No change in level
Tax Rate
31.00%
No change in rate
47
Fundamental Stock Analysis
Period
Kraft
Revenue
Sales Growth
Cost of Goods Sold (Revenue)
% Δ in COGS
COGS/Revenue
Selling, General & Administrative Expense
% Δ in S,G,&A
S,G,&A/Revenue
Operating Income
Operating Margin
Interest Expense
% Δ in Interest
Foreign Exchange Loss (G)
Net Non-Operating Loss (G)
Pretax Income
Income Tax Expense
Effective Tax Rate
Income Before XO Items
XO Loss (Gain) Pretax
Tax Effect on XO Items
Minority Interest
Net Income
EPS
Number of Shares
F2007
37,241
8.40%
24,604
12.27%
66.07%
7,767
8.09%
20.86%
4,870
13.08%
604
18.43%
539
3,727
1,137
30.51%
2,590
2,590
1.64
1,532.00
F2008
40,593
9.00%
27,064
10.00%
66.67%
8,233
6.00%
20.28%
5,295
13.04%
664
10.00%
539
4,092
1,268
31.00%
2,823
2,823
1.84
1,532.00
48
Fundamental Stock Analysis
Forecast
Oracle
Reason
Annual Sales Growth Rate
23.00%
Increase in sales primarily due to
acquisitions
% Δ in COGS
11.00%
Continuation of increasing cost trend
% Δ in S,G,&A
13.00%
Increase in sales force and bonuses
% Δ in Interest
9.00%
Reflects increase in new debt
Foreign Exchange Loss (G)
(41.00)
Continuation of current level
Net Non-Operating Loss
(G)
(250.00)
Tax Rate
30.00%
Continuation of current level
No change
49
Fundamental Stock Analysis
Period
Oracle
Revenue
Sales Growth
Cost of Goods Sold (Revenue)
% ? in COGS
COGS/Revenue
Selling, General & Administrative Expense
% ? in S,G,&A
S,G,&A/Revenue
Operating Income
Operating Margin
Interest Expense
% ? in Interest
Foreign Exchange Loss (G)
Net Non-Operating Loss (G)
Pretax Income
Income Tax Expense
Effective Tax Rate
Income Before XO Items
XO Loss (Gain) Pretax
Tax Effect on XO Items
Minority Interest
Net Income
EPS
Number of Shares
Four Quarters
Ending
2/29/2008
21,074
23.83%
4,797
19.95%
22.76%
8,954
22.37%
42.49%
7,268
34.49%
361
9.39%
(41)
(241)
7,189
2,069
28.78%
5,120
33
5,087
0.98
5,148.00
Four Quarters
Ending
2/28/2009
25,921
23.00%
5,325
11.00%
20.54%
10,118
13.00%
39.03%
10,478
40.42%
393
9.00%
(41)
(250)
10,376
3,113
30.00%
7,263
30
7,233
1.41
5,148.00
50
Estimating Future EPS
Approach 2:
Sales
1.
2.
EBIT
3.
4.
5.
EBT
Revenue
m = Operating Profit Margin = Operating
Income/Revenue
Operating Income = m Revenue
Pretax Income = Operating Rev – Interest – FX Loss
Income Before XO Item = [Operating Rev – Interest –
FX Loss – Net Nonoperating Losses](1-t)
EAT
–
–
6.
where: t = effective tax rate
t = Income tax expense/Pretax Income
Net Income = Income before XO Item – Net XO Loss
– Net Tax Effect of XO Loss – Minority Interest
51
Estimating Future EPS
Approach 2: Using Bloomberg Data: Estimation Model
1. Estimate the proportional changes in Revenue:
–
–
–
–
–
Kraft
2.
S1 = (1+g)S0
S2008 = (1+g)S2007
g = .09
S2008 = (1.09)$37,241
S2008 = $40,593
Estimate Operating Profit Margin:
–
–
Kraft 2007: m = 13.08
Kraft Forecast: m = 13.04
3. Operating Income = m S1
–
Operating Income 2008 = .1304($40,593) = $5,295
52
Estimating Future EPS
Approach 2: Using Bloomberg Data: Estimation Model
4.
Estimate interest expenses, net FX losses, and Net Non-Operating Losses
–
–
–
Pretax Income = Operating Inc. – Int – FXL - NNOL
5.
•
Kraft
6.
Int1 = (1+g)Int0
FXL1 = (1+g)FXL0
NNOL1 = (1+g)NNOL0
Forecast Pretax Income = $5295 – 664 – 0 = $4,092
Estimate effective tax rate, t:
•
t = Income tax expense/Pretax Income
–
t = .31
–
Net Income = Pretax Income(1-t)
–
Net Income = $4,092(1-.31) = $2,823
–
(excludes XO loss and XO tax)
7.
Estimate n = 1,532 (no change)
–
EPS = Net Income/n = $2,823/1,523 = $1.84
53
Estimating Future EPS
Kraft
• Approach 3:
1. Estimate the proportional changes in
revenue:
– S1 = (1+g)S0
– S2008 = (1+g)S2007
– g = .09
2. Estimate Revenue (Sales, S)
– S2008 = (1.09)$37,241
– S2008 = $40,593
54
Estimating Future EPS
Approach 3:
3. Estimate mn: mn = Net Operating Profit
Margin = Net Income/Revenue
Kraft
•
•
•
Estimate
m2007 = 2,590/37,241 = .069547
Estimate: No change
4. Net Income2008 = mnS2008
•
Net Income = .069547 ($40,593) = $2,823
5. Estimate n: No Change
– EPS = $2,823/1,532 = $1.84
55
Points on Estimating EPS
•
Sales forecast:
–
–
–
Macro analysis: Run regressions of sales against an
explanatory variable: PCE Medical
%ΔSales = a + b (%ΔPCE Medical)
Conduct Micro analysis: Study Annual Report,
analyst opinion.
•
Cost of Goods Sold Forecast:
–
Study relation between COGS and inflation or
commodity price increases.
56
Points on Estimating EPS
•
