

Investment
Analysis & Portfolio Management
(FIN630)
VU
Lesson
# 11
FUNDAMENTAL
ANALYSIS
VALUATION
PHILOSOPHIES:
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
riskaverse. 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 unbonds have higher
yields to maturity than
U.S.
Treasury
bonds, and why some shares of
stock sell for more
than others.
The
Time Value of
Money:
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:
Most
investment research deals
with predicting future
corporate earnings.
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 taxfree 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:
4.
Economic
Analysis
5.
Industry
Analysis
6.
Company
VALUE
VS GROWTH INVESTING:
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
The
Growth Approach to
Investing
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The
Information Trader:
Information
traders are in a hurry; they
believe information differentials in
the
marketplace
can be profitably exploited.
The
True Growth
Investor
How
Price Relates to
Value:
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
The
Price to Book
Ratio
The
PriceEarnings Ratio
Differences
between Industries
Neither
the priceearnings ratio nor
the price to book ratio is a
standalone 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.
SOME
ANALYTICAL FACTORS:
Growth
Rates:
Calculate
dividend growth rates using the
geometric mean rather than
the arithmetic mean.
The
Dividend Discount
Model:
D0 ( I + g )
D
po =
= 1
kg
kg
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 longterm
growth
rate is constant.
D0 ( I + g )
k=
+g
p0
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
price.
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Investment
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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
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
17%:
D
0.5($1.10)
R = 1
+ g=
+ 0.15 = 17%
p0
$
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 )
D1
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 equation in
the
following
equation.
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
78
Investment
Analysis & Portfolio Management
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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.
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
longterm growth rate be constant in
other words, a
longterm
trend
about which the annual
values fluctuate.
SmallCap,
MidCap, and LargeCap
Stocks:
Another
consideration in fundamental stock
analysis relates to the size of the
firm.
Currently,
firms are categorized as
smallcap, midcap, or largecap,
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 midcap ·firm as one
with capitalization between $800
million
and $2
billion. Others extend the
midcap range up to $6 billion.
Substantial
financial research finds
unusually good performance from
smallcap stocks;
this
phenomenon
is sometimes called the small
firm effect. Because of this
effect, some analysts
devote
particular attention to smallcap
firms.
Midcap
firms showed average
earnings growth of 15 percent
during 1993, compared
with
12
percent for largecap firms.
Some analysts believe the
midcaps offer particularly
fertile
hunting
ground for the stock
picker. Smallcap stocks tend to be
more volatile, scaring
away
the
more riskaverse investors.
Index funds and large
institutional portfolios own
largecap
stocks.
The likelihood of "striking
oil" from superior analysis
of these largecap stocks is
remote,
because too many other
people are trying to do the
same thing.
A
study by Prudential Securities
found that since 1926 midcap stocks
returned 04% less
than
smallcap stocks but were
much less volatile. Many
investors find that the
riskreturn
package
historically offered by the
midcaps is superior to that
offered by either the
small
caps
or the largecaps.
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.
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
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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
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 wellperpetrated 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 priceearnings
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
priceearning
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
smallcap stocks outperform mid or
largecap stocks. Some
analysts
believe that midcap 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.
Intrinsic
Value and Market
Price:
After
making careful estimates of
the expected stream of dividends and the
required rate of
return
for a common stock, the
value of the stock today is
estimated using the DDM.
The
value
is often called intrinsic
value of the stock, which we
denote as Vo. Note that
intrinsic
value
simply means an estimated value or a
formula value. This is the
end objective of a
discounted
cash flow technique such as
the DDM.
If Vo > Po, the asset is
undervalued and should be purchased or
held if already
owned.
If Vo < Po, the asset is
overvalued and should be avoided,
sold if held, or possibly
sold short.
If Vo = Po, this implies an
equilibrium in that the
asset is correctly
valued.
Security
analysis has traditionally
been thought of as the
search for undervalued
or
overvalued
stocks. To do this, one can calculate the
estimated or intrinsic value of the
stock
or compare
this value to the current
market price if the stock.
Most investors believe
that
stocks
are not always priced at
their intrinsic values,
thereby leading to buy and
sell
opportunities.
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The
P/E Ratio or Earnings
Multiplier Approach:
The
P/E ratio or earnings multiplier approach
is the bestknown and most
widely used
valuation
technique. Analyst are more
comfortable talking about
earnings per share (EPS)
and P/E
ratios, and this is how
their reports are often
worded. Talk about EPS and
P/Es
ratios
is the typical language of
Wall Street. Without question,
the P/E ratio is one of
the
most
widely mentioned and discussed
variables pertaining to a common
stock, and will
almost
always appear in any report
from an analyst or an investment
advisory service. For
this
reason, we develop the P/E ratio in
detail.
