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8/3/2019 6-Slides - Fundamental Analysis-3 and Private Company Valuation Size)
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11
Third Stage ofThird Stage ofFundamentalFundamentalAnalysisAnalysis
Company UsingCompany Using
Market BasedMarket BasedMethodsMethods
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FUNDAMENTAL ANALYSISFUNDAMENTAL ANALYSISPart IIIPart III
SA: Fundamental AnalysisSA: Fundamental Analysis (3) (3) 22
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3. Company Analysis3. Company Analysis
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 33
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Why Company Analysis?Why Company Analysis?
The questions are:
Which are the best companies within desirableindustries?
Are their stocks over or under priced?
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 44
Are some stocks more valuable than others?
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Company Analysis vs. Stock ValuationCompany Analysis vs. Stock ValuationGrowth Companies vs. Growth StocksGrowth Companies vs. Growth Stocks
Growth company generates returns higher thanGrowth company generates returns higher thanits cost of capital.its cost of capital.
Growth stocks have returns higher than otherGrowth stocks have returns higher than other
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 55
..
Stocks of good companies are not necessarily goodStocks of good companies are not necessarily goodinvestments.investments.
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Company Analysis vs. Stock ValuationCompany Analysis vs. Stock Valuation
Defensive Companies and Defensive Stocks:Defensive Companies and Defensive Stocks:
Earnings of defensive companies are unlikely toEarnings of defensive companies are unlikely tosuffer from economic downturns such as firms withsuffer from economic downturns such as firms withlow business and financial risks.low business and financial risks.
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 66
Defensive stocks are likely to have small or negativeDefensive stocks are likely to have small or negativebeta beta ..
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Company Analysis vs. Stock ValuationCompany Analysis vs. Stock Valuation
Cyclical Companies and Cyclical StocksCyclical Companies and Cyclical Stocks
Cyclical companys revenue move with businessCyclical companys revenue move with businesscycles.cycles.
C clical stocks have hi herC clical stocks have hi her beta beta ..
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 77
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Company Analysis vs. Stock ValuationCompany Analysis vs. Stock Valuation
Speculative Companies and Speculative StocksSpeculative Companies and Speculative Stocks
Speculative companies have greater risk withSpeculative companies have greater risk withgreater returns.greater returns.
S eculativeS eculative stocksstocks have low chances of eneratinhave low chances of eneratin
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 88
higher returns.higher returns.
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Firm competitive strategiesFirm competitive strategiesDefensive strategy
Offensive strategyLow cost strategy
Differentiation strategy
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 99
Focusing on a strategy
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SWOT AnalysisSWOT AnalysisExamination of Firms: Examination of Firms:
Strengths,Weaknesses,
Opportunities, and
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 1010
Threats.
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Estimating IV:Estimating IV: Discounted cash flow model
IV of a stock is equal to the PV of its expected cash flows. If Cis cash flow and k is required rate of return then:
1 1
(1 ) (1 )t t
t
C IV IV
k k + += +
+ +Similarly: 2 21 (1 ) (1 )
t t t
C IV IV
k k + +
+ = ++ +
SA: Fundamental AnalysisSA: Fundamental Analysis (3) (3) 1111
By substitution: 1 2 22 2(1 ) (1 ) (1 )t t t
t C C IV IV
k k k + + += + +
+ + +
and so on
Thus, IV is the PV of all future cash flows and terminal price.
What are the possible forms of cash flows available toshareholders?
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Discounted CashDiscounted Cash- -flow: An exampleflow: An example 11
SP Plc paid a dividend of 2.93 per share today. 4 years ago itSP Plc paid a dividend of 2.93 per share today. 4 years ago itwas only 2. It is expected that the companys dividends wouldwas only 2. It is expected that the companys dividends wouldgrow at this rate for next 3 years. Thereafter the growth ingrow at this rate for next 3 years. Thereafter the growth individend is expected to be only 5% per year. The required rate of dividend is expected to be only 5% per year. The required rate of return is 20% and the current market price per share is 24.return is 20% and the current market price per share is 24.
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 1212
u v y - w vshareholders).
Ms Salford approached you for your advice with the aboveMs Salford approached you for your advice with the aboveinformation. Should Ms Salford be buying these shares at theinformation. Should Ms Salford be buying these shares at thecurrent market price of 24.current market price of 24.
