305111

Investment Analysis and Portfolio
Management
First Canadian Edition

By Reilly, Brown, Hedges, Chang
Chapter 9
Company Analysis & Stock Valuation
Company Analysis versus Stock Valuation
Economic, Industry, and Structural Links
to Company Analysis
Company Analysis
Estimating Intrinsic Value
Estimating Company Earnings per Share
Shoppers Competitive Strategies
Estimating Company Earnings Multipliers
Continued
Copyright 2010 by Nelson Education Ltd.
9-2
Chapter 9
Additional Measures of Value Added
Analysis of Growth Companies
Measures of Value Added
Site Visits and the Art of the Interview
When to Sell
Influences on Analysts
Global Company and Stock Analysis
9-3

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
9-4
Which are the best companies?

Are they overpriced?
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
9-5
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 firms
required rate of return
9-6
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
9-7
Defensive Companies and Stocks

Defensive Companies
The firms whose future earnings are more
likely to withstand an economic downturn
Low business risk
No excessive financial risk
Typical examples are public utilities or
grocery chainsfirms that supply basic
consumer necessities
9-8
Defensive Companies and Stocks

Defense Stocks
The rate of return is not expected to
decline or decline less than the overall
market decline
Stocks with low or negative systematic
risk
9-9
Cyclical Companies and Stocks

Cyclical Companies
They are the companies whose sales and
earnings will be heavily influenced by
aggregate business activity
Examples would be firms in the steel,
auto, or heavy machinery industries.
9-10
Cyclical Companies and Stocks

Cyclical Stocks
They will have greater changes in rates of
return than the overall market rates of
return
They would be stocks that have high
betas.
9-11
Speculative Companies and Stocks

Speculative Companies
They are the firms whose assets involve
great risk but those that also have a
possibility of great gain
A good example of a speculative firm is
one involved in oil exploration
9-12
Speculative Companies and Stocks

Speculative Stocks
Stocks possess a high probability of low or
negative rates of return and a low
probability of normal or high rates of
return
For example, an excellent growth company
whose stock is selling at an extremely high
P/E ratio
9-13
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
9-14
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 stocks intrinsic value
based on growth and risk
9-15
Economic and Industry Influences

If trends are favourable 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
9-16
Structural Influences
Social trends, technology, political, and
regulatory influences can have significant
influence on firms
Firms can grow and succeed despite
unfavourable industry or economic conditions
due to demographic changes or shifts in
consumer tastes and lifestyles
Continued
9-17
Structural Influences
Early stages in an industrys 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
9-18
Company Analysis
Firm Competitive Strategies
Defensive strategy involves positioning firm
so that it its capabilities provide the best
means to deflect the effect of competitive
forces in the industry
9-19
Company Analysis
Firm Competitive Strategies
Offensive strategy involves using the
companys strength to affect the competitive
industry forces, thus improving the firms
relative industry position
9-20
Focusing a Strategy:
Low Cost Strategy
The firm seeks to be the low-cost producer,
and hence the cost leader in its industry
Cost advantages vary by industry and might
include economies of scale, proprietary
technology, or preferential access to raw
materials
9-21
Differentiation Strategy
Firm positions itself as unique in the industry
in an area that is important to buyers
A company can attempt to differentiate itself
based
on its distribution system or some unique
marketing approach
9-22
Differentiation Strategy
9-23
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 firms competitive strategy over
time
9-24
SWOT Analysis
Strengths
Weaknesses
Give the firm a

comparative advantage in
the marketplace
Perceived strengths can
include good customer
service, high-quality
products, strong brand
image, customer loyalty,
innovative R&D, market
leadership, or strong
financial resources
Weaknesses result when

competitors have
potentially exploitable
advantages over the firm
9-25
SWOT Analysis
Opportunities
Threats
These are environmental

factors that favour the firm
They may include a
growing market for the
firms products (domestic
and international),
shrinking competition,
favourable exchange rate
shifts, or identification of a
new market or product
segment
They are environmental

factors that can hinder the
firm in achieving its goals
Examples would include a
slowing domestic economy,
additional government
regulation, an increase in
industry competition,
threats of entry, etc
9-26
Lessons Learned from Peter Lynch

Favourable Attributes of Firms
Firms product should not be faddish
Firm should have some long-run comparative
advantage over its rivals
Firms industry or product has market stability
9-27
Lessons Learned from Peter Lynch

Favourable Attributes of Firms
Firm can benefit from cost reductions
Firms that buy back shares show there are
putting money into the firm
9-28
Warren Buffets Investment Tenets

Business Tenets
Managerial Tenets
Is the business simple and

understandable?
Does the business have a
consistent operating
history?
Does the business have
favourable long-term
prospects?
Is management rational?
Is management candid
with its shareholders?
Does management resist
the institutional
imperative?
9-29
Warren Buffets Investment Tenets

