COMPANY ANALYSIS AND

STOCK VALUATION
 Questions
Why is it important to differentiate between
company analysis and stock analysis?
What is the difference between a growth
company and a growth stock?
When valuing an asset, what are the required
inputs?
After an investor has valued an asset, what is
the investment decision process?
How is the value of bonds determined?
 Questions
What are the two primary approaches to the
valuation of common stock?
How do we apply the discounted cash flow
valuation approach, and what are the major
discounted cash flow valuation techniques?
What is the dividend discount model (DDM),
and what is its logic?
What is the effect of the assumptions of the
DDM when valuing a growth company?
 Questions
How do we apply the DDM to the valuation of
a firm that is expected to experience
temporary supernormal growth?
How do we apply the relative valuation
approach to valuation, and what are the
major relative valuation techniques (ratios)?
How can the DDM be used to develop an
earnings multiplier model?
What does the DDM model imply are the
factors that determine a stock’s P/E ratio?
 Questions
What are some economic, industry, and
structural links that should be considered in
company analysis?
What insights regarding a firm can be derived
from analyzing its competitive strategy and
from a SWOT analysis?
What techniques can be used to estimate the
inputs to alternative valuation models?
What techniques aid estimating company
sales?
 Questions
How do we estimate the profit margins and
earnings per share for a company?
What procedures and factors do we consider
when estimating the earnings multiplier for a
firm?
What two specific competitive strategies can
a firm use to cope with the competitive
environment in its industry?
When should we consider selling a stock?
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
Growth Companies and
Growth Stocks
Companies that consistently experience
above-average increases in sales and
earnings have traditionally been thought of as
growth companies
 Limitations to this definition
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
Growth Companies and
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 under-valuation
compared to other stocks
Studies indicate that growth companies
have generally not been growth stocks
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 sssets
involving great risk, but with the
possibility of great gain
 Very high business risk
Speculative stocks have the potential
for great percentage gains and losses
 May be firms whose current price-earnings
ratios are very high
 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
 The Search for True
Growth Stocks
To find undervalued
stocks, we must
understand the
theory of valuation
itself
 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
 Stream of Expected
Returns (Cash Flows)
From of returns
Depending on the investment, returns can be
in the form of:
 Earnings
 Dividends
 Interest payments
 Capital gains
Time period and growth rate of returns
When will the cash flows be received from 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
Valuation of Alternative
Investments
We will consider the valuation of two
important types of investments:
The valuation of bonds
The valuation of common stock
 Valuation of Bonds
What are the cash flows?
Bond cash flows (typically fixed)
 Interest payments every six months equal to one-
half of: (Coupon rate x Face value)
 The payment of principal (Face or par value) at
maturity
Discount at the required rate of return to find
the bond’s value
Process made relatively easy with a financial
calculator or spreadsheet software
Approaches to Common
Stock Valuation
Discounted Cash Flow Techniques
 Present value of Dividends (DDM)
 Present value of Operating Cash Flow
 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)
 Price-sales ratio (P/S)
Discounted Cash Flow
Techniques
Based on the basic valuation model: the
value of a financial asset is the present
value of its expected future cash flows
Vj = SCFt/(1+k)t
The different discounted cash flow
techniques consider different cash flows
and also different appropriate discount
rates
 Dividend Discount
Models
Simplifying assumptions help in estimating
present value of future dividends
Vj = SDt/(1+k)t
Can also assume various dividends for a
finite period of time with a reselling price, and
simply calculate the combined present value
of the dividends
 Dividend Discount
Models
Alternative dividend assumptions
Constant Growth Model:
 Assumes dividends started at D0 (last 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(I+g)
 Dividend Discount
Models
Constant Growth Model
 Growth rate
 Can be estimated from past growth in earnings
and dividends
 Can be estimated using the sustainable growth
model
 Discount rate
 Would consider the systematic risk of the
investment (beta)
 Capital Asset Pricing Model
 Dividend Discount
Models
Valuation with Temporary Supernormal
Growth
 If you expect a company to experience rapid
growth for some period of time
1. Find the present value of each dividend during
the supernormal growth period separately
2. Find the present value of the remaining dividends
when constant growth can be assumed.
3. Find the present value of the remaining dividends
by finding the present value of the estimate
obtained in step 2.
 Present Value of
Operating Cash Flows
Another discounted cash flow approach
is to discount operating cash flows
 Operating cash flows are pre-interest cash
flows, so the required rate of return would
be adjusted to incorporate the required
returns of all investors (use the WACC)
VFj = SOCFt/(1+WACCj)t
 Present Value of
Operating Cash Flows
If we further assume a growth rate of
gOCF for operating cash flows, we can
value the firm as:
VFj = OCFt/(WACCj – gOCF)
Present Value of Free
Cash Flow to Equity
A third discounted cash flow technique
is to consider the free cash flows of a
firm available to equity as the cash flow
stream to be discounted.
Since this is an equity stream, the
appropriate discount rate is the required
return on equity
VSj = SFCFt/(1+kj)t
Present Value of Free
Cash Flow to Equity
Once again, if we constant growth in
free cash flows, this expression reduces
to the following
VSj = FCFt/(kj – gFCF)
 Relative Valuation
Techniques
These techniques assume that prices
should have stable and consistent
relationships to various firm variables
across groups of firms
Price-Earnings Ratio
Price-Cash Flow Ratio
Price-Book Value Ratio
Price-Sales Ratio
 Relative Valuation
Techniques
D1 / E1
Price Earnings Ratio P / E1 
kg
 Affected by two variables:
 1. Required rate of return on its equity (k)