Administrative Expense Forecast:
–
–
•
Check Annual Report
Check trends
Interest Expense forecast:
–
–
–
•
Check interest rates
Check credit condition
Debt/Equity trends and plans
FX Loss Forecast:
–
–
–
Check global exposure
Determine direct investment and FX exposure compared to
exports and import and FX exposure.
Check Hedging policy
57
Qualitative Analysis of Profit Margin
•
In estimating operating or net operating profit
margins, one needs to consider qualitative
factors related to the firm’s competitive
position and strategy and determining its
SWOT.
58
Qualitative Analysis of Profit Margin
•
1.
2.
3.
4.
Competitive Strategy:
Brand Names
Investment in technology to lower cost
Investment in delivery systems
Low-Cost Leader: Economies of scale,
proprietary technology, access to raw material,
etc.
5. Differentiated Products: Unique marketing,
distribution system.
59
Qualitative Analysis of Profit Margin
•
1.
SWOT
Strengths: What is there competitive advantage
•
2.
Strong R&D, strong financial resources, strong buy image,
low-cost producers, high quality producer.
Weaknesses: Where competitors have exploitable
advantages
•
•
3.
Foreign competition, poor financial resources,
Question: Is the company doing anything about its weakness.
Opportunities: External factors that favor the
company
•
4.
Shrinking competition, favorable exchange rate, new product,
new market, etc.
Threats: External Factors that hurt the company
•
Slow economy, government regulations, new entrants, new
technology that makes company’s product obsolete, etc.
60
Qualitative Analysis of Profit Margin
•
1.
2.
3.
4.
Peter Lynch Tenets:
Product is not a fad (L-R market)
L-R competitive advantage
Product is stable (no need to innovate)
Company can benefit from cost reduction
61
Qualitative Analysis of Profit Margin
•
1.
Warren Buffet Tenets:
Business Tenets:
•
•
•
2.
3.
Business is simple
Consistent operating history
Favorable L-R prospects (the product is needed)
Management Tenets: Management is rationale
Financial Tenets:
•
•
•
•
4.
Focus on ROE not EPS
Look for good ROE with little or no debt
Look for high profit margins
Look at free CF
Market Tenets: What is the value of the business:
•
Look at Economic value added model
62
Qualitative Analysis of Profit Margin
• Kraft: Qualitative Analysis
• SWOT:
–
–
–
–
Kraft
Strengths: staple products, diversified,
Weaknesses: commodity prices
Opportunities: international markets
Threats: effected by consumer demand and trends
• Comparative Advantages:
–
–
–
–
#1 food manufacturer in the U.S. & #2 largest worldwide
Management of rising commodity prices
New sales initiative
Launched a 3 year growth strategy
• Debt Outstanding:
– Debt maturing in 2011, 2014, and 2018
– Refinancing strategy
63
KRAFT (KFT)
Reasons to Buy
Kraft makes products that are staples in American households. No matter what condition the
economy is in, these products will still be demanded (Nabisco Cookies, Oscar Meyer sandwich
meats, Post cereal, etc.)
Leader in industry: They are the largest food manufacturer in the U.S. and 2nd largest
worldwide; international sales comprise nearly 33% of overall revenue. They have also been
able to manage rising commodity prices by passing this along to consumers and strategically
manage the increase in fixed expenses.
Diversification: Well diversified in food processing and manufacturing compared to
competitors
Management: Piloting a new sales initiative to give store managers a single point of contact for
Kraft that will create more opportunities to showcase the products consumers want and can
ensure will always be in stock
Management: Launched a 3 year growth strategy (2007-2010) to improve product diversity,
boost sales, and reduce costs
Maturing Debt: Company has a lot of debt outstanding that is maturing in 2011, 2014, and
2018. Kraft will have to reissue debt to finance this
2008/Future Financial Goals of Kraft
Improve annual discretionary cash flow by $1 billion in the next few years, delivering cash
flow equal to 100 percent of net income as a long-term goal.
Reduce primary working capital to 11 percent of net revenue, from 14 percent today.
Reduce capital spending to below 3 percent of net revenue from 3.3 percent in 2007.
Improve return on invested capital by an average of 80 basis points per year.
Future Strategic Governing
Rewire the Organization for Growth: Kraft is reinforcing a mindset of candor, courage, and
action throughout the company and trying to strike a balance between decision-making globally
and locally
Reframe Categories: Kraft is reframing their categories to make them more relevant to
consumers and identify key consumer trends that have a big impact on our business. The
categories are now going to reflect, health & wellness, quick meals, snacks, and premium
divisions
Exploit Sales Capabilities: piloting new sales initiatives
Reduce costs without compromising quality: Kraft is taking stock of what they do best which
allows them to work more closely & efficiently with suppliers, customers, & consumers
64
Oracle (ORCL)
Overview
oWorlds largest enterprise software company
oDevelops, manufactures, markets, distributes and services database and middleware software as well as
applications software
oIn the past three years Oracle has invested over $25 billion to acquire many companies, products,
services and technologies, including the acquisition of PeopleSoft, Inc., Siebel Systems, Inc. and
Hyperion Solutions Corporation
oOracle is organized into two businesses, software and services, which are further divided into five
operating segments.
oThe software business is comprised of two operating segments: (1) new software licenses and (2)
software license updates and product support.
oThe services business is comprised of three operating segments: (1) consulting, (2) On Demand and (3)
education.
oSoftware and services businesses represented 79% and 21% of total revenues, respectively, in fiscal
2007 and 80% and 20% of total revenues, respectively, in both fiscal 2006 and fiscal 2005.
oNew software licenses revenues represents 33% of total revenues in FY 2007
Recent News
oOracle is acquiring BEA, the largest independent maker of middleware, which helps different types of
programs share information. While BEA has lost sales to larger rivals Oracle and International Business
Machines Corp., revenue from maintenance, or customer- support contracts, has increased. This
acquisition is being funded by $5 billion new debt offer.
oOracle sold $1.25 billion of 5-year 4.95 percent notes priced to yield 222 basis points more than U.S.
Treasuries of similar maturity; $2.5 billion of 10-year 5.75 percent bonds that offered an extra yield of
215 basis points; and $1.25 billion of 30-year 6.5 percent bonds with a spread of 212 basis points
oEDS and Oracle today announced they have extended their strategic alliance to develop and market
software and solutions for tax and revenue agencies around the world
oOn March 22, 2007, Oracle filed a lawsuit in U.S. Federal District Court in the Northern District of
California against SAP. Among the claims made against SAP are violations of the Federal Computer
Fraud and Abuse Act and California Computer Data Access and Fraud Act, Unfair Competition,
Intentional and Negligent Interference with Prospective Economic Advantage and Civil Conspiracy.
Risk Factors
oWeak economy
oAnalysts estimate may not be met because of poor prediction methods
oIncreased competition may pressure pricing model changes
oPeopleSoft’s Customer Assurance Program may expose the company to substantial liabilities if
triggered. The aggregate potential CAP obligation as of May 31, 2007 was $3.2 billion. Oracle expects
the aggregate potential CAP obligation to decline substantially until fiscal year 2008 when a significant
number of these provisions begin to expire. The last CAP obligation will expire on December 31, 2008
65
Comparative Analysis of EPS
•
In forecast sales, operating profit margins, and effective
tax rate to forecast EPS, one should also do a comparative
analysis of the firm with the industry and market.
•
Plot margins, sales, growth rates, and other components to
analyze trends.
66
Comparative Analysis of EPS
•
Set up tables showing the parameters for the company,
industry, and market over time.
Firm
Margin
Gross Operating Net
Year
Industry
Margin
Gross Operating Net
Market
Margin
Gross Operating Net
1980
:
2007
Mean
σ
•
Analyze the relative trends
67
EPS FORECAST
•
Notes:
Compare your forecast to the analysts’ estimates.
•
Analysts’ forecast of EPS, sales, etc are provided by
Bloomberg.
•
Once you’ve made an annual forecast, look at the quarterly
data to see how it tracks and whether or not your sales or
profit margins are over or underestimated.
68
Valuation: Discounted Cash Flow
• Dividends:
– Model
– Gordon:
V


D(1  g) t
t
(
1

k
)
t 1
D1
V
k g
– 2-stage or 3-stage growth model
69
Valuation: Discounted Cash Flow
• Requires estimating g and k.
• If g > k, then you need to use a 2-stage or
3-stage growth model.
• Assignment: Estimate the value of Kraft.
70
Valuation: Discounted Cash Flow
ESTIMATE OF RATE OF RETURN USING
THREE-STAGE GROWTH MODEL
Example of 3Stage Growth
Model Estimate
Growth = .10
Transitional
Steady State
Year
EPS
d/e
Dividend
1
$4.00
.40
$1.60
2
4.50
.45
2.03
3
5.00
.50
2.50
4
5.75
.55
3.16
5
6.50
.60
3.90
6
6.50(1.09)
.60
4.25
7
6.50(1.09)(1.08)
.60
4.59
8
6.50(1.09)(1.08)
(1.07)
.60
4.91
9
6.50(1.09)(1.08)
(1.07)(1.06)
= 8.68
.60
5.21
71
Valuation: Discounted Cash Flow
• If k = .10, then the value of the
stock would be $77.40.
Example of 3Stage Growth
Model Estimate
• If the stock is priced at $77.40,
then k = 10%.
160
.
2.03
2.50
316
.
3.90
4.25
P0  $77.40 





2
3
4
5
1  k (1  k )
(1  k ) (1  k )
(1  k ) (1  k ) 6
5.21
4.59
4.91


 k .068
 k  .10.
7
8
(1  k )
(1  k ) (1  k )
72
Note: Wells Fargo Evaluation System
• Step 1: An analysts estimates the rate of
return on a stock using the three-period
DCF model. This requires estimating D1, e,
and g for the next 5 years, determining the
length of the transitional period, and
estimating the steady state growth rate.
Given this model, the analyst solves for ke
given the current market price of the stock.
73
Wells Fargo Evaluation System
• Step 2: The analyst estimates the beta of the
stock. Example: For the above stock,
suppose the analyst estimates its beta to be
1.2.
• Step 3: Take the estimated k and beta
combinations for all stocks being analyzed
and run a cross-sectional regression to
generate an ex ante SML.
74
Step 3: Example
ESTIMATION OF SML
CROSS-SECTIONAL MODEL WITH 10 STOCKS*
Stock
Return
Beta
SML Return
Excess Return
1
10%
1.2
12.74%
-2.74%
2
8
.8
9.86
-1.86
3
15
1.4
7.18
.82
4
22
1.2
12.74
9.26
5
6
.9
10.58
-4.58
6
18
1.6
15.62
2.38
7
16
1.8
17.06
-1.06
8
12
1.0
11.30
.70
9
4
1.2
12.74
-8.74
10
16
.8
9.86
6.14
Estimated SML: ri = 4.1 + 7.2 i
75
Step 3: Example
k





10%
41%
.

