COMPANY

ANALYSIS AND
STOCK
VALUATION

P R OF I T
CHAPTER 5

I
L OS S
K
SECTION 4 – GROUP 3
1. Liya Eyob Hamda GSE/3346/14
2. Tigist Kebede Bayabil GSE/8186/14
3. Tihut Berhanu Jijo GSE/5297/14
4. Tilahun Woldeamanuel Atrago GSE/0488/14
5. Wubeshet Kifle Ayigemit GSE/7663/14
6. Yeamlaksira Markos Yetemegn GSE/1328/14
7. Yibeltal Assefa Haileselassie GSE/7805/14
8. Yonas Tufa Kukuba GSE/6060/14
1. COMPANY ANALYSIS AND
STOCK VALUATION
• 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 (market value is higher than
intrinsic value)
• Stock of a lesser company may be a superior investment since it is
undervalued
GROWTH COMPANIES AND
GROWTH STOCKS
• 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
GROWTH COMPANIES AND
GROWTH STOCKS
• Growth stocks are not necessarily shares in growth companies

• A growth stock has a higher expected rate of return than other

stocks with similar risk

• Achieves this superior risk-adjusted rate of return because the

market has undervalued it compared to other stocks.
DEFENSIVE COMPANIES
AND DEFENSIVE STOCKS
• Defensive companies’ future earnings are more likely to
withstand an economic downturn

• Normally have low business risk and not excessive financial

risk

• Defensive stocks’ Rate of return is not expected to decline

during an overall market decline or decline less than the
overall market.
• Stocks with low systematic risk
CYCLICAL COMPANIES AND
CYCLICAL STOCKS
Cyclical companies:

• Sales and earnings will be heavily influenced by aggregate

business activity

• Outperform other firms during economic expansion

• Underperform during economic contractions

• High volatility in sales (high business risk and financial

risk)

• Example steel, auto or heavy machinery industries

CYCLICAL COMPANIES AND
CYCLICAL STOCKS
Cyclical stocks:

• experiences changes in their rates of return greater than

changes in overall market rates of return

• Stocks with high betas

SPECULATIVE COMPANIES
AND STOCKS
• Speculative companies invest in assets
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
ECONOMIC, INDUSTRY, AND STRUCTURAL
LINKS TO COMPANY ANALYSIS
•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
2. COMPANY ANALYSIS
•Industry competitive environment

•SWOT analysis

•Present value of cash flows

•Relative valuation ratio techniques

 COMPETITIVE FORCES
Porter’s 5 forces is a powerful tool for assessing industry attractiveness.

Michael Porter identified five forces driving industry competition:

Potential new entrants

and barrier to entry

Suppliers and
Rivalry Amongst Buyers and Their
Their Bargaining
Firms in Industry Bargaining
Power
Power

Threat of
Substitutes
 FIRM COMPETITIVE
STRATEGIES
• a company’s competitive strategy can be either
defensive or offensive,
• Defensive strategy involves positioning firm so
that it its capabilities provide the best means to
deflect the effect of competitive forces in the industry
• Offensive strategy involves using the company’s
strength to affect the competitive industry forces,
thus improving the firm’s relative industry position
• Porter suggests two major strategies: low-cost
leadership and differentiation
PORTER'S
COMPETITIVE
STRATEGIES
•Low-Cost Strategy
• The firm seeks to be the low-cost
producer, and hence the cost leader
in its industry
•Differentiation Strategy
• firm positions itself as unique in the
industry
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
 SWOT ANALYSIS

Strengths Weaknesses

Internal factors which already exist and have contributed to the current
position and may continue to exist.

Opportunities Threats

External factors which are contingent events. Assess their importance

based on the likelihood of them happening and their impact on the
company. Also consider whether management have the intention and
ability to take advantage of the opportunity/avoid the threat.
SOME LESSONS FROM
PETER LYNCH
Favorable Attributes of Firms

1. Firm’s product should not be faddish

2. Firm should have some long-run comparative advantage

over its rivals

3. Firm’s industry or product has market stability

4. Firm can benefit from cost reductions

5. Firms that buy back shares show there are putting money
into the firm
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
INFLUENCES ON
ANALYSTS

