Chapter 15: Stock Valuation Investment Management Lakehead University
Company Analysis vs Stock Valuation The common stock of a good company is not necessarily a good investment. A stock is a good investment if its intrinsic value is above its market price. A good company may be overvalued. 2
Growth Companies and Growth Stocks A growth company is a company that consistently experiences above-average increases in sales and earnings. A growth company can also be viewed as a firm that can make investments with rates of return greater than the firm s required rate of return (WACC). A growth stock is a stock with a higher rate of return than other stocks with similar risk characteristics. 3
Defensive Companies and Stocks A defensive company is one whose future earnings are likely to withstand an economic downturn. A defensive stock is one which rate of return is not expected to decline during a market decline or is expected to decline less than the market. According to the CAPM, such a stock would had a small positive or a negative beta. 4
Cyclical Companies and Stocks A cyclical company s sales and earnings closely follow the aggregate business activity. Examples are firms in the steel and auto industries. A cyclical stock experiences changes in return closely related to the changes in the market return. In terms of the CAPM, these are stocks with a high beta. 5
Speculative Companies and Stocks A speculative company is one that involves great risk that has great gain possibilities. A speculative stock possesses a high probability of low rates of return and a low probability of high rates of return. 6
Value versus Growth Investing Values stocks are stocks that appear to be undervalued for reasons other than potential earnings growth. Growth stocks are typically stocks with high P/E and price-to-book ratios. 7
Top-Down Approach to Investing An investor is said to follow the top-down approach if he/she first starts with macroeconomic analysis, then identifies industries expected to offer attractive returns and then selects stocks within promissing industries. Another approach to investing is the bottom-up approach, which starts with desired company-specific characteristics. 8
Competitive Strategies Low-Cost Strategy: A firm that pursues that strategy wants to be cost leader in its industry. Differentiation Strategy: The firm following that strategy much be selling a product that is unique. 9
SWOT Analysis S trengths: Comparative advantage in the marketplace. W eaknesses: Potential competition. O pportunities: Environmental factors that favour the firm. T reats: Environmental factors that may hurt the firm. 10
Lessons from Peter Lynch Favorable Attributes of Firms 1. A firm s product must not be faddish 2. The company must have some long-run comparative advantages 3. The firm s industry must be stable 4. The firm can benefit from cost reduction 5. Firms buying back shares or with management buying shares (www.sedi.ca) 11
Tenets of Warren Buffet Business Tenets Simple and understandable Consistent operating history Favorable long-term prospects 12
Tenets of Warren Buffet Management Tenets Rational Tell owners everything they should know Resist institutional imperatives 13
Tenets of Warren Buffet Financial Tenets Return on equity Owner earnings (free cash flow) High profit margin One dollar of market value created for every dollar of earnings retained 14
Tenets of Warren Buffet Market Tenets Value of the business (PV of future free cash flows using government bond rate) Can the business be purchased at a significant discount? 15
Estimating Intrinsic Value Present Value of Cash Flows 1. Present value of dividends (DDM) 2. Present value of free cash flow to equity (FCFE) 3. Present value of free cash flow to the firm (FCFF) 16
Estimating Intrinsic Value Relative Valuation Techniques 1. Price/earnings ratio (P/E) 2. Price/cash flow ratio (P/CF) 3. Price/book value ratio (P/BV ) 4. Price/sales ratio (P/S) 17
Present Value of Dividends Intrinsic Value = D 1 k g, where D 1 is next year s dividend, k is the discount rate and g is the growth rate. If g is the current growth rate and D 0 is this year s dividend, then D 1 = (1 + g)d 0. 18
Present Value of Dividends How to Estimate g We can use past dividends: g = n D t D t n 1 where D t is the most recent dividend and D t n is the dividend paid n years ago. 19
Present Value of Dividends Another Method to Estimate g Let EPS t denote a firm s earnings per share at time t and let RR denote the firm s retention ratio. If RR = 0, i.e. if the firm uses all of its earnings to pay dividends, then EPS t+1 = EPS t. 20
Present Value of Dividends Another Method to Estimate g If RR > 0 and the return on the firm s investments is given by r i, then EPS t+1 = EPS t + r i RR EPS t = (1 + r i RR)EPS t. That is, EPS grows at the rate r i RR. 21
Present Value of Dividends Another Method to Estimate g Since dividends are a constant fraction of EPS, they also grow at the rate r i RR. What is r i? It is often approximated by ROE. This gives g = RR ROE 22
Present Value of Dividends Required Rate of Return (k) The required rate of return can be estimated using the CAPM. That is, historical data is used to estimate the firm s beta and then, given an expected market return of R m and risk-free rate R f, the firm s required return is given by R i = R f + β i (R m R f ) 23
