Description
It also gives the Tenets of Warren Buffet and how to determine intrinsic value of stock.
COMPANY ANALYSIS
Click to edit Master subtitle style 1/31/13
WHAT IS COMPANY ANALYSIS
At this point, you have made two decisions about your investment in equity markets: 1. What percent of your portfolio should be invested in common stocks. 2. You have identified those industries that appear to offer above-average risk-adjusted performance over your investment horizon.
1/31/13
WHAT IS COMPANY ANALYSIS
The final questions in the fundamental analysis procedure are: 1. Which are the best companies within these desirable industries? and 2. Are their stocks underpriced? Specifically, is the intrinsic value of the stock above its market value, or is the expected rate of return on the stock equal to or greater than its required rate of return? 1/31/13
CLASSIFICATION OF COMPANIES AND STOCKS
• • • •
Growth companies and stocks Defensive companies and stocks Cyclical companies and stocks Speculative companies and stocks
1/31/13
COMPANY ANALYSIS VERSUS THE VALUATION OF STOCK
The stock of a growth company is not necessarily a growth stock. Defining growth: “Companies that consistently experience above-average increases in sales and earnings”. Or “a firm with the management ability and the opportunities to make investments that yield rates of return greater than the firm’s required rate of return”. Which of the two you would prefer?
•
1/31/13
GROWTH
Growth stocks are not necessarily limited to growth companies. • A future growth stock can be the stock of any type of company; the stock need only be undervalued by the market. • For overeager/overoptimistic investors the stocks of growth companies may not been growth stocks. • Value investing vs. growth investing. 1/31/13
•
Understanding the industry’s competitive forces and the firm’s strategy for dealing with them is the key to deriving an accurate estimate of the firm’s long-run cash flows and risks of doing business. • Offensive vs. defensive strategy • SWOT analysis • Cost leadership vs. product differentiation
1/31/13
Developing the company’s story
Developing the company’s story
SWOT ANALYSIS: To help evaluate a firm’s strategies to exploit its competitive advantages or defend against its weaknesses. Strengths and weaknesses involve identifying the firm’s internal abilities or lack thereof. Opportunities and threats include external situations, such as competitive forces, discovery and development of new technologies, government regulations, and domestic and international economic trends.
1/31/13
Developing the company’s story
By recognizing and understanding opportunities and threats, an investor can make informed decisions about how the firm can exploit opportunities and mitigate threats.
1/31/13
SKILLS, RESOURCES, AND ORGANIZATIONAL REQUIREMENTS NEEDED TO SUCCESSFULLY APPLY COST LEADERSHIP AND DIFFERENTIATION
STRATEGIES
1/31/13
Favorable Attributes of Firms : Favorable Attributes of Firms :
The following attributes of firms may result in favorable stock market performance: 1. The firm’s product is not faddish; it is one that consumers will continue to purchase over time. 2. The company should have some long-run comparative competitive advantage over its rivals that is sustainable. 3. The firm’s industry or product has market stability. Therefore, it has little need to innovate or create product improvements or fear that it may lose a technological advantage. Market stability means less potential for entry. 4. The firm can benefit from cost reductions. An example would be a computer manufacturer that uses technology provided by suppliers competing to deliver a faster and less expensive machine or computer chip. 5. Firms that buy back their shares or companies where management 1/31/13 is buying shares, which indicates that its insiders are putting their
Tenets of Warren Buffet
Business Tenets • Is the business simple and understandable? (This makes it easier to estimate future cash flows with a high degree of confidence.) • Does the business have a consistent operating history? (Again, cash flow estimates can be made with more confidence.) • Does the business have favorable long-term prospects? (Does the business have a “franchise”—meaning a product or service that is needed or desired without a close substitute and is not regulated? This implies the firm should have pricing flexibility.)
