Chapter 20: Company Analysis and Stock Selection

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  • 1. CHAPTER 20: COMPANY ANALYSIS AND STOCK SELECTION • After our sojourn into bonds, we return to stocks for the remainder of the course. • Unlike all the previous chapters, this is a chapter that teaches the techniques of analysis that can make you one a good stock-picker. These are some good, sound techniques that can help us understand a company in the context of its industry and the economy. • Will the knowledge of these techniques make you an ace stock-picker overnight? Most probably not. There are two reasons for this: - First, like any art or science, stock picking is learned by experience. Many, many years have to be spent before one becomes an ace at anything. - All these techniques are fairly standard and everyone on Wall Street knows them. It is unlikely then, that they will be any source of competitive advantage. However, they are a necessary prerequisite for any analysis of stocks, and we shall consider some of these techniques. • I shall follow the text very closely in this chapter. • Different types of companies and stocks - Growth Companies are those that have consistently experienced above-average increases in sales and earnings. Growth Stocks need not be stocks in growth companies. Any stock that has a higher rate of return compares or other stocks of similar risk is a growth stock. A company might be a great growth company, but as long as it is not selling cheaper relative to its intrinsic value, it does not represent the potential to be a growth stock. - Defensive Companies are those, whose future earnings are most likely to withstand an economic downturn. Examples are utilities or grocery chains, in the business of providing basic necessities. A defensive stock is any stock whose value declines by less than one-for-one compared to a market decline. i.e. a stock with a low or negative systematic risk, or beta can be called defensive.
  • 2. - A cyclical company is one whose earnings will more or less move with the level of economic activity. Classic examples are autos, and heavy manufacturing industry, which are right now at a low point. A cyclical stock, on the other hand is any high-beta stock, which means it follows the overall stock market quite closely. - A speculative company is one whose business involves great risk, with the possibility of great return. A good example is oil exploration. A speculative stock, is any stock, which has a possibility of very negative returns. • The top-down method of investment analysis The traditional approach to investing consists of three levels. 1) Economic analysis: Analysis of the macroeconomic trends that affect every industry and company. This involves taking a view about prospects for the economy, interest rates etc. 2) Industry analysis: Analysis of specific industries, and how prospects for profitability for each look in the short run and in the long run. 3) Company analysis: This is the final step in this approach. Having decided on the economy, and the industry for investment, one needs to analyze specific companies and evaluate the prospects for investment. This is the step we will learn in this chapter. • Company Analysis Strategic Analysis In analyzing a company, we first need to understand the strategic aspects of the company. For this, we need a framework to understand the context within which a firm operates. It is useful to describe two frameworks here. 2
  • 3. Porter’s five forces model This model is presented in Figure 19.8 of your text. Prof. Michael Porter of Harvard University came up it, in describing the forces influencing competitive rivalry within an industry. According to Porter, the five basic forces influencing industry structure are: 1) Competitive structure within an industry. 2) Threat of potential entrants 3) Threat of substitute products or services 4) Bargaining power of suppliers 5) Bargaining power of buyers SWOT Analysis SWOT stands for Strengths, Weaknesses, Opportunities, and Threats analysis. The SW are internal components of the analysis, where a firm identifies its own strengths and weaknesses. The OT are external components of the analysis, the opportunities and threats to the company; opportunities to be exploited and threats to be avoided. Such is the stuff of strategic analysis of firms. But, that’s not our principal focus. We shall concentrate on the financial aspects of company analysis. The financing approach to investment consists of the following steps: 1. Compute the intrinsic value of the stock. 2. If the current market price of the stock is less than the intrinsic value, the stock is underpriced i.e. it is selling at a bargain price, and one should buy the stock. If the converse is true, i.e. if the current market price of the stock is greater than the intrinsic value, then the stock is overpriced, meaning it is too expensive relative to what we think it should be selling for. We would sell this stock. This approach is straightforward, but the problem clearly is to try and find the intrinsic value of the stock. We shall discuss several ways to do this next. 3