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Discounted CashDiscounted Cash- -flow: An exampleflow: An example22
D(t-4) = 2.00 Dividend 4 years agoD
t= 2.93 Dividend today
G 1 = 10.0% Dividend growth rate during the past 4years and expected for the next 3 years
=
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 1313
1 14 4
01
4
2.931 1 0.10 10%
2.00t
DG
D
= = = =
Calculation of growth rate (G 1):
.R = 20.0% Required rate of return
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Discounted CashDiscounted Cash- -flow: An exampleflow: An example33
1 1
(1 ) (1 )t t
t
C IV IV
k k + += +
+ +
The calculation process can be simplified as follows:
Recall:
Year Dividend Growth rate DF at 20% Present Value
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 1414
. . . .2 3.55 10.0% 0.6944 2.46
3 3.90 10.0% 0.5787 2.264 4.10 5.0%
The sum of the PV the next 3 years dividend is 7.41
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Discounted CashDiscounted Cash- -flow: An exampleflow: An example 33In year 4, the dividend per share is expected to be 4.10.Now, estimate the price of the share at the end of year 3based on the dividend of year 4 and a constant growth rateof 5%. This is estimated as:
4 4.10 27.33 DP = = =
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 1515
. .
r - g The price per share at the end of year 3 should be 27.33.
Discount 27.33 by 20% per annum (required rate of return)to estimate its present value.The PV is 15.82 (27.31*0.5787).
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Discounted CashDiscounted Cash- -flow: An exampleflow: An example44
Finally, to get the current intrinsic value of the share addthe PV of dividend receivable during the next 3 years(7.41) and the PV of the price at the end of year-3(15.82) together.
Thus, IV is 23.23 , (7.41+15.82).
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 1616
The current market price (24.00) of this share is higherthan its intrinsic ( IV < MV). It is overpriced! Ms Salfordshould not buy these shares.
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Implementing theImplementing theImplementing theImplementing theImplementing theImplementing theImplementing theImplementing the modelmodelmodelmodelmodelmodelmodelmodel 11111111
Sources of growth rates:Sources of growth rates:
(a)(a) Analysts forecastsAnalysts forecasts(b)(b) Investment plans of companiesInvestment plans of companies
SA:SA: Fundamental Analysis (3)Fundamental Analysis (3) 1717
a na ys s orecas s:a na ys s orecas s:( ) ( )
( )2 1
1
t t t
t
E EPS E EPSg
E EPS+ +
+
=
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(b) Investment plans:(b) Investment plans:E = ROE * Investment
= ROE * retentions= ROE * (retention ratio * earnings)= *
Implementing theImplementing theImplementing theImplementing theImplementing theImplementing theImplementing theImplementing the modelmodelmodelmodelmodelmodelmodelmodel 22222222
SA:SA: Fundamental Analysis (3)Fundamental Analysis (3) 1818
**
E ROE bE g ROE b
E E
= = =
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Cost of capital estimated using dividend growth modelis sensitive to the choice of growth rate in dividends.
Discounted cash flow, Growth rateDiscounted cash flow, Growth rateand the Cost of capitaland the Cost of capital
Davies et al (1999):Davies et al (1999):
SA:SA: Fundamental Analysis (3)Fundamental Analysis (3) 1919
Boots BP MKS ULVRH= 0 5.85 5.90 5.40 5.14
H= 5 6.76 7.13 6.39 5.74
H= 10 7.67 8.36 7.36 6.34
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Discounted Cash Flow Model:An Appraisal
Simple to useEstimate of IV is sensitive to gIt cannot be applied:
-
SA: Fundamental AnalysisSA: Fundamental Analysis (3) (3) 2020
if g k (in a constant growth model)
Definition and measurement of cash-flow
Overall, discounted cash-flow method of stock valuationoffers simplicity but suffers from some limitations.
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Summary: Fundamental AnalysisSummary: Fundamental Analysis
Stock Mkt. Value Intrinsic Value Strategy
A 20 24 buy
B 23 23 hold
C 45 40 sell
Consider the following:
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 2121
se
E 18 22 buy
F 32 32 hold
Overall, the challenge to security analysts is to estimate IV.
Analysts should consider global & domestic macroeconomic,industry, and firm specific factors in valuing the common stocks.
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Essential ReadingsEssential Readings
Bodie, Z., A. Kane and A. J. Marcus, (2008), Investments ,Irwin (BKN). Chapter 18
Davies, R., P. Draper, S. Unni and K. Paudyal (1999), The Cost of Equity Capital, The Chartered Institute of Management Accountants.
SA: Fundamental AnalysisSA: Fundamental Analysis (3) (3) 2222
Reilly, F. K., and K. C. Brown (2006), Investment Analysis and Portfolio Management , Thomson South-Western, Chapter14.
See Supplementary Reading list for further references.
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Seminar questionsSeminar questions
1.1. The discounted cashThe discounted cash- -flow method sounds logical in valuingflow method sounds logical in valuingshares. However, it is not free from limitations. Comment.shares. However, it is not free from limitations. Comment.
2.2. In the recent past In the recent past LanchesterLanchester Plc. has been earning 3 millionPlc. has been earning 3 milliona year and its management is confident that this will bea year and its management is confident that this will bemaintained in the future from existing production facilities.maintained in the future from existing production facilities.
