Lecture 6 Introduction to Stock Valuation (1).pptx

VALUATION & INVESTMENTS (FINC 412) Lecture 6: Introduction to Stock Valuation Muhammad M. Ma’aji, PhD, F M VA Lesson Topic Lesson Plan An Introduction to stock valuation, PESTEL, Economic cycle, Life cycle, Porter’s five forces Learning Outcomes At the end of thi...

VALUATION & INVESTMENTS (FINC 412) Lecture 6: Introduction to Stock Valuation Muhammad M. Ma’aji, PhD, F M VA Lesson Topic Lesson Plan An Introduction to stock valuation, PESTEL, Economic cycle, Life cycle, Porter’s five forces Learning Outcomes At the end of this lesson, students will be able to: Explain the valuation process Outline the steps in the valuation process. Explain the basic concept of theory of valuation. Explain uses of industry analysis and the relation of industry analysis to company analysis Describe macroeconomic, technological, demographic, governmental, and social influences on industry growth, profitability, and risk; Describe the elements that should be covered in a thorough company analysis. Explain the equity valuation concepts and basic tools, and the different approaches to equity valuation. Activities/Methods Lecture, discussion, group exercise and excel practice Reading and References Main textbook Reading: CFA Material, Equity: Part I; CFA Material, Portfolio Management: Part I Main textbook Reading: Damodaran A. (2012). Damodaran on Valuation: Security Analysis for Investment and Corporate Finance, 2nd Edition, Wiley Finance. Main textbook Reading: Bodie, Kane & Marcus (2019) Investments, 11th Edition, McGraw Hill Practice: KAPLAN Schweser Notes 2018 Exam Preparation, Equity and Portfolio Management: Part I  Overview of the valuation process Valuation is based on expected future performance not past performance and involves: $ Analysis of the Analysis An analysis of the financial Forecast the future economic of the history and prospects of the operations of the Applying acceptable environment industry business, project or asset business, project or valuation methods asset There are various valuation methodologies which may arrive at differing values for a business, project or asset. Agenda Macroeconomic Analysis Industry Analysis Company Analysis Guide to Assumptions An Overview of the Valuation: Concepts And Basic Tools External Environment Analysis PEST analysis is a useful framework for analyzing the external environment. Political Technological forecasting forecasting Identify opportunities and Anticipate React threats Social Economic forecasting forecasting Agenda Macroeconomic Analysis Industry Analysis Company Analysis Guide to Assumptions An Overview of the Valuation: Concepts And Basic Tools Industry dynamics Porter’s 5 forces is a powerful tool for assessing industry attractiveness. Michael Porter identified FIVE forces driving industry competition: Potential new entrants and barriers to entry Suppliers and their Rivalry amongst Buyers and their bargaining power firms in industry bargaining power Threat of substitutes Agenda Macroeconomic Analysis Industry Analysis Company Analysis Guide to Assumptions An Overview of the Valuation: Concepts And Basic Tools Company Analysis  Company Analysis ◦ Company analysis includes an analysis of the company’s financial position, products and/or services, and competitive strategy (its plans for responding to the threats and opportunities presented by the external environment). ◦ Try to identify if the company has a moat i.e. assessing competitive advantage ◦ Assess if the company consistently generate returns high than the cost of capital over time. ◦ The final goal is to select the best stock within a desirable industry and include it in your portfolio based on its relationship (correlation) with all other assets in your portfolio Tools for assessing Board of directors Q: When assessing a management team’s character, which particular aspects / traits should you consider? Past performance – What does their track record Experience/stability – Qualifications, business and look like? financial acumen, time in business, etc. Reputation – What do the press, customers, Attitude towards risk – Have risks been identified? suppliers, and the competition say about Are there mitigation strategies in place? management? Financial Statement Analysis  Financial ratios can help to make sense of the overwhelming amount of information that can be found in a company's financial statements.  The use of financial ratios is a time-tested method of analyzing a business. Analyst use financial ratio analysis to learn more about a company’s current financial health as well as its potential.  Financial ratios are used to assess companies’ financial condition, operations and attractiveness as an investment.  