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Investment Analysis and Portfolio Management

Investment Analysis & Portfolio Management (FIN630)
Lesson # 6
In much the same manner as Republicans and Democrats have inherent differences in
political philosophy, security analysts also may be grouped into two camps: fundamental
and technical analysts. The fundamental analyst believes that securities are priced in a
rational manner based on macroeconomic information, industry news, and the firm's
financial statements. The technical analyst believes that prices are largely determined by
investor behavior and by supply and demand, even when demand may seem irrational.
Technical analysis is a controversial part of finance and is covered in its own chapter,
Chapter Eight. Most investment research firms have both fundamental and technical
analysts on the payroll. Despite their philosophical differences, both groups agree on certain
As we enter a new millennium, however, both fundamental and technical analysts wonder
whether the old rules still work. The proliferation of seemingly high-priced Internet and
technology stocks made everyone wonder whether the prices are reasonable. Many
investors cannot decide whether they should remain on the sideline or whether the train is
about to leave without them. Forbes ASAP ran an article with the tine "Is Internet Wealth
Real7"1 in the same issue Forbes listed 53 Internet executives with a total wealth of $48
billion, which the writer calls a "blurry snapshot of a moving target." Ben Holmes, founder
of an IPO research firm, says, "This wealth isn't like other wealth. On paper, Jay Walker's
62 million shares of Price line stock are worth about $4 billion, but nobody knows what
they're really worth."
Early in the year 2000 The Wall Street Journal ran a front page article entitled "How High
Is Too High for Stocks That Lead a Business Revolution?"2 The article subtitle is "Whether
old valuation rules can be ignored for some is key to volatile NASDAQ." As this chapter
will show, investors historically have paid considerable attention to a firm's price-earnings
ratio, widely viewed as a useful measure of relative value. PEs around 15 or 20 used to be
the norm. In early 2000, however, stocks with a PE ratio in excess of 100 accounted for
about 20 percent of the total market value of the NASDAQ market.
Value comes from utility; utility comes from a variety of sources.
Fundamental analysts believe securities are priced according to fundamental economic
data. Technical analysts think supply and demand factors play the most important role.
Investors' Understanding of Risk Premiums:
Investors are almost always risk-averse. Investors often cannot explicitly define risk, but
they have an intuitive understanding of it. They do not like taking risks, but will do so in
order to increase potential investment return- Preceding chapters have discussed how
investors can use the variance of investment returns as a proxy for risk. This balance
between risk and return is the reason un-bonds have higher yields to maturity than U.S.
Treasury bonds, and why some shares of stock sell for more than others.
Investment Analysis & Portfolio Management (FIN630)
The Time Value of Money:
Everyone agrees on this basic principle, even those who would not know a balance sheet if
they saw one. People postpone paying bills and prefer a paycheck now rather than one later
Ever tiling else being equal, the longer someone must wait for the payoff from an
investment, die less the investment is worth today.
Suppose a AAA-rated firm tries to issue a zero coupon consol; at what price might it sell7 It
might have some collector's value, but its investment value is nil. What good is the right to
receive no interest forever? Similarly, when Coca-Cola and Disney issued the 100-year
bonds described in an earlier chapter, why was their initial market price such a deep
discount from par? The answer is obvious: the return of the par value is two generations
from now, and people are not willing to pay much for a cash flow that distant. The bond's
current value comes almost entirely from the coupon stream.3 In 75 years the eventual
return of the principal will start to matter, but in 1996 it had little impact on the present
value of the bond.
Everything else being equal, the longer someone must wait for the payoff from an
investment, the less the investment is worth today.
The Importance of Cash Flows:
Start-up companies often have zero sales. It takes time to develop products, particularly
those that are innovative and brimming with technology. Some of the great success stories
of recent years, like Microsoft, Yahoo and Apple, all involved a period of time when the
firms spent money at a steady pace while little was coming in. Investors understand this
process arid and are willing to put up seed capital to help new ventures get off the ground.
The market's patience is not unlimited, however. Eventually, the shareholders expect to see
their investment lead to product sales and to profits from those sales. Share price
appreciation and cash dividends stem directly from the profitability of the company.
The importance of earnings never subsides. In fact, most investment research deals
primarily with predicting future earnings. The link between earnings, dividends, and price
appreciation is well established, and all analysts know that good earnings are important.
