Third Stage of Fundamental Analysis

Valuing a Private Company Using Market Based Methods

FUNDAMENTAL ANALYSIS Part III

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3. Company Analysis

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Why Company Analysis?

The questions are: Which are the best companies within desirable industries? Are their stocks over or under priced? Are some stocks more valuable than others?

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Company Analysis vs. Stock Valuation

Growth Companies vs. Growth Stocks Growth company generates returns higher than its cost of capital. Growth stocks have returns higher than other stocks with similar risk. Stocks of good companies are not necessarily good investments.

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Company Analysis vs. Stock Valuation

Defensive Companies and Defensive Stocks: Earnings of defensive companies are unlikely to suffer from economic downturns such as firms with low business and financial risks. Defensive stocks are likely to have small or negative beta. beta.

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Company Analysis vs. Stock Valuation

Cyclical Companies and Cyclical Stocks Cyclical companys revenue move with business cycles. Cyclical stocks have higher beta. beta.

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Company Analysis vs. Stock Valuation

Speculative Companies and Speculative Stocks Speculative companies have greater risk with greater returns. Speculative stocks have low chances of generating higher returns.

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Firm competitive strategies

Defensive strategy Offensive strategy Low cost strategy Differentiation strategy Focusing on a strategy

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SWOT Analysis
Examination of Firms: Strengths, Weaknesses, Opportunities, and Threats.

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Estimating IV: Discounted cash flow model

IV of a stock is equal to the PV of its expected cash flows. If C is cash flow and k is required rate of return then:
Ct +1 IVt +1 IVt = + (1 + k ) (1 + k )

Similarly:

Ct+2 IVt+2 IVt+1 = + (1+ k) (1+ k)

By substitution:

Ct +1 Ct + 2 IVt + 2 IVt = + + 2 (1 + k ) (1 + k ) (1 + k ) 2

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 to shareholders?
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Discounted Cash-flow: An example1 CashSP Plc paid a dividend of 2.93 per share today. 4 years ago it was only 2. It is expected that the companys dividends would grow at this rate for next 3 years. Thereafter the growth in 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. (Assume that dividend is the only cash-flow available to shareholders). Ms Salford approached you for your advice with the above information. Should Ms Salford be buying these shares at the current market price of 24.

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Discounted Cash-flow: An example2 CashD(t-4) = Dt = G1 = G2 = R = 2.00 2.93 10.0% 5.0% 20.0% Dividend 4 years ago Dividend today Dividend growth rate during the past 4 years and expected for the next 3 years Dividend growth rate after 3 years Required rate of return

Calculation of growth rate (G1):

D0 2.93 G1 = 1 = 1 = 0.10 = 10% 2.00 Dt 4
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1 4

1 4

Discounted Cash-flow: An example3 CashCt +1 IVt +1 Recall: IVt = + (1 + k ) (1 + k )

The calculation process can be simplified as follows: Year 1 2 3 4 Dividend Growth rate DF at 20% Present Value 3.22 3.55 3.90 4.10 10.0% 10.0% 10.0% 5.0% 0.8333 0.6944 0.5787 2.69 2.46 2.26

The sum of the PV the next 3 years dividend is 7.41

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Discounted Cash-flow: An example3 CashIn year 4, the dividend per share is expected to be 4.10. Now, estimate the price of the share at the end of year 3 based on the dividend of year 4 and a constant growth rate of 5%. This is estimated as:

4.10 D4 = P3 = = 27.33 (r - g) ( 0.20 0.05 )

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 Cash-flow: An example4 CashFinally, to get the current intrinsic value of the share add the 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). The current market price (24.00) of this share is higher than its intrinsic (IV < MV). It is overpriced! Ms Salford should not buy these shares.

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Implementing the model1

Sources of growth rates:
(a) Analysts forecasts (b) Investment plans of companies

(a) Analysts forecasts:

E ( EPS t + 2 ) E ( EPS t +1 ) gt = E ( EPS t +1 )

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Implementing the model2

(b) Investment plans: E = ROE * Investment = ROE * retentions = ROE * (retention ratio * earnings) = ROE * bE

E ROE * bE g= = = ROE * b E E

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Discounted cash flow, Growth rate and the Cost of capital

Cost of capital estimated using dividend growth model is sensitive to the choice of growth rate in dividends. Davies et al (1999): Boots BP H= 0 H= 5 H= 10 5.85 6.76 7.67 5.90 7.13 8.36

MKS 5.40 6.39 7.36

ULVR 5.14 5.74 6.34

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Discounted Cash Flow Model:

An Appraisal
Simple to use Estimate of IV is sensitive to g It cannot be applied: for non-cash (say dividend) paying firms if g k (in a constant growth model) Definition and measurement of cash-flow Overall, discounted cash-flow method of stock valuation offers simplicity but suffers from some limitations.

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Summary: Fundamental Analysis

Consider the following: Stock Mkt. Value A 20 B 23 C 45 D E F 21 18 32 Intrinsic Value 24 23 40 18 22 32 Strategy buy hold sell sell buy 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 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. Reilly, F. K., and K. C. Brown (2006), Investment Analysis and Portfolio Management, Thomson South-Western, Chapter 14. See Supplementary Reading list for further references.

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Seminar questions
1. The discounted cash-flow method sounds logical in valuing cash-

shares. However, it is not free from limitations. Comment.

2. In the recent past Lanchester Plc. has been earning 3 million

a year and its management is confident that this will be maintained in the future from existing production facilities. Though the firms general policy is to pay-out 100% of its payearnings it plans to retain 1/3 of its earnings for the next 3 years. The new investments are expected to generate 20% return p.a. in perpetuity. Once these investment opportunities are exploited the firm will return to its policy of 100% pay-out. The required rate of return is 10%. You are payrequired to estimate the value of the firm.
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Valuing a Division or a Private Company

Market Based Methods

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Estimating cost of capital a listed firm

The Capital Asset Pricing Model: E(Ri - Rf ) = Rf + (E(RM) Rf )
Expected rate of return and risk are directly and linearly related. It concentrates on risk and expected return. It places particular emphasis on systematic risk

Recent developments in asset pricing:

Fama-French 3 factor model 4-factor model of Carhart And Others

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 Division

Estimating systematic risk when stock prices are not available: The market based approach Assumption: Systematic risk for a particular line of business is constant for all firms that compete in that line of business. Methods: a. The Pure-Play approach (Fuller and Keer, 1981) b. The Full-Information approach (Ehrhardt and Bhagwat, 1991).
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The Pure-Play approach1 PureThe concept: Find some publicly traded firms that compete in the same line of business as your unlisted firm Estimate the s of those (listed) firms Use these s to estimate of your private firm.

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The Pure-Play approach2 PureSome issues: 1. What if s of pure-play firms are far apart? Fuller and Keer (1981) suggest using median 2. Can you actually find a pure-play firm? Bower and Jenks (1975) suggest that finding pure-play firm is not easy.

3. Is there any alternative to pure-play approach? Use Full-Information approach. Full-

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FullFull-Information Approach-1
The Basis: The overall beta of a firm is the weighted average of divisional s of a division is constant There should be more firms (M) than divisions (N) in the sample.

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FullFull-Information Approach-2
Consider the following equation:

M , j = sW j , s + j
s =1

Where: Mj = Over all market of firm j wjs = weight of each segment in company j s = of segment s (a parameter to estimate) Market of firms is the dependent variable and weights for the divisions are the explanatory variables.
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Performance of Full-Information Approach FullEhrhardt and Bhagwat (1991): Main results (Using 2-digit SIC code of segment) Adj. R2 = 0.69 4 of 70 estimates are not statistically significant Generates with tighter confidence interval than the 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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Summary
Lack of market value makes valuation of unlisted firms or divisions difficult. Difficulties in finding pure play firms limits the applicability of Pure-play approach PureFullFull-information method utilizes information content in mutimuti-divisional firms.

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Essential Readings
Ehrhardt, M. C. (1994), The Search for Value: Measuring the Companys Cost of Capital, Harvard Business School Press. Chapter 4. Ehrhardt, M.C. and Y.N. Bhagwat (1991), A FullInformation Approach for Estimating Divisional Betas, Financial Management 20, 60-69. Fuller, R. J. and H. S. Kerr (1981), Estimating the Divisional Cost of Capital: An Analysis of the Pure-Play Technique, Journal of Finance 36, 997-1009. See Supplementary Reading list for further references.

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