CHAPTER 8

Equity
Valuation

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8.1 Important Distinctions

• An investment is a commitment of funds for a

period of time to derive a rate of return that
would compensate the investor for the time
during which the funds are invested, for the
expected rate of inflation during the investment
horizon, and for the uncertainty involved

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8.1.1 Fairly Valued, Overvalued, and
Undervalued
• Overvalued investments
• Some investments are so expensive that we
will not receive a fair return if we buy them
• Undervalued investments
• Some investments are so cheap that they offer
a rate of return that is a greater reward than
the risk that the investor has taken

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8.1.1 Fairly Valued, Overvalued, and
Undervalued (slide 2 of 2)
• Two approaches to valuation:
1. Discounted cash flow (DCF) valuation
2. Relative valuation

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8.1.2 Top-Down Approach versus Bottom-Up
Approach
• Two approaches to selecting, analyzing, and
valuing a stock:
1. Top-down, three-step approach
2. Bottom-up, stock valuation, stock picking
approach
• The difference between the two approaches is
the perceived importance of economic and
industry influence on individual firms and stocks
• Both of these approaches can be implemented
by either fundamentalists or technicians
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8.1.2 Top-Down Approach versus Bottom-Up
Approach (slide 2 of 8)
• The top-down approach does three studies in
the examination of a security:
1. The overall market and economy
2. The industry
3. The individual company
• Exhibit 8.1

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8.1.2 Top-Down Approach versus Bottom-Up
Approach (slide 3 of 8)

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8.1.2 Top-Down Approach versus Bottom-Up
Approach (slide 4 of 8)
• Top-down analysts:
• Examine the value of an overall market and
determine which markets to invest in or to
overweight
• Within a specific market, search for the best
industries
• Within the best industries, search for the best
companies
• May discover that the “best companies” are not
the best investments because they may be
overvalued
• May also find that a company in a good industry
offers the greatest potential for excess returns

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8.1.2 Top-Down Approach versus Bottom-Up
Approach (slide 5 of 8)
• Does the Three-Step Process Work?
• Results of several academic studies support the
three-step investment process:
• Studies consistently demonstrated that the economic
environment had a significant effect on firm earnings
• Moore and Cullity (1988) and Siegel (1991) found a
relationship between aggregate stock prices and
various economic series, which support the view that
a relationship exists between stock prices and
economic expansions and contractions
• An analysis showed that most of the changes in rates
of return for individual stocks could be explained by
changes in the rates of return for the aggregate stock
market and the stock’s industry

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8.1.2 Top-Down Approach versus Bottom-Up
Approach (slide 6 of 8)
• This investment decision approach is consistent with
the discussion that the most important decision is
the asset allocation decision
• The asset allocation specifies:
• What proportion of the portfolio will be invested in
various nations’ economies
• Within each country, how assets will be divided
among stocks, bonds, or other assets
• Industry selections, based on which industries are
expected to prosper in the projected economic
environment

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8.2 An Introduction to Discounted cash Flow
and Relative Valuation (slide 7 of 8)
• The value of an asset can be calculated by
using discounted cash flow analysis and relative
valuation
• Intrinsic value:
• The present value of cash flows (also known
as discounting the cash flows); the result will
be the value that we ascribe to the business

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8.2 An Introduction to Discounted cash Flow
and Relative Valuation (slide 8 of 8)
• Discounted cash flow analysis can be done in
several different ways:
• Free cash flow to the firm (FCFF) valuation or
weighted average cost of capital (WACC)
analysis
• Free cash flow to equity (FCFE) model
• Dividend discount model (DDM)

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8.2.1 The Foundations of Discounted Cash Flow
Valuation
• The valuation of a financial asset requires two
steps:
• Identify the cash flows that the asset will
generate
• Discount those cash flows to account for their
riskiness
• The value of a stock (or any other financial
asset) is represented by the following equation:

• Or as:

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8.2.1 The Foundations of Discounted Cash Flow
Valuation (slide 2 of 2)
• The various numerators and denominators can
be seen in the following table:

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8.2.2 The Constant Growth Model

• The constant growth model (the Gordon growth

model)
• Treats cash flow as a growing perpetuity
• Assumes k > g

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8.2.2 The Constant Growth Model (slide 2 of 6)

