Streetsmart Guide to Valuing a Stock Other Books in the Streetsmart Series Streetsmart Guide to Managing Your Portfolio Streetsmart Guide to Short Selling Streetsmart Guide to Timing the Stock Market Streetsmart Guide to Valuing a Stock The Savvy Investor’s Key to Beating the Market Second Edition Gary Gray, Patrick J Cusatis, and J Randall Woolridge McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2004 by The McGraw-HIll Companies, Inc All rights reserved Manufactured in the United States of America Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher 0-07-143623-5 The material in this eBook also appears in the print version of this title: 0-07-141666-8 All trademarks are trademarks of their respective owners Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark Where such designations appear in this book, they have been printed with initial caps McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs For more information, please contact George Hoare, Special Sales, at george_hoare@mcgraw-hill.com or (212) 904-4069 TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc (“McGraw-Hill”) and its licensors reserve all rights in and to the work Use of this work is subject to these terms Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited Your right to use the work may be terminated if you fail to comply with these terms THE WORK IS PROVIDED “AS IS” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE McGraw-Hill and its licensors not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom McGraw-Hill has no responsibility for the content of any information accessed through the work Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise DOI: 10.1036/0071436235 To Katie O’Toole, a great writer, a terrific editor, and a wonderful wife and mother G.G To my wife, Deborah, my children, Jacob and Julia, and my parents P.J.C To my daughters, Jillian, Ainsley, and Ginger J.R.W This page intentionally left blank For more information about this title, click here Contents Preface Acknowledgments CHAPTER CHAPTER xi xv INTRODUCTION AND OVERVIEW Financial Flameout Good Companies—Hot Stocks—Ridiculous Prices The Investment Decision The 10 Principles of Finance Overview of the Book THE 10 PRINCIPLES OF FINANCE AND HOW TO USE THEM Principle 1: Higher Returns Require Taking More Risk Principle 2: Efficient Capital Markets Are Tough to Beat Principle 3: Rational Investors Are Risk Averse Principle 4: Supply and Demand Drive Stock Prices in the Short-run Principle 5: When Analyzing Returns, Simple Averages Are Never Simple 13 14 21 29 31 34 Copyright 2003 by The McGraw-Hill Companies, Inc Click Here for Terms of Use vii viii CONTENTS Principle 6: Transaction Costs, Taxes, and Inflation Are Your Enemies Principle 7: Time and the Value of Money Are Closely Related Principle 8: Asset Allocation Is a Very Important Decision Principle 9: Asset Diversification Will Reduce Risk Principle 10: An Asset Pricing Model Should be Used to Value Investments Summary CHAPTER CHAPTER 40 43 48 54 56 STOCK VALUATION: SOME PRELIMINARIES 61 Introduction to Valuation DCF Stock Valuation We Caused the High-Tech Bubble Return to Stockholders Stock Price—Too High?—Too Low?—Just Right? Stock Valuation—Art, Science, or Magic? Stock Valuation Approaches: Fundamental, Technical, and MPT Stock Value, Stock Price, and Emotions Stock Value, Stock Price, and Analyst Recommendations When to Buy, When to Sell: Our Recommendation Where Do We Go Next? 61 63 69 72 77 82 HOW TO VALUE A STOCK Some Definitions Relating to Cash Flow The Free Cash Flow to the Firm Approach Why DCF and Not EPS? The Discounted FCFF Valuation Approach Microsoft—A Simple DCF Example Valuation—Growth versus Value, Large Cap versus Small Cap Valuation—The Next Step CHAPTER 36 83 88 90 92 94 97 97 102 108 110 115 123 124 FORECASTING EXPECTED CASH FLOW 127 The Five Chinese Brothers Growth Rates and the Excess Return Period Net Operating Profit Margin and NOP Income Tax Rate and Adjusted Taxes Net Investment Incremental Working Capital 127 128 138 141 143 147 Contents Free Cash Flow to the Firm Valuation Exercise: Estimating Free Cash Flow for Cisco CHAPTER CHAPTER CHAPTER 151 152 ESTIMATING THE COST OF CAPITAL 157 Don’t Count Until You Discount WACC and Market Capitalization Estimating ConEd’s WACC The Cost of Common Equity and Shares Outstanding The After-Tax Cost of Debt and Debt Outstanding The Cost of Preferred Stock and Amount Outstanding WACC Calculation—ConEd WACC Calculation—Cisco Balance Sheet Items in the Valuation Process: Our Recommendation Valuation Exercise: Cisco After the Cost of Capital—The Next Step 157 161 166 179 182 183 FINDING INFORMATION FOR VALUATIONS 185 Save a Tree—Use the Internet The Internet and Investment Information Cash Flow Valuation Inputs—Easy to Find Cash Flow Valuation Inputs Requiring Estimation Cost of Capital Valuation Inputs Custom Valuations—The Next Step Valuation Exercise: Cisco 185 186 194 167 174 177 178 179 199 200 203 203 VALUING A STOCK—PUTTING IT ALL TOGETHER 205 Overview Valuing Citigroup—December 17, 2002 Valuing Merrill Lynch—December 18, 2002 Valuing Berkshire Hathaway—December 18, 2002 Valuing Washington REIT—December 20, 2002 Summary 205 208 220 228 237 247 Glossary Acronyms Bibliography Index 249 259 261 265 ix ... Market Streetsmart Guide to Valuing a Stock The Savvy Investor’s Key to Beating the Market Second Edition Gary Gray, Patrick J Cusatis, and J Randall Woolridge McGraw-Hill New York Chicago San... international appeal Ana Vizcay and Eduardo Iriso, Mar? ?a Jesus Ruiz Ciord? ?a and Emilio Goicoechea, Luis Arguelles and Merche Amezgaray, José Marí Marco and Carmela Garraleta, Fefa Vizcay and Héctor.. .Streetsmart Guide to Valuing a Stock Other Books in the Streetsmart Series Streetsmart Guide to Managing Your Portfolio Streetsmart Guide to Short Selling Streetsmart Guide to Timing the Stock