STOCK VALUATION Company analysis, or corporate analysis, refers to actions undertaken for an in-depth

evaluation and to gain an understanding of a particular companys past performance and future prospects. A
thorough company analysis will focus on all the aspects of the corporate entity, including management structure and
expertise, finances, growth prospects, profitability, market share and intangible factors such as goodwill in the
market and brand image. Results of the analysis are used in reaching business decisions by external parties, such as
whether or not to invest in or go a partnership with the analyzed company.
When analysis is conducted internally by a businesss management, the results can help in identifying problems and
in remedying a situation. Stock valuation is the method of calculating theoretical values of companies and their
stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices,
and thus to profit from price movement- stocks that are judged undervalued (with respect to their theoretical value)
are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the
whole, rise in value, while overvalued stocks will, on the whole, fall. Stock valuation based on fundamentals aims to
give an estimate of the intrinsic value of a stock, based on predictions of the future cash flows and profitability of
the business.
DEFENSIVE STOCK is a stock that provides a constant dividends and stable earnings regardless of the state of the
overall stock market. Defensive stocks remain stable during the various phases of the business cycle. During
recessions, they tend to perform better than the market:, however, during an expansion phase it performs below the
market. Betas of defensive stocks are less than one.
GROWTH STOCK shares in the company whose expected earnings are expected to grow at an above-average rate
relative to the market. Growth stock is a stock of a company that generates substantial and sustainable positive cash
flow and whose revenues and earnings are expected to increase at a faster rate than the average company within the
same industry. Growth stocks usually pay smaller dividends, as the company typically reinvests retained earnings in
capital projects. A growth stocks usually does not pay dividend, as the company would prefer to reinvest retained
earnings in capital projects. Most technology companies are growth stocks.
Note that a growth companys stock is not always classified as growth stock. In fact, a growth companys stock is
often overvalued.
CYCLICAL STOCK is a stock that is highly correlated to the economic activity. When the economy is in a
recession the profits of a cyclical company tend to drops and so its share price. Conversely, when the economy is in
a good shape (expansion), the share price tends to goes up with the profit growth.
Cyclical stocks typically relate to companies that sell discretionary items that consumers can afford to buy more of
in a booming economy and will cut back on during a recession.
SPECULATIVE STOCK a stock with a high degree of risk. A speculative stock may offer the possibility of
substantial returns to compensate for its higher risk profile. Speculative stocks are favored by speculators and
investors because of their high-reward, high-risk characteristics. A necessary condition for investing in speculative
stocks is a high tolerance for risk. This means an investor in a speculative stock should be prepared for the
possibility of losing the full amount invested if the stock price goes down to zero.
Speculative stocks outperform in very strong bull markets, when investors have abundant risk tolerance. They
underperform in bear markets, because investors risk aversion causes them to gravitate towards larger-cap stocks
that are more stable.
BULL MARKET a financial market of a group of securities in which prices are rising or are expected to rise. The
term bull market is most often used to refer to the stock market, but can be applied to anything that is traded, such
as bonds, currencies and commodities. The use of bull and bear to describe markets comes from the way the

animals attack their opponents. A bull thrusts its horns up into the air while a bear swipes its paws down. BEAR
MARKET a market condition in which the prices of securities are falling, and widespread pessimism causes the
negative sentiment to be self-sustaining. As investors anticipate losses in a bear market and selling continues,
pessimism only grows. While corrections are often a great place for a value investor to find an entry point, bear
market rarely provide great entry points, as timing the bottom is very difficult to do. Fighting back can be extremely
dangerous because it is quite difficult for an investor to make stellar gains during a bear market unless he or she is a
short seller.
Economic, Industry and Structural Links to Company Analysis
The analysis of companies and their stocks is the final step in top-down analysis approach to investing. Rather than
selecting stocks only for the basis of company specific factors. Top-down analysis reviews the current and future
outlook for domestic and international sectors.
Our analysis concentrates on two significant determinants of a stock intrinsic value.

Growth of firms expected earnings and cash flows.

Its risk and appropriate discount rate.

