Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 20
Version 1.2
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All rights reserved. Requests for permission to make
copies of any part of the work should be mailed to:
Permissions Department
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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?
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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
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Types of Companies and Stocks
•
•
•
•
Growth
Defensive
Cyclical
Speculative
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Growth Companies
• 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
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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
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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
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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 undervaluing 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
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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
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Cyclical Companies and Stocks
• Sales and earnings heavily influenced by
aggregate business activity
• Stocks with high betas
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Speculative Companies and Stocks
• Assets involve great risk
– e.g., biotechs, bankruptcies, etc.
• Possible great gain
• Stock may be overpriced
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Economic, Industry, and Structural
Links to Company Analysis
• Company analysis is the final step in the topdown 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
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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
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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
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Company Analysis
•
•
•
•
Industry competitive environment
SWOT analysis
Present value of cash flows
Relative valuation ratio techniques
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Firm Competitive Strategies
•
•
•
•
•
Current rivalry
Threat of new entrants
Potential substitutes
Bargaining power of suppliers
Bargaining power of buyers
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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: lowcost leadership and differentiation
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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
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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
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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
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SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– Threats
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SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– Threats
INTERNAL ANALYSIS
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SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– Threats
EXTERNAL ANALYSIS
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Lynch’s Favorable Attributes
1. Firm’s product is not faddish
2. Company has competitive advantage over
rivals
3. Industry or product has potential for market
stability
4. Firm can benefit from cost reductions
5. Firm is buying back its own shares or
managers (insiders) are buying
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Lynch’s Categories of Companies
1. Slow growers
2. Stalwart
3. Fast growers
4. Cyclicals
5. Turnarounds
6. Asset plays
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Buffett’s Favorable Attributes
Examines three categories:
1. Business tenets
2. Financial tenets
3. Market tenets
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Buffett’s Business Tenets
• Business that is easy to understand & analyze
– Is the business simple and understandable? How does it make money?
– Also must have ability to adjust prices for inflation
• Does the business have a consistent operating history? Do
earnings exhibit a stable upward trend?
• Does the business have favorable long-term prospects?
– Is the business a “consumer monopoly” or a commodity-type business?
– see next slide
• Is management candid with its shareholders?
• Does management resist the institutional imperative?
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Consumer Monopoly vs.
Commodity
• Consumer monopoly:
– Repeat business, plus one or more of following:
• Strong brand or other barrier (Nike, McDonald’s, Amgen
(patents), rock quarries (transportation costs))
• Necessary gateway for mfrs. to reach customers (worldwide
advertising agencies, newspapers)
• Provide necessary services (tax preparers, insurance)
• Commodity-based business:
– Low profit margins, low ROE, absence of brand
loyalty, presence of multiple producers, existence of
substantial excess capacity, erratic profits that depend
on management’s ability to optimize the use of tangible
assets
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Buffett’s Financial Tenets
• Conservative financing
• Consistently high return on S/H’s equity
– Focus on return on equity (ROE & ROIC), not earnings per share.
• Calculate “owner earnings.”
– NI + (D + A) – (necessary capital expenditures)
– Low level of spending needed to maintain economic position
• Look for companies with high profit margins.
– Learned from Philip Fisher
– One indication of having an “economic moat” around the business
• Profitable use of retained earnings
– For every dollar retained, make sure the company has created at least