Examples included Profitability ratios, Liquidity ratios, Efficiency ratios, Solvency or Leverage ratio, Common size ratios analysis Industry related ratios Measure of Excess Return Agenda Macroeconomic Analysis Industry Analysis Company Analysis Guide to Assumptions An Overview of the Valuation: Concepts And Basic Tools Putting it all together - SWOT Strengths Weaknesses Internal factors which already exist and have contributed to the current position and may continue to exist. Give the firm a comparative advantage in the marketplace. Perceived strengths can include good customer service, high-quality products, strong brand image, customer loyalty, innovative R&D, market leadership, or strong financial resources Opportunities Threats External factors which are contingent events. Assess their importance based on the likelihood of them happening and their impact on the company. They may include a growing market for the firm’s products (domestic and international), shrinking competition, favorable exchange rate shifts, or identification of a new market or product segment. Also consider whether management have the intention and ability to take advantage of the opportunity/avoid the threat. Determine the key assumptions  From your Top-down analysis, determine the key assumptions that will drive your valuation. In particular, you must determine what will drive the following: Operating Net Profit Revenues Expenses margins Revenues growth over Estimating operating Estimate expected time: expenses over time: operating/net margins each Top-down estimation Calculate items of year: Use historical revenue operating expenses as a Set a target margin that the growth to get estimates percentage of sales over firm will move towards of revenue growth in the a 3-5 year period to spot (usually industry average). near future. trend. Adjust the current margin Decrease the growth rate Use simple average, towards the target margin as the firm becomes moving average or base (industry average) larger. on the historical trend to Fundamental/sustainable Keep track of absolute forecast the items of growth in operating revenues to make sure operating expenses. margin/net margin. Determine the key assumptions Working Capital Capital structure capital expenditure (debt versus equity) Changes in working capital: CAPEX estimation: Methods of Tie the changes in working capital Estimate a sales to recapitalization components to expected changes capital ratio that you include: in revenues or costs of goods sold will use to generate Issue debt and at the firm over time and is reinvestment needs repurchase equity expected to be steady over time. each year. Issue debt and pay a The working capital component as Reinvestment rate large dividend to a percent of revenues can be used, Growth firms that equity investors in conjunction with expected have already Issue equity and revenue changes each period invested in capacity repay debt for future years Determine the key assumptions Problem child Rising star Cash cow Dog  Practice 1 THE COCA-COLA COMPANY Founded in Georgia, with its first sales in 1886, the Coca-Cola Company was a total beverage company, with products currently sold in more than two hundred countries and territories. The company owned or licensed and marketed numerous beverage brands, which were categorized internally as (1) trademark Coca-Cola beverages; (2) sparkling flavours; (3) hydration, sports, coffee, and tea; (4) nutrition, juice, dairy, and plant-based beverages; and (5) emerging beverages. Coca-Cola owned and marketed five of the world’s top six non-alcoholic CSD brands: Coca-Cola, Sprite, Fanta, Diet Coke, and Coca-Cola Zero Sugar. Coca-Cola had a global network of independent bottling partners, distributors, wholesalers, and retailers, as well as its own bottling and distribution operations. Coca-Cola products accounted for 2.1 billion of the approximately 63 billion servings of all daily beverages consumed worldwide. Coca-Cola attributed its success to its ability to connect with consumers by providing them with a wide variety of beverage options to meet their varied desires, needs, and lifestyles. The company’s purpose to “refresh the world and make a difference” was embedded in its strategy to drive net operating revenue growth and generate long-  Practice 1 Income Statement 2018 2019 2020 2021 2022 Revenue 102,007 118,086 131,345 142,341 150,772 Cost of Goods Sold (COGS) 39,023 48,004 49,123 52,654 56,710 Gross Profit 62,984 70,082 82,222 89,687 94,062 Expenses Salaries and Benefits 26,427 22,658 23,872 23,002 25,245 Rent and Overhead 10,963 10,125 10,087 11,020 11,412 Depreciation & Amortization 19,500 18,150 17,205 16,544 16,080 Interest 2,500 2,500 1,500 1,500 1,500 Total Expenses 59,390 53,433 52,664 52,066 54,237  Practice 1 Balance Sheet 2018 2019 2020 2021 2022 Assets Cash 67,971 81,210 83,715 111,069 139,550 Accounts Receivable 5,100 5,904 6,567 7,117 7,539 Inventory 7,805 9,601 9,825 10,531 11,342 Property & Equipment 45,500 42,350 40,145 38,602 37,521 Total Assets 126,376 139,065 140,252 167,319 195,951 Liabilities Accounts Payable 3,902 4,800 4,912 5,265 5,671 Debt 50,000 50,000 30,000 30,000 30,000 Total Liabilities 53,902 54,800 34,912 35,265 35,671 Shareholder's Equity Equity Capital 70,000 70,000 70,000 70,000 70,000 Retained Earnings 2,474 14,265 35,340 62,053 90,280  Answer Required A) Develop assumptions based on historical performance and forecast the next 5 years income statement and balance sheet for Coca Cola (25 marks) Total marks: 25 marks Answer Answer Agenda Macroeconomic Analysis Industry Analysis Company Analysis Guide to Assumptions An Overview of the Valuation: Concepts And Basic Tools Theory of Valuation The value of an asset is the present value of its expected returns To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return This requires estimates of: ◦ The stream of expected returns, Earnings, Cash flows, Dividends, Interest payments, Capital gains (increases in value) and ◦ The required rate of return on the investment Theory of Valuation Investment Decision Process: A comparison of intrinsic values and current market prices ◦ You have to estimate the intrinsic value of the investment at your required rate of return and then compare this estimated intrinsic value to the current market price ◦ If intrinsic Value > Market Price, Buy (undervalued) ◦ If intrinsic Value < Market Price, Don’t Buy (overvalued) Valuation Approaches 1. Income Approach: This approach calculates the value of a company based on its ability to generate income or cash flows in the future. The main method used is the:  Discounted Cash Flow (DCF) Method: Assumptions: Assumes that the company will generate cash flows in the future and that these cash flows will grow at a stable rate, discounting the future cash flows to a present value. Data: Detailed financial projections, such as revenue, expenses, capital expenditures, working capital, tax rates, and discount rate. 2. Market Approach: This approach calculates the value of a company based on its market value relative to other similar companies. The two main methods used are:  Relative valuation or Comparable Company Analysis: Assumptions: Assumes that similar companies are trading at similar multiples and that the company being valued can be compared to these companies. Data: Publicly available market data, such as market capitalization, P/E ratio, price-to-book ratio, EV/EBITDA etc.  Comparable Transaction Analysis: Assumptions: Assumes that the value of the company can be derived from the value of comparable companies that have been sold in the past. Data: Details of comparable transactions, such as transaction size, transaction date, type of transaction, and relevant financial metrics. 3. Asset Approach: This approach calculates the value of a company based on the value of its underlying assets. Why DCF Approach The Discounted Cash Flow (DCF) model is a widely used method in equity valuation for assessing the intrinsic value of a company's stock. These techniques are obvious choices for valuation because they are the essential of how we describe value—that is, the present value of expected cash flows ◦ Dividends: Cost of equity (Ke) as the discount rate ◦ Free cash flow to firm: Weighted Average Cost of Capital (WACC) ◦ Free cash flow to equity: Cost of equity (Ke) as the discount rate Dependent on growth rates and discount rate (Potential Difficulty) Why Relative Valuation Techniques Provides information about how the market is currently valuing stocks based peers or comparable. ◦ Most asset valuations are relative. ◦ Almost 85% of equity research reports are based upon a multiple and comparable. ◦ More than 50% of all acquisition valuations are based upon multiples Valuation is an art and a science Science Art Management team Historical financials Culture and Strategy Ratios Forecasting Competition Assets Macroeconomic factors Track record Cost of capital Statistical analysis  Investment useful links – http://www.morganstanley.com – http://www.globalinsight.com – http://www.nabe.org – http://www.yardeni.com – http://www.conference-board.org – http://www.whitehouse.gov/fsbr/esbr. – http://www.bea.doc.gov/bea/pubs.htm html – http://www.stats.bls.gov – http://www.federalreserve.gov – http://www.cbo.gov – http://www.worldbankorg – http://www.whitehouse.gov/cea/ – http://www.phil.frb.org/econ/forecast/i ndex.html – http://www.gpoaccess.gov/indicators/ – browse.html http://www.spglobal.com/index.html – http://www.census.gov/csd/qfr – http://www.bis.org/cbanks.htm – http://www.federalreserve.gov/pubs/b – http://www.bankamerica.com/ ulletin Click icon to add picture Thank you for listening Q&A