Economic and Industry Influences

If economic trends are favorable for an industry, the company analysis should be focus on firm in that industry will
benefit in economic trends.
Manufacturing Industry: The branch of manufacturing and trade based on the fabrication, processing, or
preparation of products from raw materials and commodities. This includes all foods, chemicals, textiles, machines,
and equipment.
Firms in an industry will have varying sensitivities to economic variables.
An economic variable is any measurement that helps to determine how an economy functions.
1. Interest rate- is the rate at which interest is paid by borrowers (debtors) for the use of money that they borrow
from lenders (creditors) company and have resonating long term effects.
2. Input cost of direct material , direct labor , and other overhead items devoted to the production of a good or
service.
3. Exchange rates -The price of a nations currency in terms of another currency. An exchange rate thus has two
components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly. In a direct
quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency. In an indirect
quotation, the price of a unit of domestic currency is expressed in terms of the foreign currency. An exchange rate that
does not have the domestic currency as one of the two currency components is known as a cross currency, or cross
rate.
Structural Influences
1.

Political: These factors determine the extent to which a government may influence the economy or a
certain industry

2.

Social: These factors scrutinize the social environment of the market, and gauge determinants like cultural
trends, demographics, population analytics etc.

3.

Technological: These factors pertain to innovations in technology that may affect the operations of the
industry and the market favorably or unfavorably.

4.

Legal: These factors have both external and internal sides. There are certain laws that affect the business
environment in a certain country while there are certain policies that companies maintain for themselves. Legal
analysis takes into account both of these angles and then charts out the strategies in light of these legislations.

5.

Environmental: These factors include all those that influence or are determined by the surrounding
environment.

Company Analysis
Company analysis is a process used to evaluate the value of a company using the metrics of other businesses of
similar size in the same industry. It operates under the assumption that similar companies will have similar valuation
multiples. Analysts will compile a list of available statistics for the companies being reviewed, and will calculate the
valuation multiples in order to compare them. Comparisons often involved creating benchmarks.
Firms Competitive Strategy. A companys competitive strategy can either be defensive or offensive. A defensive
competitive strategy involves positioning the form to deflect the effect of competitive forces in the industry. It may
include investing in fixed assets and technology to lower production costs or creating strong band image with
increased advertising expenditures.
An offensive competitive strategy is one in which the firm attempts to use its strengths to affect the competitive
prices in the industry.
Porter (1980, 1985) suggest two major competitive strategies that dictate how a firm decided to cope with the
competitive conditions that define an industrys environment.
1. Low-cost Strategy. The firm that pursues the low-cost strategyis determined to become a low-cost producer and
cost leader in an industry. Cost advantages vary by industry and might include economies scale, proprietary
technology, or preferential access to raw materials. In order to benefit from cost leadership, the firm must command
prices near the industry average, which means that it must differentiate itself about as well as other firms. If the firm
discounts price too much, it could erode the superior rates of return available because of its low-cost.
2. Differentiation Strategy. Under this strategy, a firm seeks to identify itself as unique in its industry in an area
that is important to buyers. The possibilities for differentiation vary widely by industry. A company can attempt to
differentiate itself base on its distribution system (selling in stores, by mail order, or door-to-door) or some technique
approach. A firm employing the differentiation strategy will enjoy above-average rates of return only if the price
premium attribute to its differentiation exceeds the extra cost of being unique.
SWOT Analysis
It involves examination a firms strengths, weaknesses, opportunities and threat. It should help you evaluate a firms
strategies to exploit its competitive advantages or defend against its weaknesses. Strength and weaknesses involves

identifying the firms internal abilities. Opportunities and threats include external situation such as competitive
forces, discovery and development of new discoveries.
Strengths of a company give the firm comparative advantages in the market place. Weaknesses result when
competitors have potentially exploitable advantages over the firm. Opportunities or environmental factors that favor
the firm, can include growing market for the firms product, shrinking competition, favorable exchange rate shifts,
or identification of a new market or product segment.
Threats are environmental factors that can hinder the firm in achieving its goals.
Tenets of Warren Buffet
The following tenets are from Robert Hagstrom (2001):
1. Business tenets

Is the business simple and understandable?