• Efficient Markets
• Paralysis of Analysis
• Analyst Conflicts of Interest
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
 ANALYST CONFLICTS OF
INTEREST
• 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
GLOBAL COMPANY AND
STOCK ANALYSIS

Factors to Consider:
• Availability of Data
• Differential Accounting Conventions
• Currency Differences (Exchange Rate
Risk)
• Political (Country) Risk
• Transaction Costs
• Valuation Differences
EQUITY VALUATION MODELS
• WHY Equity Valuation?
• The purpose of fundamental analysis is to identify
stocks that are mispriced relative to some measure
of “true” or intrinsic value that can be derived from
observable financial data.
• In practice, stock analysts use models to estimate the
fundamental value of a corporation’s stock from
observable market data and from the financial
statements of the firm and its competitors
• These valuation models differ in the specific data
they use and in the level of their theoretical
sophistication.
 OVERVIEW OF FINANCIAL VALUATION
TECHNIQUES
EQUITY
VALUATION

Balance sheet Discounted Cash Earning multiplier

methods Flow (Intrinsic (Relative Value)
Value)

Book Dividend
Price Earnings
value Discount Model
ratio (P/E)

Liquidation Free Cash Flow to Price cash flow

value Equity (FCFE) ratio (P/CF)

Free Cash Flow to Price book value

Replacement
Firm (FCFF) ratio (P/BV)
Cost

Price sales ratio

(P/S)
 1. BALANCE SHEET VALUATION
• seek to determine the company’s value by estimating
the value of its assets.
• traditionally used methods that consider that a
company’s value lies basically in its balance sheet.
• They determine the value from a static viewpoint,
which, therefore, does not take into account the
company’s possible future evolution or money’s
temporary value.
1. BALANCE SHEET VALUATION
• Neither do they take into account other factors, that do not appear in
the accounting statements, that also affect the value such as:
• the industry’s current situation,

• human resources or organizational problems,

• contracts, etc.

• Some of these methods are the following:

• book value,

• adjusted book value,

• liquidation value, and

• replacement value.
a) BOOK VALUE
• is a company’s equity value as reported in its financial statements

TOTAL
BOOK VALUE TOTAL ASSETS
Share capital + RE CA + NCA LIABILITIES
CL + NCL
b) LIQUIDATION VALUE
• an estimation of the final value that will be received by the holder
of financial instruments when an asset is sold, typically under a
rapid sale process.

• This value is calculated by deducting the business’s liquidation

expenses (redundancy payments to employees, tax expenses and
other typical liquidation expenses) from the adjusted net worth.
b) LIQUIDATION VALUE
continued

LIQUIDATION
NRV of assets LIABILITIES
VALUE

When working with liquidation value calculations, an investor should

exclude the intangible assets, such as goodwill, brand recognition,
and intellectual property.
c) REPLACEMENT COST
• Refers to the price that it would cost to replace an existing asset
with a similar asset at the current market price.

• Analyst believe that the market value of the firm cannot get too
far above its replacement cost for long because, if it did
competitors would enter the market

• This idea is popular among economists, and the ration of market

price to replacement cost is known as Tobin’s Q
TOBIN’S Q APPLICATION
Q>1
Company is
overvalue
Q>1
Q ratio Company is
fairly valued
Q>1
Company is
undervalue
2. DISCOUNTED CASH FLOW
1. Present value of cash flows (PVCF)
• a. Present value of dividends (DDM)
• b. Present value of free cash flow to equity (FCFE)
• c. Present value of free cash flow (FCFF)
 a) PRESENT VALUE OF DIVIDENDS (DDM)

• This model has a typical assumption that the dividend will grow at
a constant rate over time.

• Although this assumption is not realistic for fast growing or

cyclical firms, this assumption may be appropriate for many
mature firms

Intrinsic Value = D1/(k-g)

D1= D0(1+g)
 a) PRESENT VALUE OF
DIVIDENDS (DDM) continued

Growth rate estimates

• Average Dividend Growth Rate

Where
Dn Dn = company's dividend value for a
n 1 specific period (n)
D0 = company's dividend value for the
D0 initial period
a) PRESENT VALUE OF
DIVIDENDS (DDM) continued

• Model requires k>g

• With g>k, analyst must use multi-stage model
B. PRESENT VALUE OF FREE CASH FLOW
TO EQUITY
• Free cash flows are used to determine how much cash a
company has left after satisfying its sustainable obligations.

