CHAPTER SEVEN
FUNDAMENTAL STOCK ANALYSIS
1
Practical Investment Management
Robert A. Strong
Outline

Valuation Philosophies
Investors’ Understanding of Risk Premiums
 The Time Value of Money
 The Importance of Cash Flows
 The Tax Factor
 EIC Analysis


Value vs. Growth Investing
The Value Approach to Investing
 The Growth Approach to Investing
 How Price Relates to Value
 Value Stocks and Growth Stocks:
How to Tell by Looking

South-Western / Thomson Learning © 2004
7-2
Outline

The Price-to-Book Ratio
The Price-Earnings Ratio
 Differences between Industries

South-Western / Thomson Learning © 2004
7-3
Outline

Some Analytical Factors
Growth Rates
 The Dividend Discount Model
 The Importance of Hitting the Earnings Estimate
 The Multistage DDM
 Caveats about the DDM
 False Growth
 A Firm’s Cash Flows
 Small-Cap, Mid-Cap, and Large-Cap Stocks
 Ratio Analysis
 Cooking the Books

South-Western / Thomson Learning © 2004
7-4
Valuation Philosophies


Fundamental analysts believe
securities are priced according to
fundamental economic data.
Technical analysts think investor behavior
and supply and demand factors play the
most important role.
South-Western / Thomson Learning © 2004
7-5
Valuation Philosophies

Investors’ understanding of risk premiums:
Investors are almost always risk-averse.

The time value of money:
Everyone agrees on this basic principle.

The importance of cash flows:
Most investment research deals with
predicting future corporate earnings.

The tax factor:
The tax code is complicated and not all
investments are taxed equally.
South-Western / Thomson Learning © 2004
7-6
Valuation Philosophies

Economy, Industry and Company (EIC)
analysis:

The analyst first considers conditions in
the overall economy (market risk),

then determines which industries are the
most attractive in light of the economic
conditions (using Porter’s competitive
strategy analysis framework, for example),

and finally identifies the most attractive
companies within the attractive
industries.
South-Western / Thomson Learning © 2004
7-7
Valuation Philosophies
Insert Figure 7-1 here.
South-Western / Thomson Learning © 2004
7-8
Value vs. Growth Investing
The Value Approach to Investing

A value investor believes that securities
should be purchased only when the
underlying fundamentals (macroeconomic
information, industry news, and a firm’s
financial statements) justify the purchase.

Value investors believe in a regression
to the mean.
South-Western / Thomson Learning © 2004
7-9
Regression to the Mean
Cumulative Return
+
Overvalued stock: Sell
x
xx
Most of the time a
security’s longterm return is
consistent with its
risk.
x
x
x
x
xx x
x
Undervalued stock: Buy
x
x
x
x
0
Over the long run, a security
cannot survive with a cumulative
return that is negative.
Time in the Long Term
South-Western / Thomson Learning © 2004
7 - 10
Value vs. Growth Investing
The Growth Approach to Investing

Growth investors seek steadily growing
companies. There are two factions:
 Information traders are in a hurry; they
believe information differentials in the
marketplace can be profitably exploited.
 True growth investors are more willing to
wait, but they share the belief that good
investment managers can earn aboveaverage returns for their clients.
South-Western / Thomson Learning © 2004
7 - 11
Value vs. Growth Investing
How Price Relates to Value

In the early days of the market, before the
Great Crash of 1929, price played a minor
role: “A stock with good long-term
prospects is always a good investment.”

The modern perspective is that
value is inextricably intertwined
with price.
South-Western / Thomson Learning © 2004
7 - 12
Value vs. Growth Investing
Value Stocks and Growth Stocks:
How to Tell by Looking

No precise definition exists.

Classification by Morningstar Mutual Funds:
relative
relative
 1.75


price-to-book + price-earnings   2.25

ratio
ratio
 otherwise
South-Western / Thomson Learning © 2004
- value
- growth
- blend
7 - 13
The Price-to-Book Ratio

Book value per share is an accounting
concept synonymous with equity per share
or net asset value.