one dollar of market value.
– Basically, Market-Value Added (MVA)
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Buffett’s Market Tenets
• What is the value of the business?
– Discounted cash flow (DCF) approach
• Compare investment in bonds (value with no growth):
– relative value = EPS / Long-Term T-bond yield
• What value can growth add to this?
– Key questions:
– What is the value of growth “within the franchise”?
– How long will the company’s “economic moat” last, and to
what extent can the company increase its size and grow within
it?
– What future price would such growth allow the stock to reach?
– Will this future price allow 15% return?
• Can the business be purchased with a “margin of safety” or
“margin of protection” from its underlying business value?
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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)
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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)
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Growth Rate Estimates
• Average Dividend Growth Rate
n
Dn
1
D0
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Growth Rate Estimates
•
Average Dividend Growth Rate
n
Dn
1
D0
– Problem – highly dependent upon specific dividends used
in estimation
•
Three alternatives:
1. Sustainable Growth Rate = RR X ROE
2. Regression-based estimates of growth rates
3. Back out
growth rate from estimated size of future market
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Required Rate of Return Estimate
• Nominal risk-free interest rate
• Risk premium
• Market-based risk estimated from the firm’s
characteristic line using regression
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Required Rate of Return Estimate
• Nominal risk-free interest rate
• Risk premium
• Market-based risk estimated from the firm’s
characteristic line using regression
R stock  E(RFR)   stock [E(R market )  E(RFR)]
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The Present Value of
Dividends Model (DDM)
• Model requires k>g
• With g>k, analyst must use multi-stage
model
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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
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Present Value of
Free Cash Flow to Equity
FCFE =
FCFE1
Value 
Net Income
k  g FCFE
+ Depreciation Expense
- Capital Expenditures
- D in Working Capital
- Principal Debt Repayments
+ New Debt Issues
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Present Value of
Free Cash Flow to Equity
FCFE1
Value 
k  g FCFE
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
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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
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Present Value of
Operating Free Cash Flow
FCFF1
Firm Value 
WACC  g FCFF
Oper . FCF1
or
WACC  g OFCF
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Present Value of
Operating Free Cash Flow
FCFF1
Firm Value 
WACC  g FCFF
Oper . FCF1
or
WACC  g OFCF
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
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An Alternate Measure of Growth
g = (RR)(ROIC)
where:
– RR = the average retention rate
– ROIC = EBIT (1-Tax Rate)/Total Capital
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Calculation of WACC
WACC = WEk + Wdi
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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
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Relative Valuation Techniques
• Price Earnings Ratio
D1 / E1
P / E1 
kg
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Relative Valuation Techniques
• Price Earnings Ratio
D1 / E1
P / E1 
kg
– Affected by two variables:
– 1. Required rate of return on its equity (k)
– 2. Expected growth rate of dividends (g)
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Relative Valuation Techniques
• Price Earnings Ratio
D1 / E1
P / E1 
kg
– Affected by two variables:
– 1. Required rate of return on its equity (k)
– 2. Expected growth rate of dividends (g)
• Price/Cash Flow Ratio
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Relative Valuation Techniques
• Price Earnings Ratio
D1 / E1
P / E1 
kg
– Affected by two variables:
– 1. Required rate of return on its equity (k)
– 2. Expected growth rate of dividends (g)
• Price/Cash Flow Ratio
• Price/Book Value Ratio
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Relative Valuation Techniques
• Price Earnings Ratio
D1 / E1
P / E1 
kg
– Affected by two variables:
– 1. Required rate of return on its equity (k)
– 2. Expected growth rate of dividends (g)
• Price/Cash Flow Ratio
• Price/Book Value Ratio
• Price-to-Sales Ratio
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Relative Valuation Techniques
• Price Earnings Ratio
D1 / E1
P / E1 
kg
– Affected by two variables:
– 1. Required rate of return on its equity (k)
– 2. Expected growth rate of dividends (g)
• Price/Cash Flow Ratio
• Price/Book Value Ratio
• Price-to-Sales Ratio
Analyze the differences in the various ratio techniques
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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 can they earn these excess profits?
• How long are they likely to earn these excess
profits?
• How long does the market expect them to earn
these excess profits?
• Is the stock properly valued?
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Alternative Growth Models
• Growth companies and the DDM
– Constant growth model not appropriate
• No growth firms:
– All earnings paid out as dividends  g = 0
– V=D/k=E/k
• Long-run / Simple growth model:
– Assume some earnings are reinvested
– Value = PV(constant dividend) + PV(growth investment)
E 1  b  bEm
V