1/31/13
Tenets of Warren Buffet
Management Tenets • Is management rational? (Is the allocation of capital to projects that provide returns above the cost of capital? If not, do they pay capital to stockholders through dividends or repurchase stock?) • Is management candid with its shareholders? (Does management tell owners everything you would want to know?) • Does management resist the institutional imperative? (Does management not attempt to imitate the behavior of other managers?) 1/31/13
Tenets of Warren Buffet
Financial Tenets • Focus on return on equity, not earnings per share. (Look for strong ROE with little or no debt.) • Calculate “owner earnings.” (“Owner earnings” are basically equal to “free cash flow” after capital expenditures.) • Look for a company with relatively high profit margins for its industry. • Make sure the company has created at least one dollar of market value for every dollar retained.
1/31/13
Tenets of Warren Buffet
Market Tenets • What is the value of the business? (Value is equal to future free cash flows discounted at a government bond rate. Using this low rate is considered appropriate because the business owner is very confident of his/her cash flow estimates due to extensive analysis, and this confidence implies low risk.) • Can the business be purchased at a significant discount to its fundamental 1/31/13
The rule: INTRINSIC VALUE > MARKET VALUE INTRINSIC VALUE < MARKET VALUE
ESTIMATING INTRINSIC VALUE
BUY SELL
Valuation Techniques:
Cash Flow Based (PVCF) 1. Present value of dividends (DDM) 2. Present value of free cash flow to equity (FCFE) 3. Present value of free operating cash flow to the firm (FCFF) 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)
1/31/13
ESTIMATING INTRINSIC VALUE
Dividend Discount Model (DDM) Intrinsic Value = D1 / (k – g) D1= D0 (1+g) For applying DDM k and g need to be determined. Current dividend (D0) is known.
1/31/13
ESTIMATING INTRINSIC VALUE
Dividend Discount Model (DDM)
Determining the Growth rate (g)
But can we rely solely on the past dividends for determining the growth rate? The dividend growth rate will be influenced by: the age of the industry life cycle; structural changes, and economic trends. Economic-industryfirm analysis provides valuable information regarding future trends in dividend growth. Information derived about management’s plans to 1/31/13 expand the firm, diversify into new areas, or change
ESTIMATING INTRINSIC VALUE
Dividend Discount Model (DDM)
So growth rate is defined as Sustainable growth rate (SGR) SGR (g) = RR X ROE. Estimating the required rate of return: Recall the CAPM: E(Rstock) = E(RFR) + ?stock [E(Rmarket) – E(RFR)]
1/31/13
ESTIMATING INTRINSIC VALUE (Multi-stage DDM)
1/31/13
Free Cash Flow to Equity (FCFE) = Net Income + Depreciation Expense – Capital Expenditures – ? in Working Capital – Principal Debt Repayments + New Debt Issues
1/31/13
ESTIMATING INTRINSIC VALUE (FCFE)
If the firm is in its mature phase the FCFE model can be used as: Value of the Firm = FCFE 1/(k – g FCFE) But in cases where the firms are either witnessing exponential growth or are yet to reach a mature growth phase, the above model cannot be used. A two-stage/ three stage model is used instead. 1/31/13
ESTIMATING INTRINSIC VALUE (FCFE)
ESTIMATING INTRINSIC VALUE (FCFE)
1/31/13
Free Cash Flow to Firm (FCFF) or Operating free cash flow = EBIT (1 – Tax Rate) + Depreciation Expense – Capital Expenditures – ? in Working Capital – ? in other assets
ESTIMATING INTRINSIC VALUE (FCFF)
1/31/13
ESTIMATING INTRINSIC VALUE (FCFF) Value of the Firm = FCFF 1/(WACC – g FCFF)
g FCFF = (RR)(ROIC)
RR = the average retention rate ROIC = EBIT (1 – Tax Rate)/Total Capital
WACC = WEk + WDi
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 capital10 i = the after-tax cost of debt
1/31/13
But in cases where the firms are either witnessing exponential growth or are yet to reach a mature growth phase, the above model cannot be used. A two-stage/ three stage model is used instead.
ESTIMATING INTRINSIC VALUE (FCFF)
1/31/13
ESTIMATING INTRINSIC VALUE (FCFF)
1/31/13
doc_128757812.pptx
It also gives the Tenets of Warren Buffet and how to determine intrinsic value of stock.
