Chapter 9

THE TOP-DOWN APPROACH TO MARKET, INDUSTRY,

AND COMPANY ANALYSIS

1.1.Introduction to Market Analysis

The first step in top-down analysis is to examine the attractiveness of a particular market.
Stock prices reflect investors' expectations about what is happening in the economy. More
specifically, stock prices reflect investors' expectations of future economic events.

Observing stock prices as a reflection of the economy allows for two complementary
approaches to view the market as a whole:

1. The macroanalysis approach. This approach attempts to directly link stock values
with the economy.
2. The microvaluation approach. This approach seeks to assess the market by
discounting cash flows and using relative valuation.

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The returns of the overall market (or individual stocks) can be considered as a combination of
three factors:

1. Earnings growth.
2. Multiple expansion (or contraction).
3. Dividend yield.

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We know that:

( )
1
Ending Value n
CAGR= −1, with n is the number of years
BeginingValue

P/E = 14, $1 of earnings, so the stocks are trading at $14.

- Earnings Growth: $ 1 x ( 1+6 . 5 % )5=$ 1 .3 7

- Multiple Expansion: 16. $ 1 , 37=$ 21 , 92

( )
1
$ 21 . 92 5
- CAGR from Price appreciation¿ −1=9. 383 %
$ 14
- We add the dividend yield,

Total CAGR¿ Price appreciation CAGR+ Dividend yield =9,383 %+ 2, 5 %=11, 88 %

Alternative method:

As the P/E ratio increases from 14 to 16 over 5 years.

The annualized contribution from Market Multiple Explansion will be:

( )
1/ 5
16
−1=2 . 7 %
14

Earnings Growth: 6.5% annually.

We have:

CAGR from Price appreciation¿ ( 1+6 , 5 % )( 1+2 , 7 % )−1=1,065.1,027−1=9,383 %

Total CAGR¿ Price appreciation CAGR+ Dividend yield =9,383 %+ 2, 5 %=11, 88 %

1.1. Aggregate Market Analysis (Macroanalysis)

Economic growth leads to higher stock prices. This seems to suggest an easy conclusion:
Study GDP growth, and it will enable us to predict stock prices. Unfortunately, there are three
problems with this approach:

1. Preliminary GDP data is released approximately one month after the end of each
quarter, meaning it is not timely.
2. Preliminary GDP data will be revised, and often, those revisions are significant.
3. The stock market moves ahead of the economy. In other words, investors anticipate
future cash flows.

There are two possible reasons why stock prices lead the economy. One is that stock prices
reflect expectations of earnings, dividends, and interest rates. As investors attempt to forecast

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the future, their stock price decisions reflect expectations for future economic activity. The
second possible reason is that the stock market reacts to a variety of leading indicators, the
most important of which are corporate earnings, corporate profit margins, and interest rates.

Other measures of the economy as we will mention later:

1. The leading, coincident, and lagging economic indicators

2. Sentiment indicators
3. Interest rates

1.1.1. Leading, Coincident, and Lagging Indicators

The cyclical indicator approach to monitoring and forecasting the economy is based on the
understanding that the aggregate economy goes through periods of expansion and
contraction, which can be identified through movements in specific economic series. These
series are classified into three main categories: leading indicators, coincident indicators, and
lagging indicators.

1. Leading Indicators: This first category includes economic series that typically reach
peaks or troughs before corresponding peaks or troughs in aggregate economic
activity. Leading indicators are useful for forecasting future economic conditions, as
they provide early signs of upcoming changes in the economy. Examples include the
stock market, consumer confidence, building permits, and new orders for durable
goods.

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 2. Coincident Indicators: These are economic series that have peaks or troughs that
roughly coincide with the peaks and troughs in the business cycle. Coincident
indicators move in parallel with the overall economy, providing a real-time view of
the current economic situation. Examples include GDP, industrial production,
unemployment rates, and retail sales.

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 3. Lagging Indicators: Lagging indicators include economic series that experience their
peaks and troughs after those of the aggregate economy. These indicators confirm
trends and are useful in assessing long-term patterns. Examples of lagging indicators
include unemployment rate, business profits, interest rates, and consumer debt.