While earnings are clearly important, it is less clear how important dividends are to the
contemporary investor. At one time many investors selected a stock largely on the basis of
its expected dividends; the average yield was about 5% in the early 1980s. There was a bird-
in-the-hand argument that placed a high priority on cash receipts now, with a much lesser
emphasis on growth in corporate equity. This is much less true today. About 80% of the
stocks in the SP 500 index paid a dividend in 1999. Of the top I5 performers for die year,
however, 14 paid no dividend. Many highly successful, and popular, companies pay no
dividends and have no plans to do so: Microsoft, Cisco Systems, AOL, MCI WorldCom,
and Oracle are ready examples. It is also true that the average dividend yield has been
falling for two decades. Growth of the Internet and changing attitudes toward technology
are influencing the investment process in many ways, perhaps including our attitude toward
dividend checks.
Most investment research deals with predicting future corporate earnings.
Investment Analysis & Portfolio Management (FIN630)
The Tax Factor:
Taxes are supposedly "one of the two certainties in life. Investors also know that, in
addition to being a certainty, the tax code is complicated and not all investments are taxed
equally. For this reason, municipal bonds (paying tax-free interest) can sell with a lower
expected rate of return than a taxable corporate bond of equal risk, and some investors will
favor growth stocks (with tax deferral of appreciation) over income stocks (with immediate
taxation of dividends).
EIC Analysis:
The traditional approach to security selection involves EIC analysis, which stands for
economy, industry, and company. The analyst first considers conditions in the overall
economy, and then determines which industries are most attractive in light of the economic
conditions, and finally identifies the most attractive companies within the attractive
1. Economic Analysis:
Every issue of common stock has a common characteristic: susceptibility to market risk.
This tendency of stocks as a group means that they move together as economic conditions
improve or deteriorate.
Stock prices react favorably to earnings growth, low inflation, increasing gross national
product, a better balance of trade, and other positive macroeconomic news. Signs that
inflation is picking up, that unemployment is rising, or that earnings estimates are being
revised downward will and to depress stock prices.
In fact, this relationship is sufficiently reliable that the Standard & Poor's 500 stock index (a
popular market indicator) is one of the U.S. Commerce department's leading indicators of
the U.S. economy. The stock market will anticipate a recession or economic boom well in
advance of signs visible to the average citizen. Research by the Federal Reserve Bank of
New York found that the slope of the yield curve is the best predictor of economic growth
more than three months out. A positive slope is good, while a negative slope predicts a
To the investor, the implications of market risk should be obvious. When the economy
appears to be moving into a recession, stocks as a group are going to be c hurt. All
companies, whether they are high performing or lackluster, will suffer the effects of the
recession. When the economy is surging ahead, most stocks will follow suit. During 1999,
for instance, the overall stock market advanced sharply, and few investors lost money in
stocks. This positive performance was not because the year's crop of CEOs was
exceptionally good, but principally because of a strong economy. The shared market risk
characteristic tended to pull up the price of most stocks, even those with substandard
2. Industry Analysis:
While all stocks carry market risk and are hurt by a recession, they will not suffer to the
same degree. As pointed out earlier, a defensive stock (like a retail food chain) will be hurt
less than a cyclical stock (like a steel company). Once the economy bottoms out, the
cyclical stocks are precisely the place to be, because their sales and profits are closely tied
Investment Analysis & Portfolio Management (FIN630)
to overall economic activity- Determining which industries are likely to fare best in the
anticipated economic environment is the essence of industry analysis.
A standard approach to industry analysis is the competitive strategy analysis framework
proposed by Michael Porter in 1980. Threats of new entrants measure the barriers to entry
into the industry and the expected reaction of existing competitors to new competitors. In
some industries a new company would have great difficulty in competing successfully.
Consider the difficulty a new automobile manufacturer would have going up against Ford,
General Motors, and Daimler Chrysler. The last such effort, by De Lorean, was an ex-
pensive failure. In other industries, such as financial planning, entry is easier. New
businesses simply hang out their shingle, put an ad in the yellow pages, do some local
advertising, and begin to build a customer base while politics is not exactly an industry; it is
a good example of how the reaction of existing competitors can be important. Most states
have their own set of "existing competitors" for public office. A newcomer is often looked
upon with great suspicion. Consider the negative reaction by both Democrats and
Republicans to the Ross Perot presidential bid.
The rivalry among existing competitors, if intense, will slow industry growth and tend to
level the playing field among the competitors. Profit margins can be depressed as firms seek
to gain market share at the expense of current earnings. Much greater opportunity for
product differentiation and enhanced profits exists in industries where the rivalry is modest
or even friendly. Heavy competition is good for the consumer, but not necessarily good for
the investor in the firm. Consider the frequent fare price wars in the airline industry. In this
industry the competition for customers is intense. When one airline cuts prices, the other
airlines are obligated to do the same to keep customers.
A substantial threat of substitutes means that firms are not free to raise their prices as they
might wish. Too high a price means that buyers will simply choose an alternate product
providing essentially the same Junction- Consider, for instance, video games such as Sega
and Nintendo, These brands are direct competitors. If Sega unilaterally raises its prices, new
video game customers will be favorably inclined toward Nintendo. A potential investor is
concerned when a firm faces a high degree of this risk of product substitution. It puts a
damper on future earnings growth.
The buyer's bargaining power is strong when a buyer accounts for a substantial percentage
of a seller's sales. In such a case, profit margins tend to be low. The seller really cannot
afford to lose the customer and might be forced to make concessions in order to keep the
business. Consider the case of a ship-building company for whom the U.S. Navy is the
principal customer. The firm may only produce two or three ships per year, and the loss of a
navy contract would be disastrous- On the other hand, when a business has many small
customers, as in department stores, the loss of any particular customer is not cause for
concern. Customers don't have much bargaining power at JC Penney (JCP, NYSE}, but
they do at Boeing (BA, NYSE).
This industry factor need not be limited to a capital-intensive industry like ship building
Consider the need for consultants in a retail computer sales store. While a need will
probably always exist for computer technicians to help people with their system problems,
consumers in general are more sophisticated about personal computers than they were must
five years ago. They are better informed and more willing to make their own decisions
about their hardware and software needs. In essence, they have more power when they
approach the sales staff.
A firm facing powerful supplier groups encounters more difficulty negotiating favorable
contract terms. The firm needs the products supplied and has little control over their costs. If
Investment Analysis & Portfolio Management (FIN630)
the firm is unable to raise the price of its finished goods because of the presence of
substitutes or powerful buyer groups, its profit margin and earnings are tenuous. The
potential investor views the presence of powerful supplier groups negatively.
By considering each of these five elements of industry structure, a financial analyst will
develop a better estimate of how the industry is likely to fare in the forthcoming economic
environment. Having determined which industries currently seem attractive, the next step is
recommending specific firms within the industry.
Porter's competitive strategy analysis helps evaluate industry prospects.
3. Company:
Most of the rest of this chapter deals with the last part of EIC analysis: choosing specific
companies. Some people refer to this activity as stock picking, or, more formally, as
security analysis- Many different schools of thought offer methods on how to go about this
task. We now review this topic in some detail.
The two factions within the fundamental analysts' camp are the value investors and the
growth investors. These terms became popular in the 1980s and are now a standard part of
the investment lexicon.
The Value Approach to Investing:
A value investor believes that securities should be purchased only when the underlying
fundamentals (macroeconomic information, industry news, and a firm's financial
statements) justify the purchase, even when these fundamentals seem to be inconsistent with
the belief of the overall marketplace. Value investors consider financial statement
information such as the price to book ratio, return on assets, and return on equity.7 Value
players evaluate earning growth within a particular industry, many of which have low
growth rates. They attempt to spot those companies that have above-average earnings
growth in that industry. The value investor is willing to wait to reap the rewards from his or
her research-Value investors often seek out new corporate ventures with sound ideas and
experienced management, but they prefer not to chase pie-in-the-sky ideas or subscribe to
the bandwagon approach to investing. They don't mind sitting out the next dance if they
view it as a passing fad with no long-term prospects.
Value investors also believe in a regression to the mean. They think securities have long-
term expected returns that are consistent with the level of risk associated with them.
Suppose you live in an area where the average annual temperature is 59°. If the current
temperature were 75°, in the absence of any other information you would predict that
temperatures will fall over the next few months. Similarly, if it is currently 25° outside, your
long-range forecast should be for rising temperatures. Value investors subscribe to this logic
with stock prices and the associated returns- When a stack's returns have been below their
expected long-term level, the stock is likely to make up the difference in the future, rising
more than other securities Conversely, returns that have been unusually good probably will
not persist; instead, future re- A turns are likely to be depressed until the long-term average
is back in line with the associated level of risk.
Stated another way, a security may perform unusually well for a while, but this over-
performance will likely be subdued in subsequent periods when the returns are less than
expected. The trick is to find securities mat are currently below their long run trend and buy
Investment Analysis & Portfolio Management (FIN630)
them. Similarly, a value investor would consider selling securities that are performing above
their long-run expected rate of return. Figure illustrates this concept.
A study in the Financial Analysts Journal looked at the performance of 29 companies
identified in the best-selling book In Search of Excellence: Lessons from America's Best-
Run Companies, by Thomas Peters and Robert Waterman. Using the same financial ratios
as in the book, the author of the FAJ article found that the financial health of these firms
began to decline once the book identified them. At the same time, a control group of
companies that ranked low according to the Peters and Waterman criteria showed
substantial improvement over the subsequent five years-These results are consistent with the
notion of security performance reverting to some long-term mean value.
Value investors are willing to wait.
The Growth Approach to Investing:
In the investment community, the term growth is used as both an investment objective and
as an investment style. In this latter case, a growth investor seeks steadily growing
companies. The two factions within the growth investor camp are the information trader and
the true growth investor.
The Information Trader:
The information trader is in a hurry and believes that profits are to be made by processing
the news better than the next person. The information trader also believes that information
differentials characterize the marketplace. That is, some people have access to better quality
information than others, and some people are better at processing the available information.
By using more complete information and using it more effectively than the next person, an
information trader believes that above-average profits are possible.11 As an example, one of
Wall Street's most widely watched statistics is the weekly unemployment figure, released
every Friday morning at 8:30 EST. When the actual statistic deviates from what was
expected, the bond market reacts instantly because of the implications for inflationary
pressure on the economy. As an example, the keynote speaker for the annual Chicago Board
of Trade/Chicago Board Options Exchange Risk Management conference is often at the
podium when the unemployment data are released. The audience of portfolio managers and
risk managers is extremely interested in "the number," and at about 8:32 an exchange
employee hands the speaker a note to read containing the just-released statistic. If the
number is a surprise, some people scurry out of the conference in their rush to get to a
Information traders are in a hurry; they believe information differentials in the
marketplace can be profitably exploited.
The True Growth Investor:
The true growth trader is more willing to wait than the information trader, but shares the
belief that good investment managers can earn above-average returns for their clients. A
growth trader often focuses on companies that are currently in favor in the financial
community. The proliferation of home computers and information superhighway
developments led to significant price rises for firms like Intel, Microsoft, and Gateway
(GTW, NYSE). Sometimes the notion of whether the existing level of earnings is sufficient
to justify a particularly high stock price is unclear. Growth traders are willing to pay more
than might seem reasonable because they like the stack's future prospects; they are buying
future earnings that may or may not develop.
Investment Analysis & Portfolio Management (FIN630)
How Price Relates to Value:
Categorizing an investment approach as either growth or value oriented is not really a new
idea. The book that holds the distinction as all-time best seller in the investment business is
probably Security Analysis by Benjamin Graham and David Dodd. In this book, the authors
describe a precursor to the present-day value-versus-growth dichotomy called historical
optimism and growth selectivity. Graham and Dodd state:
"The principle of selectivity was an old and obvious guidepost in Wall Street. It was no
more than the truism that some companies are better than others, and hence some stocks
will fare better than others in the market- In the 1920s, however, selectivity took on a new
character by reason of the overshadowing placed on expected future growth as the prime
criterion of an attractive investment."
A remarkable thing about investment theory in the early days of the market is the minor role
that price played, Graham and Dodd summarize the attitude in one statement: "A stock with
good long-term prospects is always a good investment" As the stock market soared in the
late 1920s, the primary determinant of value, in the minds of many people at least, was its
growth potential. A stock that experienced high earnings growth was a quality stock, and no
external factor could change that, not even a stock price run-up to exorbitant levels.
The Great Crash of 1929 and resulting depression changed a lot of minds about the source
of value. Firms whose equity was reasonably backed by assets and a popular product fared
far better than firms peddling fanciful visions of what might some-day be.
Since the Depression, the economy has traversed both recessions and economic expansions.
The stock market severely penalizes growth stocks without a firm foundation during the
recessions, but falls in love with them during boom times. Most of today's investment
managers look favorably upon a history of earnings and dividend growth, but also look at
the firm's financial statements to see if future growth can reasonably be expected. Unlike
their predecessors, though, contemporary analysts understand that value is inextricably
intertwined with price, and that the most efficient and productive company in the world is a
poor investment if the stock price is too high.
The modern perspective: Value is inextricably intertwined with price.
The most efficient and productive company in the world is a poor investment if the stock
price is too high.
Value Stocks and Growth Stocks:
How to Tell by Looking:
No precise definition of value stock or growth stock will satisfy everyone. However, a
firm's price to book ratio and its price-earnings ratio play important roles in this segregation.
Morningstar Mutual Funds is a popular source of information on public investment
portfolios called mutual funds the principal topic of Chapter Nineteen. This service sorts
mutual funds into three groups; value, blend, and growth. The placement criteria are the
fund's relative price to book and PE ratios. For each fund, its PE is divided by the market
average to produce a relative PE; an average fund has a relative PE of 1.0. The same thing is
done with the price to book ratio. Adding these two values gives the magic number. An
average fund, by definition, has a rating of 2.00. If a fund's magic number is below 1.75,
Morningstar classifies the fund as a value fund. Ratings over 2-25 are growth funds, with
Investment Analysis & Portfolio Management (FIN630)
those in between classified as blend funds. While the Morningstar system is not definitive,
some variant of it is probably used by many value-oriented investors. Morningstar explains
their rating rationale as follows:
We have opted to combine both the price-earnings ratio (PE) and the price to book ratio for
each of the funds, thus emphasizing relative, rather than absolute, numbers. After all a PE of
15 can be cheap in one market, but dear in another; what's really important is knowing how
that compares with other funds. By combining each fund's relative PE and price to book
ratios, we arrive at a multidimensional picture of where each stock fund stands on the
value/growth spectrum.
Given the importance of these two ratios in determining the value or growth style, we now
look at these statistics in detail.
The Price to Book Ratio:
Book value per share is an accounting concept that measures what shareholders would
receive if all the firm's liabilities were paid and all its assets could be sold at their balance
sheet value. The term is synonymous with equity per share or net asset value.
Share price normally is not equal book value. Depreciation methods, a firm's method of
allowing for uncollectible debts, the presence of goodwill, and a host of other things can
distort book value. The market value of a building usually appreciates, for instance, while
the owner often can depreciate it. An apartment complex may have a book value of
$250,000, but a market value of $1 million. A value- 0 oriented investor would be favorably
inclined toward a stock whose market price was below its book value. It might seem curious
that this would ever be the case, but it frequently occurs. Note in the guidelines from
Graham and Dodd the criterion that price be less than two-thirds of book value. Of me
securities in the Compustat data base, nearly one-third traded below book value at some
time.13 In October 1999, 471 of the 6,135 stocks covered in the expanded Value Line
Investment Survey traded below book value.
Economic obsolescence is another reason market value and book value may diverge.
Consider the personal computer market. Someone might begin to depreciate a new, $2,700
personal computer over a three-year period. After two years, its book value will be $900.
The way technology is moving in this industry, after two years the computer may well have
virtually no resale value. If this is the case, its book value overstates the actual market value.
Table 7-1 shows stocks selling at less than half their book value. The mere fact that a stock
sells below book value is insufficient evidence that a value investor would recommend it.
Such a stock is likely, however, to attract the value investor's attention. Additional research
is necessary to discover whether any good reasons explain why the stock is selling at such a
seemingly low price.
Another problem is characteristic of the price to book value ratio. It stems from the
changing nature of life in the 1990s and the increasingly intangible aspects of some
investment value. Rich Karlgaard, editor of Forbes ASAP, states:
"As an index, book value is dead as a doornail, an artifact of the Industrial Age. We live in
the Information Age, of course, though remarkably few people have come to terms with that
fact. Failure to understand the declining relevance of book value and the tangible assets
that form the ratio's numerator is proof of this. Human intelligence and intellectual
resources are now any company's most valuable assets."
Investment Analysis & Portfolio Management (FIN630)
The Price-Earnings Ratio:
The price-earnings ratio (PE) is one of the most widely followed statistics about a common
stock. It is computed by dividing the current stock price by the firm's earnings per share.
There are two versions of the PE ratio. A trailing PE is the current market price divided by
the company's reported earnings per share from the past year. The stock market is much
more concerned about what' will happen in the future than what happened in the past, so
some analysts prefer to compute the PE based on expected earnings rather than on actual,
realized earnings. Although a PE calculated this way has no particular name, it is indicated
by statements such as the stock sells at 15 times estimated earnings." This description
means the current market price divided by the earnings estimate for the next year equals 15.
Growth stocks tend to have PE ratios higher than average. Corporate management generally
likes a firm's PE to be high. A higher PE ratio allows management to raise capital more
easily without having to sell a large number of shares.
A number of academic studies provide evidence supporting the theory that low PE stocks
are attractive. The most important of-these is probably a now-classic study by Sanjoy Basu,
finding above-average performance with low PE stocks.
In general, a low price-earnings ratio implies greater risk. Higher leverage means higher
risk, and higher leverage tends to produce a low PE, because leverage increases the
volatility in a firm's earnings, regardless of whether the leverage comes from the fixed costs
associated with capital investment or from interest payments on debt. Increased uncertainty
in earnings may depress the stock price, and hence produce a lower PE ratio. You should
not, however, automatically assume that a low PE stock is highly leveraged.
Stock Market investors are more concerned with future than with the past.
Differences between Industries:
Neither the price-earnings ratio nor the price to book ratio is a stand-alone statistic.
Important industry differences need to be considered. A firm whose primary asset is
brainpower (such as a software company) has fewer capital assets than a smokestack
company (like a steel mill). The software industry would normally have a higher price to
book ratio than the steel industry.
For this reason, relative ratios are commonly computed for both the PE and the price to
book statistics. This calculation provides the ratio of the firm's statistic to the industry
average statistic.