 2. Expected growth rate of dividends (g)

 Relative Valuation
Techniques
D1 / E1
Price Earnings Ratio 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-Earnings Ratio
Look at the relationship between the current
market price and expected earnings per
share over the next year
 The ratio is the earnings multiplier, and is a
measure of the prevailing attitude of investors
regarding a stock’s value
P/E factors
 Expected growth in dividends and earnings
 Required rate of return on the stock
 Price-Earnings Ratio
Using the P/E approach to valuation:
1. Estimate earnings for next year
2. Estimate the P/E ratio (Earnings
Multiplier)
3. 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)
Price-Book Value Ratio
Book values can also be used as a
measure of relative value
The steps to obtaining valuation
estimates are again similar to using the
P/E ratio
V =BV1x(P/BV)
 Price-Sales Ratio
Finally, sales can be used in relation to stock
price.
 Some drawbacks, in that sales do not necessarily
produce profit and positive cash flows
 Advantage is that sales are also less susceptible
to manipulation
The steps are similar to using the P/E ratio
V =S1x(P/S)
 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.
 Competitive Forces:
1. Current rivalry
2. Threat of new entrants
3. Potential substitutes
4. Bargaining power of suppliers
5. 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. 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
Categorizing Companies
Lynch further recommends the
following categorization of firms:
1. Slow growers
2. Stalwart
3. Fast growers
4. Cyclicals
5. Turnarounds
6. Asset plays
Specific Valuation with
the P/E Ratio
Earnings per share estimates
 Time series – use statistical analysis
 Sales - profit margin approach
 EPS = (Sales Forecast x Profit Margin)/ Number of
Shares Outstanding
 Judgmental approaches to estimating earnings
 Last year’s income plus judgmental evaluations
 Using the consensus of analysts’ earnings estimates
 Once annual estimates are obtained, do quarterly
estimates and interpret announcements
accordingly
Site Visits, Interviews,
and Fair Disclosure
Fair Disclosure (FD) requires that all
disclosure of material information be made
public to all interested parties at the same
time
 Many firms will not allow interviews with
individuals, only provide information during large
public presentations
Analysts now talk to people other than top
managers
 Customers, suppliers
Making the Investment
Decision
If the estimate of the stock’s intrinsic value is
greater than or equal to the current market
price, buy the stock
If your estimate of the stock’s future intrinsic
value would yield a return greater than your
required rate of return (based on current
investment price), then buy the stock
If the value is less than its current price, or its
return would be less than your required rate
of return, do not buy the stock
 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
 Influences on Analysts
Several factors make it difficult for analysts to
outperform the market
Efficient Markets
 Markets tend to price securities correctly, so
opportunities are rare
 Most opportunities are likely in small, less followed
companies
Paralysis of Analysis
 Must see the forest (the appropriate
recommendation) despite all of the trees (data)
that complicate the decision
Influences on Analysts
Investment bankers may push for
favorable evaluations of securities when
the same firm does (or wants to do)
underwriting business with the firm in
question
 Are analysts independent and unbiased in
their recommendations?
 Ideally, analysts will remain independent
and show confidence in their analyses