Chapter Five:

Company Analysis
and Stock Valuation
Group Members
• Mekdelawit Teferi – GSE/6741/14
• Ruth Tewodros – GSE/5981/14
• Kidest Ayalew – GSE/1900/14
• Yostena Amlaku – GSE/5105/14
• Abigail Dejene – GSE/7264/14
• Saba Tsegaye – GSE/2423/14
• Alexandra Sultan – GSE/9357/14
• Beamlak Melesse – GSE/8136/14
5.1 Company Analysis Vs Stock Valuation
• Common stocks are not always good investments. After analyzing a company and deriving an understanding
of its strengths and risks, you need to compute the intrinsic value of the firm’s stock and compare this to its
market value to determine if the company’s stock should be purchased.
• The stock of a wonderful firm with superior management and strong performance measured by current and
future sales and earnings growth can be priced so high that the intrinsic value of the stock is below its current
market price (i.e., the stock is overvalued)

5.1.1 Company Analysis

• Goal of the company analysis is to understand the internal workings
of the company and its relationships to its external environment.
• This includes research made in a range of different areas such as
Environmental/ industry analysis , Competitive advantage and
Competitive Strategies the firm is following such as Defensive or
offensive, Finance, management strategy, and marketing and
technology
• SWOT analysis is then used develop recommendations that take
advantage of strengths or develop new way to purse opportunities or
mitigate threats.
 5.1.2 Stock Valuation
❑ Stock valuation is a method of determining the intrinsic value of a stock. The intrinsic value may be different
from its current market price. This informs an investor if the stock is over or undervalued at the market price.
❑ For example, if a Stock of a company may be overpriced (market value is higher than intrinsic value) then the
investor will not invest in it.

5.1.3 Growth Companies

❑ Growth companies have historically been defined as companies that consistently experience above-average
increases in sales and earnings
❑ Financial theorists define a growth company as one with management and opportunities that yield rates of
return greater than the firm’s required rate of return

5.1.4 Growth Stocks

• Growth stocks are not necessarily shares in 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.
 5.1.5 Defensive Companies and Stocks
• Defensive companies’ future earnings are more likely to withstand an economic downturn and exhibit low
business risk Not excessive financial risk. Supply basic consumer necessities such as Public utilities or grocery
stores.
• Defensive Stocks, The rate of return is not expected to decline during an overall market decline or decline less than
the overall market.
• Stock with low or negative systematic risk
• Or in other words, a stock that has a low positive or negative beta (the expected return of an asset based on its
expected market returns is low)

5.1.6 Cyclical Companies and Stocks

• Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business
activity
• Outperform other firms during economic expansion and Underperform during economic contractions
• High volatility in sales (high business risk and financial risk), Example steel, auto or heavy machinery industries
• Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall
market rates of return, Stocks with high betas
 5.1.7 Speculative Companies and Stocks

• Speculative companies are those whose assets involve great risk but those that also have a possibility of
great gain
• Speculative stocks possess a high probability of low or negative rates of return and a low probability of
normal or high rates of return
• Might be the case for an excellent growth stock that is substantially overvalued

5.1.8 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
5.2 Company Analysis
These two analyses should provide an understanding of a
firm’s overall strategic approach.
• Porter discussion of an industry’s competitive
environment
• The basic SWOT analysis
Given these analysis, two valuation approaches were
demonstrated:
1. The present value of cash flows, and
2. Relative valuation ratio techniques.
• There are five competitive forces that could affect the
competitive structure and profit potential of an industry.
They are:
• Current rivalry
• Threat of new entrants
• Potential substitutes
• Bargaining power of suppliers
• Bargaining power of buyers
 Firm Competitive Strategies
• Defensive strategy involves positioning firm so that it its capabilities provide the best means to deflect the
effect of competitive forces in the industry/ Examples may include investing in fixed assets and technology
to lower production costs or creating a strong brand image with increased advertising expenditures.
• Offensive strategy involves using the company’s strength to affect the competitive industry forces, thus
improving the firm’s relative industry position. For example, Walmart used its buying power to obtain price
concessions from its suppliers. This cost advantage, coupled with a superior delivery system to its stores,
allowed Walmart to grow against larger competitors and eventually become the leading U.S. retailer.
• Low-Cost Strategy ,the firm seeks to be the low-cost producer, and hence the cost leader in its industry
• Differentiation Strategy, firm positions itself as unique in the industry

SWOT Analysis
• SWOT analysis involves an examination of a firm’s:
• Strengths
• Weaknesses
• Opportunities
• Threats
• Internal Analysis includes strength and weaknesses
• External analysis includes opportunities and threats
5.3. Estimating Intrinsic Value
What is Intrinsic Value
➢ Is a value used to measure the worth of an asset.
➢ Although it differs from the current market price of an asset, comparing it to the current
price gives investors an idea whether the asset is undervalues or overvalued.
Measuring Intrinsic Value
Even though there is no universal standard for measuring intrinsic value of a stock/company,
analysts attempt to estimate an asset`s intrinsic value through fundamental & technical
analysis to size it`s actual performance.
Investors should always keep in mind that the estimate obtained is only an estimate. Among
the methods used, the one often used is the discounted cash flow analysis.
Calculating Intrinsic Value

➢ Cash flows are estimated based on the future performance of a firm using the discounted cashflow
(DFC) analysis. These cashflows are then discounted to today`s value to get the company`s intrinsic
value.
➢ The discount rates used can either be a risk-free rate of return or the company`s weighted average
cost of Capital (WAAC).
Discounted cash flow formula
DCF = CF1/(1+r)1 + CF2/(1+r)2 + . . . + TV/(1+r) n
CF – expected cash flow for a specific period
R – Discount rate
TV – the terminal value (estimated cash flow after the projection period)
N – period (years, months, quarters)
5.4 Estimating company Earnings Per Share
• Earnings per share is the value of a company’s earning/net profit per the number
of common shares outstanding. It is an indicator of how much money a company
makes for each share of its stock or in other words its profitability. Therefore, it is
a function of the sales forecast and the estimated profit margin.

• Earnings per share can be calculated in either

1. Earnings per share which is the net income after Tax/Total number of
outstanding shares
2. Weighted earnings per share: which is the net income after tax minus the Total Dividend
divided by the number of outstanding shares
• EPS is a popular measure for estimating corporate value. A high EPS means a higher profit which makes
investors pay more for the shares expecting higher return. Earnings per Share is also used to calculate price
to earnings ratio, which gives an investor the ability to make comparisons of the value of a stock against the
market’s willingness to pay for each dollar of earnings.
When estimating the company Earnings Per Share, in company profit margin there are three points to consider
which are the company profit margin
• 1. identification and evaluation of the firm’s specific competitive strategy which could be low cost or
differentiation,
• 2. The firm’s internal performance and the company trends and those that could affect its future
performance.
• 3. The firm’s relationship with its industry which indicates how the firm’s performance was achieved that is
attributable to the industry or unique to the firm.

Draw Backs of EPS

1. One of the drawbacks of EPS is that capital is usually ignored which could have indicated or compared
company’s efficiency.
2. EPS result is intentionally increased when the company reduces its number of shares outstanding and by
buying back the stock
3. In addition, it does not show whether a stock is under or overvalued.
5.5 Estimating company earnings multipliers

• Earning multiplier is a method used to compare the current share price of a company to its earnings per share
(EPS). The earnings multiplier also shows how much an investor will be paying for one dollar earned by the
company. It can be used to assess a company’s financial health. It also calculates the return an investor will get
against the invested amount. Investors can use the earnings multiplier for the valuation of a firm’s stocks and
compare it with industry counterparts or market indexes.
• Earnings Multiplier or P/E Ratio = Price Per Share/ Earnings Per Share
• we use two approaches to estimate a company multiplier. First, we estimate the P/E ratio which is a
macroanalysis. Second, we estimate a multiplier based on the three components of the multiplier: the dividend-
payout ratio, the required rate of return, and the rate of growth. We then resolve the estimates derived from
each approach and settle on a set of estimates.
• The earnings multiplier can be high or low due to the following reasons:
• When a greater number of investors show interest in the shares of a company, the price of the shares increases,
which results in a higher earnings multiplier. In the case where the share price is undervalued, the earnings
multiplier is low.
• Companies that are exhibiting growth tend to report a high earnings multiplier. Similarly, companies with low
or negative growth show a low earnings multiplier.
 • The following are the two most common types of earnings multipliers:
A) Forward Earnings Multiplier/ the estimated earnings multiplier
• it is used to compare the present earnings with future earnings. It provides a clear picture of the
company’s earnings in the future – assuming no changes or adjustments. However, companies may either
overestimate or underestimate their earnings to meet the expected earnings multiplier.
A) Trailing Earnings Multiplier
• It depends on the company’s past performance, considering a 12-month period for calculations. It is the
most commonly used price-to-earnings indicator, as it is based on facts assuming that the reported
earnings are accurate. Investors prefer the trading earnings multiplier, as they often lack faith in estimates
presented by others. However, the past performance of a company does not always reflect its future
performance.
• If the forward earnings multiplier is lower than the trailing earnings multiplier, it implies that the analysts are
predicting an increase in the company’s earnings. Conversely, if the forward earnings multiplier is higher, the
analysts are predicting a decrease in the company’s earnings.

5.5.1 Macroanalysis of the Earnings Multiple

• It is the relationship between multiplier for the industry and the market.
 • The variables that influence the multiplier are:
✓ Required rate of return
✓ Expected growth rate of earnings and dividend
✓ Dividend payout ratio

5.5.1 Microanalysis of the Earnings Multiple

• Estimate the variables that influence the industry earnings multiplier and compare them to the comparable values
for the market P/E.
• Industry multiplier versus the market multiplier
• Comparing dividend-payout ratio
• Estimating the required rate of return
• Estimating the expected growth rate

5.5.1 Microanalysis of the Earnings Multiple

• The required comparisons are the estimated values derived using the present value of cash flow models and the
values estimated using the earnings multiple models to the current market price.
• To make investment decision we can compute the estimated intrinsic value for an investment using required rate of
return as the discount rate. If this intrinsic value is equal to or greater than the current market price of the
investment, it’s recommended to buy it. If the estimated intrinsic value is less than the market price it’s advised to not
buy it or if you own it to sell it.
5.6 Growth Company Analysis
• Dividends are expected to grow at a constant rate for an infinite time period although these assumptions are
reasonable when evaluating the aggregate market and some large mature industries, they can be very tenuous when
analyzing individual securities. These assumptions are extremely questionable for a true growth company.
• Growth company has the opportunities and ability to invest capital in projects
• that generate rates of return greater than the firm’s cost of capital
• In a competitive economy, if the rates of return for a given industry or company exceed the rates of return expected
based on the risk involved, other companies will enter the industry, increase the supply, and eventually drive prices
down until
• The rates of return earned on capital invested are consistent with the risk involved.

• Investors determine their required return for owning a firm based on the risk of its investments compared to the risk
of other firms. This required rate of return on all the firm’s capital is referred to as the firm’s weighted average cost
of capital (WACC).
• In a state of equilibrium, the rates of return earned on risky investments by the firm should equal the rates of
return required by investors. Because many firms have derived excess profits for a number of years, these
excess returns Because many firms have derived excess profits for a number of years, these excess returns
• In a purely competitive economy, true growth companies would not exist because competition would not
allow continuing excess return investments. Since our economy is not perfectly competitive.
• growth stock is expected to experience above-average risk-adjusted rates of return during some future
period. This means that any undervalued stock can be a growth stock, regardless of the type of company.
• The no-growth firm is a mythical company that is established with a specified portfolio of investments that
generate a constant stream of earnings (E) equal to the rate of return on assets(r) times the value of assets.
• In the no-growth case, the earnings stream never changes because the asset base never changes, and the rate
of return (r) on the assets never changes. Therefore, the value of the firm never changes, and investors
continue to receive k on their investment. k = E/V
• Long-run models assume some of the earning share reinvested. In all cases, it is assumed that the market value
(V) of an all-equity firm is the capitalized value of three component forms of returns discounted at the rate k.
• The simple growth model assumes the firm has growth investment opportunities that provide rates of return
equal to r, where r is greater than k (m is above 1).
• The expansion model assumes a firm retains earnings to reinvest but receives a rate of return on its investments
that is equal to its cost of capital (m = 1, so r = k).
• The negative Growth model applies to a firm that retains earnings (b > 0) and reinvests these funds in projects
that generate rates of return below the firm’s cost of capital (r < k or m < 1). m < 1, the net present value of the
growth investments would be negative.
• Capital gain is determined by the amount of capital invested in growth investments, the relative rate of return
earned on the funds retained and the time for these growth investments
• The dynamic true growth model applies to a firm that invests a constant percentage of current earnings in
projects that generate rates of return above the firm’s required rate (r > k, m > 1).firm’s earnings and dividends
will grow at a constant rate that is equal to the percentage of earnings retained times the return on investments.
5.7 Measuring Value added
• Market value added (MVA) is the amount of wealth that a company is able to create for its stakeholders since
its foundation. In simple terms, it’s the difference between the current market value of the company’s stock
and the initial capital that was invested in the company by both bondholders and stockholders.
Economic Value Added vs. Market Value Added
Economic value added (EVA) measures the real profits generated by a company. Essentially, it’s used to
determine how profitable an organization has become within a given period. EVA is computed by subtracting the
product of the company’s initial capital and the percentage cost of capital from its after-tax net profit.
Market value added is simply the difference between the current value of the company on the market and the
initial contributions made by its investors. Contrary to what many assume, MVA is not a performance indicator.
Instead, it is a metric used to measure wealth. Essentially, it is used to determine exactly how much value the
firm has accumulated over time.
The advantages of the Market Value Added is that it makes companies more attractive to potential investors and
boosts the survival chances of a company.
 5.8 Equity Valuation Models
• The main purpose of equity valuation is to estimate a value for a firm or its security. A key assumption of any
fundamental value technique is that the value of the security (in this case an equity or a stock) is driven by the
fundamentals of the firm’s underlying business at the end of the day. There are a number of different methods
of value a company with one of the primary ways being the comparable (or comparable) approach.

5.8.1 Balance Sheet Valuation

• The balance sheet provides an overview of the state of a company's finances at a moment in time. Investors
can get a senseof a company's financial wellbeing by using a number of ratios that can be derived from a
balance sheet, including the debt-to-equity ratioand the acid-test ratio, along with many others. The income
statement and statement of cash flows also provide valuable context for assessing a company's finances, as
doany notes or addenda in an earnings report that might refer back to the balance sheet
5.8.2 Dividend Discount Model

• The dividend discount model (DDM) is a quantitative method used

for predicting the price of a company's stock based on the theory
that its present-day price is worth the sum of all of its future
dividend payments when discounted back to their present value. It
attempts to calculate the fair value of a stock irrespective of the
prevailing market conditions and takes into consideration the
dividend payout factors and the market expected returns. If the
value obtained from the DDM is higher than the current trading
price of shares, then the stock is undervalued and qualifies for a
buy, and vice versa.
• DDM Implications
• The constant-growth rate DDM implies that a stock’s value will be
greater:
• 1.The larger its expected dividend per share.
• 2.Thelower the market capitalization rate, k.
• 3.The higher the expected growth rate of dividends.
• The stock price is expected to grow at the same rate as dividends.
5.8.3 Free Cash Flow Models

• Value the firm by discounting the free cash flows. It is computed by subtracting investment during the period
from Net operating profit after taxes. In free cash flow valuation, intrinsic value of a company equals the
present value of its free cash flow, the net cash flow left over for distribution to stockholders and debt-holders
in each period.
• There are two approaches to valuation using free cash flow.
1. Discounting projected free cash flow to firm (FCFF)at the weighted average cost of the capital (WACC) to
find a company's total value (i.e., sum of its equity and debt).
2. Discounting the free cash flow to equity(FCFE)at the cost of equity to find the value of the company's
shareholders equity.
5.8.4 Earnings Multiplier Approach

• The earnings multiplier which is also known as the price to earnings ratio is a
simplified valuation tool that gives the ratio of price per share by earnings per
share. It allows investors determine how expensive the current price of a stock is
relative to the company’s earning per share of that stock.