Growth Rates:
Dividend and earnings growth rates are important to both value and growth investors, but
especially to the growth investor. The estimation of further growth rates is an art rather than
a science. Many models that attempt to calculate a stock's worth are quite sensitive to the
growth rate used; consequently, an analyst needs to be careful in preparing this statistic.
Corporations like to establish a predictable dividend payout pattern, normally including an
annual increase in the dividend payment- Some people feel that predictable dividends
reduce the uncertainty surrounding the future cash flows to which shareholders are entitled.
Investment Analysis & Portfolio Management (FIN630)
PepsiCo (PEP, NYSE'), a familiar soft-drink company, is also the parent corporation for
Frito-Lay and Tropicana Products. Table 7-4 shows historical dividend and earnings
information that will be used in the examples to follow. In its 1994 annual report, the
company states that its current payout target is approximately one-third of the prior year's
income from continuing operations. Since 1988, the average annual payout ratio is 33.7
Of the two common ways of determining growth rates, the first method uses the company's
past history of dividends. The other method uses the firm's earnings retention rate coupled
with the firm's return on equity. We will look at each of these methods.
Calculate dividend growth rates using the geometric mean rather than the arithmetic
The Dividend Discount Model:
Stock potentially has an infinite life. If the stack's dividends increase by a known growth
rate each year, it is valued as a growing perpetuity. Standard present value tables cannot be
used for a growing perpetuity, but fortunately a mathematical identity makes present value
determinations a simple task. Equation (7-3) shows a relationship known as the dividend
discount model (DDM), also called Gordon's growth model.
D0 ( I + g )
po =
=    1
In this equation, Do is the current dividend; D1 is the dividend to be paid next year; g is the
expected dividend growth rate; and k is the discount factor according to the riskiness of the
stock.20 the model assumes that the dividend stream is perpetual and that the long-term
growth rate is constant.
The DDM is sometimes used to get an idea of how risky the market thinks a particular stock
is at the moment. In equation (7-3), we can observe the current stock price and the current
dividend. We can estimate the dividend growth rate. The one variable we cannot observe is
the discount rate k. This value, however, can be calculated if we know the other variables in
the equation. The variable k is sometimes called the shareholders' required rate of return.
D0 ( I + g )
Note that the expression for k, the shareholders' required rate of return, is the sum of two
components: the expected dividend yield on the stock and the expected growth rate. If the
dividend yield is a constant, g represents the anticipated capital appreciation in the stock
The shareholders' required rate of return is the sum of the expected sum of the expected
dividend yield and the expected stock price appreciation.
The Importance of Hitting the Earnings Estimate:
Corporate CFOs know the importance of hitting Wall Street's earnings estimates. Analysts
are in frequent contact with the company, know its operations well, and usually base their
Investment Analysis & Portfolio Management (FIN630)
estimates on sound information- The market often penalizes a company's stock substantially
when the earnings report is disappointing. This is especially true when the required rate of
return and the estimated growth rate are high.
Suppose a company has a dividend payout ratio of 50%, analysts expect earnings of $1.10
in the coming year, the consensus median dividend growth rate is 15%, and the current
stock price is $27'/2, According to the DDM, the shareholders' required rate of return is
R =  1 + g=
+ 0.15 = 17%
$ 27.50
Suppose also that the expected earnings in the upcoming quarter are $0.29, but the company
reports only $0.27- This is a negative surprise, meaning that actual earnings were below
expectations. This might cause the analyst to reduce the estimate of future growth and,
because of the uncertainty, to boost the discount rate. Perhaps the analyst adjusts the growth
rate to 13% and the required rate of return to 18%. If future estimates for the year remain on
track, the anticipated earnings per share will be only $1.08. How does this affect the stock
price? You might first think that being off by two cents is not a big deal, but as the
following equation shows, the stock price is hit hard by this news. It falls by nearly 61%.
D2   D2 (1.g ) /(k - g )
P0 =
(1 + k )  (1 + k )  2
(1 + k )  2
These results indicate why the whisper number is important and why CFOs do not like to
feed incomplete information to the analysts who follow their companies.
The Multistage DDM:
Small firms often show initially high levels of growth that cannot reasonably be expected to
persist. In such a case, it is appropriate to use two (or more) growth rates. Suppose a firm
currently pays a $1 dividend that is expected to grow by 20 percent for the net two years,
and then grow by 5 percent annually thereafter. A growth rate that can reasonably be
expected to persist is called a customable growth rate. What is the most an investor can pay
for this stock if the required rate of return is 17%? To find out, solve for pq in the following
The term for the dividend in year three is discounted only twice because the formula for tile
growing perpetuity is based on next year's dividend. Therefore, the numerator is discounted
only twice, not three times.
