Firm Valuation and Analysis
Company Analysis and Stock Selection
• Good companies are not necessarily good
investments
• In the end, we want to compare the intrinsic
value of a stock to its market value
– Stock of a great company may be overpriced
– Stock of a lesser company may be a superior
investment since it is undervalued
Defensive Companies and Stocks
• Defensive companies’ future earnings are
more likely to withstand an economic
downturn
– Low business risk
– Not excessive financial risk
• Defensive stocks’ returns are not as
susceptible to changes in the market
– Stocks with low systematic risk
Cyclical Companies and Stocks
• Sales and earnings heavily influenced by
aggregate business activity
– High business risk
– Sometimes high financial risk as well
• Cyclical stocks experience high returns is up
markets, low returns in down markets
– Stocks with high betas
Speculative Companies and Stocks
• Speculative companies invest in assets
involving great risk, but with the possibility of
great gain
– Very high business risk, likely no current cash
flows
– Example: biotech
• Speculative stocks have the potential for great
percentage gains and losses
– Often characterized by high P/E ratios
Value versus Growth Investing
• Growth stocks will have positive earnings
surprises and above-average risk adjusted
rates of return
– So long as they continue to grow and surprise to
the upside)
• Value stocks appear to be undervalued, may
have disappointed investors in the past and
are now forgotten, left for dead, despised
– Value stocks usually have low P/E ratio or low
ratios of price to book value
– Are housing stocks value stocks or value traps?
Theory of Valuation
• The value of a financial asset is the present
value of its expected future cash flows
• Required inputs:
– The stream of expected future returns, or cash
flows
– The required rate of return on the investment
Required Rate of Return
•
•
Determined by the risk of an investment and
available returns in the market
Determined by:
1. The real risk-free rate of return, plus
2. The expected rate of inflation, plus
3. A risk premium to compensate for the uncertainty of
returns
•
Sources of uncertainty, and therefore risk premiums, vary by the
type of investment
Investment Decision Process
• Once expected (intrinsic) value is calculated,
the investment decision is rather
straightforward and intuitive:
– If Estimated Value > Market Price, buy
– If Estimated Value < Market Price, do not buy
• The particulars of the valuation process vary
by type of investment
Approaches to Common Stock
Valuation
• Discounted Cash Flow Techniques
– Present value of Dividends (DDM)
– Present value of Free Cash Flow
• Relative valuation techniques
– Price-earnings ratio (P/E)
– Price-cash flow ratios (P/CF)
– Price-book value ratios (P/BV)
• Used most often for banks and other capital-intensive businesses
• Not appropriate for many “asset-light” businesses
Dividend Discount Models
• Constant Growth Model:
– Assumes dividends started at D0 (current year’s dividend)
and will grow at a constant growth rate
– Growth will continue for an infinite period of time
– The required return (k) is greater than the constant rate of
growth (g)
V = D1/(k-g)
where D1= D0(1+g)
Dividend Discount Models
Example 10.1 Consider a situation in which we
are valuing a share of common stock that we
plan to hold for only one year. What will be the
value of the stock today if it pays a dividend of
$2.00, is expected to have a price of $75 and the
investor’s required rate of return is 12%?
FIN3000, Liuren Wu
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Dividend Discount Models
Value of Common stock
= Present Value of future cash flows
= Present Value of (dividend + expected
selling price)
= ($2+$75) ÷ (1.12)1
= $68.75
FIN3000, Liuren Wu
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Dividend Discount Models
Example 10.2 Continue example 10.1. What will be
the value of common stock if you hold the stock for
two years and sell it for $82? Assume the dividend
payment is fixed at $2 per year.
• Value of Common stock
= Present Value of future cash flows
= Present Value of (dividends + expected selling
price)
= {($2) ÷ (1.12)1 } + {($2+$82) ÷ (1.12)2 }
= $71.14
FIN3000, Liuren Wu
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Determinants of Growth Rate of
Future Dividends
Firm’s growth opportunities relate to:
The rate of return the firm expects to earn when they
reinvest earnings (the return on equity, ROE), and
The proportion of firm’s earnings that they reinvest.
This is known as the retention ratio, b, = 1- dividend
payout ratio.
The growth rate can be formally expressed as
follows:
 g = the expected rate of growth of dividends
 D1/E1 = the dividend payout ratio
 ROE = the return on equity earned when the firm reinvests a portion of its earning
back into the firm.
FIN3000, Liuren Wu
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Discounted Cash Flow Model
• Also called the free cash flow method. Suggests the
value of the entire firm equals the present value of
the firm’s free cash flows.
• A firm generates free cash flows for its stock holders
and debt holders, so:
• Market value of a firm=Market value of stocks +
market value of debt
DCF Continued
• Find the Enterprise Value (EV) of the firm.
– PV of firm’s future FCFs
– FCF = cash providing by operating activities, less capital
expenditures (capex)
• Subtract market value of firm’s debt (and preferred stock, if
any) to get total value of common stock (equity).
– Value of equity = EV of firm – MV of debt
• Divide value of equity by the number of shares outstanding.
– Value per share = value of equity / # of shares of common stock
DCF Continued
The value of a business is usually computed as the
discounted value of FCF out to a valuation horizon
(H).
• The value after H is sometimes called the terminal
value or horizon value.
FCF1
FCF2
FCFH
TVH
PV 

 ... 