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No indicator is perfect. The Conference Board acknowledges the following limitations, which
are also discussed in Koenig and Emery (1991):

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 1. False signals. A series that moves in one direction can suddenly reverse, negating
previous signals or creating uncertainty, making it difficult to interpret. High
variability within the series causes this problem.
2. Timeliness of data and revisions. Some data series take time to be reported, but a
bigger issue is data revisions, especially if revisions alter the implied direction of the
original data.
3. Unrepresented sectors of the economy. Examples include the service sector, export-
import data, and many international series.

1.1.2. Sentiment and Expectations Surveys

Consumer expectations are considered relevant as the economy approaches a turning point in
the cycle. Two widely followed consumer expectation surveys are reported monthly:

 The University of Michigan Consumer Sentiment Index

 The Conference Board Consumer Confidence Index

Both indices survey a sample of households about their expectations. While the two indices
may diverge from month to month, over longer periods, they tend to track each other closely.
Both indices are intended to serve as leading indicators of the economy.

1.1.1. Interest Rates

In addition to leading economic indicators and sentiment indicators, another key approach to
tracking the economy involves monitoring interest rates. Several important measures are used
for this purpose:

1. The Real Federal Funds Rate: This is the federal funds rate adjusted for inflation
and is a crucial tool in monetary policy. Analysts closely monitor the level of the
federal funds rate to assess whether it is intended to stimulate or restrict the economy.
The natural rate, or neutral rate, represents a level that would neither stimulate nor
restrict economic growth. If the Fed's policy is accommodative, it aims to increase

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 growth, while a restrictive policy is designed to slow down the economy to control
inflation, which typically is not beneficial for stock prices.

2. The Yield Curve (Term Spread): The yield curve is one of the most important
economic indicators for analysts. It shows the relationship between short-term and
long-term interest rates, providing insights into market expectations of future
economic conditions:
o A normal yield curve occurs when long-term yields are higher than short-
term yields, indicating expectations of economic growth.
o A flat yield curve happens when long-term rates are similar to short-term
rates, signaling uncertainty in the economy.

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 o An inverted yield curve occurs when long-term yields are lower than short-
term yields, often viewed as a predictor of an economic recession. The yield
curve has historically inverted before every recession since 1970.
3. Risk Premium Between Treasury Bonds and BBB-Rated Bonds: The risk
premium measures the additional yield that investors require to hold riskier corporate
bonds (such as BBB-rated bonds) compared to safer Treasury bonds. A larger spread
indicates greater fear in the markets, as investors demand higher compensation for
taking on additional credit risk. This measure provides insights into market sentiment
and investor appetite for risk.

4. The Fed Model: This model, introduced by Alan Greenspan in 1997, compares the
earnings yield of stocks (the inverse of the P/E ratio) with the yield on long-term
Treasury bonds to assess the relative attractiveness of stocks versus bonds. According
to the Fed model, the value of the S&P 500 should be determined by dividing next
year's earnings by the yield on the 10-year Treasury bond. The model has shown a
strong correlation with actual stock prices over time, although it is not without its
critics.

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1.1.Micro valuation Analysis

After analyzing the health of the economy and the trajectory of the business cycle, the
analyst's goal is to estimate the true market value. We will consider doing this in two ways:
the Free Cash Flow to the Equityholder (FCFE) model and relative valuation.
Additionally, as part of the valuation process, we will examine the Cyclically Adjusted
Price-Earnings (CAPE) ratio developed by Robert Shiller.

1.1.1. FCFE to Value the Market

We can use either a two-stage FCFE model or a constant growth model. In this chapter, we
will focus on valuing the market using the constant growth model. Although sometimes, we
assess the market as a whole by considering a few years of very high or very low growth. To
use the FCFE model, you need estimates of next year's cash flows (including the growth
rate) and the discount rate. We will review each of these two components:

Cash Flows

Estimating cash flows can be done in several ways. The simplest approach is to use
consensus estimates for earnings per share (EPS). However, you can also build a model
organically by estimating these factors that influence cash flows:

1. Growth Rate of Sales per Share:

o Start with the sales per share for the most recent year and estimate the growth
rate of sales.

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 o When estimating future sales growth, consider the long-term factors such as
labor force growth and productivity, as these impact GDP growth and, by
extension, company sales. It’s important to remember that growth rates depend
on broader economic factors and are not just about short-term predictions.

2. Operating Margin:
o To move from sales per share to operating profit, multiply sales per share by
the operating margin. This figure is crucial but difficult to estimate accurately.
o The best approach is to start by examining the current operating margin and its
historical trend, adjusting for expected changes due to economic conditions or
company-specific factors.