COMPANY ANALYSIS
Click to edit Master subtitle style 1/31/13
WHAT IS COMPANY ANALYSIS
At this point, you have made two decisions about your investment in equity markets: 1. What percent of your portfolio should be invested in common stocks. 2. You have identified those industries that appear to offer above-average risk-adjusted performance over your investment horizon.
1/31/13
WHAT IS COMPANY ANALYSIS
The final questions in the fundamental analysis procedure are: 1. Which are the best companies within these desirable industries? and 2. Are their stocks underpriced? Specifically, is the intrinsic value of the stock above its market value, or is the expected rate of return on the stock equal to or greater than its required rate of return? 1/31/13
CLASSIFICATION OF COMPANIES AND STOCKS
• • • •
Growth companies and stocks Defensive companies and stocks Cyclical companies and stocks Speculative companies and stocks
1/31/13
COMPANY ANALYSIS VERSUS THE VALUATION OF STOCK
The stock of a growth company is not necessarily a growth stock. Defining growth: “Companies that consistently experience above-average increases in sales and earnings”. Or “a firm with the management ability and the opportunities to make investments that yield rates of return greater than the firm’s required rate of return”. Which of the two you would prefer?
•
1/31/13
GROWTH
Growth stocks are not necessarily limited to growth companies. • A future growth stock can be the stock of any type of company; the stock need only be undervalued by the market. • For overeager/overoptimistic investors the stocks of growth companies may not been growth stocks. • Value investing vs. growth investing. 1/31/13
•
Understanding the industry’s competitive forces and the firm’s strategy for dealing with them is the key to deriving an accurate estimate of the firm’s long-run cash flows and risks of doing business. • Offensive vs. defensive strategy • SWOT analysis • Cost leadership vs. product differentiation
1/31/13
Developing the company’s story
Developing the company’s story
SWOT ANALYSIS: To help evaluate a firm’s strategies to exploit its competitive advantages or defend against its weaknesses. Strengths and weaknesses involve identifying the firm’s internal abilities or lack thereof. Opportunities and threats include external situations, such as competitive forces, discovery and development of new technologies, government regulations, and domestic and international economic trends.
1/31/13
Developing the company’s story
By recognizing and understanding opportunities and threats, an investor can make informed decisions about how the firm can exploit opportunities and mitigate threats.
1/31/13
SKILLS, RESOURCES, AND ORGANIZATIONAL REQUIREMENTS NEEDED TO SUCCESSFULLY APPLY COST LEADERSHIP AND DIFFERENTIATION
STRATEGIES
1/31/13
Favorable Attributes of Firms : Favorable Attributes of Firms :
The following attributes of firms may result in favorable stock market performance: 1. The firm’s product is not faddish; it is one that consumers will continue to purchase over time. 2. The company should have some long-run comparative competitive advantage over its rivals that is sustainable. 3. The firm’s industry or product has market stability. Therefore, it has little need to innovate or create product improvements or fear that it may lose a technological advantage. Market stability means less potential for entry. 4. The firm can benefit from cost reductions. An example would be a computer manufacturer that uses technology provided by suppliers competing to deliver a faster and less expensive machine or computer chip. 5. Firms that buy back their shares or companies where management 1/31/13 is buying shares, which indicates that its insiders are putting their
Tenets of Warren Buffet
Business Tenets • Is the business simple and understandable? (This makes it easier to estimate future cash flows with a high degree of confidence.) • Does the business have a consistent operating history? (Again, cash flow estimates can be made with more confidence.) • Does the business have favorable long-term prospects? (Does the business have a “franchise”—meaning a product or service that is needed or desired without a close substitute and is not regulated? This implies the firm should have pricing flexibility.)