• Important takeaways:
• If the cash flow is larger (because the company has higher
earnings or can pay out a larger percentage of earnings), the
intrinsic value is greater
• If the cash flow is less risky, it is discounted at a lower cost of
equity (k), and the intrinsic value is greater
• If the cash flow grows at a faster rate (g), the stock will be more
valuable
• Model assumes that a company is relatively mature and in a
steady state
• As no analyst is actually expecting the company’s growth rate to
be constant forever, the growth rate reflects an average growth
rate for the long term
• As a general rule, the growth rate for a large company is capped
at the growth rate of the economy
• The highest economic growth rate that can be used in this
equation is the nominal growth rate, not the real growth rate

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8.2.2 The Constant Growth Model (slide 3 of 6)

• It is important to understand the math behind the

growing perpetuity equation and the three variables
D , g, and k (and V , the value of the stock):
1 0

• The growth rate (g) describes how much the

dividend increases each year; it also describes
how much the value of the investment must grow
each year
• The required rate of return (k) describes the
amount that the investment earns each year
• The company cannot pay out the entire k; it must
retain g to grow
• The amount that can be paid out is k – g
• Exhibit 8.2

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8.2.2 The Constant Growth Model (slide 4 of 6)

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8.2.2 The Constant Growth Model (slide 5 of 6)

• There are three uses that an analyst should consider:

• A general estimate of value
• Analysts will be helped to the extent that they can use the
constant growth model to determine whether a stock is
grossly undervalued, relatively fairly priced, or grossly
overvalued
• The basis for understanding fundamental multiples
• The constant growth dividend discount model can be used
to estimate a company’s (or the overall market’s)
appropriate price–earnings ratio, as well as its price–sales
ratio and price–book ratio
• The terminal value of a model
• Analysts often build models that involve two or more
stages of growth: high growth in early years and will
anticipate that growth will eventually stabilize

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8.2.2 The Constant Growth Model (slide 6 of 6)

• An Example of Using the Constant Growth

Model to Estimate Value
• In 2000, CSCO had earnings per share of 53 cents. Assume that
Cisco was able to pay out all of its earnings. At the time, CSCO
likely had a cost of equity of at least 12 percent. Assume that
CSCO was going to grow its earnings at 10 percent per year into
perpetuity
• Using these assumptions the value of CSCO would have been:

• In 2000, the stock traded as high as $82 and was overvalued

according to this model

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8.2.3 The No-Growth Model

• In the no-growth model, the assumption is that a

company’s cash flows are not growing
• The no-growth assumption can be seen as a
special case of the constant growth assumption

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8.2.3 The No-Growth Model (slide 2 of 4)

• Important takeaways:
• The larger the cash flow, the greater the value of
the firm or the equity
• A less risky cash flow requires a lower discount
rate (lower cost of equity or WACC)
• This model is used when the best prediction is
that this company does not have any growth
opportunities
• If a company does grow and the overall economy
does grow, the company will become a smaller
part of the economy in real terms

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8.2.3 The No-Growth Model (slide 3 of 4)

• 100 Percent Payout

• With the no-growth model, the assumption is
that a company can pay out all of its earnings
• It may seem strange to think of paying out 100
percent of earnings
• Exhibit 8.3

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8.2.3 The No-Growth Model (slide 4 of 4)

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8.2.4 Multistage (or Two-Stage) Growth
Assumption
• Often, it is not correct to assume that a company’s
cash flows will grow at a constant rate or won’t grow
at all:
• The company might be in a high-growth phase of
its life cycle, and after the high-growth period, the
model might return to a constant growth
assumption
• The company might have a high-growth period
followed by a transitional period of slowing growth
and then a period of constant (slower) growth
• The company is currently growing at a slow rate,
but growth is expected to increase

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8.2.4 Multistage (or Two-Stage) Growth
Assumption (slide 2 of 3)
• The two-stage model can be considered thus:

• Exhibit 8.4

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8.2.4 Multistage (or Two-Stage) Growth
Assumption (slide 3 of 3)

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8.3 Discounted Cash Flow

• Present value of some measure of cash flow,

including dividends, operating cash flow, and
free cash flow

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8.3.1 Method #1: The Dividend Discount Model

• The DDM is the basis of all valuation

• Key ideas:
• The numerator is next year’s dividend
• The discount rate in the denominator is the
cost of equity
• Most frequently, this will be calculated using
the capital asset pricing model:

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8.3.1 Method #1: The Dividend Discount Model
(slide 2 of 12)
• Constant Growth Examples
• An analyst is valuing a company that is
expected to pay a dividend of $1.05 next year
• The dividend is expected to grow 5 percent
per year, and the cost of equity is 15 percent
• The value would equal $1.05/(.15 - .05) = $10.50

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8.3.1 Method #1: The Dividend Discount Model
(slide 3 of 12)
• Constant Growth Examples (continued)
• Earnings and payout could be described as:
• The analyst could have been told that next year’s earnings will be $1.50 and the
payout ratio would be 70 percent
• Could be stated as a 70 percent payout ratio or a 30 percent retention ratio (or
plowback ratio)
• The payout ratio plus the retention ratio must always add up to 100 percent
• Last year’s dividend was $1.00 per share and dividends are expected to grow 5
percent per year
• Last year’s earnings were $1.43, earnings are expected to grow 5 percent per
year forever, and the payout ratio is 70 percent

• The discount rate of 15 percent could be described in many ways:

• The cost of equity is 15 percent
• The risk-free rate is 7.8 percent, the beta is 1.2, and the market risk premium is
6 percent
• The risk-free rate is 7.8 percent, the expected return from the market is 13.8
percent, and the beta is 1.2
• In this way of describing the data, you are told the expected return from the
market (13.8 percent) and the risk-free rate (7.8 percent), and you use those
two numbers to calculate the risk premium of 6 percent

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8.3.1 Method #1: The Dividend Discount Model
(slide 4 of 12)
• No-Growth Examples
• A company will earn $1.50 next year and has
no growth opportunities
• The company has a cost of equity of 15
percent
• The value of the equity would equal $1.50/15% =
$10

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8.3.1 Method #1: The Dividend Discount Model
(slide 5 of 12)
• No-Growth Examples (continued)
• It is important to remember that if a company has
no growth opportunities, the correct assumption is
that the company will be able to pay out 100
percent of the earnings
• The numerator could have been described in
other ways:
• Next year’s dividend will be $1.50, and there will be
no growth opportunities.
• The earnings (or dividend) for the year that just ended
were $1.50, and the company has no growth
opportunities in the future

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8.3.1 Method #1: The Dividend Discount Model
(slide 6 of 12)
• Present Value of the Growth Opportunity
(PVGO), Using Both the Constant Growth
Model and the No-Growth Model
• The PVGO represents the portion of a stock’s
intrinsic value that is attributable to the
company’s growth
• When an analyst is valuing a stock that is
expected to have some growth, it is important
to know how much of the intrinsic value is
derived from growth

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8.3.1 Method #1: The Dividend Discount Model
(slide 7 of 12)
• The sustainable growth rate equation describes
how fast a company can grow if they generate a
certain amount of additional equity (the ROE)
and retain some percentage of it (the plowback
ratio)

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8.3.1 Method #1: The Dividend Discount Model
(slide 8 of 12)
• The PVGO is calculated in three steps:
1. Calculate the intrinsic value of the stock
• This is frequently done using the constant growth
DDM, using a two-stage model or any other way
2. Calculate the no-growth value of the stock
• This assumes that the company could pay out 100
percent of its Year 1 earnings
• If the company is not going to grow, the company
does not need to retain any earnings
• This no growth value is the value of the
assets-in-place
3. Calculate the PVGO by subtracting the
no-growth value from the intrinsic value

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8.3.1 Method #1: The Dividend Discount Model
(slide 9 of 12)
• PVGO as a Risk Factor
• For an analyst, it is very important to
understand how much of a model’s value
comes from assets-in-place and how much
comes from future growth
• The PVGO calculation is crucial in helping
analysts understand the significance of growth
in valuation—and this may be thought of as a
risk factor

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8.3.1 Method #1: The Dividend Discount Model
(slide 10 of 12)
• PVGO Can Be Negative
• Value is created by earning more on capital
than the capital costs
• Applying this to the dividend discount model,
this means that growth is valuable if the return
on equity is greater than the cost of equity

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8.3.1 Method #1: The Dividend Discount Model
(slide 11 of 12)
• Two-Stage DDM
• In addition to the constant growth assumption
and the no-growth assumption, an analyst
may assume two or three stages of growth or
even irregular growth for some time period
• Exhibit 8.5

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8.3.1 Method #1: The Dividend Discount Model
(slide 12 of 12)

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM
• FCFE is defined (measured) as follows:

• The goal is to determine the free cash flow that

is available to the stockholders after payments
to all other capital suppliers and after providing
for the continued growth of the firm
• This model is a more general version of the
dividend discount model

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 2 of 12)
• The retention rate (RR) is the percentage of earnings that are
retained or plowed back
• The sustainable growth rate equation can be represented as:
Sustainable Growth Rate (g) = Return on Equity x Retention Rate
• The sustainable growth rate equation makes two assumptions:
• The firm will keep the capital structure the same
• The debt has to increase by the same percentage amount as the
equity
• The firm is not becoming any more or less efficient. This
means that the firm needs the asset turnover ratio
(Sales/Assets) to stay constant
• Exhibit 8.6

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 3 of 12)

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 4 of 12)
• Analysts also estimate how efficient and
profitable the company will be, as well as how
the capital structure may change
• These estimates are all captured in the estimate
for the return on equity:

• Exhibit 8.7

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 5 of 12)

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 6 of 12)
• Example, value of CSCO at the end of 2016
• Four forecasts are needed:
• Sales growth
– At the end of 2016, CSCO had sales per share of $9.78
– Sales are expected to grow by approximately 4 percent per year
for the next five years
– After that, forecast slightly lower growth (3.75 percent) into
perpetuity
• Profit margin
– The company’s profit margin is approximately 24 percent
– Profit margin represents the net income divided by the sales
• Return on equity
– Assume that CSCO will have a return on equity of 20 percent
• Cost of equity
– CSCO’s cost of equity is estimated as 9.5 percent
• Exhibit 8.8

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 7 of 12)

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 8 of 12)
• Returning to DDM and PVGO
• From the dividend discount model, we know that the value of the
stock is next year’s cash flow divided by the difference between
the cost of equity minus the growth rate:
• Value $1.95/(9.5% - 4%) = $35.51

• Assume that CSCO would be able to pay out all of its earnings if it
never grew again after Year 1:
• Value $2.44/.095 = $25.68

• Because we believe the company is worth $34.66 but it would be

worth only $25.68 if it never grew again, the PVGO is $8.98
• Almost 25 percent of the intrinsic value comes from our estimate of
future growth

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 9 of 12)
• Framing Your Research
• Another way of using this valuation is that it
helps to frame the research:
1. Do you expect that CSCO can continue to grow
at 4 percent into the future?
2. Do you expect profit margins of 24 percent to be
attainable over the long term?
3. Can CSCO continue to earn an ROE of 20
percent?
4. Will a 9.5 percent return justify the risk that you
are taking by investing in Cisco?

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 10 of 12)
• What if the Stock Is Trading at Intrinsic
Value?
• FCFE model came out to a value of $34.66
• Assume that the current stock price is also
$34.66
• If all the forecasts turn out to be exactly
correct, what would be your long-term rate of
return on this investment?
• 9.5 percent per year—the cost of equity
• In effect, you would be compensated
appropriately for the risk you are assuming

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 11 of 12)
• FCFE for a Bank
• For banks, the forecasts are:
1. Asset growth
2. Return on asset
3. Return on equity
4. Cost of equity
• Exhibit 8.9

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8.3.2 Method #2: Free Cash Flow to
Equity—The Improved DDM (slide 12 of 12)

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8.3.3 Method #3: Discounted Cash Flow (FCFF)

• The FCFF uses different cash flows, a different

discount rate, and results in a different value:
1. The free cash flow in the FCFF model is the
cash flow that is available to distribute to all
providers of capital after estimating the cash flow
generated from running the business and
reinvesting in the business
• FCFE uses cash flow after the debtholders were
already paid
• FCFF does not subtract payments to debtholders

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8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 2 of 12)
2. Because the cash flows in the FCFF model
belong to all providers of capital, the
discount rate must incorporate all the
different costs of capital
• The discount rate must include the cost of equity,
the cost of debt, and the cost of preferred stock (if
the firm has issued preferred stock)
• This discount rate is known as the weighted
average cost of capital (WACC)
3. The resulting value of this calculation is the
value of the firm: the enterprise value

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8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 3 of 12)
• Steps in Calculating Free Cash Flow to the Firm
1. Forecast the sales
2. Forecast the operating profits.
3. Forecast the taxes as a percentage of the
operating profit
4. Calculate the net operating profit after taxes
(NOPAT)
5. Add back depreciation
6. Subtract the capital expenditures
7. Subtract the investment in additional net working
capital (NWC)
8. Calculate the free cash flow to the firm