3. Interest Expense:
o Interest expense must be deducted from operating profit and depends on two
factors: the amount of debt and the interest rate.
o Estimating debt involves considering the company's growth, asset turnover
trends (sales divided by assets), and changes in financial leverage. Assess
whether the company is increasing its debt or improving its asset efficiency.

4. Tax Rate:
o The tax rate is another key component. Consider the current tax rate and any
political actions that might affect it.
o You should also evaluate the trends in where goods are produced and sold, as
tax rates vary across different jurisdictions, impacting the overall tax burden.

Discount Rate

After estimating the cash flows, the next step is to determine the discount rate, which is
crucial for calculating the present value of the FCFE.

 Cost of Equity: Since we are discounting cash flows available to equity holders
(shareholders), the appropriate discount rate is the cost of equity for the overall
market.
 The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM),
which takes into account the risk-free rate and the market risk premium.

The Risk-Free Rate and Market Risk Premium

 Risk-Free Rate: A bond is considered risk-free if it has no default risk and no interest
rate risk, including reinvestment rate risk. To eliminate default risk, analysts often use
Treasury bonds as a proxy for risk-free assets.
 The market risk premium represents the additional return investors expect from the
market over the risk-free rate. This is usually based on historical data and expected
future market conditions.

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1.1.1. Multiplier Approach

In addition to using the discounted cash flow approach to value the market, an analyst can
also use the multiple approach, which is actually more common.

To use the price-to-earnings (P/E) multiple approach, an analyst needs to estimate two
variables: earnings per share (EPS) and the multiple.

Earlier in this chapter, when we discussed using the FCFE methodology, we explored how to
estimate EPS. Analysts must estimate the following:

 The growth rate. This involves forecasting the long-term growth of earnings, often
tied to GDP growth, productivity, and labor force expansion.
 The cost of capital. This is the required return demanded by investors, typically
influenced by risk-free rates, equity premiums, and market conditions.
 The return on equity (ROE). This measures the profitability relative to shareholders'
equity and is a key determinant of sustainable growth and valuation multiples.

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1.1.1. Shiller P/E Ratio

The Shiller P/E ratio, also known as the Cyclically Adjusted Price-to-Earnings (CAPE)
multiple, is a methodology used to value the overall market. The CAPE multiple aims to
smooth out the volatility of one-year earnings by using an average of past earnings over
several years. This approach is based on the idea that one-year earnings are highly volatile
and subject to mean reversion. By averaging earnings over a longer period, we gain a more
accurate sense of the strength of corporate or market-wide earnings over the long term, which
helps to reduce the impact of short-term fluctuations.

In the CAPE approach, the numerator remains the same— the value of the S&P 500 index.
However, the denominator is adjusted. Instead of using just the past year’s earnings (or next
year’s earnings for a forward multiple), past earnings are inflated to reflect the current year
and then averaged. This adjustment helps to account for cyclical fluctuations in earnings and
provides a more reliable long-term valuation of the market.

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1.1.1. Macro valuation and Micro valuation of World Markets

Each market is unique, with economies growing at different rates, varying economic data,
different risks, and distinct accounting standards. Additionally, the types of companies that
make up public markets may differ across countries. Despite these variations, there are three
key factors to consider when evaluating markets globally:

1. Basic Valuation Models Apply Globally: The fundamental valuation models and
concepts are universally applicable. Specifically, value is still based on the discounted
value of future cash flows, regardless of the country.
2. Variations in Input Values: While the core models and concepts remain the same,
the input values—such as growth rates, interest rates, and economic conditions—will
vary significantly across countries. These differences in input values lead to variations
in valuations and create diverse investment opportunities.
3. Challenges in Valuing Non-Domestic Markets: Valuing non-domestic markets
tends to be more complex due to several additional variables and constraints that must
be considered, such as exchange rate risk, country-specific risks, and differences in
accounting standards. These factors make the valuation process for foreign markets
more onerous compared to domestic markets.

1.1. Introduction To Industry Analysis: Why Industry Analysis Matters

Four considerations in analyzing an industry:

1. How the business cycle impacts the industry.

o The overall economic cycle can have a significant effect on industry
performance, with some industries being more sensitive to economic
expansions or recessions.
2. Structural issues impacting the industry.
o These include factors like technological changes, regulatory shifts, or changes
in consumer preferences that alter the industry's dynamics and profitability.