Financial Tenets
Market Tenets
Focus on return on equity,

not earnings per share
Calculate owner earnings
Look for companies with
high profit margins
For every dollar retained,
make sure the company
has created at least one
dollar of market value
What is the value of the

business?
Can the business be
purchased at a significant
discount to its fundamental
intrinsic value?
9-30

Present value of cash flows (PVCF)
Present value of dividends (DDM)
Present value of free cash flow to equity
(FCFE)
Present value of free cash flow (FCFF)
9-31

Relative valuation techniques
Price
Price
Price
Price
earnings ratio (P/E)

cash flow ratios (P/CF)
book value ratios (P/BV)
sales ratio (P/S)
9-32
Present Value of Dividends

Simplifying assumptions help in estimating
present value of future dividends
Constant Growth DDM
Intrinsic Value = D1/(k-g) and D1= D0(1+g)
Growth Rate Estimates

Average Dividend Growth Rate
Dn
n
g
1
D0
Sustainable Growth Rate
g = RR X ROE
9-33

Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the
firms characteristic line using regression
E(R stock ) E(RFR) stock [E(R market ) E(RFR)]
9-34

The Present Value of Dividends Model
(DDM)
Model requires k>g
With g>k, analyst must use multi-stage
model
9-35
Defining Free Cash Flow to Equity (FCFE)

Computing the FCFE
FCFE =Net Income
+ Depreciation Expense
- Capital Expenditures
- in Working Capital
- Principal Debt Repayments
+ New Debt Issues
9-36
Present Value of
Free Cash Flow to Equity
The Constant Growth Formula
FCFE1
Value
k g FCFE
where:
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
A multi-stage model similar to DDM can also be

applied
9-37
Present Value of
Operating Free Cash Flow
Discount the firms operating free cash flow
to the firm (FCFF) at the firms weighted
average cost of capital (WACC).
FCFF =EBIT (1-Tax Rate)
+ Depreciation Expense
- Capital Spending
- in other assets
9-38
Present Value of
FCFF1
Firm Value
WACC g FCFF
OFCF1
or
WACC g OFCF
where: FCFF1 = the free cash flow in period 1
OFCF1 = the firms operating free cash flow in period 1
WACC = the firms weighted average cost of capital
gFCFF = the constant growth rate of free cash flow
gOFCF = the constant growth rate of operating free cash flow
9-39
Comparing Operating Free Cash Flow

& Free Cash Flow to Equity
Free Cash Flow to Equity
FCFF =EBIT (1-Tax Rate)

+ Depreciation Exp.
- Capital Spending
- in other assets
FCFE =Net Income

+ Depreciation Exp.
- Capital Expenditures
- Principal Debt
Repayment
+ New Debt Issues
9-40
Shoppers Competitive Strategies

The Internal Performance
Industry Factors
Company Performance
Net Profit Margin Estimate
Computing Earnings per Share
Importance of Quarterly Estimates

A way to confirm annual estimate
9-41
Estimating Company Earnings

Multipliers
Macroanalysis of the Earnings Multiplier
Microanalysis of the Earnings Multiplier
Comparing dividend-payout ratios
Estimating the required rate of return
Estimating the expected growth rate
Computing the earnings multiplier
Estimates of intrinsic value for Shoppers
9-42
Additional Measures of Relative Value

Price/Book Value (PB/V) Ratio
Book value is a reasonable measure of value for
firms that have consistent accounting practice
It can been applied to firms with negative
earnings or cash flows
Should not attempt to use this ratio to compare
firms with different levels of hard assetsfor
example, a heavy industrial firm and a service
firm
See Exhibit 9.9
9-43

Price/Cash Flow (P/CF) Ratio
The price/cash flow ratio has grown in prominence and use because many
observers contend that a firms cash flow is less subject to manipulation
See Exhibit 9.9
Price/Sales (P/S) Ratio

Sales growth drives the growth of all subsequent earnings and cash flow
and sales is one of the purest numbers available
See Exhibit 9.9
9-44
9-45
Analysis of Growth Companies

Generating rates of return greater than the
firms cost of capital is considered to be
temporary
Earnings higher the required rate of return
are pure profits
How long can they earn these excess profits?
9-46
Value of No-Growth Firms

A No-Growth Firm
E = r x Assets
E = r x Assets = Dividends (Firms has retention
ratio, b, of 0)
Firm Value
V
E
k
1 b E
k
E
k
V
9-47
Long-Run Growth Models

Simple Growth Model
It assumes the firm has growth investment
opportunities that provide rates of return equal to
r, where r is greater than k
r=mk (m is the relative rate of return operator)
D=E (1-b)
Gross Present Value of Growth Investments
bEmk bEm
2
k
k
bEm bE
k
k
9-48

Simple Growth Model
Firm Value
V
E
k
bEm bE
k
k
9-49
Long Run-Growth Models

PV of Constant Dividend + PV of
Growth Investment
V
D bEm
k
k
9-50

PV of Constant Earnings + PV of
Excess Earnings from Growth
Investment
E bE (m
1)
V
k
k
9-51
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
In this case, m = 1 so r = k
Firm Value
E bE (m 1)
V
k
k
9-52

