Practice investment management pim3 ch07

CHAPTER SEVEN

FUNDAMENTAL STOCK ANALYSIS
A

1

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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


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Outline


The Price-to-Book Ratio
The Price-Earnings Ratio
 Differences between Industries


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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


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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.

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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.

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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.

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Valuation Philosophies

Insert Figure 7-1 here.

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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.

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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
0

Over the long run, a security
cannot survive with a cumulative
return that is negative.

Time in the Long Term
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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 aboveaverage returns for their clients.
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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.”


$8

The modern perspective is that
value is inextricably intertwined
with price.

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Value vs. Growth Investing
Value Stocks and Growth Stocks:
How to Tell by Looking


No precise definition exists.



Classification by Morningstar Mutual Funds:

relative
relative

 < 1.75
price-to-book + price-earnings  > 2.25
 otherwise
ratio
ratio

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- value
- growth
- blend

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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

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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.

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The Price-to-Book Ratio

Insert Figure 7-3 here.

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The Price-to-Book Ratio

Insert Figure 7-4 here.

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Some Analytical Factors: Growth Rates


Growth rates from historical data:
1

 ending value  n
 − 1
growth rate geometric mean = 
 beginning value 
where n = number of compounding periods


Growth rates from earnings retention:
growth rate = ( 1- payout ratio ) × return on equity
using arithmetic averages

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Some Analytical Factors: Growth Rates

Insert Table 7-4 here.

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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.

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Some Analytical Factors: Growth Rates

Insert Table 7-5 here.

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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.

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The Dividend Discount Model (DDM)


Also called Gordon’s growth model.
D0 ( 1 + g )
D1
current price P0 =
=
k −g
k −g
where D0 is the current dividend
D1 is the dividend to be paid next year
g is the expected dividend growth rate
k is the discount factor according to
the riskiness of the stock



The model assumes that the dividend
stream is perpetual and that the longterm growth rate is constant.

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The Dividend Discount Model (DDM)


The variable k is sometimes called the
shareholders’ required rate of return.
D0 ( 1 + 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.

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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.

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