Share price is not normally equal to book
value because of



depreciation, uncollectible debts, goodwill, etc.
economic obsolescence
intangible assets
South-Western / Thomson Learning © 2004
7 - 14
The Price-to-Book Ratio

The price-earnings ratio (PE) is computed
by dividing the current stock price by the
firm’s earnings per share.

Because of differences among industries,
relative ratios are commonly computed.
South-Western / Thomson Learning © 2004
7 - 15
The Price-to-Book Ratio
Insert Figure 7-3 here.
South-Western / Thomson Learning © 2004
7 - 16
The Price-to-Book Ratio
Insert Figure 7-4 here.
South-Western / Thomson Learning © 2004
7 - 17
Some Analytical Factors: Growth Rates

Growth rates from historical data:
 ending value 

growth rate geom etricm ean  
 beginning value 
where n  number of compoundin g periods

1
n
1
Growth rates from earnings retention:
growth rate  1- payout ratio return on equity
using arithmetic averages
South-Western / Thomson Learning © 2004
7 - 18
Some Analytical Factors: Growth Rates
Insert Table 7-4 here.
South-Western / Thomson Learning © 2004
7 - 19
Some Analytical Factors: Growth Rates
Choosing a Growth Rate

Financial analysts typically calculate a
number of growth rates using different
ways to determine a likely range for the
statistic.

Recent data may be more reliable than data
from the more distant past.

Company statements regarding company
targets may be considered too.
South-Western / Thomson Learning © 2004
7 - 20
Some Analytical Factors: Growth Rates
Insert Table 7-5 here.
South-Western / Thomson Learning © 2004
7 - 21
Some Analytical Factors: Growth Rates
Growth Rate Estimates from Other Analysts

Another important source of growth rate
estimates is from other security analysts.

Three popular services that monitor and
report these estimates are Zacks, First Call,
and the Institutional Brokers Estimate
System (I/B/E/S).

The term whisper number refers to what
people really think the earnings will be,
and not what the published estimate is.
South-Western / Thomson Learning © 2004
7 - 22
The Dividend Discount Model (DDM)

Also called Gordon’s growth model.
D0  1  g 
D1
current price P0 

k g
k g
where D0 is the current dividend
D1 is the dividend to be paid next year
g is the expected dividend growth rate
k is the discount factor according to
the riskiness of the stock

The model assumes that the dividend
stream is perpetual and that the longterm growth rate is constant.
South-Western / Thomson Learning © 2004
7 - 23
The Dividend Discount Model (DDM)

The variable k is sometimes called the
shareholders’ required rate of return.
D0  1  g 
k
g
P0

Note that the shareholder’s required rate of
return is the sum of the expected dividend
yield and the expected stock price
appreciation.
South-Western / Thomson Learning © 2004
7 - 24
The Importance of Hitting the Earnings Estimate
 The market often penalizes a company’s
stock substantially when the earnings
report is disappointing.
 This is especially true when the required
rate of return and the estimated growth rate
are high.
South-Western / Thomson Learning © 2004
7 - 25
The Multistage DDM

Often, initial high growth levels cannot be
sustained.

Suppose the growth rate g is expected to
persist from the third year:
D1
D2
D2  1  g  k  g 
P0 


 1  k   1  k 2
 1  k 2
South-Western / Thomson Learning © 2004
7 - 26
Some Analytical Factors

Caveats about the DDM:
The DDM is at most a useful tool in
security analysis - it requires certain
assumptions and it has shortcomings.

False growth:
False growth occurs when a firm acquires
another firm with a lower price-earnings
ratio - historical data should always be
scrutinized carefully when used to
determine a growth rate.
South-Western / Thomson Learning © 2004
7 - 27
False Growth
Insert Table 7-7 here.
South-Western / Thomson Learning © 2004
7 - 28
Some Analytical Factors

A firm’s cash flow:
The statement of cash flows is a useful
analytical tool - the cash flow from
operations figures are widely used as a
check on a firm’s earnings quality.
South-Western / Thomson Learning © 2004
7 - 29
Some Analytical Factors

Small-cap, mid-cap, and large-cap stocks:
Another consideration in fundamental
stock analysis relates to the size of the
firm - for example, the small firm effect.
South-Western / Thomson Learning © 2004
7 - 30
Some Analytical Factors: Ratio Analysis

The fundamental analyst is necessarily
interested in the firm’s accounting
statements and in the prevailing general
economic conditions.

