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Administrative Studies
ADMS 4501
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Advanced Portfolio Management ADMS 4501 – Winter 2012 – Lois King Lecture 9 – Chapter 9 – Stock Analysis, Part II – Mar 8 Company Analysis and Stock Valuation - After analyzing the economy and stock markets for several countries, you have decided to invest some portion of your portfolio in common stocks. - After analyzing various industries, you have identified those industries that appear to offer above-average risk-adjusted performance over your investment horizon. - Good companies are not necessarily good investments. Company Analysis - Approaches to equity valuation o DCF techniques  Present value of dividends (DDM)  Present value of operating cash flow  Present value of free cash flow o Relative valuation techniques  Price/earnings ratio (P/E)  Price/cash flow ratio (P/CF)  Price/book value ratio (P/BV)  Price/sales ratio (P/S) xc - Both of these approaches and all of these valuation techniques have several common factors: o All of them are significantly affected by investor’s required rate of return on the stock because this rate becomes the discount rate or is a major component of the discount rate; o All valuation approaches are affected by the estimated growth rate of the variable used in the valuation technique. Why and When to Use the DCF Approach - When you can calculate cash flow o Dividends (DDM)  Cost of equity is the discount rate. o Free cash flow to equity (FCFE)  Cost of equity is the discount rate. o Operating cash flow (FCFF or OFCF)  Weighted average cost of capital (WACC) is the discount rate. - When you can estimate growth rates and discount rates fairly well. Why and When to Use the Relative Valuation Techniques - When you need information about how the market is currently valuing stocks o Aggregate market o Alternative industries o Individual stocks within industries - No guidance as to whether valuations are appropriate o Best used when one has comparable entities o Aggregate market and company’s industry are not at a valuation extreme. Relative Valuation Techniques - Value can be determined by comparing to similar stocks based on relative ratios. - Relevant variables include earnings, cash flow, book value, and sales. - Relative valuation ratios include: o Price/earnings (p/e) o Price/cash flow (p/cf) o Price/book value (p/bv) o Price/sales (p/s) Earnings Multiplier Model - This values the stock based on expected annual earnings. - The price earnings (p/e) ratio, or earnings multiplier. o p/e = current market price/expected 12 month earnings - the p/e ratio is determined by o Expected dividend payout ratio. o Required rate of return on the stock. o Expected growth rate of dividends. Additional Measures of Relative Value - Price/book value (p/bv) ratio o Book value is a reasonable measure of value for firms that have consistent accounting practice. o It can be applied to firms with negative earnings or cash flows. o Should not attempt to use this ratio to compare firms with different levels of hard assets – for example, a heavy industrial firm and a service firm. - Price/cash flow (p/cf) ratio o The price/cash flow ratio has grown in prominence and use because many observers contend that a firm’s cash flow is less subject to manipulation. Good for companies in industries with high operating leverage. - Price/sales (p/s) ratio o Sales growth drives the growth of all subsequent earnings and cash flow and sales is one of the purest numbers available. Good for comparing firms in different countries. Types of Companies - Defensive companies - Cyclical companies - Speculative companies - Growth versus value companies Defensive Companies and Stocks - Defensive companies o The firms whose future earnings are more likely to withstand an economic downturn. o Low business risk. o No excessive financial risk. o The rate of return is not expected to decline, or it declines less than the overall market decline. o Stocks with low or negative systematic risk. o Typical examples are public utilities or grocery chains – firms that supply basic consumer necessities. Cyclical Companies and Stocks - Cyclical companies o They are the companies whose sales and earnings will be heavily influenced by aggregate business activity. o Examples would be firms in the steel, auto or heavy machinery industries. o
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