FUNDAMENTAL ANALYSIS II

1. N 8 5 FUNDAMENTAL ANALYSIS II CHAPTER EIGHT Practical Investment Management Robert A. Strong

2. Outline • Market Analysis • The Major Indexes • The Greenspan Model • The Equity Risk Premium

3. Outline • Company Analysis • The Greenspan Model • Growth At a Reasonable Price (GARP) • Pro-Forma Earnings • EBITDA • The Growing Role of Cash Flow • DuPont Analysis • Present Value of Growth Opportunities • Regulation Fair Disclosure

4. Market Analysis There are several important ways in which analysts can try to get a handle on the status of “the market.” What do you think of the market?

5. The Major Indexes • A portfolio of securities, or equivalently, an index like the S&P 500 or the Dow Jones Industrial Average, can be valued using the dividend discount model (DDM). • Recall that DDM states that the current share price equals the discounted value of a perpetually growing stream of dividends:

6. The Major Indexes We can substitute earnings for dividends, and, with a few minor adjustments, apply the basic DDM to indexes.

7. The Greenspan Model • The Greenspan model is a heuristic for estimating the over- or under-valuation of the broad market. • Greenspan market value = 10-year Treasury – S&P 500 earnings yield yield • Greenspan market value > 0  the market is overvalued • Greenspan market value < 0  the market is undervalued

8. The Greenspan Model Insert Figure 8-1 here.

9. The Equity Risk Premium • Equity risk premium is the anticipated return advantage to common stock over fixed income securities. • Equity risk premium may be presented relative to short-term Treasury bills or to long-term Treasury bonds. • There is growing evidence that in the future the equity risk premium is going to be less than it has historically been.

10. Company Analysis There are several important ways in which analysts can dig deeper into the company. What do you think of this company?

11. The Greenspan Model • The Greenspan model can be adapted for use with individual equity securities. • Greenspan stock value =estimated annual earnings per share 10-year Treasury rate • Greenspan stock value > stock price  the stock is undervalued • Greenspan stock value < stock price  the stock is overvalued

12. The Greenspan Model Insert Table 8-3 here.

13. Growth At a Reasonable Price (GARP) • The GARP (Growth At a Reasonable Price) technique seeks to combine elements of both growth and value investing. • Value investors like low price/earnings ratios, while growth investors like high growth rates.

14. Growth At a Reasonable Price (GARP) • The PEG ratio, which is the principal GARP yardstick, combines both perspectives. PEG ratio = price earnings ratio . annual earnings per share growth rate • GARP investors like a low number, and many seek stocks with a PEG ratio that is less than one.

15. Growth At a Reasonable Price (GARP) Insert Table 8-4 here.

16. Pro-Forma Earnings • In general, pro forma earnings refer to net income excluding the effects of write-downs or goodwill amortization. • Pro forma earnings data give the investor more reliable information on which to assess future corporate prospects. • However, the more firms choose to exclude from net income, the better their earnings ratios will look. • Pro forma earnings are also called cash earnings or core earnings.

17. EBITDA • EBITDA (earnings before interest, taxes, depreciation, and amortization) is similar to pro forma earnings in that it excludes non-operational expenses from the earnings figure. • People involved in the valuation of businesses often base their analysis in part on EBITDA multiples and may call the figure operating cash flow.

18. The Growing Role of Cash Flow • Many analysts prefer to focus on cash flow rather than on earnings. • There are many legitimate choices the firm’s accountants may take as they work their way down the income statement, but cash flow is much less subjective. • Free cash flow represents a firm’s cash flow minus the amount required for necessary capital expenditures.

19. DuPont Analysis • DuPont analysis investigates the interplay of three aspects of corporate performance: • Profitability: Is the company selling its products for more than it costs to provide them? • Efficiency: Is the company making productive use of its assets? • Leverage: To what extent does the firm rely on bondholders and the bank?

20. DuPont Analysis Insert Figure 8-2 here.

21. DuPont Analysis Insert Table 8-5 here.

22. DuPont Analysis Insert Figure 8-3 here.

23. Present Value of Growth Opportunities • The present value of growth opportunities (PVGO) comes from closer scrutiny of the dividend discount model. • It is the difference between the stock price and the present value of a perpetual stream of the current earnings level.

24. Present Value of Growth Opportunities Insert Table 8-6 (PepsiCo and Coca-Cola Stock Data) here.

25. Regulation Fair Disclosure • In August 2000, the Securities and Exchange Commission approved Regulation Fair Disclosure (Regulation FD). • The principal provision of the rule prevents companies from giving material information to security analysts, mutual funds, or institutional investors unless the company simultaneously issues the same information to the general public.

26. Regulation Fair Disclosure • However, to avoid violating the rule, companies in general have begun to provide less information between quarterly reports.

27. Review • Market Analysis • The Major Indexes • The Greenspan Model • The Equity Risk Premium

28. Review • Company Analysis • The Greenspan Model • Growth At a Reasonable Price (GARP) • Pro-Forma Earnings • EBITDA • The Growing Role of Cash Flow • DuPont Analysis • Present Value of Growth Opportunities • Regulation Fair Disclosure