CHAPTER SEVEN

FUNDAMENTAL STOCK ANALYSIS

Practical Investment Management

Robert A. Strong

South-Western College Publishing ©1998 2

Outline Valuation Philosophies

Investors’ Understanding of Risk Premiums The Time Value of Money The Importance of Cash Flows The Tax Factor EIC Analysis

Value v.s. Growth Investing The Value Approach to Investing The Growth Approach to Investing How Price Relates to Value Value Stocks and Growth Stocks:

How to Tell by Looking

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Outline

Some Analytical Factors Growth Rates The Dividend Discount Model The Multistage DDM Caveats about the DDM False Growth A Firm’s Cash Flows Small-Cap, Mid-Cap, and Large-Cap Stocks Ratio Analysis

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Valuation Philosophies

Fundamental analysts believesecurities are priced according to fundamental economic data.

Technical analysts think supply and demand factors play the most important role.

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Valuation Philosophies

Investors’ understanding of risk premiums:Investors are almost always risk-averse.

The time value of money: Everyone agrees on this basic principle.

The importance of cash flows:Most investment research deals with predicting future corporate earnings.

The tax factor:The tax code is complicated and not all investments are taxed equally.

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Valuation Philosophies

Economy, Industry and Company (EIC)analysis:

The analyst first considers conditions inthe overall economy (market risk),

then determines which industries are themost attractive in light of the economic conditions (using Porter’s competitive strategy analysis framework, for example),

and finally identifies the most attractivecompanies within the attractive industries.

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Value v.s. Growth Investing

A value investor believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm’s financial statements) justify the purchase.

Value investors believe in a regression to the mean.

The Value Approach to Investing

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Regression to the Mean

Most of the time a security’s long-term return is consistent with its risk.

Over the long run, a security cannot survive with a cumulative return that is negative.

Cu

mu

lati

ve R

etu

rn

Time in the Long Term

0

+

-

xxx

x

x

x

xxx

xx

x

xx

xUndervalued stock: Buy

Overvalued stock: Sell

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Value v.s. Growth Investing

Growth investors seek rapidly growing companies. There are two factions:

Information traders are in a hurry; they believe information differentials in the marketplace can be profitably exploited.

True growth investors are more willing to wait, but they share the belief that good investment managers can earn above-average returns for their clients.

The Growth Approach to Investing

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Value v.s. Growth Investing

In the early days of the market, before the Great Crash of 1929, price played a minor role: “A stock with good long-term prospects is always a good investment.”

How Price Relates to Value

The modern perspective is thatvalue is inextricably intertwined with price.

$ 8

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Value v.s. Growth Investing

No precise definition exists.

Classification by Morningstar Mutual Funds:

Value Stocks and Growth Stocks: How to Tell by Looking

blend - otherwise growth - 2.25 value - 1.75 relative

price to bookratio

relativeprice-earnings

ratio+

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Value v.s. Growth Investing

The price to book ratio: book value per share is an accounting concept synonymous with equity per share.

The price-earnings ratio (PE) is computedby dividing the current stock price by the firm’s earnings per share.

Because of differences among industries, relative ratios are commonly computed for both statistics.

Some Analytical Factors: Growth Rates

Growth rates from historical data:

periods gcompoundin of number where

value beginning

value endingrate growth mean geometric

n

n1

1

averages arithmetic using

equity on returnratiopayout -1 rate growth

Growth rates from earnings retention:

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Some Analytical Factors: Growth Rates

Financial analysts typically calculate a number of growth rates using different ways to determine a likely range for the statistic.

Recent data may be more reliable than data from the more distant past.

Company statements regarding companytargets may be considered too.

Choosing a Growth Rate

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The Dividend Discount Model (DDM)

Also called Gordon’s growth model.

The model assumes that the dividendstream is perpetual and that the long-term growth rate is constant.

stock the of riskiness the to according factordiscount the is

rate growth dividend expected the is next year paid be to dividend the is

dividendcurrent the is where

pricecurrent

kgDD

gk

D

gk

gDP

1

0

100

1

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The Dividend Discount Model (DDM)

The variable k is sometimes called the shareholders’ required rate of return.

Note that the shareholder’s required rate ofreturn is the sum of the expected dividend yield and the expected stock price appreciation.

g

P

gDk

0

0 1

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The Multistage DDM

Often, initial high growth levels cannot be sustained.

Suppose the growth rate g is expected to persist from the third year:

2

22

210

1

1

11 k

gkgD

k

D

k

DP

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Some Analytical Factors

Caveats about the DDM: The DDM is at most a useful tool in security analysis - it requires certain assumptions and it has shortcomings.

False growth: False growth occurs when a firm acquires another firm with a lower price-earnings ratio - historical data should always be scrutinized carefully when used to determine a growth rate.

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Some Analytical Factors

A firm’s cash flow: The statement of cash flows is a useful analytical tool - the cash flow from operations figures are widely used as a check on a firm’s earnings quality.

Small-cap, mid-cap, and large-cap stocks: Another consideration in fundamental stock analysis relates to the size of the firm - for example, the small firm effect.

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Some Analytical Factors: Ratio Analysis

The fundamental analyst is necessarilyinterested in the firm’s accounting statements and in the prevailing general economic conditions.

To assist in the analysis, several organizations publish comparative statistics for industry groups.e.g. Dun and Bradstreet’s Industry Norms & Key Business Ratios, which includes solvency, efficiency and profitability ratios.

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Review Valuation Philosophies

Investors’ Understanding of Risk Premiums The Time Value of Money The Importance of Cash Flows The Tax Factor EIC Analysis

Value v.s. Growth Investing The Value Approach to Investing The Growth Approach to Investing How Price Relates to Value Value Stocks and Growth Stocks:

How to Tell by Looking

South-Western College Publishing ©1998 22

Review

Some Analytical Factors Growth Rates The Dividend Discount Model The Multistage DDM Caveats about the DDM False Growth A Firm’s Cash Flows Small-Cap, Mid-Cap, and Large-Cap Stocks Ratio Analysis