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Firm Valuation and Analysis. 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 - PowerPoint PPT Presentation

Firm Valuation and Analysis

Company Analysis and Stock SelectionGood companies are not necessarily good investmentsIn the end, we want to compare the intrinsic value of a stock to its market valueStock of a great company may be overpricedStock of a lesser company may be a superior investment since it is undervalued

Defensive Companies and StocksDefensive companies future earnings are more likely to withstand an economic downturnLow business riskNot excessive financial riskDefensive stocks returns are not as susceptible to changes in the marketStocks with low systematic risk

Cyclical Companies and StocksSales and earnings heavily influenced by aggregate business activityHigh business riskSometimes high financial risk as wellCyclical stocks experience high returns is up markets, low returns in down marketsStocks with high betas

Speculative Companies and StocksSpeculative companies invest in assets involving great risk, but with the possibility of great gainVery high business risk, likely no current cash flowsExample: biotechSpeculative stocks have the potential for great percentage gains and lossesOften characterized by high P/E ratios

Value versus Growth InvestingGrowth stocks will have positive earnings surprises and above-average risk adjusted rates of return So long as they continue to grow and surprise to the upside)Value stocks appear to be undervalued, may have disappointed investors in the past and are now forgotten, left for dead, despisedValue stocks usually have low P/E ratio or low ratios of price to book valueAre housing stocks value stocks or value traps?

Theory of ValuationThe value of a financial asset is the present value of its expected future cash flowsRequired inputs:The stream of expected future returns, or cash flowsThe required rate of return on the investment

Required Rate of ReturnDetermined by the risk of an investment and available returns in the marketDetermined by:The real risk-free rate of return, plusThe expected rate of inflation, plusA risk premium to compensate for the uncertainty of returnsSources of uncertainty, and therefore risk premiums, vary by the type of investment

Investment Decision ProcessOnce expected (intrinsic) value is calculated, the investment decision is rather straightforward and intuitive:If Estimated Value > Market Price, buyIf Estimated Value < Market Price, do not buyThe particulars of the valuation process vary by type of investment

Approaches to Common Stock ValuationDiscounted Cash Flow TechniquesPresent value of Dividends (DDM)Present value of Free Cash FlowRelative valuation techniquesPrice-earnings ratio (P/E)Price-cash flow ratios (P/CF)Price-book value ratios (P/BV) Used most often for banks and other capital-intensive businessesNot appropriate for many asset-light businesses

Dividend Discount ModelsConstant Growth Model:Assumes dividends started at D0 (current years dividend) and will grow at a constant growth rate Growth will continue for an infinite period of timeThe required return (k) is greater than the constant rate of growth (g)V = D1/(k-g) where D1= D0(1+g)

Dividend Discount ModelsExample 10.1 Consider a situation in which we are valuing a share of common stock that we plan to hold for only one year. What will be the value of the stock today if it pays a dividend of $2.00, is expected to have a price of $75 and the investors required rate of return is 12%?FIN3000, Liuren Wu*

FIN3000, Liuren Wu

Dividend Discount ModelsValue of Common stock= Present Value of future cash flows= Present Value of (dividend + expected selling price)= ($2+$75) (1.12)1= $68.75FIN3000, Liuren Wu*

FIN3000, Liuren Wu

Dividend Discount ModelsExample 10.2 Continue example 10.1. What will be the value of common stock if you hold the stock for two years and sell it for $82? Assume the dividend payment is fixed at $2 per year.Value of Common stock= Present Value of future cash flows= Present Value of (dividends + expected selling price)= {($2) (1.12)1 } + {($2+$82) (1.12)2 } = $71.14FIN3000, Liuren Wu*

FIN3000, Liuren Wu

Determinants of Growth Rate of Future DividendsFirms growth opportunities relate to:The rate of return the firm expects to earn when they reinvest earnings (the return on equity, ROE), and The proportion of firms earnings that they reinvest. This is known as the retention ratio, b, = 1- dividend payout ratio.The growth rate can be formally expressed as follows:

g = the expected rate of growth of dividendsD1/E1 = the dividend payout ratioROE = the return on equity earned when the firm reinvests a portion of its earning back into the firm.