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 3. Industry life cycle.
o Every industry goes through stages such as introduction, growth, maturity, and
decline. Understanding the current stage can help in forecasting future trends
and identifying investment opportunities.
4. Competitive forces within the industry (Porter's Analysis).
o Michael Porter's Five Forces framework analyzes the competitive pressures
within an industry, including the threat of new entrants, the bargaining power
of suppliers and buyers, the threat of substitutes, and the level of industry
rivalry.

1.1. Industry Analysis

1.1.1. The Business Cycle and Industry Sectors

The business cycle refers to the period of time during which the output of goods and services
in the economy peaks, contracts (during a recession), recovers from the previous expansion to
reach the previous peak (recovery), and then grows further (expansion). Different industries
tend to perform well or poorly at different stages of the business cycle.

Some investors try to implement sector rotation, where they monitor economic trends and
attempt to shift their investments from one sector (or industry within a sector) to another (or
industry) as economic trends change.

Some general beliefs about sectors:

• Toward the end of a recession, financial stocks often recover first because their earnings
rise in anticipation of improved loan performance and new lending activity (as the
economy begins to recover).
• Consumer durable goods perform well as the economy recovers.
• Capital goods tend to perform well when the economy moves past recovery and into
expansion.
• Cyclical companies tend to move to anticipate the business cycle, reversing to anticipate
recovery and retracting if signs of economic weakness appear.
• Consumer staples tend to outperform during economic slowdowns.
9.5.2. Structural Economic Changes Impact the Industry (Noncyclical
Factors)

As an analyst studying an industry, one must look for major changes in the economy and
understand how they function. Four categories of changes are demographics, lifestyle,
technology, and politics and regulation.

• Demographics

Demographics are crucial for both the demand (consumption) and supply (particularly labor)
sides. When examining demographics, we look at population growth, age distribution,
changes in ethnic composition, geographic distribution of people, and changes in income
distribution.

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• Lifestyles

Lifestyles relate to how people live, work, form households, consume, enjoy leisure time, and
educate themselves. Important lifestyle issues include divorce rates, dual-career families,
population shifts from cities, and computer-based education and entertainment.

• Technology

Technology can impact many industry factors, including products or services and how they
are produced and delivered. Clearly, new technologies can significantly change industries.
Simple examples include Amazon's impact on the retail industry or Uber's impact on local
transportation businesses.

• Politics and Regulation

Politics and regulation can have a profound impact on industries. Political changes reflect
social values, and as a result, today's social trends may lead to future laws, regulations, or
taxes.

1.1.1. Industry Life Cycle

When predicting sales and profitability of an industry, insights can be gained by observing
the industry's experiments over time and dividing its development into stages similar to those
humans go through. When analyzing an industry, it's important to ask how long the industry
will remain in a particular stage of its life cycle.

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The industry life cycle typically consists of four main stages:

1. Introduction: The industry is in its early phases, with new products or services being
developed and marketed. Growth is often slow, and profitability may be limited due
to high costs and low demand.
2. Growth: The industry experiences rapid growth as demand increases, and
profitability improves due to economies of scale and market acceptance.
3. Maturity: Growth slows as the industry becomes saturated, with high competition
and stable demand. Profitability may stabilize or decrease slightly as competition
intensifies.
4. Decline: The industry faces reduced demand, technological obsolescence, or shifts in
consumer preferences, leading to declining sales and profitability.

1.1.1. Industry Competition

Industry competition has a tremendous impact on profitability. Michael Porter's concept of

competitive strategy is described as a company's search for a profitable competitive position
within an industry. To create a profitable competitive strategy, a company must first examine
the basic competitive structure of its industry, as the potential profitability of a company is
greatly influenced by the profitability of the industry itself.

Porter believes that the competitive environment of an industry (the intensity of competition
among companies within the industry) determines a company's ability to maintain a return on
invested capital above average.

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9.6.Estima
ting
Industry
Rates of
Return
1.1.1.

Estimating the Cost of Capital

Regardless of whether you use discounted cash flows or relative valuation, your estimate of
the cost of capital is crucial. The simplest way to calculate the cost of equity (k) is by using
the Capital Asset Pricing Model (CAPM). If you want to know the historical beta of an
industry (to gain insights for your forward-looking beta estimate), you should compare the
specific industry to the market.