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8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 4 of 12)
• Steps in Calculating Free Cash Flow to the Firm
(continued)
9. Calculate the weighted average cost of capital (the
discount rate)
10. Calculate the terminal value at the end of Year 5
11. Discount all of the free cash flow back to the present
12. Sum the present values
13. Add the value of any nonoperating assets
14. Add the value of any excess cash
15. Subtract the value of debt
16. Subtract any other debt that was not captured by the DCF
analysis
17. Calculate the value of the equity on a per share basis
• Exhibits 8.10, 8.11, 8.12, 8.13, 8.14

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8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 5 of 12)

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posted to a publicly accessible website, in whole or in part.
8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 6 of 12)

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posted to a publicly accessible website, in whole or in part.
8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 7 of 12)

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posted to a publicly accessible website, in whole or in part.
8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 8 of 12)

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posted to a publicly accessible website, in whole or in part.
8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 9 of 12)
• Putting Together the FCFF Model
• Sales for the year that just ended: $48.9 billion
• Sales growth for next five years: 4 percent
• Sales growth after Year 5: 3.75 percent
• Operating margins = 33 percent
• Tax rate = 22 percent
• Net margins = 24 percent
• Debt = $25 billion
• Pre-tax cost of debt = 4:54 percent
• Number of shares outstanding = 5 billion
• Book value of equity: $61.05 billion
• Book value of assets: $86.05
• ROA (calculated as NOPAT1/Equity0): 15.21 percent
• Percentage of NOPAT that must be reinvested (calculated as growth
rate/ROA):
– Reinvestment rate Years 1–5: 26.29 percent
– Reinvestment rate after Year 5: 24.65 percent
• Market value of equity: $150 billion
• Market value of debt: $25 billion 8-61
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• Cost of toEquity
posted a publicly=accessible
9:5 percent
website, in whole or in part.
8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 10 of 12)

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posted to a publicly accessible website, in whole or in part.
8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 11 of 12)
• Why Didn’t the FCFF Model Value Equal the FCFE
Model Value?
1. The values will be similar but will just be different by
a few dollars per share
2. If you make the same assumptions, the values
should be the same
• Assumption needed in order for the FCFF to
have the same value as the FCFE:
• When the enterprise value is calculated, assign values
based on the weights used in the WACC
• Exhibit 8.15

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posted to a publicly accessible website, in whole or in part.
8.3.3 Method #3: Discounted Cash Flow (FCFF)
(slide 12 of 12)

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posted to a publicly accessible website, in whole or in part.
8.4 Relative Valuation
• Relative valuation attempts to value a company by
comparing it to similar companies or the overall
market or the stock’s own trading history
• When analysts use multiples, they are typically used
in one of the following ways:
1. Comparing multiples to comparable companies
2. Comparing a stock multiple to the market
multiple
3. Comparing a stock’s multiple to its historic
multiple
4. Comparing a stock’s multiple to recent
transactions

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8.4 Relative Valuation (slide 2 of 2)

• Three steps involved in performing relative

valuation analysis:
1. Find comparable companies
2. Determine the appropriate multiple to use
3. Apply the multiple

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posted to a publicly accessible website, in whole or in part.
8.4.1 Implementing Relative Valuation

• Step 1: Find Comparable Companies

• When trying to find comparable businesses
within an industry, the analyst can think about
factors that make the business similar or
different
• The most common approach is to ask how
they are different from a business risk
perspective and financial risk perspective

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posted to a publicly accessible website, in whole or in part.
8.4.1 Implementing Relative Valuation (slide 2
of 8)
• Step 2: Determine the Appropriate Multiple
• Determine which multiple to use
• The first approach is simply to understand what
multiples other analysts use
• The second approach is to try to determine what
underlying metric seems to move a stock
• Step 3: Apply the Multiple
• An analyst must understand the fundamentals
that drive multiples: fundamental multiples
• Price–earnings, price–sales, and price–book
value

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posted to a publicly accessible website, in whole or in part.
8.4.1 Implementing Relative Valuation (slide 3
of 8)
• Price–Earnings
• Trailing P/E Multiple:

• Forward P/E Multiple:

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posted to a publicly accessible website, in whole or in part.
8.4.1 Implementing Relative Valuation (slide 4
of 8)
• Price–Earnings (continued)
• Investors should pay more for a dollar of
earnings if:
1. Those earnings will grow at a higher rate
2. The company is more efficient
3. The cash flows are lower risk
• The price–earnings multiple should be higher
if growth (g) is higher, the payout ratio is
higher, or the cost of equity (r) is lower

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8.4.1 Implementing Relative Valuation (slide 5
of 8)
• Price–Sales
• Trailing P/S Multiple:

• Trailing P/S Multiple:

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8.4.1 Implementing Relative Valuation (slide 6
of 8)
• Price–Sales (continued)
• Investors should be willing to pay more for a
dollar of sales if a company:
1. Has a higher profit margin
2. Is more efficient
3. Has less risky cash flows
4. Has higher growth

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posted to a publicly accessible website, in whole or in part.
8.4.1 Implementing Relative Valuation (slide 7
of 8)
• Price–Book
• Trailing P/B Multiple:

• Investors will pay more for a dollar of book

value if a company:
1. Generates a higher return on equity
2. Is less risky—meaning that the cost of equity is
lower
3. Is expected to grow its book value at a faster
rate

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posted to a publicly accessible website, in whole or in part.
8.4.1 Implementing Relative Valuation (slide 8
of 8)
• How to Remember Fundamental Multiples
• Start with the constant growth dividend discount
model
• In the numerator, replace next year’s dividend
• For the price–earnings multiple, ask how to start with
earnings and eventually reach dividends
• For the price–sales multiple, replace next year’s
dividend and start with sales
• With price–book multiple, replace next year’s dividend
with book value
• Ask how you move from that underlying metric
(earnings, sales, or book value) to dividend

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8.4.2 Relative Valuation with CSCO

• Assumptions

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8.4.2 Relative Valuation with CSCO (slide 2 of
2)

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posted to a publicly accessible website, in whole or in part.
8.4.3 Advantages of Multiples

• Multiples can be easy to use

• For a money manager with a mandate to be fully
invested, relative value is what matters
• Multiples are widely used on both the buy side
and the sell side
• Multiples are a great way to confirm the value
that you have calculated with your discounted
cash flow analysis

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posted to a publicly accessible website, in whole or in part.
8.4.4 Disadvantages of Multiples

• While multiples are simple to use, they are

difficult to use correctly
• Using multiples to purchase a security because
it is “less overvalued” than some other securities
is not a valid investment strategy
• When you find that the stock you are analyzing
is cheaper than some others, you are making a
significant assumption when you conclude that
the one stock is incorrectly priced
• It is possible that the other stocks may be
mispriced

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posted to a publicly accessible website, in whole or in part.
8.5 Ratio Analysis

• Ratio analysis:
• Helps to make better estimates for the
discounted cash flow model and to better
understand the business
• May also help to ask better questions

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posted to a publicly accessible website, in whole or in part.
8.5.1 Growth Rate of Sales
• A company can grow its earnings by growing revenue or
cutting expenses
• Sales growth provides an analyst with information about
demand for the company’s product and the company’s
pricing power
• Important to understand:
• Whether the sales growth rate is changing
• How it compares to peer companies
• How it compares to the overall economy’s growth rate
(GDP)
• If sales are growing organically or through acquisition
• Search for economic indicators that are correlated with
the revenue growth of the company and use this
relationship to help predict the future

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posted to a publicly accessible website, in whole or in part.
8.5.2 Gross Margins

• The gross margin is defined as:

Gross profit/Sales
• Important to understand:
• Whether revenue or cost of goods sold is growing
at a faster rate and how gross margins compare
to peer companies
• Company’s pricing power and the pricing power of
suppliers
• Some costs may be fixed and economies (or
diseconomies) of scale may explain changes
• Changes in the product mix must also be
investigated

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8.5.3 Operating Margins

• Operating margins are defined as:

Operating Profit/Sales
• Important to understand:
• Any changes in margins and how these margins
compare to the competition
• What is included in the Selling, General &
Administrative (SG&A) expense as well as any
changes in depreciation methodologies
• How much of the SG&A expense is fixed as
opposed to variable

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posted to a publicly accessible website, in whole or in part.
8.5.4 Net Margins

• Net margins are defined as:

Net Income/Sales
• Important to understand:
• Changes in gross margins, operating margins,
interest expense, and taxes
• Changes in the amount of debt, changes in
interest rates, and changes in effective tax rates