FIN3000, Liuren Wu*

FIN3000, Liuren Wu

Discounted Cash Flow ModelAlso called the free cash flow method. Suggests the value of the entire firm equals the present value of the firms free cash flows.A firm generates free cash flows for its stock holders and debt holders, so:Market value of a firm=Market value of stocks + market value of debt

DCF ContinuedFind the Enterprise Value (EV) of the firm.PV of firms future FCFsFCF = cash providing by operating activities, less capital expenditures (capex)Subtract market value of firms debt (and preferred stock, if any) to get total value of common stock (equity).Value of equity = EV of firm MV of debt Divide value of equity by the number of shares outstanding.Value per share = value of equity / # of shares of common stock

DCF ContinuedThe value of a business is usually computed as the discounted value of FCF out to a valuation horizon (H). The value after H is sometimes called the terminal value or horizon value.

DCF Continued

PV (free cash flows)PV (terminal value)

Given the long-run gFCF = 6%, and firm discount rate of 10%, use the corporate value model to find the firms value.

If the firm has $40 million in debt and has 10 million shares of stock, what is the firms stock value per share?MV of equity= MV of firm MV of debt= $416.94m - $40m= $376.94 millionValue per share= MV of equity / # of shares= $376.94m / 10m= $37.69

When to use the DCF vs. DDMWhen firms dont pay dividends or when dividends are hard to forecast, use the DCF model if possibleProjecting free cash flows might give us more accurate estimates of a firms valueA lot of accounting information to predict free cash flow (FCF).

P/E Ratio Valuation ModelPrice/Earnings ratio (P/E ratio) is a popular measure of stock valuation. P/E ratio is a relative value model because it tells the investor how many dollars investors are willing to pay for each dollar of the companys earnings.

Vcs = the value of common stock of the firm.P/E1 = the price earnings ratio for the firm based on the current price per share divided by earnings for end of year 1.E1 = estimated earnings per share of common stock for the end of year 1.

FIN3000, Liuren Wu*

FIN3000, Liuren Wu

P/E Ratio FactorsThe ratio is the earnings multiplier, and is a measure of the prevailing attitude of investors regarding a stocks valueP/E is determined by CASH FLOW, not vice versa

What causes the growth rate in dividends (and earnings) and the investors required rate of return to go up and down? These are the real determinants of the P/E ratio.Firm factors impacting the investors required rate of return (increase in perceived risk) Economic or macro factors impacting the investors required rate of return (growth outlook, interest rates/inflation) Firm factors impacting the earnings/dividend growth rate dividend policy and firm investment opportunities.

Price-Earnings RatioUsing the P/E approach to valuation:Estimate earnings for next yearEstimate the P/E ratio (Earnings Multiplier)Multiply expected earnings by the expected P/E ratio to get expected priceV =E1x(P/E)

Price-Cash Flow RatioCash 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 ratioV =CF1x(P/CF)

Company Analysis: Examining InfluencesCompany analysis is the final step in the top-down approach to investingMacroeconomic analysis identifies industries expected to offer attractive returns in the expected future environmentAnalysis of firms in selected industries concentrates on a stocks intrinsic value based on growth and risk

Economic and Industry InfluencesIf trends are favorable for an industry, the company analysis should focus on firms in that industry that are positioned to benefit from the economic trendsFirms with sales or earnings particularly sensitive to macroeconomic variables should also be consideredResearch analysts need to be familiar with the cash flow and risk of the firms

Structural InfluencesSocial trends, technology, political, and regulatory influences can have significant influence on firmsEarly stages in an industrys life cycle see changes in technology which followers may imitate and benefit fromPolitics and regulatory events can create opportunities even when economic influences are weak

Company AnalysisCompetitive forces necessitate competitive strategies.Competitive Forces:Current rivalryThreat of new entrantsPotential substitutesBargaining power of suppliersBargaining power of buyersSWOT analysis is another useful tool

Firm Competitive StrategiesDefensive or offensiveDefensive strategy deflects competitive forces in the industryOffensive competitive strategy affects competitive force in the industry to improve the firms relative positionPorter suggests two major strategies: low-cost leadership and differentiation

Low-Cost StrategySeek