Practice investment management pim3 ch08e

CHAPTER EIGHT

VALUATION TOOLS
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Practical Investment Management
Robert A. Strong


Outline
 Market Analysis
 The Major Indexes
 The Greenspan Model
 The Equity Risk Premium

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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

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Market Analysis

What do you think of the market?

There are several important ways in which
analysts can try to get a handle on the status
of “the market.”

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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:

D0  1  g 
P0 
k g
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The Major Indexes
We can substitute earnings for
dividends, and, with a few minor
adjustments, apply the basic DDM
to indexes.

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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
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The Greenspan Model

Insert Figure 8-1 here.

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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.

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Company Analysis

What do you think of this company?

There are several important ways in which
analysts can dig deeper into the company.

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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

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The Greenspan Model

Insert Table 8-3 here.

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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.

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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.

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Growth At a Reasonable Price (GARP)

Insert Table 8-4 here.

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Pro-Forma Earnings
 In general, pro forma earnings refer to net

income excluding the effects of writedowns 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.
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EBITDA
 EBITDA (earnings before interest, taxes,
depreciation, and amortization) is similar to
pro forma earnings in that it excludes nonoperational 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.

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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.

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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?
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DuPont Analysis

Insert Figure 8-2 here.

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DuPont Analysis

Insert Table 8-5 here.

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DuPont Analysis

Insert Figure 8-3 here.

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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.

EPS1
P0 
 PVGO
k

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Present Value of Growth Opportunities

Insert Table 8-6 (PepsiCo and
Coca-Cola Stock Data) here.

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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.

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