Caveats about the DDM:
The dividend discount model is a useful tool in security analysis. It is not, however, a
method to predict the future. As with most analytical techniques, the DDM helps an analyst
make a better decision, but it does not make the decision. Users should understand the
shortcomings of the DDM.
First, the DDM requires that g. If the dividend growth rate is greater than or equal to the
shareholders' required rate of return, the equation cannot be used. Dividing by zero or by a
negative number obviously gives an absurd result. Also, the results are sensitive to the
estimate of g. Minor differences in the growth rate selected can materially affect the results.
As shown, there are numerous ways of estimating g.
Investment Analysis & Portfolio Management (FIN630)
Another consideration is the assumption that the dividend yield remains constant. A change
in dividend policy can affect the apparent growth rate. A change in the growth rate will
produce different values from the model. Finally, the model implicitly assumes the long-
term ROE is constant. The DDM does not require that every year's growth be identical.
Rather, it requires that the long-term growth rate be constant in other words, a long-term
trend about which the annual values fluctuate.
False Growth:
Historical data must always be scrutinized carefully when used to determine a growth rate.
Remember that in the investing business the future is much more important than the past
Sometimes accounting changes, mergers, or other unusual events can muddy the water for
the financial analyst. One such situation occurs when one firm acquires another firm
through a stock swap.
Some shareholders may-decide not to tender their shares, but most are likely to do so. In
any event, after the merger, when the accounting records of the two firms are consolidated,
we see that A's earnings per share have risen. This appreciation is due solely to the merger
and is a phenomenon called false growth. False growth occurs anytime a firm acquires
another firm with a PE ratio lower than its own. The stock price does not matter; the PE
ratio determines the outcome.
When using historical data to estimate a stack's dividend growth rate, an analyst should be
alert for instances of false growth contained in the data- If acquisitions occurred during the
period, the analyst may need to consider that fact in arriving at an estimate of the growth
False Growth occurs anytime a firm acquires another firm with a lower price-earnings
A Firm's Cash Flow:
Earnings are important to individual and institutional investors alike. Increasing earnings
are a good sign, and investors like to see growth in this statistic. The trained financial
analyst knows, however, that taking stated earnings at face value can be a mistake. For this
reason, security analysts pay particularly close attention to cash flow, the movement of
funds into and out of the firm. The Wall Street Journal once reported in an editorial.
"A lot of executives apparently believe that if they can figure out a way to boost reported
earnings, their stock prices will go up even if the higher earnings do not represent: any
underlying economic change. In other words, the executives think they are smart and the
market is dumb. The market is smart. Apparently the dumb one is the corporate executive
caught up in the earnings-per-share mystique."
The formal definition of cash flow is net: income after taxes plus non-cash expenses. The
most important non-cash expense is depreciation. Depreciation is a tax-deductible business
expense, but no check is written for it. No funds leave the firm to pay for depreciation
expense; it is non-cash. Some financial analysts calculate a variation known as free cash
flow, often defined as net income after taxes plus non-cash expenses minus required capital
expenditures. This concept recognizes that even though the checking account contains
certain funds, they are not necessarily available for discretionary use. If a firm must replace
a fleet of trucks next month, the money to do so is encumbered and should not be viewed as
profit to be distributed or invested in new ventures.
Investment Analysis & Portfolio Management (FIN630)
Some evidence indicates that market valuation is more a function of corporate cash flow
than corporate earnings. A famous study by Kaplan and Roll examined market reaction to
changes in depreciation-methods.24 Switching from straight-line to an accelerated method
will decrease earnings but increase cash flow; switching from an accelerated method to
straight-line will do just the opposite. This study found that the market reacts negatively to
firms that increase earnings at the expense of cash flow, and vice versa.
Statement of Financial Accounting Standard number 95 requires a firm to separate cash
flows from operations, financing activities, and investment activities on its statement of
cash flows. However, these numbers hold more than initially meets the eye. Cash flow from
operations is the firm's lifeblood. If this statistic is weak, it calls into question the firm's
health or even its ability to survive. In this example, cash flow from operations steadily
declined over the four years, from $88 million in 1996 to $35 million in 1999. In the past
two years the firm's operating cash flow was insufficient to cover the dividends paid. In
fact, equipment sales helped provide the funds necessary for the dividend checks.
Similarly, the firm borrowed $20 million in 1997. It is not clear from this statement whether
the firm used those funds productively. While net income was up the following year,
operating cash flow was down. Accounts receivable and inventory rose substantially;
analysts know these changes may be a bad sign. Accounts receivable can be increased by
easing credit terms, and rising inventory levels may indicate that customers are not buying
the firm's products. Perhaps the firm used long-term debt to finance the acquisition of
current assets.