Does the business have a consisiten operating history?
Does the business have favorable long-term prospects?

2. Management tenets

Is the management rational?

Is management can did with its shareholders?
Does management resist the institutional imperative?

3. Financial tenets

Focus on return on equity, not earning per share. (Look for strong ROE with little or no debt)
Calculate owner earnings. (Owner earnings are basically equal to free cash flow after capital expenditures)
Look for 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 intrinsic value of the business?

(Value is equal to the future free cash flows discounted at government bond rate. Using this low discount rate is
considered appropriate because Warren Buffet is very confident of his cash flow estimates due to extensive
analysis and this confidence implies low risk.)

Can the business be purchased at a significant discount to its fundamental intrinsic value?

ESTIMATING INTRINSIC VALUE

Intrinsic Value
The actual value of a company or an asset based on an underlying perception of its true value including all aspects of
the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current
market value.
Two General Approaches to Valuation

 Present Value of Cash Flows (PVCF)

Present Value of Dividends (DDM) -The present value of all future dividends is difficult; analysts typically apply
simplifying assumptions when employing the dividends discount models (DDM).The typical assumption is that the
stocks dividends will grow at a constant rate over time.
Recall that the constant growth (DDM) implies that when dividends grow at a constant rate, a stocks price should
equal next years dividend, D1 divided by investors required rate of return on the stock (k) minus the dividend
growth rate (g).
The formula for the constant growth model is:
Intrinsic Value = D1 (k g)
Where:
D1 =

dividend for the coming year

k = required rate of return;

g = growth rate of dividends
(Decimals and not percentages must be used for the model to work.)
Growth Rate Estimates If the stock has had fairly constant dividend growth over 5 to10 years, one estimate of the
constant growth rate is to use the actual growth of dividends over this period.
The average compound rate of growth is found by computing:
Average Dividend Growth Rate =
Required Rate of Return Estimates Required Rate of Return has two basic components; the nominal risk-free
interest rate and a risk premium. If the market is efficient, over time the return earned by investors should
compensate them for the risk of the investment. A common formula for estimating the possible required rate of
return is:
Formula:
Risk-free rate + (Market Risk Premium Beta for Equity)
Present Value of Free Cash Flow to Equity (FCFE) - This is a measure of how much cash can be paid to the equity
shareholders of the company after all expenses, reinvestment and debt requirement.
Calculated as:

FCFE = Net Income - Net Capital Expenditure - Change in Net Working Capital + New Debt - Debt
Repayment
Present Value of Free Operating Cash Flow to Equity (FCFF) - Is the cash generated by operations, which is
attributed to all providers of capital in the firm's capital structure. This includes debt providers as well as equity.
Calculating the OFCF is done by taking earnings before interest and taxes and adjusting for the tax rate, then adding
depreciation and taking away capital expenditure, minus change in working capital and minus changes in other
assets. This is also referred to as the free cash flow to the firm.
Formula:
OFCF = EBIT (1-T ax rate) + Depreciation Expense Capital Expenditures - Change in Working
Capital Change in other assets
Where:
EBIT= earnings before interest and taxes
Relative Valuation Techniques
Price/earnings ratio (P/E) - A valuation ratio of a company's current share price compared to its per-share earnings.
Calculated as:

Market Value per Share / Earnings per Share (EPS)

Price/cash flow ratio (P/CF) - The ratio of a stocks price to its cash flow per share. The price-to-cash-flow ratio is
an indicator of a stocks valuation.
Calculated as:

Price/Book Value ratio (P/BV) -A valuation ratio used by investors which compares a stock's per-share price
(market value) to its book value (shareholders' equity). The price-to-book value ratio, expressed as a multiple (i.e.
how many times a company's stock is trading per share compared to the company's book value per share), is an
indication of how much shareholders are paying for the net assets of a company.

Formula
Price/sales ratio (P/S) - A stock's price/sales ratio (P/S ratio) is another stock valuation indicator similar to the (P/E)
ratio. The P/S ratio measures the price of a company's stock against its annual sales, instead of earnings.

Formula: