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CHAPTER SEVENFUNDAMENTAL STOCK ANALYSIS

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2001 South-Western College Publishing

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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 Some Analytical Factors

Growth Rates

The Dividend Discount Model

The Multistage DDM

Caveats about the DDM

False Growth

A Firms Cash Flows

Small-Cap, Mid-Cap, and Large-Cap Stocks

Ratio Analysis

Cooking the Books

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Valuation Philosophies

Fundamental analysts believesecurities are priced according to

fundamental economic data.

Technical analysts think investor behaviorand supply and demand factors play the

most important role.

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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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Economy, Industry, and Company (EIC)

analysis:

The analyst first considers conditions in

the overall economy(market risk),

then determines which industries are themost attractive in light of the economic

conditions (using Porters competitive

strategy analysis framework, for example),

and finally identifies the most attractive

companies within the attractiveindustries.

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A value investor believes that securitiesshould be purchased only when the

underlying fundamentals (macroeconomicinformation, industry news, and a firms

financial statements) justify the purchase.

Value investors believe in a regression

to the mean.


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Regression to the Mean

Most of the time

a securitys long-term return is

consistent with its

risk.

Over the long run, a security

cannot survive with a cumulativereturn that is negative.C

umulative

Return

Time in the Long Term

0

+

-

xxx

x

x

x

xxx

xx

x

xx

xUndervalued stock: Buy

Overvalued stock: Sell

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Growth investors seek steadily growingcompanies. There are two factions:

Information traders are in a hurry; theybelieve information differentials in themarketplace can be profitably exploited.

True growth investors are more willing to

wait, but they share the belief that goodinvestment managers can earn above-

average returns for their clients.

The Growth Approach to Investing

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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.

How Price Relates to Value

The modern perspective is thatvalue isinextricably intertwined

with price.

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No precise definition exists.

Classification by Morningstar Mutual Funds:



blend-otherwise

growth-2.25value-1.75relative

price to book

ratio

relative

price-earnings

ratio

+

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The price to book ratio: book value pershare is an accounting concept

synonymous with equity per share.

The price-earnings ratio (PE) is computedby dividing the current stock price by the

firms earnings per share.

Because of differences among industries,

relative ratios are commonly computed forboth statistics.

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Some Analytical Factors: Growth Rates

Growth rates from historical data:

periodsgcompoundinofnumberwhere

valuebeginning

valueendingrategrowth meangeometric

n

n1

1

averagesarithmeticusing

equityonreturnratiopayout-1rategrowth Growth rates from earnings retention:

13

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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 datafrom the more distant past.

Company statements regarding companytargets may be considered too.

Choosing a Growth Rate

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Another important source of growth rate

estimates is from other security analysts.

Two popular services that monitor andreport these estimates are Zacks and theInstitutional Brokerage Estimate Service

(I/B/E/S).

Growth Rate Estimates from Other Analysts

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The Dividend Discount Model (DDM)

Also called Gordons growth model.

The model assumes that the dividendstream is perpetual and that the long-

term growth rate is constant.

stocktheofriskinessthetoaccordingfactordiscounttheisrategrowthdividendexpectedtheis

next yearpaidbetodividendtheis

dividendcurrenttheiswhere

pricecurrent

kgD

Dgk

D

gk

gDP

1

0

100

1

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The Dividend Discount Model (DDM)

The variable k is sometimes called theshareholders required rate of return.

Note that the shareholders required rate of

return is the sum of the expected dividendyield and the expected stock price

appreciation.

gP

gD

k

0

0 1

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The Multistage DDM

Often, initial high growth levels cannot besustained.

Suppose the growth rate g is expected topersist from the third year:

222210 11

11 k

gkgD

k

D

k

DP

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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 bescrutinized carefully when used to

determine a growth rate.

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Some Analytical Factors

A firms 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 firms earnings quality.Small-cap, mid-cap, and large-cap stocks:

Another consideration in fundamental

stock analysis relates to the size of thefirm - for example, the small firm effect.

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Some Analytical Factors: Ratio Analysis

The fundamental analyst is necessarily

interested in the firms accountingstatements and in the prevailing general

economic conditions.

To assist in the analysis, severalorganizations publish comparative

statistics for industry groups.

e.g. Dun and Bradstreets Industry Norms

& Key Business Ratios, whichincludes solvency, efficiency and

profitability ratios.

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Some Analytical Factors: Cooking the Books

All publicly traded firms in the United Statesmust have their financial statements

audited to ensure they fairly present the

companys financial position.

Still, every year there is at least one story ofaccounting fraud at a major firm.

Unfortunately, there is not much the analyst

can do about fraud.

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Review Valuation Philosophies

Investors Understanding of Risk Premiums The Time Value of Money

The Importance of Cash Flows

The Tax Factor

EIC Analysis



The Growth Approach to Investing How Price Relates to Value



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Review

Some Analytical Factors Growth Rates

The Dividend Discount Model

The Multistage DDM

Caveats about the DDM False Growth

A Firms Cash Flows

Small-Cap, Mid-Cap, and Large-Cap Stocks

Ratio Analysis

Cooking the Books

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