SML






This stock would
not be selected.
12
.

76
Wells Fargo Evaluation System
• Step 4: Accept stocks into the portfolio with
positive excess returns (i.e., k and beta
coordinates above the estimated SML) and
reject stocks with negative excess returns
(i.e., those with coordinates below the line).
77
Relative Valuation: Multiplier Approach
•
P/E Multiplier Approach 1: Compare Forecasted
EPS with Bloomberg’s Best P/E
1. Estimate EPS for next year (12-months out)
2. Using the current price, calculate you P/E based
on your forecast.
3. Compare your P/E to P/E based on analysts’
forecasted EPS.
4. Use Bloomberg to find Best P/E
78
Relative Valuation: Multiplier Approach
• P/E Multiplier Approach 1:
Kraft
–
–
–
–
–
Current Price = $30.90
Our Estimate of EPS = $1.84
Our P/E = $30.90/$1.84 = 16.79
Analyst estimate of EPS = $1.50
Their P/e $30.90/$1.50 = 20.60
• Based on this, we would buy.
• Note: we could simply compare our forecasted
EPS with Best EPS forecast.
79
Relative Valuation: Multiplier Approach
• P/E Multiplier Approach 2: Forecast P/E
1. Do a macro analysis of company’s P/E
with industry and market.
80
Relative Valuation: Multiplier Approach
• P/E Multiplier Approach 2: Forecast P/E
2. Note trends, Ranges in P/E, Recent Trends, etc.
3. Consistency: Determine if the trends are
consistent with your analysis.
•
•
For example, if the company has a higher growth
rate, then its P/E should be higher. See if that is the
case by reviewing your historical growth, DuPont
ratios, etc.
If the company has more financial risk or business
risk, then its k should be lower and therefore its P/E
lower. See if that is the case by reviewing the
comparative ratios measuring fundamental risks.
81
Relative Valuation: Multiplier Approach
• P/E Multiplier Approach 2: Forecast P/E
4. Project P/E
•
•
Based on your analysis determine if the
company P/E should be higher or lower than
the market.
If there is a forecast of the market P/E and
industry P/E (Best P/E from Bloomberg), then
adjust your company P/E relative to the
industry and market.
82
Relative Valuation: Multiplier Approach
• P/E Multiplier Approach 2: Forecast P/E
5. Forecast P/E internally:
•
•
•
Use Gordon model
Use your estimates of g, k, D/E for next year.
Note: k > g requirement for using Gordon.
6. Compare Projected P/E with internally
forecasted P/E, select one or use both.
83
Relative Valuation: Multiplier Approach
•
P/E Multiplier Approach 2: Forecast P/E
7. Determine stock’s intrinsic value (V)
•
Estimate next year’s EPS
•
•
•
•
•
Multiply current EPS by your estimated growth
rate, g.
You could use your estimate EPS.
Take projected P/E and/or Forecasted P/E
Determine Value (s):
V = (P/E) E(EPS)
84
Relative Valuation: Multiplier Approach
• P/E Multiplier Approach 2: Forecast P/E
1. Comparison of P/E
Kraft
•
•
•
Industry P/E = 18.31
S&P 500 P/E = 23.88
Kraft P/E = 16.71
2. Trend:
•
•
Kraft was below its historical P/E average of 19.47.
The industry and market were below their historical
averages.
3. Internal estimate of Kraft’s was 15.59 (based on
a cross-sectional multiple regression model).
85
Relative Valuation: Multiplier Approach
• A cross-sectional regression model was used to estimate Kraft’s P/E.
In estimating the model, we regressed the 2007 P/E ratios of 439 S&P
500 stocks against their average retention ratios (RR), growth ratios
(g), and betas (ß):
P / ei  C0  C1(RR i )  C2 (g i )  C3 (i )  i
P / ei  7.46  12.45 RR i  11.02 g i  3.63 i  i
(1.40) (2.68)
(1.23)
(1.84)
Kraft
• Using this equation, we forecasted no changes in Kraft’s retention
ratios, growth ratios, and betas from its historical averages.
Substituting Kraft’s historical parameter values (RR, g, and ß) into the
regression equation, we obtained an equilibrium P/E for Kraft of
15.59.
86
Relative Valuation: Multiplier Approach
Kraft
• P/E Multiplier Approach 2: Forecast P/E
4. Selected a baseline P/E for Kraft of 15.5
5. Considered three P/E cases: 14.5, 15.5 and
16.5.
6. Based on our estimated EPS of $1.84, the
intrinsic values were:
•
•
•
V = (14.5)($1.84) = $22.68
V = (15.5)($1.84) = $28.52
V = (16.5)($1.84) = $30.38
87
Criterion of the Investment Decision
• Two Approaches
1. Compare estimated IV with market price
•
•
If IV > PMkt then Buy
If IV < PMkt then Sell
•
Use discounted CF or P/E approach in valuation
88
Criterion of the Investment Decision
• Two Approaches
2. Compare expected rate of return with k
•
•
E(R) can be estimated as an E(HPY) or from
the Gordon Model or 2-stage or 3-stage
growth model
E(HPY):
E(R ) 
E(R ) 
E(D)  (IV  P Mkt )
P Mkt
(D / E)EPS(1  g)  (IV  P Mkt )
P Mkt
89
Criterion of the Investment Decision
• Two Approaches
2. Compare expected rate of return with k
•
Gordon: Solve for k
D1
P