  • 4. • Estimating intrinsic value I shall follow the Walgreen example presented in your text. The idea is to find the intrinsic value of Walgreen stock in the year 1999. The market price of Walgreen at the time was around $30. Be sure to read these notes along with the tables etc. from Chapter 20 pertaining to Walgreen, in your text. Method 1: Present Value of Cash Flows This method says that investors can calculate the intrinsic value of any stock by estimating future cash flows and discounting them at appropriate discount rates. Specifically, we have three methods under this broad framework. 1. PV(Dividends) or Dividend Discount Model (DDM) Here the idea is that the price of a stock is the present value of all future dividends. D1 D2 D3 Dn P0 = + + ++ + (1 + k) (1 + k) 2 (1 + k) 3 (1 + k) n The model itself is very intuitive, but in order to use it, we need to estimate all future dividends. Obviously, it is not possible to estimate all future dividends. A way out is to make some assumptions regarding dividend growth. For example, the simplest assumption one might make is that dividends are going to remain a constant number for the rest of the firm’s life. i.e. we are assuming D1=D2=…=Dn=….= D. According to this model, the price of a firm’s stock can be found as the present value of a perpetuity of D dollars per period, which is, given by: P0=D/k. The assumption of constant, perpetual dividends is great for preferred stock, but not a great one for common stock. It is typical to assume some growth. The simplest model with growth is to assume that dividends will grow at a constant growth rate g forever. i.e. D1=D0(1+g); D2=D1(1+g); …;Dn= Dn-1(1+g) , which means that dividends under this model are a growing perpetuity. Thus, the price of common 4
  • 5. stock today is given by the formula for the PV of a growing perpetuity, which is: D1 D (1 + g) P0 = = 0 (k - g) (k - g) Here, D0 and D1 are the expected dividends now and next year respectively. k is the rate of return required by investors on this common stock, while g is the constant growth rate at which dividends are expected to grow forever. D0 is the current dividend, and is hence known. What about k and g? How do we set about estimating them? Estimating g There are two methods to estimate g the constant growth rate expected in the future. One is to look at past data regarding the particular stock and calculate a historical growth rate. If the firm has had a fairly constant growth rate, this is a sensible method. Let us say we have a series of dividend numbers from the past n periods (usually years): D0 through Dn. Then, the average growth rate is given by the g that Dn solves the following: Dn = D0(1+g)n, or g = n − 1 . In the Walgreen example, we D0 can take a sample of 10 years, from 1988 to 1998. D1988 is $0.04 per share, and D1998 is $0.125 per share (See Table 20.2). The average growth rate is: D1998 0.125 g = 10 − 1 = 10 − 1 = 12.068% D1988 0.04 Remember, this method works only if the historical growth rate is reasonably constant. If there were big jumps in between, obviously blind plugging-in is not going to help. There is another method to estimate the constant growth in dividends. Under this method, the growth rate g is given by the following formula: g = Retention ratio × Return on Equity = (1-dividend payout ratio)× Return on Equity 5
  • 6. For Walgreen, the Retention Ratio is given to us as 75%, and the Return on Equity is 19%, which yields a growth rate estimate of g= 0.75 × 19% = 14.25%. After calculations by both methods, we have two values of g, 12.07% and 14.25%. So, we now have a range of 12.07% through 14.25%. The authors of your text have placed more weight on the second method, as they feel (subjectively) that the ROE of Walgreen is the factor driving the growth; hence they settle on a value of 14.0% for growth. Estimating k One can use the good old CAPM to estimate k, the rate of return that investors require on the firm’s stock. You will recall (from Chapter 10) that the CAPM relates the expected return and the systematic risk of any asset. ki = rf+βi[E(rM)-rf] At the time of this analysis, i.e. at the end of 1998, the risk free rate was 6%. There are different numbers that analysts plug in for the market risk premium. The actual historical market risk premium i.e. the excess returns of stocks over risk-free treasury securities is about 8%. Academics contend that the number to plug in should be a lot smaller, like 3%. The authors of your text have chosen to be in the middle of the road, and picked 5%. The beta of Walgreen is found by estimating the characteristic line: RWAG = αWAG+βWAG.RM +εWAG You will recall that we plotted a line like this for Coke way back in the course, during our discussion of the CAPM. Basically, this amounts to fitting a line with the rate of return on the market (typically, a proxy such as the S&P 500 rate of return on the X- axis, and the rate of return on Walgreen stock on the Y-axis. The slope of the fitted line is the estimated beta of Walgreen – 0.90 in the calculation by the authors using a sample of data for 5 years from 1994-1998. Plugging in these inputs, we can estimate the expected rate of return on Walgreen stock as: kWAG = 6% + 0.90(5%) = 10.5% 6
