CHAPTER SEVEN
FUNDAMENTAL STOCK ANALYSIS
1
© 2001 South-Western College Publishing
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

2
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
 Cooking the Books

3
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.
4
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 Porter’s 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
The Value Approach to 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.
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Regression to the Mean
Cumulative Return
+
Overvalued stock: Sell
x
xx
Most of the time
a security’s longterm return is
consistent with its
risk.
x
x
x
x
xx x
x
Undervalued stock: Buy
x
x
x
x
0
Over the long run, a security
cannot survive with a cumulative
return that is negative.
Time in the Long Term
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Value vs. Growth Investing
The Growth Approach to 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 aboveaverage returns for their clients.
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Value vs. Growth Investing
How Price Relates to Value

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.”

The modern perspective is that
value is inextricably intertwined
with price.
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Value vs. Growth Investing
Value Stocks and Growth Stocks:
How to Tell by Looking

No precise definition exists.

Classification by Morningstar Mutual Funds:
relative
relative
 1.75


price to book + price-earnings   2.25

ratio
ratio
 otherwise
- value
- growth
- blend
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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
firm’s earnings per share.

Because of differences among industries,
relative ratios are commonly computed for
both statistics.
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Some Analytical Factors: Growth Rates

Growth rates from historical data:
1
 ending value  n
  1
growth rate geom etricm ean  
 beginning value 
where n  number of compoundin g periods

Growth rates from earnings retention:
growth rate  1- payout ratio return on equity
using arithmetic averages
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Some Analytical Factors: Growth Rates
Choosing a Growth Rate

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.
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Some Analytical Factors: Growth Rates
Growth Rate Estimates from Other Analysts

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).
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The Dividend Discount Model (DDM)

Also called Gordon’s growth model.
D0  1  g 
D1
current price P0 

k g
k g
where D0 is the current dividend
D1 is the dividend to be paid next year
g is the expected dividend growth rate
k is the discount factor according to
the riskiness of the stock

The model assumes that the dividend
stream is perpetual and that the longterm growth rate is constant.
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The Dividend Discount Model (DDM)

The variable k is sometimes called the
shareholders’ required rate of return.
D0  1  g 
k
g
P0

Note that the shareholder’s required rate of
return is the sum of the expected dividend
yield and the expected stock price
appreciation.
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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:
D1
D2
D2  1  g  k  g 
P0 


 1  k   1  k 2
 1  k 2
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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 necessarily
interested 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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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
company’s 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

23
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
 Cooking the Books

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