FUNDAMENTAL STOCK ANALYSIS

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 6

FUNDAMENTAL STOCK ANALYSIS

VALUATION PHILOSOPHIES:

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

things.

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.

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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.

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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

industries.

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

recession.

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

management.

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

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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

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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.

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:

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

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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

phone.

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.

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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

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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."

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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.

SOME ANALYTICAL FACTORS:

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.

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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

percent.

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

mean.

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

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.

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

price.

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

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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 pq 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

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

rate.

False Growth occurs anytime a firm acquires another firm with a lower price-earnings

ratio.

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.

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