If you decide not to use the Capital Asset Pricing Model, you can estimate the cost of capital
by considering all significant risks: business risk, financial risk, liquidity risk, exchange rate
risk, and country risk.

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9.6.2 Sales Growth Estimates
When estimating sales growth for an industry, several methodologies can be applied to
forecast future performance. Below are three key approaches:
1. Time Series Analysis

Time series analysis involves studying historical data to identify patterns or trends over time.
By overlaying industry sales data with business cycles, analysts can estimate how sales are
likely to evolve as the economy goes through different stages (e.g., expansion, recession).
This method helps forecast future sales by recognizing past cyclical patterns and
extrapolating them forward.

For example, if an industry consistently experiences sales growth during periods of economic
recovery and downturns during recessions, the time series analysis will reveal these trends,
which can be useful in making short- or long-term predictions about sales performance.

2. Input/Output Analysis

Input/output (I/O) analysis identifies the relationships between suppliers and customers
within an industry. This approach examines how the supply of raw materials and services
(inputs) to one company leads to the production of goods and services that are sold to
customers (outputs). By understanding these relationships, analysts can better assess the
industry's overall sales outlook by looking at the future trends of suppliers and customers.

For example, if a key supplier in a particular industry is experiencing growth, it could

indicate a positive long-term sales outlook for companies that depend on those supplies.
Conversely, if a customer base is shrinking or shifting due to economic factors, this could
signal potential declines in industry sales.

3. Industry–Economy Relationship

The industry-economy relationship focuses on identifying the economic variables that

have the most significant influence on demand within an industry. For example, interest
rates, inflation, unemployment levels, and consumer confidence can all have a direct
impact on the demand for certain products or services within an industry.

By analyzing how changes in these variables affect consumer behavior, production, and
industry sales, analysts can create more accurate sales growth estimates. For instance, an
industry that is highly sensitive to interest rates, like the housing market or automotive
industry, might see a slowdown in sales when interest rates rise. Conversely, industries
related to essential goods may show more stability regardless of economic shifts.

9.6.3 Other Considerations

 It is very difficult to apply regression and time series analysis.

 Industry tax rates may differ significantly from the overall market tax rate.
 Relative valuation often involves comparing industry multiples with market multiples.
 Always understand the underlying fundamentals driving the multiples.

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  It is always important to ask yourself why the market views an industry in a certain
way.

1.1. Global Industry Analysis

As many firms are increasingly active in foreign markets and the proportion of foreign sales
grows for numerous companies, it is essential to consider the effects of foreign firms on
industry returns. Global industry analysis has gained importance, as documented by
Cavaglia, Brightman, and Aked (2000). Prior research showed that country factors were
dominant in explaining equity returns. However, the study by Cavaglia et al. provided
evidence that industry factors have grown in importance and now often dominate country
factors.

When conducting global industry analysis, these factors must be considered:

1. The Macro Environment: The overall economic conditions in the major producer
and consumer countries for an industry must be analyzed, as they have a significant
impact on industry performance.
2. Analysis of Significant Global Companies: A thorough analysis of major global
companies within the industry, their products, and their performance is crucial. This
includes assessing the companies' success through the lens of the three DuPont
components—profit margin, asset turnover, and financial leverage.
3. Accounting Differences by Country: It is important to recognize and understand the
accounting differences across countries, as these can impact relative valuation ratios
and comparisons between companies in different regions.
4. Currency Exchange Rate Trends: The impact of currency exchange rate trends
between major countries is another critical factor. Exchange rate fluctuations can
significantly affect the profitability and valuation of companies operating in
international markets.

1.1. Company Analysis

An analyst has made two decisions about their equity market investments. First, after
analyzing the economy and stock markets of several countries, they have decided what
percentage of their portfolio should be invested in common stocks and its allocation to
alternative countries (i.e., overweight, market weight, or underweight). Second, after
analyzing various industries, they have identified sectors that seem to offer above-average
risk-adjusted performance over their investment horizon. In the top-down approach section,
we will examine:

1. The difference between company analysis and stock valuation.

2. Company analysis.
3. Valuation.

(using the valuation concepts from Chapter 8 or earlier in this chapter, which are about
analyzing an industry.)

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3.1.1. Growth Companies and Growth Stocks

Practitioners generally describe a growth company as one that consistently increases sales
and earnings at a rate faster than the overall economy. In contrast, financial theorists such as
Solomon (1963) and Miller and Modigliani (1961) define a growth company as one with
management ability and opportunities to consistently make investments that yield returns
greater than the company's required rate of return.