  • 7. Now, let us try plugging these inputs into our DDM formula, with D1 = $0.16: D1 0.16 P0 = = (k - g) (10.5% - 14.0%) Wait! Something is wrong here. The denominator is a negative number, which implies a negative price for Walgreen stock, which cannot be true at all. What happened here? The answer is: The numbers are telling us that this is not an appropriate method to use. The company is growing way too fast for it to maintain the same growth rate forever. Thus, we need to improve upon this method. One method, known as the non- constant growth dividend discount model, is as follows: Pick a time period during which one expects abnormal or above-normal growth of 14% in dividends. Here, let’s pick the above-normal growth rate period as extending from 2000 through 2004. Then, assume that the growth rate tapers off over the next few years, until the growth steadies in 2010 to 8% forever. The following presents the dividends of Walgreen with these assumptions. Walgreen Company PV @ Year Growth Dividends 10.50% 1999 - 0.140 High growth period 2000 14% 0.160 $0.144 2001 14% 0.182 $0.149 2002 14% 0.207 $0.154 2003 14% 0.236 $0.159 2004 14% 0.270 $0.164 $0.769 Declining growth period 2005 13% 0.305 $0.167 2006 12% 0.341 $0.170 2007 11% 0.379 $0.170 2008 10% 0.417 $0.170 2009 9% 0.454 $0.167 $0.844 Steady growth period 2010 8% 0.490 Price at the end of 2009 19.614 $7.227 Total present value- Price per stock $8.840 7
  • 8. Starting with a 1999 value of $0.14 per share, we have dividends growing at 14% until 2004, for five years. The present value of the first five dividends during this above-normal phase is $0.769. From 2005 through 2009, the growth rate declines until it reaches 9% in 2009. As can be seen from the above table, the present value of dividends during this phase is $0.844. Finally, from 2010 onwards, the dividends grow at 8% forever. That is, dividends are a growing perpetuity from 2010 onwards. This is shown as below: 0.49 0.49(1.08) 0.49(1.082) 0.49(1.083) 2009 2010 2011 2012 2013 …. The present value of this series can be found by the growing perpetuity formula, which means that the P2009 is estimated to be: D 2010 0.49 P2009 = = = $19.614 . The present value of this is estimated as: (k - g) (10.5% - 8.0%) 19.614 = $7.227 . (1 + .105) 9 Thus, the total price of Walgreen stock is found as: $(0.769+0.844+7.227) = $8.84 Notice that this method results in a price of $8.84, compared to the then market price of about $30. This method says that Walgreen stock is very much overpriced compared to its intrinsic value. What about a company that does not pay any dividends, e.g. Microsoft? Obviously, the DDM is not going to work. We need another method to deal with this and other such tricky cases. 2. PV(FCFE): PV(Free Cash Flow to Equity) method Here the idea is that the total value of a company’s equity is the present value of all the free cash flows that are expected to flow to equity holders (shareholders) of the firm. 8
  • 9. FCFE1 FCFE 2 FCFE 3 FCFE n Market value of equity = + + ++ + (1 + k) (1 + k) 2 (1 + k) 3 (1 + k) n The definition of FCFE is: FCFE = Net Income + Depreciation Expense – Capital Expenditures -∆ in working capital – Principal repayments on debt +New debt issues Let us apply a non-constant growth model to FCFE. Again, the algorithm is similar to that for dividends. Pick a time period during which one expects abnormal or above- normal growth in FCFE. If one looks at Table 20.2, we can see that FCFE has had a growth of about 20 percent over the 15-year period, but this growth is highly volatile. So, the authors decided on 16% as a conservative value for the above normal growth. Again, let’s pick the above-normal growth rate period as extending from 2000 through 2004. Then, assume that the growth rate tapers off over the next few years, until the growth steadies in 2012 to 8% forever. The following presents the FCFE and the valuation of Walgreen with these assumptions. Walgreen Company PV @ Year Growth FCFE ($ M) 10.50% 1999 - 204 High growth period 2000 16% 237 214 2001 16% 275 225 2002 16% 318 236 2003 16% 369 248 2004 16% 428 260 1,183 Declining growth period 2005 15% 493 271 2006 14% 562 279 2007 13% 635 286 2008 12% 711 289 2009 11% 789 291 2010 10% 868 289 2011 9% 946 286 1,991 Steady growth period 2012 8% 1022 Value at the end of 2011 40874 12,334 Total present value of FCFE 15,507 Number of shares 1,003 Value per share 15.46 9