SA: Fundamental Analysis (3)SA: Fundamental Analysis (3) 2323
oug t e rm s genera po cy s to payoug t e rm s genera po cy s to pay- -out o tsout o tsearnings it plans to retain 1/3 of its earnings for the next 3earnings it plans to retain 1/3 of its earnings for the next 3years. The new investments are expected to generate 20%years. The new investments are expected to generate 20%return p.a. in perpetuity. Once these investment return p.a. in perpetuity. Once these investment
opportunities are exploited the firm will return to its policyopportunities are exploited the firm will return to its policyof 100% payof 100% pay- -out. The required rate of return is 10%. You areout. The required rate of return is 10%. You arerequired to estimate the value of the firm.required to estimate the value of the firm.
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Valuing a Division or a Private CompanyValuing a Division or a Private Company
SA: Valuing a Private CompanySA: Valuing a Private Company 2424
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Estimating cost of capital a listed firmEstimating cost of capital a listed firm
Expected rate of return and risk are directly and linearlyrelated.It concentrates on risk and expected return.
The Capital Asset Pricing Model:E(R i - Rf ) = R f + (E(R M) R f )
SA:SA: Valuing a Private CompanyValuing a Private Company 2525
It p aces particu ar emp asis on systematic ris
Recent developments in asset pricing:Fama-French 3 factor model4-factor model of Carhart And Others
The Issue:The Issue: How to estimate the value (or the Cost of Capital) when historical prices are not available?
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Valuing a Private Company or a DivisionValuing a Private Company or a Division
Estimating systematic risk when stock prices are notavailable: The market based approach
Assumption:Assumption:
Systematic risk for a particular line of business is
SA: Valuing a Private CompanySA: Valuing a Private Company 2626
constant for all firms that compete in that line of business.
Methods:Methods:
a. The Pure-Play approach (Fuller and Keer, 1981)b. The Full-Information approach ( (Ehrhardt and
Bhagwat, 1991).
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TheThe PurePure- -PlayPlay approachapproach11
The concept: The concept:
Find some publicly traded firms that compete in thesame line of business as your unlisted firm
Estimate the s of those listed firms
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Use these s to estimate of your private firm.
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TheThe PurePure- -PlayPlay approachapproach22
Some issues: Some issues: 1. What if s of pure-play firms are far apart?
Fuller and Keer (1981) suggest using median
-
SA: Valuing a Private CompanySA: Valuing a Private Company 2828
. Bower and Jenks (1975) suggest that finding
pure-play firm is not easy.
3. Is there any alternative to pure-play approach? Use FullUse Full--Information approach.Information approach.
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FullFull--Information ApproachInformation Approach--11
The Basis:
The overall beta of a firm is the weighted averageof divisional s
of a division is constant
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There should be more firms (M) than divisions (N)in the sample.
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, ,1
N
M j s j s js
W =
= +
FullFull--Information ApproachInformation Approach--22
Where:
Consider the following equation:
SA: Valuing a Private CompanySA: Valuing a Private Company 3030
Market of firms is the dependent variable and weightsfor the divisions are the explanatory variables.
Mj = Over all market of firm jw js = weight of each segment in company js = of segment s (a parameter to estimate)
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Performance of FullPerformance of Full- -Information ApproachInformation Approach
Ehrhardt and Bhagwat (1991):
Main results (Using 2-digit SIC code of segment)
Adj. R2 = 0.694 of 70 estimates are not statistically significant
SA: Valuing a Private CompanySA: Valuing a Private Company 3131
pure-play method.
Explains higher proportion of variation in
Is the superiority of Full-Information approach is robust?
Robust to alternative measures of segment weight, and
Robust to 3-digit SIC classification.
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SummarySummary
Lack of market value makes valuation of unlisted firmsLack of market value makes valuation of unlisted firmsor divisions difficult.or divisions difficult.
Difficulties in finding pure play firms limits theDifficulties in finding pure play firms limits theapplicability of Pureapplicability of Pure- -play approachplay approach
uu -- n orma on me o u zes n orma on con en nn orma on me o u zes n orma on con en nmutimuti--divisional firms.divisional firms.
SA: Valuing a Private CompanySA: Valuing a Private Company 3232
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Essential ReadingsEssential Readings
Ehrhardt, M. C. (1994), The Search for Value: Measuringthe Companys Cost of Capital , Harvard Business School
Press. Chapter 4.Ehrhardt, M.C. and Y.N. Bhagwat (1991), A Full-Information Approach for Estimating Divisional Betas,
SA: Valuing a Private CompanySA: Valuing a Private Company 3333
nanc a anagement , - .
Fuller, R. J. and H. S. Kerr (1981), Estimating theDivisional Cost of Capital: An Analysis of the Pure-PlayTechnique, Journal of Finance 36, 997-1009.
See Supplementary Reading list for further references.
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