Growth stocks are not necessarily stocks in companies that are growing. A growth stock is a
stock with an expected rate of return higher than other stocks in the market with the same risk
characteristics.

3.1.2. Defensive Companies and Stocks

Defensive companies are those whose future earnings are likely to withstand economic
downturns. They are expected to have relatively low business risk and moderate financial
risk. Common examples include fast food chains and grocery stores—companies that supply
basic consumer needs.

There are two closely related concepts of defensive stocks:

1. The return on defensive stocks is not expected to decrease during an overall

market downturn, or it is expected to decrease less than the market as a whole.
2. Our discussion of CAPM shows that the relevant risk of an asset is its
covariance with the market portfolio of risky assets—that is, the asset's
systematic risk. Stocks with low or negative systematic risk (small positive or
negative beta) may be considered defensive stocks under this theory because
their returns are unlikely to be significantly harmed in a bear market.

 Cyclical Companies and Stocks

Sales and earnings of cyclical companies will be significantly influenced by aggregate

business activity. Cyclical stocks will experience greater fluctuations in their returns than the
overall market return. In terms of CAPM, these would be stocks with a high beta. However,
not all stocks of cyclical companies are necessarily cyclical. Cyclical stocks refer to stocks of
any company that exhibit returns more volatile than the overall market—that is, high-beta
stocks with a high correlation to the overall market and greater volatility.

 Speculative Companies and Stocks

Speculative companies are those whose assets involve significant risk but also offer the
potential for substantial returns. A good example of a speculative company is one involved in
oil exploration.

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Speculative stocks have a high probability of low or negative returns and a low probability of
normal or high returns. Specifically, speculative stocks are those that are overpriced, leading
to a high likelihood that during the upcoming period, when the market adjusts the stock price
to its true value, it will experience low or possibly negative returns. Such expectations may
occur in companies with very strong growth prospects whose stocks are sold at very high
price-to-earnings ratios—i.e., those that are substantially overvalued.

 Value versus Growth Investing

Value stocks are those that appear to be undervalued for reasons other than potential earnings
growth. Value stocks are typically identified by analysts as having low price-to-earnings
(P/E) or price-to-book (P/B) ratios. Specifically, when comparing growth stocks and value
stocks, the specification of growth stocks is inconsistent with our previous discussion.

While growth stocks are characterized by higher expected future earnings and higher P/E
ratios, value stocks are generally seen as undervalued relative to their intrinsic worth, often
with the expectation that the market will eventually recognize their true value over time.

1.1.Connecting Industry Analysis to Company Analysis

1.1.1. Firm Competitive Strategy
A company's competitive strategy can be either defensive or offensive. A defensive
competitive strategy involves positioning the company to deflect the influence of
competitive forces within the industry. An offensive competitive strategy, on the other hand,
is where the company attempts to leverage its strengths to influence the competitive forces in
the industry.

Types of Competitive Strategies:

1. Low Cost Strategy

Companies pursuing a low-cost strategy aim to become the lowest-cost producer and,
therefore, the cost leader in their industry. To gain the advantages of cost leadership, the
company must set prices near the industry average, meaning it needs to differentiate itself
from other companies.

2. Differentiation Strategy

With a differentiation strategy, the company strives to position itself as unique in its
industry in ways that are important to buyers. The degree of differentiation varies greatly
depending on the industry and the nature of the buyers.

3. Focusing Strategy

Regardless of the chosen competitive strategy, the company must decide where it will
focus its efforts. Specifically, the company needs to select a segment within the industry
and tailor its strategy to serve this particular group.

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9.9.2. SWOT Analysis

SWOT analysis involves examining strengths, weaknesses, opportunities, and threats.

This helps you evaluate a company’s strategy to leverage its competitive advantages or
defend against its weaknesses. Strengths and weaknesses involve identifying a company’s
internal capabilities or shortcomings. Opportunities and threats involve external factors,
such as competitive forces, technological innovations and developments, government
regulations, and domestic and international economic trends.

9.10. Calculating Intrinsic Value

After analyzing a company from both qualitative and quantitative perspectives, analysts need
to calculate the intrinsic value of the stock. Most analysts will create a discounted cash flow
model (using either dividends, FCFE or FCFF) and will also use relative valuation.

9.10.1. Some Additional Insights on Valuation-For Individual Companies

1. Using historical growth rates or margins is not accurate.

2. When examining a company’s sales, always study how the sales mix has changed.
3. A company's growth rate will be influenced by where the industry is in its life cycle,
structural changes, industry competition, and economic trends.
4. When looking at historical growth, always try to differentiate between organic growth
and acquired growth.
5. Remember what your equity cost represents.
6. When forecasting a particular company's profit margins, make sure to understand the
competitive strategy (low cost or differentiation).
7. Be aware that it's important for you to have quarterly estimates for the upcoming year.
8. When doing relative valuation, compare the company with its historical multiples,
competitors in the industry, the industry’s overall multiples, and market multiples.
9.10.2. Analyzing Growth Companies

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Growth companies are those that have the ability to continually reinvest a substantial amount
of capital and generate a rate of return greater than their cost of capital. For a stock to be
considered a growth stock, where compounded returns exceed the required market rate, the
growth company must be undervalued. The characteristic of such a company is its potential
to reinvest significant amounts of capital at rates of return higher than the firm's cost of
capital.

When analyzing growth companies, financial analysts often assume constant growth in their
models. This assumption may be sufficient for markets, industries, or mature companies, but
it is questionable for true growth companies. Returns that exceed the cost of capital are
referred to as pure profits or excess profits, which can only exist in a noncompetitive market.

Analysts must consider three essential factors:

1. The amount of capital invested in growth: How much capital is being allocated to
growth investments?
2. The rate of return on retained funds: What is the return on funds that the company
retains for reinvestment?
3. The duration of growth: How long can the company maintain its growth at these
high levels?

When using the constant growth model to evaluate a company that is earning more than its
cost of capital, it is essential to recognize that several strong assumptions are being made:

1. Constant Growth of Earnings and Dividends: The model assumes that earnings and
dividends will grow at a constant rate indefinitely. This is a significant assumption, as
real-world growth rates tend to fluctuate over time due to market conditions,
competitive pressures, and other factors.
2. Increasing Investment in High-Return Projects: The model presumes that the
company will continuously invest more capital into projects that generate returns
higher than its cost of capital. While this may be the case for a while, there are limits
to the company's ability to maintain this level of profitable investment, especially as
the business matures or faces diminishing returns.
3. Infinite Duration of High Returns: The model further assumes that the company can
sustain this level of investment and profitability for an infinite amount of time. In
reality, no firm can maintain above-average returns forever due to market dynamics,
technological advancements, regulatory changes, and competitive threats.

Growth Duration Model

The Growth Duration Model helps analysts evaluate the high P/E ratio of a growth company's
stock by relating it to the company’s expected growth rate and the duration of that growth.
The P/E ratio of a stock is influenced by three factors:

 The firm’s expected rate of growth in earnings per share (EPS).

 The stock's required rate of return.
 The firm’s dividend payout ratio.

The growth duration model is based on two assumptions:

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 1. Equal risk: The technique assumes that the firms being analyzed have the same level
of risk. This assumption is acceptable when comparing two large, established
companies within the same industry.
2. Similar payout ratios: It is assumed that the firms in question have no significant
differences in their payout ratios.

The P/E ratios of the two stocks are in direct proportion to the ratio of composite growth rates
raised to the Tth power. Allowing g to represent the high-growth company and a to represent
the market or slower growth company, you can solve for T by using the following equation:

ln ( Pg(0)/Eg (0)
Pa(0)/Ea(0) )
≈ T . ln ¿ ¿

The growth duration model answers the question of how long the earnings of the growth
stock must grow at this expected high rate, relative to the nongrowth stock, to justify its
prevail- ing above-average P/E ratio.

Example:

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Factors to Consider in Growth Analysis

When using the growth duration technique, analysts should keep in mind the following
considerations:

1. Risk Assumption: This technique assumes equal risk, which is acceptable when
comparing two companies in the same industry that are large and well-established.
2. Growth Estimates: The growth rate (g) should be based on factors influencing it,
such as the retention ratio and components of return on equity (ROE).
3. P/E Ratio Assumption: The growth duration technique assumes that stocks with
higher P/E ratios tend to have higher growth rates.