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posted to a publicly accessible website, in whole or in part.
8.5.5 Accounts Receivable Turnover

• Accounts receivable turnover is defined as:

Sales/Average Accounts Receivable
• Ratio can serve as a warning if a company
has changed its credit policies in order to meet
sales goals
• If accounts receivable are growing relative to
sales, then the company may be pushing
excess product out to customers with the
promise that customers can pay later

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posted to a publicly accessible website, in whole or in part.
8.5.6 Inventory Turnover

• Inventory turnover is defined as:

Cost of Goods Sold=Average Inventory
• Ratio can serve as a warning if inventories are
growing too quickly
• It may serve as evidence that the company is
having difficulty selling its product
• This could lead to lower margins in the future
or a write-off

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posted to a publicly accessible website, in whole or in part.
8.5.7 Net PP&E Turnover

• Net PP&E turnover is defined as:

Sales=Net PP&E
• If this ratio is growing, then the analyst will try
to determine whether the company is
becoming more efficient or if the company is
not doing necessary capital expenditures
• If this ratio is shrinking, then the analyst wants
to understand whether the company is
becoming less efficient

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posted to a publicly accessible website, in whole or in part.
8.5.8 Debt as a Percentage of Long-Term
Capital
• Ratio is defined as:
Debt/Long-Term Capital
• Debt can be a low-cost source of capital until
the company has too much debt
• A company with too much debt is said to have
financial risk
• Financial risk increases the sensitivity of a
stock’s performance to changes in the
economy

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posted to a publicly accessible website, in whole or in part.
8.5.9 Changes in Reserve Accounts

• Analysts watch for significant changes in

reserve accounts, such as allowances for bad
debts
• Reserves are a great tool to manage earnings
• Management may “under-reserve” in order to
meet earnings expectations or they may
“over-reserve” in order to smooth future
earnings
• It is crucial to understand that reserves must
match the underlying fundamentals of the
business and the business cycle
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posted to a publicly accessible website, in whole or in part.
8.5.10 Operating Earnings/GAAP Earnings

• Analysts know that companies usually want to report the highest

earnings possible
• The analyst has to be aware of companies that seem to have
recurring “non-recurring” expenses!
• In other words, it is easy to appear profitable if all expenses are
considered non-recurring or if a company writes down its assets so
that future expenses are low
• Analysts examine much more in financial statements than just ratios
• For example, analysts will try to understand the strategy as it is
discussed in the Management’s Discussion and Analysis (MD&A)
• Analysts will also examine the proxy statement in order to
understand the compensation structure
• They will try to understand how forthcoming management is in the
financial reports as well as the earnings conference call

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posted to a publicly accessible website, in whole or in part.
8.6 The Quality of Financial Statements

• Quality financial statements are a good

reflection of reality; accounting tricks and
one-time changes are not used to make the firm
appear stronger than it really is

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8.6.1 Balance Sheet

• A high-quality balance sheet:

• Typically has limited use of debt or leverage
• Contains assets with market values greater
than their book value
• The presence of off-balance-sheet liabilities also
harms the quality of a balance sheet, but this is
offset by capitalizing operating leases

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posted to a publicly accessible website, in whole or in part.
8.6.2 Income Statement

• High-quality earnings are:

• Repeatable earnings
• Result from the use of conservative
accounting principles that do not result in
overstated revenues and understated costs
• The closer the earnings are to cash earnings,
the higher the quality of the income statement

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posted to a publicly accessible website, in whole or in part.
8.6.3 Footnotes

• Read the footnotes!

• While the footnotes may not reveal everything,
you should know if you do not read them, then
you cannot hope to be informed
• Many analysts recommend that you should read
an annual report backward, that is, you would
read the footnotes first!

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posted to a publicly accessible website, in whole or in part.
8.7 Moving on to Chapter 9

• The purpose of this chapter is to help to develop

a sense of valuation
• This chapter is crucial to a future in investing
• Chapter 9 examines the top-down approach to
investing

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posted to a publicly accessible website, in whole or in part.
Appendix Chapter 8
• Derivation of Constant-Growth Dividend Discount
Model (DDM)

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posted to a publicly accessible website, in whole or in part.
Appendix Chapter 8 (slide 2 of 3)

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posted to a publicly accessible website, in whole or in part.
Appendix Chapter 8 (slide 3 of 3)

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posted to a publicly accessible website, in whole or in part.