k
k
where m = r / k; b = ret. rate
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Alternative Growth Models
• Expansion model:
– Firm retains earnings to reinvest, but receives a
rate of return on its investment equal to its cost of
capital
m = 1 so r = k
E 1  b  bE E
V


k
k
k
Copyright © 2000 by Harcourt, Inc. All rights reserved
Alternative Growth Models
• Negative growth model:
– Firm retains earnings, but reinvestment returns are below
the firm’s cost of capital
– Since growth will be positive, but slower than it should
be, the value will decline when the investors discount the
reinvestment stream at the cost of capital
– Key lesson = not all growth is “value-adding”
– If company retains earnings but m < 1, then company is
destroying shareholder wealth even though it is growing!
• Note: m < 1  r < k  NPV < 0
• I.e., if a company goes for growth by investing in negative NPV
projects, the shareholders will be worse off, not better!
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Dynamic True Growth Model
• Firm invests a constant percentage of
current earnings in projects that generate
rates of return above the firm’s required rate
of return
D1
V
kg
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Measures of Value-Added
• Economic Value-Added (EVA)
– Compare net operating profit less adjusted taxes
(NOPLAT) to the firm’s total cost of capital in
dollar terms, including the cost of equity
• EVA return on capital
EVA/Capital
• Alternative measure of EVA
– Compare return on capital to cost of capital
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Measures of Value-Added
• Market Value-Added (MVA)
– Measure of external performance
– How the market has evaluated the firm’s
performance in terms of market value of debt
and market value of equity compared to the
capital invested in the firm
• Relationships between EVA and MVA
– mixed results
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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/E
Incremental Franchise P/E = Franchise Factor X Growth Factor
Rk

G
rk
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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:
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Growth Duration
T

(1  G g  D g ) 
 Pg (0)/E g (0) 


  
T 

 Pd 0  / E a (0)   (1  G a  D a ) 
 Pg (0)/E g (0) 
 (1  G g  Dg ) 
  T ln 

ln 
 Pd 0 / E a (0) 
 (1  G a  Da ) 
 P/E g 

ln 
P/E a 

T
 (1  G g  D g ) 

ln 
 (1  G a  D a ) 
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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
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Extensions on Growth Duration
• For more information and additional
extensions and applications in using marketbased information to infer the market’s
assumptions about the various factors that
drive a stock’s valuation, see:
– www.expectationsinvesting.com
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A Flexible Growth Stock
Valuation Model
• Mao’s three-stage valuation model
– dynamic growth period
– simple growth period
– declining growth period
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A Flexible Growth Stock
Valuation Model
t 1
n

1  br  (Value of Dynamic
r k 

bE 
t
Growth Opportunities)
 k 
t 1 1  k 
1
1
r k 

bE 
t
 k 
t 1 1  k 
(Value of Simple
Growth Opportunities)

n3  t  1
r k 

bE 
t
 k 
t 1 n3 1  k 
(Value of Declining
Growth Opportunities)
n1
n1
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A Flexible Growth Stock
Valuation Model
n1 1
n1 1




E r k 
1  br 
1  br 
P  
B
C
bE  A 
n1
n1  n2
k  k 
1  k 
1  k 


• Assumptions
– no change in the required rate of return
– same rate of return on all growth projects
– same retention rate (b) during the three growth
periods
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A Flexible Growth Stock
Valuation Model
n1 1
n1 1




E r k 
1  br 
1  br 
P  
B
C
bE  A 
n1
n1  n2
k  k 
1  k 
1  k 


• Very theoretical model
– Key value in application comes not from filling in the numbers
in the equation,
– but in using this framework to better structure the valuation
process
– Provides a framework for thinking about the factors that drive
value how much value they will bring
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Site Visits and the
Art of the Interview
• Focus on management’s plans, strategies, and
concerns
• Restrictions on nonpublic information
• “What if” questions can help gauge sensitivity
of revenues, costs, and earnings
• Management may indicate appropriateness of
earnings estimates
• Discuss the industry’s major issues
• Review the planning process
• Talk to more than just the top managers
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When to Sell
• 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
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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?
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Forces Pulling on the Analyst
• Investment bankers may push for favorable
evaluations
• Corporate officers may try to convince
analysts
• Analyst must maintain independence and
have confidence in his or her analysis
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Global Company Analysis
•
•
•
•
Earnings per share analysis
Common stock statistics
Share price performance
Individual company analysis
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The Internet
Investments Online
www.better-investing.com
www.fool.com
www.cfonews.com
www.ibes.com
www.zacks.com
www.valueline.com
www.financialweb.com
investor.msn.com
www.marketedge.com
www.nyssa.org
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End of Chapter 20
–Company Analysis and
Stock Selection
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Future topics
Chapter 8
•
•
•
•
Portfolio management
Alternative measures of risk
Computing expected return
The risk-return efficient frontier
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Future topics
Chapter 22
• Equity Portfolio Management
Strategies
Copyright © 2000 by Harcourt, Inc. All rights reserved
Copyright © 2000 by Harcourt, Inc. All rights reserved