CHAPTER SEVEN

FUNDAMENTAL STOCK ANALYSIS

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2001 South-Western College Publishing
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Outline
Valuation Philosophies
Investors Understanding of Risk Premiums
The Time Value of Money
The Importance of Cash Flows
The Tax Factor
EIC Analysis
Value vs. 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
3
Outline
Some Analytical Factors
Growth Rates
The Dividend Discount Model
The Multistage DDM
Caveats about the DDM
False Growth
A Firms Cash Flows
Small-Cap, Mid-Cap, and Large-Cap Stocks
Ratio Analysis
Cooking the Books
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Valuation Philosophies
Fundamental analysts believe
securities are priced according to
fundamental economic data.
Technical analysts think investor behavior
and 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 in
the overall economy (market risk),
then determines which industries are the
most attractive in light of the economic
conditions (using Porters competitive
strategy analysis framework, for example),
and finally identifies the most attractive
companies within the attractive
industries.
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Value vs. Growth Investing
A value investor believes that securities
should be purchased only when the
underlying fundamentals (macroeconomic
information, industry news, and a firms
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 securitys long-
term return is
consistent with its
risk.
Over the long run, a security
cannot survive with a cumulative
return that is negative.
C
u
m
u
l
a
t
i
v
e

R
e
t
u
r
n

Time in the Long Term
0
+
-
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
Undervalued stock: Buy
Overvalued stock: Sell
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Value vs. Growth Investing
Growth investors seek steadily 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 vs. 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 that
value is inextricably intertwined
with price.
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Value vs. 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 book
ratio
relative
price-earnings
ratio
+
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Value vs. 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 computed
by dividing the current stock price by the
firms 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 g compoundin of number where
value beginning
value ending
rate growth
mean geometric
=

|
|
.
|

\
|
=
n
n
1
1
( )
averages arithmetic using
equity on return ratio payout - 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 company
targets may be considered too.
Choosing a Growth Rate
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Some Analytical Factors: Growth Rates
Another important source of growth rate
estimates is from other security analysts.
Two popular services that monitor and
report these estimates are Zacks and the
Institutional Brokerage Estimate Service
(I/B/E/S).
Growth Rate Estimates from Other Analysts
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The Dividend Discount Model (DDM)
Also called Gordons growth model.
The model assumes that the dividend
stream is perpetual and that the long-
term growth rate is constant.
( )
stock the of riskiness the
to according factor discount the is
rate growth dividend expected the is
next year paid be to dividend the is
dividend current the is where

price current
k
g
D
D
g k
D
g k
g D
P
1
0
1 0
0
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 shareholders required rate of
return is the sum of the expected dividend
yield and the expected stock price
appreciation.
( )
g
P
g D
k +
+
=
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
2
2
2 1
0
1
1
1
1
k
g k g D
k
D
k
D
P
+
+
+
+
+
+
=

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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 firms 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 firms 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 necessarily
interested in the firms 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 Bradstreets Industry Norms
& Key Business Ratios, which
includes solvency, efficiency and
profitability ratios.
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Some Analytical Factors: Cooking the Books
All publicly traded firms in the United States
must have their financial statements
audited to ensure they fairly present the
companys financial position.
Still, every year there is at least one story of
accounting fraud at a major firm.
Unfortunately, there is not much the analyst
can do about fraud.
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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 vs. 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
24
Review
Some Analytical Factors
Growth Rates
The Dividend Discount Model
The Multistage DDM
Caveats about the DDM
False Growth
A Firms Cash Flows
Small-Cap, Mid-Cap, and Large-Cap Stocks
Ratio Analysis
Cooking the Books