FUNDAMENTAL STOCK ANALYSIS

1. A 3 1 FUNDAMENTAL STOCK ANALYSIS CHAPTER SEVEN Practical Investment Management Robert A. Strong

2. Outline • Valuation Philosophies • Investors’ Understanding of Risk Premiums • The Time Value of Money • The Importance of Cash Flows • The Tax Factor • EIC Analysis • Value vs. Growth Investing • The Value Approach to Investing • The Growth Approach to Investing • How Price Relates to Value • Value Stocks and Growth Stocks: How to Tell by Looking

3. Outline • The Price-to-Book Ratio • The Price-Earnings Ratio • Differences between Industries

4. Outline • Some Analytical Factors • Growth Rates • The Dividend Discount Model • The Importance of Hitting the Earnings Estimate • The Multistage DDM • Caveats about the DDM • False Growth • A Firm’s Cash Flows • Small-Cap, Mid-Cap, and Large-Cap Stocks • Ratio Analysis • Cooking the Books

5. Valuation Philosophies • Fundamental analysts believe securities are priced according to fundamental economic data. • Technical analysts think investor behavior and supply and demand factors play the most important role.

6. Valuation Philosophies • Investors’ understanding of risk premiums: Investors are almost always risk-averse. • The time value of money: Everyone agrees on this basic principle. • The importance of cash flows: Most investment research deals with predicting future corporate earnings. • The tax factor: The tax code is complicated and not all investments are taxed equally.

7. Valuation Philosophies • Economy, Industry and Company (EIC) analysis: • The analyst first considers conditions in the overall economy(market risk), • then determines which industries are the most attractive in light of the economic conditions (using Porter’s competitive strategy analysis framework, for example), • and finally identifies the most attractive companies within the attractive industries.

8. Valuation Philosophies Insert Figure 7-1 here.

9. Value vs. Growth Investing 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. • Value investors believe in a regression to the mean.

10. + Most of the time a security’s long-term return is consistent with its risk. Overvalued stock: Sell x x x x x x x x x x x x Undervalued stock: Buy x x x Cumulative Return 0 Over the long run, a security cannot survive with a cumulative return that is negative. - Time in the Long Term Regression to the Mean

11. Value vs. Growth Investing The Growth Approach to Investing • Growth investors seek steadily growing companies. There are two factions: • Information traders are in a hurry; they believe information differentials in the marketplace can be profitably exploited. • True growth investors are more willing to wait, but they share the belief that good investment managers can earn above-average returns for their clients.

12. The modern perspective is that value isinextricably intertwined with price. $ 8 Value vs. Growth Investing How Price Relates to Value • In the early days of the market, before the Great Crash of 1929, price played a minor role: “A stock with good long-term prospects is always a good investment.”

13. relative price-to-book ratio relative price-earnings ratio + Value vs. Growth Investing Value Stocks and Growth Stocks: How to Tell by Looking • No precise definition exists. • Classification by Morningstar Mutual Funds:

14. The Price-to-Book Ratio • Book value per share is an accounting concept synonymous with equity per share or net asset value. • Share price is not normally equal to book value because of • depreciation, uncollectible debts, goodwill, etc. • economic obsolescence • intangible assets

15. The Price-to-Book Ratio • The price-earnings ratio (PE) is computed by dividing the current stock price by the firm’s earnings per share. • Because of differences among industries, relative ratios are commonly computed.

16. The Price-to-Book Ratio Insert Figure 7-3 here.

17. The Price-to-Book Ratio Insert Figure 7-4 here.

18. Some Analytical Factors: Growth Rates • Growth rates from historical data: • Growth rates from earnings retention:

19. Some Analytical Factors: Growth Rates Insert Table 7-4 here.

20. Some Analytical Factors: Growth Rates Choosing a Growth Rate • Financial analysts typically calculate a number of growth rates using different ways to determine a likely range for the statistic. • Recent data may be more reliable than data from the more distant past. • Company statements regarding company targets may be considered too.

21. Some Analytical Factors: Growth Rates Insert Table 7-5 here.

22. Some Analytical Factors: Growth Rates Growth Rate Estimates from Other Analysts • Another important source of growth rate estimates is from other security analysts. • Three popular services that monitor and report these estimates are Zacks, First Call, and the Institutional Brokers Estimate System (I/B/E/S). • The term whisper number refers to what people really think the earnings will be, and not what the published estimate is.