k g
D
k  M kt  g
P
M kt
•
•
Let k be the estimate of E(R)
2-Stage or 3-Stage: See Wells Fargo Model
90
Criterion of the Investment Decision
Market Price = $38
IV = $26.86, 28.32, $30.30
Kraft
IV < PMkt
Therefore Don’t Buy
D
k  M kt  g
P
EPS(D / E )
E(R ) 
g
M kt
P
($1.84)(.5)
E(R ) 
 .06
$38
E (R )  .084
Estimated k  .09
E(R) < k
Therefore Don’t Buy
91
Other Valuation Approaches
•
•
1.
2.
3.
4.
P/BV
P
Current Market Pr ice

BV Expected Year  End BV
Points:
Measure good for companies with consistent
accounting practices.
Good for comparison of companies in the same
industry; may not be good for inter-industry
comparison
P/BV = f(ROI – WACC) (i > k)
Do historical comparison of P/BV for company,
competitors, and market (plot P/BV ag. time).
92
Other Valuation Approaches
•
•
P/CF:
Points:
1. What CF should be used?
2. Common CF = EBDITA
3. Do relative comparisons of company,
industry, and market (plot P/CF ag. time)
93
Other Valuation Approaches
•
P/S:
P
Current Market Pr ice

S Expected Sales  per  Share
•
Points:
1. Sales drive most ratios
2. Sales are not as subject to accounting
manipulation.
3. P/S may be good for foreign stocks
4. Do comparative analysis (plot P/S ag. Time)
94
Other Valuation Approaches
•
•
Economic Value Added, EVA
EVA = EBIT(1-t) – (WACC) (Assets)
–
–
–
Take oil well company that made a one-time
only investment of $6m, with: i = .30, ke =
.24, D/E = .5, kd = .08, WACC = .144,
EBIT = $12m + .3($6m) = $13.8m, Assets =
$50m + $6m = $56m.
EVA = $13.8m(1-.4) – (.144)($56m) =
$.216 m
If i = .24, then EVA = 0.
95
Growth Duration Model
•
Growth Duration Model
•
Companies with extraordinary growth rates
will not grow at those rate for an extended
time. They will eventually run out of
potentially high return investments.
•
Finding how long a company will grow at
extraordinary rate or equivalently how long it
will take to reach a steady-state rate is
important, especially for determining 2-stage
and 3-stage models.
96
Growth Duration Model
•
Growth Duration Model
•
One duration model is based on assuming that
the current P/E of a growth stock will
eventually converge to a value that is
proportional to the market P/E, with the
proportion being based on earnings and the
same steady-state growth as the market.
•
Growth duration is found by determining the
implied time it would take for the proportional
P/E to converge.
97
Growth Duration Model
•
•
Growth Duration Model
Model:
•
•
•
P(0) = current price
E(0) = current earnings
G = Estimated growth rate in earnings
(sustained)
D = Dividend yield
•
 (P(0) / E(0) 
ln 