Present Value of Dividends If a company s calculate growth rate in dividends is relatively high, we have to assume that this growth rate will decrease over time. If, for example, the actual growth rate is 11%, we may assume that this growth rate will last for 5 years, after which it will decrease linearly (1% per year) over 6 years to reach and remain 5% into perpetuity. 24
PV of Free Cash Flow to Equity (FCFE) FCFE = Net Income + Depreciation Capital Expenditure Working Capital Principal Debt Repayment + Net New Debt Issue 25
PV of Free Cash Flow to Equity (FCFE) The firm s intrinsic value using this method is calculated as Intrinsic Value of Equity = FCFE 1 k g FCFE, where g FCFE is the expected growth rate in FCFE. Note that we use the same discount rate as with the dividend discount model. 26
PV of Free Cash Flow to Equity (FCFE) The fair stock price is then the intrinsic value of equity divided by the number of shares outstanding: Fair Stock Price = Intrinsic Value of Equity Number of Shares Outstanding 27
PV of Free Cash Flow to the Firm (FCFF) FCFF = (1 t)ebit + Depreciation Capital Expenditure Working Capital Other Assets where t is the firm s tax rate. The term (1 t)ebit is ofen referred to as the firm s net operating profit after tax. 28
PV of Free Cash Flow to the Firm (FCFF) Using this method, the firm s intrinsic value is given by Intrinsic Value of the Firm = FCFF 1 WACC g FCFF where WACC is the firm s weighted average cost of capital and g FCFF is the expected growth rate in FCFF. 29
PV of Free Cash Flow to the Firm (FCFF) If we subtract the value of debt and divide by the number of shares outstanding, we obtain the fair value of the stock: Fair Stock Price = Intrinsic Value of the Firm Value of Debt Number of Shares Outstanding 30
PV of Free Cash Flow to the Firm (FCFF) The firm s WACC is calculated as WACC = W E k + W D (1 t)r D, where W E is the market-value weight of equity in the firm s capital structure and W D = 1 W E is the market-value weight of debt, and r D is the pre-tax cost of debt. 31
Return on Invested Capital (ROIC) An alternative measure of the firm s return on investments is ROIC = (1 t)ebit Total Capital, where ROIC stands for return on invested capital and Total Capital represents the sum of the book values of long-term debt and equity. 32
Return on Invested Capital (ROIC) The long-run growth rate can then be calculated as g = RR ROIC. 33
When to Use Discounted Cash Flow Valuation (Textbook, p. 378) The cash flow valuation models are very useful for companies that are stable, mature entities for which a relatively constant growth rate is appropriate. Since the values obtained with these methods heavily depend on the estimates of the growth and the discount rates, these two must be carefully assessed. 34
Relative Valuation Techniques An advantage of relative valuation techniques is that they reveal how the market is currently valuing a company. One problem, however, is that current valuations may not be correct. Relative valuation techniques are approriate when: 1. There is a good set of comparable entities 2. Valuations in the market or the firm s industry are not extreme 35
Relative Valuation Techniques Exhibit 15.4 shows the basic data required to compute the relative valuation ratios. Exhibit 15.5 shows the four sets of relative valuation ratios for Walgreens, its industry and the aggregate market. 36
Company Sales Forecasts The information can be used to make sales forecasts. We can compare the firm s sales to the industry s sales or to government figures related to the firm s activities. Figuring out the relationship between a company s sales and some government numbers may prove very useful. Government agencies often publish forecasts of some figures. In the text, personal consumption expenditures (PCE) and PCE in medical care are used. 37
Estimating Earnings per Share To estimating earnings per share, we need an estimate of the firm s profit margin. The profit margin depends on: 1. The firm s specific competitive strategy 2. The firm s internal performance 3. The firm s relationship with its industry It is important to also make quarterly estimates since each quarterly results will eventually tell us whether the annual forecast is feasible. 38
Estimating the Earnings Multiplier (P/E) Macroanalysis of the earnings multiplier Comparison of the company s P/E with that of the industry Microanalysis of the multiplier Estimating the payout ratio Estimating the required rate of return Estimating the expected growth rate (DuPont identity) 39
Additional Relative Valuation Measures Price/Book Value Ratio (P/BV ): P/BV has been shown to have a significant impact on stock returns (Fama & French, 1992). Price/Cash Flow Ratio (P/CF ): Observers agree that cash flow is harder to manipulate than earnings. Price/Sales Ratio (P/S): Sales growth drives all subsequent earnings and cash flow and sales is one of the purest numbers available. 40
Economic Value Added (EVA) EVA = NOPLAT Dollar Cost of Capital where NOPLAT stands for net operating profits less adjusted taxes: NOPLAT = Adjusted EBIT Cash Operating Taxes 41
Economic Value Added (EVA) Adjusted EBIT = EBIT + Implied Interest on Operating Leases + Increase in the LIFO Reserve + Goodwill Amortization 42
Economic Value Added (EVA) Cash Operating Taxes = Tax Expense Increase in Deferred Taxes + Tax Benefit from Interest Expenses + Tax Benefit from Interest on Leases Taxes on Nonoperating Income 43
Economic Value Added (EVA) where Dollar Cost of Capital = WACC Total Capital Total Capital = Total Assets + Accumulated Goodwill Amortization + LIFO Reserve + Present Value of Operating Leases 44