TOPIC 5

COMPANY ANALYSIS AND

STOCK VALUATION
Refer to:
Reilly, Brown & Leeds
Chapter 8 & 9

1
 At the end of this topic, students should be able to
answer the following questions:

• What do you mean by fairly priced, overvalued and

undervalued stock?
• What is the difference between a constant-growth
model, a no-growth model, and a multistage model?
• What is the intrinsic value of a business?
• What is the difference between free cash flow to
equity model and the dividend discount model?
• What is relative valuation?
• What are the underlying assumptions in the price-
earnings ratio model?
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 • After analyzing the economy and
stock markets for several countries,
you have decided to invest some
Company portion of your portfolio in common
Analysis and stocks
Stock • After analyzing various industries, you
Valuation have identified those industries that
appear to offer above-average risk-
adjusted performance over your
investment horizon
• Which are the best companies?
• Are they overpriced?

3
• Good companies are not necessarily good
investments
• Compare the intrinsic value of a stock to its market
value
• Stock of a great company may be overpriced
• Stock of a growth company may not be growth
stock

4
 Growth Companies versus Growth Stocks

• Growth Companies
– Historically, consistently experience above-average
increases in cash flows or earnings (faster than the
overall economy)
– Theoretically, yield rates of return greater than the
firm’s required rate of return
– Tend to have very profitable investment
opportunities

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 Growth Companies versus Growth Stocks

• Growth Stocks
– Necessarily the stocks of growth companies
– A growth stock has a higher rate of return than
other stocks with similar risk
– Superior risk-adjusted rate of return occurs
because of market undervaluation compared to
other stocks

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 Defensive Companies and Stocks
• Defensive Companies
– The firms whose future earnings are more likely to
withstand an economic downturn
– Low business risk
– No excessive financial risk
– e.g. companies that deal with public utilities or
grocery chains, supply basic consumer necessities
• Defense Stocks
– The rate of return is not expected to decline or
decline less than the overall market decline
– Stocks with low or negative systematic risk
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 Cyclical Companies and Stocks

• Cyclical Companies
– They are the companies whose sales and earnings
will be heavily influenced by aggregate business
activity
– Examples would be firms in the steel, auto, or
heavy machinery industries.
• Cyclical Stocks
– They will have greater changes in rates of return
than the overall market rates of return
– They would be stocks that have high betas.
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Speculative Companies and Stocks
• Speculative Companies
– They are the firms whose assets involve great risk
but those that also have a possibility of great gain
– e.g. firm which is involved in oil exploration
• Speculative Stocks
– Stocks possess a high probability of low or
negative rates of return and a low probability of
normal or high rates of return
– For example, an excellent growth company whose
stock is selling at an extremely high P/E ratio

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 Value versus Growth Investing
• Growth stocks will have positive earnings
surprises and above-average risk adjusted
rates of return because the stocks are
undervalued
• Value stocks appear to be undervalued for
reasons besides earnings growth potential
• Value stocks usually have low P/E ratio or low
ratios of price to book value

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 • Company analysis is the final step in
Economic, the top-down approach to investing
Industry, • Macroeconomic analysis identifies
industries expected to offer attractive
and
returns in the expected future
Structural
environment
Links to • Analysis of firms in selected industries
Company concentrates on a stock’s intrinsic value
Analysis based on growth and risk
Economic Analysis
Industry
Analysis
Company
Analysis 11
 Economic and Industry Influences
• If trends are favorable for an industry, the
company analysis should focus on firms in
that industry that are positioned to benefit
from the economic trends
• Firms with sales or earnings particularly
sensitive to macroeconomic variables should
also be considered
• Research analysts need to be familiar with the
cash flow and risk of the firms
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 Structural Influences
• Social trends, technology, political, and regulatory
influences can have significant influence on firms
• Firms can grow and succeed despite unfavorable
industry or economic conditions due to demographic
changes or shifts in consumer tastes and lifestyles
• Early stages in an industry’s life cycle see changes in
technology which followers may imitate and benefit
from
• Politics and regulatory events can create
opportunities even when economic influences are
weak
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 COMPANY ANALYSIS
• Involves analyzing the performance of a company
and its stock
• Fundamental approach in company analysis
• Firm’s Overall Strategic Approach
– Industry competitive environment (eg. Porter
model, SWOT analysis
• Company Stock’s Valuation Approaches
– Present value of cash flows
– Relative valuation ratio techniques