1
2
H
(1  r ) (1  r )
(1  r )
(1  r ) H
DCF Continued
FCF1
FCF2
FCFH
TVH
PV 

 ... 

1
2
H
(1  r ) (1  r )
(1  r )
(1  r ) H
PV (free cash flows)
PV (terminal value)
Given the long-run gFCF = 6%, and firm discount rate of
10%, use the corporate value model to find the firm’s
value.
0 r = 10%
-5
-4.545
8.264
15.026
398.197
416.942
1
2
10
3
4
...
g = 6%
20
21.20
21.20
530 =
0.10 - 0.06
= TV3
If the firm has $40 million in debt and has 10
million shares of stock, what is the firm’s stock
value per share?
• MV of equity = MV of firm – MV of debt
= $416.94m - $40m
= $376.94 million
• Value per share = MV of equity / # of shares
= $376.94m / 10m
= $37.69
When to use the DCF vs. DDM
• When firms don’t pay dividends or when dividends
are hard to forecast, use the DCF model if possible
• Projecting free cash flows might give us more
accurate estimates of a firm’s value
• A lot of accounting information to predict free cash
flow (FCF).
P/E Ratio Valuation Model
Price/Earnings ratio (P/E ratio) is a popular
measure of stock valuation.
P/E ratio is a relative value model because it
tells the investor how many dollars investors
are willing to pay for each dollar of the
company’s earnings.
 Vcs = the value of common stock of the firm.
 P/E1 = the price earnings ratio for the firm based on the current price per
share divided by earnings for end of year 1.
 E1 = estimated earnings per share of common stock for the end of year 1.
FIN3000, Liuren Wu
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P/E Ratio Factors
– The ratio is the earnings multiplier, and is a measure of the prevailing
attitude of investors regarding a stock’s value
– P/E is determined by CASH FLOW, not vice versa
 What causes the growth rate in dividends (and earnings) and the
investor’s required rate of return to go up and down? These are the real
determinants of the P/E ratio.
Firm factors impacting the investor’s required rate of
return (increase in perceived risk)
 Economic or macro factors impacting the investor’s
required rate of return (growth outlook, interest
rates/inflation)
 Firm factors impacting the earnings/dividend growth rate
– dividend policy and firm investment opportunities.
Price-Earnings Ratio
•
1.
2.
3.
Using the P/E approach to valuation:
Estimate earnings for next year
Estimate the P/E ratio (Earnings Multiplier)
Multiply expected earnings by the expected
P/E ratio to get expected price
V =E1x(P/E)
Price-Cash Flow Ratio
• Cash flows can also be used in this approach,
and are often considered less susceptible to
manipulation by management.
• The steps are similar to using the P/E ratio
V =CF1x(P/CF)
Company Analysis: Examining
Influences
• 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
•
Competitive forces necessitate competitive
strategies.
–
1.
2.
3.
4.
5.
•
Competitive Forces:
Current rivalry
Threat of new entrants
Potential substitutes
Bargaining power of suppliers
Bargaining power of buyers
SWOT analysis is another useful tool
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
• Must still command prices near industry
average, so still must differentiate
• Discounting too much erodes superior rates of
return
Differentiation Strategy
• Seeks to be identified
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
• Firms with focused strategies:
– Select segments in the industry
– Tailor the 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
• Competitive advantages in the marketplace
– Weaknesses
• Competitors have exploitable advantages of some kind
– Opportunities
• External factors that make favor firm growth over time
– Threats
• External factors that hinder the firm’s success
Favorable Attributes of Firms
•
Peter Lynch’s list of favorable attributes:
1.
2.
3.
4.
5.
Firm’s product is not faddish
Company has competitive advantage over rivals
Industry or product has potential for market stability
Firm can benefit from cost reductions
Firm is buying back its own shares or managers (insiders)
are buying
Categorizing Companies
•
Lynch further recommends the following
categorization of firms:
1.
2.
3.
4.
5.
6.
Slow growers
Stalwart
Fast growers
Cyclicals
Turnarounds
Asset plays
When to Sell
• Hold on or move on?
• If stocks decline right after purchase, is that a further
buying opportunity or a signal of a mistaken
investment?
• Continuously monitor key assumptions that led to
the purchase of the investment
– Know why you bought, and see if conditions have changed
• Evaluate when market value approaches estimated
intrinsic value
Stock Market
r
Math
Earnings Growth
+
∆ PE ∆ Pi c e
+
Dividends
=
Total Return from Stock(s)/
OR
Earnings Growth
+
∆ PE
+
Dividends
=
Total Return from Stock(s)
11
Sources of Return
Practical Example:
12
Wal-Mart -- A Typical Sideways Market Stock…
2001 - 2010
13
Sources of Return: Secular Sideways and Bear Markets (S&P 500)
SIDEWAYS MARKETS
Sideways Markets: P/E Contraction + Earnings Growth = Low Returns
Bear Markets: P/E Contraction + Earnings Decline = Negative Returns
14
“By the Book” Bear Mr ket – Japan
15