Negative Growth Model
Firm retains earnings, but reinvestment returns
are below the firms cost of capital. That is, r<k
and m>1
Since growth will be positive (r>0) but slower
than it should be (r<k), the value will decline
when the investors discount the reinvestment
stream at the cost of capital
9-53

Capital Gain Component
Gross present value of growth investments
bEm / k
Three factors influence capital gain component:

Amount of capital invested in growth investments (b)
Relative rate of return earned on the funds retained (m)
Time period for these growth investments
9-54

Dynamic True Growth Model
Firm invests a constant percentage of current earnings in
projects that generate rates of return above the firms
required rate of return
In this case, r>k and m>1
Firm value for the dynamic growth model for an infinite
time period
D1
k g
9-55

Economic Value-Added (EVA)
It is equal to the net operating profit less adjusted taxes
(NOPLAT) minus the firms total cost of capital in dollar
terms, including the cost of equity
EVA Return on Capital

EVA/Capital
This ratio can compare firms of different sizes and
determine which firm has the largest economic profit per
dollar of capita
Alternative Measure of EVA

Compare return on capital to cost of capital
9-56

Market Value-Added (MVA)
Measure of external performance
How the market has evaluated the firms 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
9-57

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
9-58

The Franchise Factor
Franchise P/E = Observed P/E - Base P/E
Incremental Franchise P/E
= Franchise Factor X Growth Factor
where R= the expected return on the new opportunities
k=the current cost of equity
r = the current ROE on investment
G= the PV of the new growth projects relative to the
Rk
G
rk
current value of the firm
9-59
Site Visits & the Art of the Interview

Focus on managements 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 industrys major issues
Review the planning process
Talk to more than just the top managers
9-60
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
9-61
Efficient Markets
In most instances, the value estimated for a stock
will be very close to its market price, which
indicates that it is properly valued
Paralysis of Analysis
To earn above-average returns, there are two
requirements: (1) the analyst must have
expectations that differ from the consensus, and
(2) the analyst must be correct
9-62
Analyst Conflicts of Interest
A potential conflict can arise if
communication occurs between a firms
investment banking and equity research
division
9-63
Efficient Markets
Opportunities are mostly among less wellknown 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
9-64
Analysts Conflicts of Interest

Investment bankers may push for favourable
evaluations
Corporate officers may try to convince
analysts
Analyst must maintain independence and
have confidence in his or her analysis
9-65
Global Company and Stock Analysis

Factors to Consider
Availability of Data
Differential Accounting Conventions
Currency Differences (Exchange Rate Risk)
Political (Country) Risk
Transaction Costs and Liquidity
Valuation Differences
9-66

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Investment Analysis and Portfolio

First Canadian Edition

Copyright 2010 by Nelson Education Ltd.

Company Analysis & Stock Valuation

Copyright 2010 by Nelson Education Ltd.

Company Analysis & Stock Valuation

Which are the best companies?

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Defensive Companies and Stocks

Defensive Companies and Stocks

Copyright 2010 by Nelson Education Ltd.

Cyclical Companies and Stocks

Copyright 2010 by Nelson Education Ltd.

Cyclical Companies and Stocks

Copyright 2010 by Nelson Education Ltd.

Speculative Companies and Stocks

Copyright 2010 by Nelson Education Ltd.

Speculative Companies and Stocks

Copyright 2010 by Nelson Education Ltd.

Value versus Growth Investing

Copyright 2010 by Nelson Education Ltd.

Economic, Industry and Structural Links to

Copyright 2010 by Nelson Education Ltd.

Economic and Industry Influences

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Give the firm a

Weaknesses result when

Copyright 2010 by Nelson Education Ltd.

These are environmental

They are environmental

Copyright 2010 by Nelson Education Ltd.

Lessons Learned from Peter Lynch

Copyright 2010 by Nelson Education Ltd.

Lessons Learned from Peter Lynch

Copyright 2010 by Nelson Education Ltd.

Warren Buffets Investment Tenets

Is the business simple and

Copyright 2010 by Nelson Education Ltd.

Warren Buffets Investment Tenets

Focus on return on equity,

What is the value of the

Copyright 2010 by Nelson Education Ltd.

Estimating Intrinsic Value

Copyright 2010 by Nelson Education Ltd.

Estimating Intrinsic Value

earnings ratio (P/E)

Copyright 2010 by Nelson Education Ltd.

Present Value of Dividends

Growth Rate Estimates

Copyright 2010 by Nelson Education Ltd.

Present Value of Dividends

E(R stock ) E(RFR) stock [E(R market ) E(RFR)]

Copyright 2010 by Nelson Education Ltd.

Present Value of Dividends

Copyright 2010 by Nelson Education Ltd.