• Not all companies pay dividend

• An alternative approach to the dividend discount model values

the firm using free cash flow
FCFE =
Net Income
+ Depreciation Expense
- Capital Expenditures
- D in Working Capital
- Principal Debt Repayments
+ New Debt Issues
B. PRESENT VALUE OF FREE CASH FLOW
TO EQUITY continued
FREE CASH FLOW TO THE EQUITY (FCFE)

Net income Accounting profit

+ Depr/Amortization Non-cash items

+/- changes in WC Deduct increase/Add decrease in WC

- CAPEX Investments

- Principal debt Financing

repayment
+ new debt issued Financing

= FCFF Inflow/outflow
B. PRESENT VALUE OF FREE CASH FLOW
TO EQUITY continued

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
 C. PRESENT VALUE OF FREE
CASH FLOW TO FIRM
• 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
 C. PRESENT VALUE OF
OPERATING FREE CASH FLOW
continued

FREE CASH FLOW TO THE FIRM (FCFF)

EBIT Accounting earning

(1-Tax rate) Tax expense

+ Depr/Amortization Non-cash items

+/- changes in WC Deduct increase/Add decrease in WC

- CAPEX Investments

= FCFF Inflow/outflow
 C. PRESENT VALUE OF
OPERATING FREE CASH FLOW
continued
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
3. EARNING MULTIPLIER
APPROACHES

• The value of an asset is derived from the pricing of

comparable assets.

• Relative valuation techniques

• a. Price earnings ratio (P/E)

• b. Price cash flow ratios (P/CF)

• c. Price book value ratios (P/BV)

• d. Price sales ratio (P/S)

 3. EARNING MULTIPLIER
APPROACHES
XYZ CO. FINANCIAL STATEMENT EXTRACTS
XYZ Inc. Balance Sheet XYZ Inc. Income Statement
Assets $Millions Income Statement $Millions

Cash 0 Sales 1,000

Other Current Assets 250 Operating Expenses (350)
PP&E 800 EBITDA 650
Total Assets 1,050 Depreciation (400)
EBIT 250
Liabilities
Interest (100)
Short-term Debt 50 Earnings Before Tax 150
Other Current Liabilities 100 Tax (50)
Long-term Debt 250 Earnings After Tax 100
Common Stock 250 Number of Shares 100 Million
Retained Earnings 400 Share Price 20.00
Total Equity 650
Total Liabilities 1,050
a) PRICE TO EARNINGS MULTIPLE

P/E Market Capitalization $2,000MM

20x
Multiple Net Earnings $100MM

Price to earnings multiples are driven

by:

1. Growth Prospects 2. Shareholder Risk 3. Cash Flow Generation

D1 / E1
P / E1 
kg
a) PRICE TO EARNINGS MULTIPLE
continued

Problems With
Price to Earnings

Problems with cyclical

Cannot cope with Earnings can be Earnings can be firms
negative manipulated volatile • Trough of cycle - high
earnings P/E

• Peak of cycle - low P/E

b) PRICE TO FREE CASH FLOW MULTIPLE

P/FCFE Market Capitalization $2,000MM

40x
Multiple Free Cash Flow to $50MM
Equity

High P/FCFE Firm may be

overvalued

Low P/FCFE Firm may be

undervalued
c) PRICE TO BOOK MULTIPLE
The book value of equity is the total shareholders’ equity
on the balance sheet.

P/B Market Capitalization $2,000MM

3.1x
multiple Book Value of Equity $650MM
d) PRICE/SALES MULTIPLE
Enterprise value to sales multiple:

Price Sales Market Capitalization $2,000MM

2x
Sales $1,000MM
 WHY AND WHEN TO USE
Multiple Characteristics

• Straight forward measure of cash flow

Discounted cash flow method
• Pattern of sales clear
• Ignores operating economics
• Ignores capital structure
• Operating cash flow positive
Relative valuation methods
• Incorporates profitability
• Ignores capital structure
• Ignores tax differences
• Operating profit
EV to EBIT
• Ignores capital structure
• Ignores tax differences
• Stable operating economics
Price to Earnings
• Stable capital structure
• Profit and cash flow similar