  • 10. This method results in a price of $15.46, compared to the then market price of about $30. This method again says that Walgreen stock is very much overpriced compared to its intrinsic value. 3. PV(FCFF): PV(Free Cash Flow to Firm) method Here the idea is that to find the entire firm, and then subtract from that value, the value of debt, to arrive at the value of equity. The total value of a company’s equity is the present value of all the free cash flows that are expected to flow to the firm (note: the firm, not just the shareholders of the firm). FCFF1 FCFF2 FCFF3 FCFFn Market value of firm = + + ++ + (1 + WACC) (1 + WACC) 2 (1 + WACC) 3 (1 + WACC) n The definition of FCFF is: FCFF = EBIT(1-Tax rate) + Depreciation Expense – Capital Expenditures -∆ in working capital – ∆ in other assets Notice that the above formula says we should discount the FCFFs at not k, but the WACC. This is the Weighted Average Cost of Capital, and is the appropriate rate to discount cash flows to the firm. You should have seen the WACC in a corporate finance course. The definition of WACC is: WACC = wE.ke+wD.kd(1-t), i.e. the WACC is a weighted average of the costs of equity and debt, with the weights being the proportions of debt and equity in the firm’s capital structure. Think of this as a rate of return on a portfolio (firm) with two assets (debt and equity) in its portfolio. The weights on the two assets have to add up to 1. Calculation of WACC: The WACC calculation needs wE and wD, the proportions of debt and equity in the firm’s capital. It is important that we realize that these proportions must be based on the market values of debt and equity, not the book values from the accounting statements. In your text, it is given that wE=0.90, and wD=0.10, based on market values. This means that Walgreen uses very little debt. 10
  • 11. It is also given that kd(1-t) = 7%(1-0.39) =4.3%. Earlier, we estimated ke=10.5%. Let’s plug these values into the WACC equation: WACC = wE.ke+wD.kd(1-t) = 0.90.(10.5%)+0.10.(7%).(1-0.39)=9.88% We should use this rate now to discount the free cash flows to the firm, or the FCFF. Again, we shall use a non-constant growth model to value the FCFFs. Once again, the algorithm is identical. Let’s pick a time period during which one expects abnormal or above-normal growth in FCFF. The authors decided on 14% as a value for the above normal growth, during the period from 2000 through 2004. Then, assume that the growth rate tapers off over the next few years, until the growth steadies in 2011 to 7% forever. The following presents the FCFF and the valuation of Walgreen with these assumptions. Walgreen Company PV @ Year Growth FCFF ($ M) 9.88% 1999 - 202 High growth period 2000 14% 230 210 2001 14% 263 217 2002 14% 299 226 2003 14% 341 234 2004 14% 389 243 1,129 Declining growth period 2005 13% 439 250 2006 12% 492 255 2007 11% 546 257 2008 10% 601 257 2009 9% 655 255 2010 8% 708 251 1,525 Steady growth period 2011 7% 757 Value at the end of 2011 26286 9,324 Total present value of FCFF 11,979 Minus: Value of debt 4250 Value of equity 7,729 Number of common shares 1003 Value per share 7.71 This method results in a price of $7.71, that is once again substantially lower than the market price of about $30. Again, our analysis suggests that Walgreen stock is very much overpriced compared to its intrinsic value. Method 2: Relative Valuation ratio Techniques 11
  • 12. Here, we try to estimate the earnings of a company, and multiply that by the appropriate Price/Earnings (P/E) ratio for the company, and arrive at a stock price. The various steps of this method are explained below for Walgreen. Step 1: Forecasting Sales for Walgreen Here, the analyst tries to get at a “best guess” forecast of sales based on several factors. On alternative is to use some measure of consumer spending and relate it to the company in hand. After all, consumers have to buy the products that this company offers. As we know, Walgreen is primarily a pharmacy, hence personal spending on medical care might be especially important. Table 20.5 tries to compare Walgreen sales over the past 20 years (1977-1998) to various measures. Figure 20.2 plots the relationship between Walgreen sales and the Personal Consumption Expenditure – Medical (PCE-Medical), and finds a strong relationship between the two. This suggests that is we know how PCE-Medical is going to grow, we can try to get an estimate for Walgreen sales. Economists are forecasting the PCE will grow at 6.3% in 1999 which will result in a dollar figure for PCE of $6,177 billion. Of this, 15.3% is expected to be expenditure on medical care, which says that PCE-Medical care will be about (15.3% ×6,177)=$945 billion, which is a growth rate of 6.5% from 1998. Using the relationship between PCE-Medical care and Walgreen Sales, such as the one in Figure 20.2, we can forecast Walgreen sales growth in 1999 as 11%. Another way to get at the same quantity, i.e. Walgreen sales growth is based on total square footage in all Walgreen stores
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