P
(
0
)
/
E
(
0
)
M

T  M
 (1  G  D 
ln 

1

G

D
M
M

98
Growth Duration Model
 (P(0) / E (0) 
 39 
ln 
ln  

P
(
0
)
/
E
(
0
)
M

 25 
T  M
 8.31 years
 (1  G  D 
 (1  .13  .01 
ln 
 ln  1  .07  .02 
1  G M  D M 
Walgreens:
S&P 500:
•
•
•
•
•
•
P(0)/E(0) = 39
G = 13%
D = 1%
P(0)/E(0) = 25
G = 7%
D = 2%
Assignment: Find T for Kraft
99
Growth Duration Model
•
•
Use of Growth Duration Model
Investment Criterion:
–
–
•
If you think the actual growth duration is
greater than the implied, then buy.
If you think the actual growth duration is
less than the implied, then don’t buy.
Use Growth Duration model to estimate
T for use in 2-stage or 3-stage growth
models.
–
Used in the Well-Fargo Model.
100
When to Sell
•
•
•
Your job does not end, once you’ve
estimated the IV and made your buy
recommendation.
After you buy a stock, the next question
is when do you sell it.
Answer: The answer to when to sell
should be based on the research (or
convictions) that convinced you to buy
the stock in the first place.
101
When to Sell
•
•
•
The key drivers you have identified for
buying the stock need to be monitored
and updated.
If the key drivers weaken, it is time to
reevaluate and possibly sell.
As a rule: When the stock approaches its
IV, it may be time to sell and reinvest the
funds it another underpriced stock.
102
When to Sell
•
•
Rule:
If you know why you bought the stock,
then you’ll be able to recognize when to
sell it.
103
Points on Fundamental Analysis
•
•
•
•
An efficient market is difficult to outsmart.
Sometimes it is the stock of a small company
or one that is neglected that may provide an
opportunity.
In U.S. (and other countries), there is
information/data overload – blessing and curse.
May be opportunity for finding underpriced
stocks by looking globally.
104
Points on Fundamental Analysis
•
•
•
•
•
•
•
•
Global Investments:
May be opportunity for finding underpriced
stocks by looking globally.
Currency risk
Political risk
External market risk (not as marketable)
Transaction cost higher (bid-ask spreads
bigger)
Lack of accounting standards
Valuation differences: use P/S
105
Web Sites
•
•
•
•
•
•
•
•
•
•
•
•
•
www.finra.org
www.businessweek.com
www.yahoo.com
www.zacks.com
www.cfonews.com
www.valueline.com
www.moneycentral.msn.com
www.fool.com
www.nyssa.org links
www.dnb.com
www.hoovers.com
www.sec.gov (EDGAR)
www.invescopowershares.com ETFs
106
Web Sites
•
•
•
•
www.nabe.com NABE
www.stats.bls.gov Government data
source link
www.census.gov
www.conference-board.org
107
Web Sites
• Useful financial information sites:
–
–
–
–
–
–
–
–
–
–
–
–
–
www.Finance.Yahoo.com
http://www.hoovers.com
http://www.bloomberg.com
http://www.businessweek.com
http://www.ici.org
http://seekingalpha.com
http://bigcharts.marketwatch.com
http://www.morningstar.com
http://free.stocksmart.com
http://online.wsj.com/public/us
http://finra.org
www.pinksheets.com
www.nasdaq.com
108
Web Sites
• To monitoring several stocks, interest rates,
and other market information download
MarketBrowser:
– http://www.marketbrowser.com.
109