CHAPTER SEVEN FUNDAMENTAL STOCK ANALYSIS A Practical Investment Management Robert A Strong 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 South-Western / Thomson Learning © 2004 7-2 Outline The Price-to-Book Ratio The Price-Earnings Ratio Differences between Industries South-Western / Thomson Learning © 2004 7-3 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 South-Western / Thomson Learning © 2004 7-4 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 South-Western / Thomson Learning © 2004 7-5 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 South-Western / Thomson Learning © 2004 7-6 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 South-Western / Thomson Learning © 2004 7-7 Valuation Philosophies Insert Figure 7-1 here South-Western / Thomson Learning © 2004 7-8 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 South-Western / Thomson Learning © 2004 7-9 Regression to the Mean Cumulative Return + Overvalued stock: Sell x xx Most of the time a security’s longterm return is consistent with its risk x x x x xx x x Undervalued stock: x x Buy x x Over the long run, a security cannot survive with a cumulative return that is negative Time in the Long Term South-Western / Thomson Learning © 2004 - 10 The Dividend Discount Model (DDM) The variable k is sometimes called the shareholders’ required rate of return D0 ( + g ) k= +g P0 Note that the shareholder’s required rate of return is the sum of the expected dividend yield and the expected stock price appreciation South-Western / Thomson Learning © 2004 - 24 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 South-Western / Thomson Learning © 2004 - 25 The Multistage DDM Often, initial high growth levels cannot be sustained Suppose the growth rate g is expected to persist from the third year: D1 D2 D2 ( + g ) ( k − g ) P0 = + + ( 1+ k) ( 1+ k)2 ( 1+ k)2 South-Western / Thomson Learning © 2004 - 26 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 South-Western / Thomson Learning © 2004 - 27 False Growth Insert Table 7-7 here South-Western / Thomson Learning © 2004 - 28 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 South-Western / Thomson Learning © 2004 - 29 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 South-Western / Thomson Learning © 2004 - 30 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 South-Western / Thomson Learning © 2004 - 31 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 South-Western / Thomson Learning © 2004 - 32 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 10 Sales to Net Working Capital = Sales/Net Working Capital Measures aggressiveness or conservatism in financing sales 11 Accounts Payable to Sales = Accounts Payable/Annual Net Sales Measures how rapidly company pays its suppliers South-Western / Thomson Learning © 2004 - 33 Some Analytical Factors: Ratio Analysis Dun & Bradstreet’s 14 Key Business Ratios Profitability Ratios 12 Return on Sales (Profit Margin) = Net Profit after Taxes/Annual Net Sales Measures profit per dollar of net sales 13 Return on Assets = Net Profit after Taxes/Total Assets Measures company’s efficiency in using assets to produce operating profit 14 Return on New Worth (Return on Equity) = Net Profit after Taxes/Net Worth Measures return to the suppliers of equity capital South-Western / Thomson Learning © 2004 - 34 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 about fraud South-Western / Thomson Learning © 2004 - 35 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 South-Western / Thomson Learning © 2004 - 36 Review The Price-to-Book Ratio The Price-Earnings Ratio Differences between Industries South-Western / Thomson Learning © 2004 - 37 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 South-Western / Thomson Learning © 2004 - 38 ... 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 South-Western... exploited True growth investors are more willing to wait, but they share the belief that good investment managers can earn aboveaverage returns for their clients South-Western / Thomson Learning... Crash of 1929, price played a minor role: “A stock with good long-term prospects is always a good investment. ” $8 The modern perspective is that value is inextricably intertwined with price South-Western