What
is the P/E Ratio?
As a
definition, the P/E ratio is
simply the number of times
investors value earnings
as
expressed
in the stock price. For
example, a stock priced at $100,
With most recent
12month
earnings
of $5, is said to selling for a
multiple of 20, In contrast, if
another stock had earnings
of
$2.50
and was selling for $100,
investors would be valuing
the stock at 40 times earnings,
thus,
the
P/E ratio as reported daily
in such sources as The Wall
Street Journal is simply
an identity
calculated
bydividing the current market price of
the stock by the latest 12month
earnings. As
such, it
tells investors the price being
paid for each $1 ofmost
recent 12month earnings.
Determinants
of P/E Ratio:
What
variables affect the P/E
ratio? To shed some light on
this question, the P/E ratio
can be
derived
from the dividend discount
model, which, as we have seen,
isthe foundation of
valuation
for
common stocks. Note, however; that this process
directly
applies only for the
case of
constant
growth.
If a multiple period growth model is
applicable to the' stock being
considered, a different
formulation
from the one presented
here will be needed. In fact,
using the P/E ratio
for multiple
growth
rate companies can be
misleading and should be done
with care.
Understanding
the P/E Ratio:
Most
investors intuitively realize
that the P/E ratio should be
higher for companies
whose
earnings
are expected to grow
rapidly. However, how much
higher is not an easy question
to
answer?
The market will assess the
degree of risk involved in
the expected future growth
of
earnings,
if the higher growth rate
carries a high level of
risk, the P/E ratio will be
affected
accordingly.
Furthermore, the high
growth rate may be attributable to
several different factors,
some
of which are more desirable
than others. For example, rapid
growth in unit sales owing
to
strong
demands for a firm's products is
preferable to favorable tax situations,
which may
change,
or liberal accounting procedures,
which one day may
cause reversal in the
firm's
situation.
P/E
ratios reflect investors' expectations about
the growth potential of a
stock and
the
risk involved. These two
factors can offset each
other. Other things being
equal, the
greater
the risk of a stock, the
lower the P/E ratio;
however, growth prospects
may offset the
risk
and
lead to a higher P/E ratio.
The Internet companies that
were so popular in the late
1990s
were
clearly very risky, but
investors valued their
potential very highly, and
were willing to
pay
very high prices for
these companies.
The
P/E ratio reflects investor
optimism and pessimism. It is related to
the required rate of
return.
As the required rate of
return increases, other
things being equal, the P/E
ratio
decreases.
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The
required rate of return, in turn, is
related to interest rates, which
are the required
returns
on bonds. As
interest rates increase,
required rates of return on
all securities, including stocks,
also
generally increase. As interest
rates increase, bonds become more
attractive compared to
stocks
on a current return basis.
Based on these relationships, an inverse
relationship between
P/E
ratios and interest ratesis to be
expected. As interest rates rise
(decline), other things
being
equal,
P/E ratios should decline
(rise).
Which
Approach to Use?
We
have described the two
most often used approaches
in fundamental analysis,
discounted
cashflow
techniques and relative valuation
techniques. Which should be
used?
In
theory, the discounted cashflow
approach is a correct, logical,
and sound position.
Conceptually,
the
best estimate of the current
value of a company's common stock is the
present value of the
(estimated)
cash flows to be generated by
that company. However, some
analysts and
investors
feel
that this model is unrealistic. After
all; they argue, with
regard to the DDM, no one
can
forecast
dividends into the distant future
with very much accuracy.
Technically, the model calls for
anestimate
of all dividends from now to
infinity, which is an impossible
task. Finally, many
investors
want capital gains and
not dividends, so for some
investors focusing solely on
dividends
is
not desirable.
The
previous discussion dealt with
these objections that some
raise about the dividend discount
model.
Can you respond to these
objections based on this
discussion?
Possibly
because of the objections to the
dividend discount model cited
here, or possibly
because
it is
easier to use, relative valuation
techniques such as the
earnings multiplier or P/E
model remain a
popular
approach to valuation. They
are less sophisticated less
formal and more intuitive
models. In
fact,
understanding the P/E model
can help investors to understand the
DDM. Because
dividends
are
paid out of earnings,
investors must, estimate the growth in
earnings before they can
estimate the
growth
in dividends or dividends
themselves.
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