The inconsistency between the expected growth and the P/E ratio can indeed stem from
several factors. Here's a breakdown of the four potential reasons you’ve mentioned:

1. Major Difference in Risk:

A assumption when comparing P/E ratios and expected growth is that the stocks being
compared carry the same level of risk. If one stock is riskier than another, it may
warrant a lower P/E ratio, even if the expected growth rate is higher. The P/E ratio
reflects both growth expectations and the level of risk, so a stock with higher risk will
typically have a lower P/E ratio as investors demand a higher return for taking on that
risk.

2. Inaccurate Growth Rate Estimates:

Growth estimates can sometimes be overly optimistic or overly conservative. If

analysts overestimate the growth potential of a company, they might assign a higher
P/E ratio based on that growth, which can lead to an overvaluation. Conversely,
underestimating growth potential can result in a stock being undervalued, even if it
has a seemingly high P/E ratio. The accuracy of growth projections is crucial in
determining whether a stock is correctly priced.

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 3. Undervaluation of Low P/E Stock with High Expected Growth:

A stock that has a low P/E ratio relative to its expected growth might be undervalued.
This could be because the market has not fully recognized the company's growth
potential, or there might be temporary factors causing the stock to be undervalued
(e.g., market pessimism, short-term setbacks). Investors may view it as a buying
opportunity if they believe the market will eventually correct its mispricing.

4. Overvaluation of High P/E Stock with Low Expected Growth:

A stock with a high P/E ratio but low expected growth is likely to be overvalued. This
could be due to market overoptimism, speculation, or a general overestimation of the
company’s future prospects. Stocks with high P/E ratios but low growth potential
might be driven by momentum or other factors, and investors may eventually realize
that the stock is not living up to its lofty price expectations, potentially leading to a
price correction.

1.1. Lessons from some Legends

1.1.1. Some Lessons from Lynch

Peter Lynch outlined the following beneficial attributes when analyzing a company:

1. Product Consistency: The company's product is not a passing trend; it is one that
consumers will continue to buy over time.
2. Sustainable Competitive Advantage: The company has a sustainable comparative
competitive advantage over its competitors.
3. Market Stability: The industry or product of the company has market stability.
Therefore, the company does not need to innovate or create product improvements or fear
losing technological advantage. Market stability implies less potential for new entrants.
4. Cost Reduction Benefits: The company can benefit from cost reductions (e.g., a
computer manufacturer using technology provided by suppliers to produce products more
quickly and cheaply).
5. Stock Buybacks or Insider Buying: The company repurchases its shares or management
buys shares, indicating that insiders are putting their money into the company.

9.11.2. Tenets of Warren Buffett

The following tenets of Warren Buffet are from Robert Hagstrom (2001).
1. Business Tenets:
 Is the business simple and understandable?
 Does the business have a consistent operating history?
 Does the business have favorable long-term prospects?
2. Management Tenets:
 Is management rational?
 Is management candid with its shareholders?
 Does management resist the institutional imperative?

3. Financial Tenets:

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 Focus on return on equity, not earnings per share.
Calculate owner earnings.
Look for a company with relatively high sustainable profit margins for its
industry.
 Make sure the company has created at least one dollar of market value for
every dollar retained.
4. Market Tenets:
 What is the intrinsic value of the business?
 Can the business be purchased at a significant discount to its fundamental
intrinsic value?

1.1.1. Tenets of Howard Marks

Some key takeaways from Howard Marks' book: The Most Important Thing are:

 To succeed, you must engage in second-level thinking. You need to understand how
prices reflect consensus opinions, the range of possible outcomes, how your views
differ, and the likelihood that you're correct.
 An investor must have an accurate understanding of intrinsic value. Without this, all
you have are hopes.
 There are times when some investors are forced to sell (e.g., due to a margin call).
This is when other investors have a real opportunity.
 Risk is the risk of permanent loss of capital. This risk is greatest when prices are
relatively high compared to intrinsic value.
 The greatest risk occurs when other investors say there is no risk, and so on.
 Almost everything in business is cyclical
 The market is a pendulum that swings between fear and greed
 The way to avoid trouble is to avoid greed, fear, envy, dismissal of logic, following
the herd, and ego
 To be a successful investor, you must understand intrinsic value, be able to act when
prices deviate from value, understand past cycles, understand how bad behavior can
hurt you, and remember the idea that when things seem too good to be true, they are
 A great investor must be able to buy when other investors are despondent and selling
 You should keep a list of potential investments
 You must exercise patience
 You have to understand what you know and what you do not know
 You should always have context about where we are right now

---THE END---

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