To assist in the analysis, several
organizations publish comparative
statistics for industry groups.
e.g. Dun and Bradstreet’s Industry Norms
& Key Business Ratios, which
includes solvency, efficiency and
profitability ratios.
South-Western / Thomson Learning © 2004
7 - 31
Some Analytical Factors: Ratio Analysis
Dun & Bradstreet’s 14 Key Business Ratios
Solvency Ratios
1. Quick Ratio = (Cash + Accounts Receivable)/Current Liabilities
Measures ability to raise cash quickly, ignores inventory
2. Current Ratio = Current Assets/Current Liabilities
General measure of liquidity
3. Current Liabilities to Net Worth = Current Liabilities/Net Worth
Compares short-term liabilities to permanent invested capital
4. Current Liabilities to Inventory = Current Liabilities/Inventory
Measures extent to which payment of current debts relies on sale of
inventory
5. Total Liabilities to Net Worth = Total Liabilities/Net Worth
Measures firm’s reliance on debt financing
6. Fixed Assets to Net Worth = Fixed Assets/Net Worth
Measures proportion of firm’s equity tied up in long-term assets
South-Western / Thomson Learning © 2004
7 - 32
Some Analytical Factors: Ratio Analysis
Dun & Bradstreet’s 14 Key Business Ratios
Efficiency Ratios
7. Collection Period = Accounts Receivable/Credit Sales per Day
Measures firm’s efficiency in turning credit sales into cash
8. Sales to Inventory = Annual Net Sales/Inventory
Measures speed that inventory moves from shelf to customer
9. Assets to Sales = Total Assets/Net Sales
Measures efficiency with which assets are used to produce sales
10. Sales to Net Working Capital = Sales/Net Working Capital
Measures aggressiveness or conservatism in financing sales
11. Accounts Payable to Sales = Accounts Payable/Annual Net Sales
Measures how rapidly company pays its suppliers
South-Western / Thomson Learning © 2004
7 - 33
Some Analytical Factors: Ratio Analysis
Dun & Bradstreet’s 14 Key Business Ratios
Profitability Ratios
12. Return on Sales (Profit Margin) = Net Profit after Taxes/Annual Net
Sales
Measures profit per dollar of net sales
13. Return on Assets = Net Profit after Taxes/Total Assets
Measures company’s efficiency in using assets to produce operating profit
14. Return on New Worth (Return on Equity) = Net Profit after Taxes/Net
Worth
Measures return to the suppliers of equity capital
South-Western / Thomson Learning © 2004
7 - 34
Some Analytical Factors: Cooking the Books

All publicly traded firms in the United States
must have their financial statements
audited to ensure they fairly present the
company’s financial position.

Still, every year, there is at least one story of
accounting fraud at a major firm.
Unfortunately, there is not much the analyst
can do about fraud.
South-Western / Thomson Learning © 2004
7 - 35
Review

Valuation Philosophies
Investors’ Understanding of Risk Premiums
 The Time Value of Money
 The Importance of Cash Flows
 The Tax Factor
 EIC Analysis


Value vs. Growth Investing
The Value Approach to Investing
 The Growth Approach to Investing
 How Price Relates to Value
 Value Stocks and Growth Stocks:
How to Tell by Looking

South-Western / Thomson Learning © 2004
7 - 36
Review

The Price-to-Book Ratio
The Price-Earnings Ratio
 Differences between Industries

South-Western / Thomson Learning © 2004
7 - 37
Review

Some Analytical Factors
Growth Rates
 The Dividend Discount Model
 The Importance of Hitting the Earnings Estimate
 The Multistage DDM
 Caveats about the DDM
 False Growth
 A Firm’s Cash Flows
 Small-Cap, Mid-Cap, and Large-Cap Stocks
 Ratio Analysis
 Cooking the Books

South-Western / Thomson Learning © 2004
7 - 38