1/31/13
Tenets of Warren Buffet
Management Tenets • Is management rational? (Is the allocation of capital to projects that provide returns above the cost of capital? If not, do they pay capital to stockholders through dividends or repurchase stock?) • Is management candid with its shareholders? (Does management tell owners everything you would want to know?) • Does management resist the institutional imperative? (Does management not attempt to imitate the behavior of other managers?) 1/31/13
Tenets of Warren Buffet
Financial Tenets • Focus on return on equity, not earnings per share. (Look for strong ROE with little or no debt.) • Calculate “owner earnings.” (“Owner earnings” are basically equal to “free cash flow” after capital expenditures.) • Look for a company with relatively high profit margins for its industry. • Make sure the company has created at least one dollar of market value for every dollar retained.
1/31/13
Tenets of Warren Buffet
Market Tenets • What is the value of the business? (Value is equal to future free cash flows discounted at a government bond rate. Using this low rate is considered appropriate because the business owner is very confident of his/her cash flow estimates due to extensive analysis, and this confidence implies low risk.) • Can the business be purchased at a significant discount to its fundamental 1/31/13
The rule: INTRINSIC VALUE > MARKET VALUE INTRINSIC VALUE < MARKET VALUE
ESTIMATING INTRINSIC VALUE
BUY SELL
Valuation Techniques:
Cash Flow Based (PVCF) 1. Present value of dividends (DDM) 2. Present value of free cash flow to equity (FCFE) 3. Present value of free operating cash flow to the firm (FCFF) 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)
1/31/13
ESTIMATING INTRINSIC VALUE
Dividend Discount Model (DDM) Intrinsic Value = D1 / (k – g) D1= D0 (1+g) For applying DDM k and g need to be determined. Current dividend (D0) is known.
1/31/13
ESTIMATING INTRINSIC VALUE
Dividend Discount Model (DDM)
Determining the Growth rate (g)
But can we rely solely on the past dividends for determining the growth rate? The dividend growth rate will be influenced by: the age of the industry life cycle; structural changes, and economic trends. Economic-industryfirm analysis provides valuable information regarding future trends in dividend growth. Information derived about management’s plans to 1/31/13 expand the firm, diversify into new areas, or change
ESTIMATING INTRINSIC VALUE
Dividend Discount Model (DDM)
So growth rate is defined as Sustainable growth rate (SGR) SGR (g) = RR X ROE. Estimating the required rate of return: Recall the CAPM: E(Rstock) = E(RFR) + ?stock [E(Rmarket) – E(RFR)]
1/31/13
ESTIMATING INTRINSIC VALUE (Multi-stage DDM)
1/31/13
Free Cash Flow to Equity (FCFE) = Net Income + Depreciation Expense – Capital Expenditures – ? in Working Capital – Principal Debt Repayments + New Debt Issues
1/31/13
ESTIMATING INTRINSIC VALUE (FCFE)
If the firm is in its mature phase the FCFE model can be used as: Value of the Firm = FCFE 1/(k – g FCFE) But in cases where the firms are either witnessing exponential growth or are yet to reach a mature growth phase, the above model cannot be used. A two-stage/ three stage model is used instead. 1/31/13
ESTIMATING INTRINSIC VALUE (FCFE)
ESTIMATING INTRINSIC VALUE (FCFE)
1/31/13
Free Cash Flow to Firm (FCFF) or Operating free cash flow = EBIT (1 – Tax Rate) + Depreciation Expense – Capital Expenditures – ? in Working Capital – ? in other assets
ESTIMATING INTRINSIC VALUE (FCFF)
1/31/13
ESTIMATING INTRINSIC VALUE (FCFF) Value of the Firm = FCFF 1/(WACC – g FCFF)
g FCFF = (RR)(ROIC)
RR = the average retention rate ROIC = EBIT (1 – Tax Rate)/Total Capital
WACC = WEk + WDi
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 capital10 i = the after-tax cost of debt
1/31/13
But in cases where the firms are either witnessing exponential growth or are yet to reach a mature growth phase, the above model cannot be used. A two-stage/ three stage model is used instead.
ESTIMATING INTRINSIC VALUE (FCFF)
1/31/13
ESTIMATING INTRINSIC VALUE (FCFF)
1/31/13
doc_128757812.pptx