The cash flow from operations figures are widely used as a check on a firm's earnings
quality. Rising earnings associated with declining operating cash flow means the earnings
are of low quality- A security analyst will temper estimates of future dividend or earnings
growth if the earnings are low quality. For this reason, the statement of cash flows is a
useful analytical tool.
Cash Flow from operations is a firm's lifeblood.
Small-Cap, Mid-Cap, and Large-Cap Stocks:
Another consideration in fundamental stock analysis relates to the size of the firm.
Currently, firms are categorized as small-cap, mid-cap, or large-cap, cap being short for
capitalization. Although no precise definition has been stated for these terms most analysts
consider a firm with capitalization less than $500 million to be a small cap stock' Lipper
Analytical Services defines a mid-cap ·firm as one with capitalization between $800 million
and $2 billion. Others extend the mid-cap range up to $6 billion.
Substantial financial research finds unusually good performance from small-cap stocks; this
phenomenon is sometimes called the small firm effect. Because of this effect, some analysts
devote particular attention to small-cap firms.
Mid-cap firms showed average earnings growth of 15 percent during 1993, compared with
12 percent for large-cap firms. Some analysts believe the mid-caps offer particularly fertile
hunting ground for the stock picker. Small-cap stocks tend to be more volatile, scaring away
the more risk-averse investors. Index funds and large institutional portfolios own large-cap
stocks. The likelihood of "striking oil" from superior analysis of these large-cap stocks is
remote, because too many other people are -trying to do the same thing.
Investment Analysis & Portfolio Management (FIN630)
A study by Prudential Securities found that since 1926 mid-cap stocks returned 0-4% less
than small-cap stocks but were much less volatile. Many investors find that the risk-return
package historically offered by the mid-caps is superior to that offered by either the small-
caps or the large-caps.
Future study on relative performance by market capitalization is going to be complicated by
the definitional problem. We have traditionally defined market capitalization as the current
share price multiplied by the number of outstanding shares. This definition, however, can
pose a dilemma for the thoughtful security analyst. Y Suppose you are hired as a large-
capitalization common stock manager. Your job is to build and manage a portfolio of large-
cap stocks. How should you view a company like Yahoo! (YHOO, NASDAQ)? In February
2000 the company's stock price of about $156 gave it a capitalization of $82-2 billion. The
price-earnings ratio, however, was over 1,600. Suppose its PE were "only" 100, a figure that
is still well above the market average. This would drop the capitalization into the mid-cap
range. Overlay this with the fact that the company has only about 700 employees, and you
might be hard pressed to call Yahoo! a large-cap firm in the historical sense.
Cooking the Books:
Ail publicly traded firms in the United States must have their financial statements audited to
ensure they fairly present the company's financial position. Still, every year there is at least
one story of accounting fraud at a major firm. In 1992, for instance, the women's clothing
firm Leslie Fay admitted it had manipulated inventory numbers to produce earnings of
$23.9 million when, in fact, it lost $13.7 million. The news cut the stock price in half and
led to bankruptcy two months later. In recent years there have been accounting bombshells
at other firms including Comptronix Corp., Cascade International, Maxwell Communication
Corp., Chambers Development, MiniScribe, Cendant, and numerous others. Unfortunately,
there is not much the analyst can do about fraud. As Patricia McConnell, a respected analyst
at Bear Steams says, "A well-perpetrated fraud is impossible to detect." The important thing
to remember is that the marketplace is full of many types of risk, and fraud is one of them.
Fundamental analysts believe securities are priced according to economic data; technical
analysts believe supply and demand factors are most important. Most investment research
deals with predicting future earnings. A value investor believes a security should only be
purchased when the underlying fundamentals justify the purchase. They believe in a
regression to the mean of security returns.
A growth investor seeks rapidly growing companies. Value investors place a great deal of
importance on a stock's price to book ratio and its price-earnings ratio. A future earning
growth rate is unobservable. Most analysts use several methods to estimate this statistic to
determine a likely range for the value rather than a single number.
The dividend discount model (also called Gordon's growth model) can be used to value
stock as a growing perpetuity. The shareholders' required rate of return is an input to the
model. False growth in earnings occurs any time a firm acquires another firm with a lower
price-earning ratio. Cash flow from operations is a firm's lifeblood. This value is often used
as a check on the quality of a firm's earnings.
The evidence shows that small-cap stocks outperform mid- or large-cap stocks. Some
analysts believe that mid-cap stocks are particularly fertile hunting ground for the security
analyst because they receive less attention from the marketplace. Spectacular gains are
occasionally associated with initial public offerings (IPO).these gains usually disappear
within the first year or two of the new stock's life.