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 FIRM’S OVERALL STRATEGIC APPROACH

Firm Competitive Strategies

Defensive vs Offensive Strategy

• Defensive strategy involves positioning firm so that

its capabilities provide the best means to deflect the
effect of competitive forces in the industry
• A way to retain valuable customers from competitors
• Joint venture, retrenchment-regrouping, divestment,
liquidation
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 FIRM’S OVERALL STRATEGIC APPROACH

Firm Competitive Strategies

• Offensive strategy involves using the company’s

strength to affect the competitive industry forces,
thus improving the firm’s relative industry position
• direct attacks on competitors (e.g. price cutting, add
new features)
• End-on offensive: tap new market
• Preemptive competitive strategies and acquisition
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• Porter suggests two major strategies:
– Low-Cost Strategy
• The firm seeks to be the low-cost producer, and hence
the cost leader in its industry
• Cost advantages vary by industry and might include
economies of scale, proprietary technology, or
preferential access to raw materials
– Differentiation Strategy
• Firm positions itself as unique in the industry in an area
that is important to buyers
• A company can attempt to differentiate itself based
on its distribution system or some unique marketing
approach
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Focusing a Strategy

• Select segments in the industry

• Tailor strategy to serve those specific groups
• Determine which strategy a firm is pursuing
and its success
• Evaluate the firm’s competitive strategy over
time

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 SWOT Analysis

Internal
Analysis

External
Analysis

Source: https://www.competitivefutures.com/wp-content/uploads/2017/03/SWOT-analysis-example.png
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 SWOT Analysis
• Internal Analysis
– Strengths
• Give the firm a comparative advantage in the
marketplace
• Perceived strengths can include good customer
service, high-quality products, strong brand
• image, customer loyalty, innovative R&D, market
leadership, or strong financial resources
– Weaknesses
• Weaknesses result when competitors have
potentially exploitable advantages over the firm
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• External Analysis
– Opportunities
• These are environmental factors that favor the
firm
• They may include a growing market for the
firm’s products (domestic and international),
shrinking competition, favorable exchange rate
shifts, or identification of a new market or
product segment

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• External Analysis
– Threats
• They are environmental factors that can
hinder the firm in achieving its goals
• Examples would include a slowing domestic
economy, additional government regulation,
an increase in industry competition, threats of
entry, etc.

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 COMPANY STOCK
VALUATION
• The single most important issue in the stock
valuation process is what a stock will do in
the future.
• Value of a stock depends upon its future returns from
dividends and capital gains/losses.
• We use historical data to gain insight into the future
direction of a company and its profitability.
• Past results are not a guarantee of future results.
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 • Three steps are necessary to
project key financial variables
Steps
into the future:
in
Valuing – Step 1: Measuring and forecasting
earnings
a
Company – Step 2: Forecast future EPS and
Stock dividends
– Step 3: Estimating the stock’s
intrinsic value

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Why estimate a company stock’s Intrinsic Value
(IV)?

• We can compare it with the traded i.e.. market

price (MP), and make investment decisions.
• Intrinsic value refers to the actual value of the
security
• IV can include other variables (brand name,
trademark, copyright) that are often difficult to
calculate and sometimes not accurately reflected in
the market price.
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intrinsic value (IV) vs Market Price (MP)

Investment
Decision

IV > MP Undervalued Hold (Buy)

IV < MP Overvalued do not hold

IV = MP Fairly priced Hold (Buy)

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 ESTIMATING THE INTRINSIC VALUE OF
SHARES
• Present value of cash flows (PVCF)
– Present value of dividends (DDM)
– Present value of free cash flow to equity (FCFE)
– Present value of free cash flow (FCFF)
• Relative valuation techniques
– Price earnings ratio (P/E) or Earnings Multiplier
– Price cash flow ratios (P/CF)
– Price book value ratios (P/BV)
– Price sales ratio (P/S)
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 ESTIMATING THE INTRINSIC VALUE OF
SHARES

• Present value of cash flows (PVCF)

– Present value of dividends (DDM)

• Relative valuation techniques

– Price earnings ratio (P/E) or Earnings Multiplier

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DIVIDEND DISCOUNT MODEL (DDM)

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 1. Dividend Discount Model (DDM):
with Infinite Period

Vi = D0(1+g)1 + D0(1+g)2 +…….. + D0(1+g)n

(1+k)1 (1+k)2 (1+k)n
Vi = Value of common stock i or Stock Price
D0 = the dividend payment in the current period
k = required rate of return on Stock i
g = the constant growth rate of dividends
n = the number of period, assume to be infinite

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• Constant Growth Rate Model is simplified as:
V0 = D1
k–g

where g = constant growth rate of the dividend

k = the required rate of return of Stock i
D1= dividend payment in period 1= D0(1+g)

• Assumptions:
– A constant growth rate.
– An infinite time period.
– The required return on the investment (k) is greater
than the expected growth rate (g).

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 EXAMPLE 1
A stock’s current dividend is RM0.50 a share. The
company’s earning and dividend will grow at 8%. The
long-run required rate of return on this stock is 12%.
Determine the value of the stock. If the stock’s price is
RM12, should you buy the stock?

V0 = D1 = 0.50 (1.08)
k–g 0.12 – 0.08
= 0.54 = RM13.50
0.04
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Investment decision
• If the market price is RM12.00, what would be your
investment decision?

• If Intrinsic Value, V0 > SP : Undervalue

Buy (or hold)

If Intrinsic Value, V0 < SP : Overvalue

Don’t Buy (don’t hold)

Buy the stock since the IV (RM13.50) is > than the

market price
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 2. Dividend Discount Model (DDM):
Stock with Holding Period
• If the stock is not held for an infinite period:
E.g.: hold for 3 years only.

V0 = D1 + D2 + D3 + V3
(1+k)1 (1+k)2 (1+k)3 (1+k)3
where V3 = estimated selling price of stock at
year 3

• The value is equal to the present value of dividend

payments during Year 1 to year 3 plus the sale price
(V3) for stock i at the end of Year 3.
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 EXAMPLE 2
. Dividend Discount
with Holding Period
Model (DDM): Stock

Assume that an investor would like to hold a stock for 3

years and the estimated dividend payment per share
at the end of each year is as below:
Year 1 2 3
RM0.50 0.70 0.80
The stock’s expected share price 3 years from now is
RM6.50 and the required rate of return is 12%.
Determine the value of the stock today.

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V0 = D1 + D2 + D3 + V3
(1+k)1 (1+k)2 (1+k)3 (1+k)3
= 0.50 + 0.70 + 0.80 + 6.50
(1.12)1 (1.12)2 (1.12)3 (1.12)3

= 0.4464 + 0.5580 + 0.5694 + 4.6267 = RM6.2005

Using the fin. Calculator

CF CF0 0
C01 0.50 FO1 = 1
C02 0.70 F02 = 1
C03 7.30 FO3 = 1
C04 NPV I = 12 CPT 6.2005
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Investment decision
• If the market price is RM7.50, what would be
your investment decision?

Don’t buy the stock since IV is less than

the market price

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 3. Dividend Discount Model (DDM):
Multiple Growth / Multistage Model
• Combinations of the previous DDM.
• Involves examining each year dividend
individually and then, compute the remaining
value assuming constant growth when the
growth rate stabilize

V0 = D1 + D2 + …….. Dn + Vn
(1+k)1 (1+k)2 (1+k)n (1+k)n
where Vn = D0 (1+g)
k -g
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 EXAMPLE 3
Opal Corporation just paid dividends of RM3 per share.
Assume that over the next 3 years dividends will grow
as follows: 5% next year, 15% in year 2, and 25% in
year 3. After that growth is expected to level off to a
constant growth rate of 10% per year. The required
rate of return is 15%. Calculate the intrinsic value using
the multistage model.

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 V0 = D1 + D2 + …….. D3 + V3
(1+k)1 (1+k)2 (1+k)3 (1+k)3
where V3 = D3 (1+g) = D4
k –g k-g

D1 = D0 (1 + g)
D1 = 3 (1.05) =3.15
D2 = 3.15 (1.15) =3.6225
D3 = 3.6225 (1.25) = 4.5281
D4 = 4.5281 (1.10) = 4.9809

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V3 = D4 / k-g = 4.9809 / (0.15 - 0.10)
= RM99.618

Price, V0 = 3.15/(1.15)1 + 3.6225/(1.15)2 +

4.5281/(1.15)3 + 99.618/(1.15)3

= RM73.96

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RELATIVE VALUATION TECHNIQUES
PRICE EARNINGS RATIO (P/E) OR
EARNINGS MULTIPLIER

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 The P/E (Expected Earnings Multiplier)
Technique
• Step 1: Estimate expected Earning per share (EPS) of
the companies.
• Step 2: Estimate Earning Multiplier (P/E) of the
companies. The infinite period DDM can also be
used to indicate the variables that determine the
value of the P/E ratio:
P/E = Dividend payout ratio
(k-g)
k = required rate of return
g = growth rate of dividend
based on constant growth model (DDM)
• Step 3: Estimate the Intrinsic value (IV) = P/E x EPS143
 EXAMPLE 4
The following information pertains to Taiko Bhd’s current
financial standing:
Net Sales: RM500 million and is estimated to increase by
20% next year
Net profit margin: 5% and is expected to remain the
same for next year
Shares outstanding (NOSO): 50 million units
Shareholders’ Equity value per share: RM2
Investor’s required rate of return (k) : 18%
The firm is expected to declare 45 sens dividend per
share for next year

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Compute next year’s estimated:
a) Sales1
RM500 m x 1.20 = RM600 m

b) Net Profit margin = 5%

therefore, net profit = 600 m x 0.05 = RM30 m

c) EPS1
= Net profit / NOSO = 30 m / 50 m shares
= RM0.60 per share

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d) ROE
= Net profit margin x Assets Turnover x Financial Leverage
= (NI/Sales) x (Sales/TA) x (TA/Equity)
= NI/Equity
= RM30 m / (RM2 x 50m)
= RM30 m / RM100 m = 0.30 = 30%

e) Dividend payout ratio (DPOR)

= Div per share/ EPS or Total Div / Net Profit
= RM0.45 / RM0.60
= 0.75
= 75%
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f) Earnings retention rate (RR) or b
= 1 – DPOR
= 1 – 0.75 = 0.25
= 25%

g) growth rate (g)

= b x ROE
= 0.25 x 30 = 7.5%

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h) P/E = DPOR / k-g
= 0.75 / 0.18 – 0.075
= 7.1429

i) So, the stock’s Intrinsic value (IV)

= P/E x EPS1
= 7.1429 x RM0.60
= RM4.2857

If the stock’s market price is RM6.00, then the

stock is considered overvalued; thus do not buy/
hold 48
 OR
P/E = DPS/ k-g
= RM0.45 / 0.18 – 0.075
Intrinsic value (IV) = RM0.45/0.1050
= RM4.2857

If the stock’s market price is RM6.00, then the

stock is considered overvalued; thus do not buy/
hold

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 EXAMPLE 5
• A stock has an expected dividend payout of 30%, a
required rate of return of 12%, and an expected
growth rate for dividend of 5%.

• Calculate the P/E Ratio.

Pi / E 1= DPOR1
k–g
= 0.30 / (0.12-0.05) = 4.29 times

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• Assume require rate of return (k) increase from
12% to 16%, what is the P/E ratio?
Pi / E 1= DPOR1
k–g
= 0.30 / (0.16 - 0.05) = 2.73

• Assume growth rate (g) increase from 5% to 7%,

what is the P/E ratio?
Pi / E 1= DPOR1
k–g
= 0.30 / (0.12 – 0.07) = 6

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 EXAMPLE 6
Given current earnings (E0) of RM2.5 per share, growth
rate (g) of 5% , and expected dividend payout ratio is
30%. Estimate the value of the stock if required rate of
return (k) is 12% .