23. The Dividend Discount Model (DDM) • Also called Gordon’s growth model. • The model assumes that the dividend stream is perpetual and that the long- term growth rate is constant.

24. The Dividend Discount Model (DDM) • The variable k is sometimes called the shareholders’ required rate of return. • Note that the shareholder’s required rate of return is the sum of the expected dividend yield and the expected stock price appreciation.

25. The Importance of Hitting the Earnings Estimate • 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.

26. The Multistage DDM • Often, initial high growth levels cannot be sustained. • Suppose the growth rate g is expected to persist from the third year:

27. Some Analytical Factors • Caveats about the DDM: The DDM is at most a useful tool in security analysis - it requires certain assumptions and it has shortcomings. • False growth: False growth occurs when a firm acquires another firm with a lower price-earnings ratio - historical data should always be scrutinized carefully when used to determine a growth rate.

28. False Growth Insert Table 7-7 here.

29. Some Analytical Factors • A firm’s cash flow: The statement of cash flows is a useful analytical tool - the cash flow from operations figures are widely used as a check on a firm’s earnings quality.

30. Some Analytical Factors • Small-cap, mid-cap, and large-cap stocks: Another consideration in fundamental stock analysis relates to the size of the firm - for example, the small firm effect.

31. Some Analytical Factors: Ratio Analysis • The fundamental analyst is necessarily interested in the firm’s accounting statements and in the prevailing general economic conditions. • To assist in the analysis, several organizations publish comparative statistics for industry groups. e.g. Dun and Bradstreet’s Industry Norms & Key Business Ratios, which includes solvency, efficiency and profitability ratios.

32. Some Analytical Factors: Ratio Analysis Dun & Bradstreet’s 14 Key Business Ratios • Solvency Ratios • Quick Ratio = (Cash + Accounts Receivable)/Current Liabilities Measures ability to raise cash quickly, ignores inventory • Current Ratio = Current Assets/Current Liabilities • General measure of liquidity • Current Liabilities to Net Worth = Current Liabilities/Net Worth • Compares short-term liabilities to permanent invested capital • Current Liabilities to Inventory = Current Liabilities/Inventory • Measures extent to which payment of current debts relies on sale of inventory • Total Liabilities to Net Worth = Total Liabilities/Net Worth • Measures firm’s reliance on debt financing • Fixed Assets to Net Worth = Fixed Assets/Net Worth • Measures proportion of firm’s equity tied up in long-term assets

33. Some Analytical Factors: Ratio Analysis Dun & Bradstreet’s 14 Key Business Ratios • Efficiency Ratios • Collection Period = Accounts Receivable/Credit Sales per Day • Measures firm’s efficiency in turning credit sales into cash • Sales to Inventory = Annual Net Sales/Inventory • Measures speed that inventory moves from shelf to customer • Assets to Sales = Total Assets/Net Sales • Measures efficiency with which assets are used to produce sales • Sales to Net Working Capital = Sales/Net Working Capital • Measures aggressiveness or conservatism in financing sales • Accounts Payable to Sales = Accounts Payable/Annual Net Sales • Measures how rapidly company pays its suppliers

34. Some Analytical Factors: Ratio Analysis Dun & Bradstreet’s 14 Key Business Ratios • Profitability Ratios • Return on Sales (Profit Margin) = Net Profit after Taxes/Annual Net Sales • Measures profit per dollar of net sales • Return on Assets = Net Profit after Taxes/Total Assets • Measures company’s efficiency in using assets to produce operating profit • Return on New Worth (Return on Equity) = Net Profit after Taxes/Net Worth • Measures return to the suppliers of equity capital

35. Some Analytical Factors: Cooking the Books • All 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. Unfortunately, there is not much the analyst can do about fraud.

36. Review • Valuation Philosophies • Investors’ Understanding of Risk Premiums • The Time Value of Money • The Importance of Cash Flows • The Tax Factor • EIC Analysis • Value vs. Growth Investing • The Value Approach to Investing • The Growth Approach to Investing • How Price Relates to Value • Value Stocks and Growth Stocks: How to Tell by Looking

37. Review • The Price-to-Book Ratio • The Price-Earnings Ratio • Differences between Industries

38. Review • Some Analytical Factors • Growth Rates • The Dividend Discount Model • The Importance of Hitting the Earnings Estimate • The Multistage DDM • Caveats about the DDM • False Growth • A Firm’s Cash Flows • Small-Cap, Mid-Cap, and Large-Cap Stocks • Ratio Analysis • Cooking the Books