VALUATION PHILOSOPHIES

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Investment Analysis & Portfolio Management (FIN630)

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 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.

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 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:

Economic Analysis

Industry Analysis

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 Price-Earnings Ratio

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.

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 )

po =

= 1

k-g

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.

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

price.

Investment Analysis & Portfolio Management (FIN630)

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%:

0.5($1.10)

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 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

Investment Analysis & Portfolio Management (FIN630)

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 long-term growth rate be constant in other words, a long-term

trend about which the annual values fluctuate.

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.

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.

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

Investment Analysis & Portfolio Management (FIN630)

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 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.

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.

Investment Analysis & Portfolio Management (FIN630)

The P/E Ratio or Earnings Multiplier Approach:

The P/E ratio or earnings multiplier approach is the best-known 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 12-month

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 by-dividing the current market price of the stock by the latest 12-month earnings. As

such, it tells investors the price being paid for each $1 of-most recent 12-month 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, is-the 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.

Investment Analysis & Portfolio Management (FIN630)

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 rates-is 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

cash-flow techniques and relative valuation techniques. Which should be used?

In theory, the discounted cash-flow 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

an-estimate 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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