P/E = DPOR1 = 0.30 = 4.29

k–g (0.12 – 0.05)

E1 = E0 (1+g) = 2.50 (1.05) = 2.625

Value of stock = Vi = Pi / E1 x E1
= 4.29 x 2.625 = RM11.2613

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Estimating the Variables in the Relative Valuation Models

• The estimated required rate of return (k) and the

estimated growth rate (g) are important variables
under the P/E Ratio model.
• Factors influencing the estimated required Rate of
Return (k):
a) Economy’s real risk-free rate (RRFR)
b) Expected rate of inflation (I)
c) Risk premium (RP)

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• Estimating the expected growth rate (g)
g = Retention rate x Return on Equity
= b x ROE
where b = 1 - DPR
ROE = Net Income/Equity

ROE can also be developed as

ROE = Net Income x Sales x Total Asset
Sales Total Asset Equity

= Profit Margin x Total Asset Turnover X Fin Leverage

• A company is considered a growth company, when a given ROE

> required rate of return
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 Valuation of Common Stock
• “Growth” for a company means able to :

– invest in new projects through debt financing.

– To issue shares.

– Acquire another company that will increase the its

asset.

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 Implementing the Technique

1. Compare the valuation ratio to the comparable ratio

for the market/ industry or other stock.
– Is the ratio similar, consistently at a premium or
discount?

2. Explain the relationship.

– To know what factor determine the specific
valuation ratio and make comparison.

56
For example
• If the comparison indicates that company’s PE
are consistently above other sets, you need to
consider whether the fundamental factors
that affect the PE ratio justify the higher PE.

• If the firm had a historical and expected

growth rate that was substantially above all
the comparables and it should have a lower
ROR this would indicate the higher PE ratio
is justify.
57
 Intra-Industry Analysis
• Directly compare two firms in the same industry
• An alternative use of T to determine a reasonable
P/E ratio
• Factors to consider
- A major difference in the risk involved
- Inaccurate growth estimates
- Stock with a low P/E relative to its growth rate is
undervalued
- Stock with high P/E and a low growth rate is
overvalued
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 Site Visits and the Art of Interview
• Focus on management’s plans, strategies, and
concerns
• Restrictions on nonpublic information
• “What if” questions can help gauge sensitivity of
revenues, costs, and earnings
• Management may indicate appropriateness of
earnings estimates
• Discuss the industry’s major issues
• Review the planning process
• Talk to more than just the top managers
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 Tips on when to sell Stocks
• Holding a stock too long may lead to lower returns
than expected
• If stocks decline right after purchase, is that a
further buying opportunity or an indication of
incorrect analysis?
• Continuously monitor key assumptions
• Evaluate closely when market value approaches
estimated intrinsic value
• Know why you bought it and watch for that to
change
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 Influence on the Analysis
Efficient Markets
– In most instances, the value estimated for a stock
will be very close to its market price, which
indicates that it is properly valued
Paralysis of Analysis
– To earn above-average returns, there are two
requirements: (1) the analyst must have
expectations that differ from the consensus, and
(2) the analyst must be correct
Analyst Conflicts of Interest
– A potential conflict can arise if communication
occurs between a firm’s investment banking and
equity research division 61
 Efficient Markets

• Opportunities are mostly among less well-known

companies
• To outperform the market you must find disparities
between stock values and market prices - and you
must be correct
• Concentrate on identifying what is wrong with the
market consensus and what earning surprises may
exist

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 Analyst Conflicts of Interest

• Analysts such as investment bankers may push for

favorable evaluations
• Corporate officers may try to convince analysts
• Analyst must maintain independence and have
confidence in his or her analysis

63
 Global Company and Stock Analysis

• Factors to Consider
– Availability of Data
– Differential Accounting Conventions
– Currency Differences (Exchange Rate Risk)
– Political (Country) Risk
– Transaction Costs and Liquidity
– Valuation Differences

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