Professional Documents
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SOURCES OF INFORMATION
SEC Filings - All publicly traded companies are required to file periodic
statements with the Securities & Exchange Commission (the SEC).
17 A, this is a companys main annual filing, which includes
financial results for the year (income statement, balance sheet,
etc.) as well as narrative reports from management about the
companys operations and prospects.
with its peers. If Company A has a larger asset turnover than its peer
group, one could hypothesize that the firm is being managed at a
higher efficiency level. Why would this company yield a higher amount
of sales for a given unit of assets than another company in the same
industry? Perhaps the management of Company A has striven for a
higher level of productivity from its asset base and therefore, yields a
higher amount of sales for a given unit of assets, or perhaps a company
just hired 50 new salespeople. In our peer group, however, debt
(leverage) may be (incorrectly) seen as an asset when it is not; again,
the importance of the equity portion of the ROE equation.
one minus the interest burden is the true drag to the company
due to the costs of leverage.
3. Operating Margin - This ratio evaluates the companys
operating margin or the companys effectiveness at minimizing
costs. It measures the true efficiency of the management at
running the company. By using Earnings Before Interest and
Taxes (EBIT) (instead of net earnings, where the ratio would
be known as the net profit margin), we get a true read on the
firms operating efficiency without the effects of leverage or
taxes.
4. Asset Turnover - This measures the asset utilization efficiency
of the firm. How many times do the assets need to be turned
to produce the level of sales? This lever will certainly differ
dramatically between industries; an airline manufacturer
(capital intensive and therefore greater number of assets
needed to produce a sales amount) will definitely have a lower
ATO than that of a janitorial supplies firm given a similar level
of sales.
Other Turnover Ratios. Asset turnover is a relatively general
measure because it refers to all of a companys assets. In
practice, two more refined ratios are also used.
Accounts Receivable Turnover: Sales divided by
average accounts receivable (average of beginning and
ending balance of accounts receivable for the period).
This measures how efficiently a company collects its
sales on credit. Often the accounts receivable
collection period is calculated as well (this is 360 days
divided by accounts receivable turnover). The result is
the number of days that it takes the company, on
average, to collect on its credit sales. Contractual terms
in many industries require payment within 3045 days.
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or
With the preceding derivations as well as the other ROErelated levers at ones disposal, the proactive investor is able to simply
(yes, I mean simply) plug and chug to achieve the desired result. As
the examples make obvious, the equations are all chain-linked, so
that pieces cancel out and the entire equation collapses into a more
simplified model.
MANAGEMENT ANALYSIS
A more complete picture of the effectiveness of management can be
ascertained than through a simple gut check of the CEO.
Centralization vs Decentralization or simply the management
hierarchy.
Organizational Structure companys functional division.
Innovation drives performance, from cuttings costs,
developing new products and finding more costumers.
Customer Service good customer service program.
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INDUSTRY ANALYSIS
Once we have a handle on the somewhat nebulous concept of
management evaluation, we need to turn to the evaluation of the
industry in which a particular company competes. This industry
competition is synonymous to the soil conditions that a farmer would
be subject to in cultivating a crop: If the land is hilly and the soil is full
of rocks, the farmer certainly needs to evaluate his crop-growing
scenario to maximize his output.
EVALUATING GROWTH
Another critical input in the valuation of an equity security is
growth. After all, it is hoped that future cash flows will grow over time
(at least as much as inflation), since it is these future cash flows that
are discounted to present value, leading to the ultimate valuation of the
security. Many techniques are used to analyze and track growth.
Sustainable Growth
The sustainable growth rate theory starts with defining growth
as:
=
=
Where (b) is calculated as follows:
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= 1
=1
*Retention Rate also known as Plowback
This equation for growth makes some intuitive sense ROE
is the return on the book equity of a firm and the retention ratio is the
amount of those earnings (return) that is not paid out to shareholders,
but rather retained and plowed back into the firm for growth
(positive net present value) projects.
The sustainable growth framework allows corporate officers to
develop critical firm strategies based on the relationship between
sustainable growth and actual growth. To show this, we will consider
the following two scenarios.
1. Sustainable Growth less than the Actual Growth (g*<g) This would mean that Companys financial management would
need to develop strategies to raise capital or decrease (yes,
decrease) actual growth (for not doing so could lead to a severe
cash crisisthe demise of many financial managers at fastgrowing companies). If this situation is expected to continue
and is not an industrywide phenomenon, then one option the
firm might consider would be reducing its payout ratio. The
firm could also consider selling new equity or increasing
leverage. These two methods of raising capital would generate
additional resources for the firm to increase its sustainable
growth rate. However, both have their drawbacks. Selling
equity is an expensive proposition that dilutes earnings, and
increased borrowing increases the risk of financial distress.
Finally, the firm might consider profitable pruning, which is
the sale of marginal operations to plow the capital back into
the remaining businesses.
2. Sustainable Growth greater than Actual Growth (g*>g) Conversely, we can consider the other side of the growth
paradigm, when sustainable growth is greater than actual
growth. Ignoring the problem will not simply make it go
awayit will leave the company ripe for the picking by a
corporate raider or competitor who recognizes the underlying
sustainable growth prospects of the company and will seek to
acquire the company to unlock the hidden growth. As such,
the company must start with some soul-searching to identify
and remove any internal constraints on company growth. Or
simply the company looks afraid in investing money back to the company.
Growth Evaluation
Always investigate and ask the following question to yourself:
1. How the company achieved its growth? Through cost
reduction or revenue enhancement?
2. If through cost reduction, which cost were reduced? (salaries,
marketing expenses and others).
3. If through revenue enhancement, which strategies were
employed?
a. Existing product line?
i. Increased volume? (new costumers, existing,
new stores and so on).
ii. Increased in price?
b. New product development? what?
c. Acquisitions? What company were acquired?
EVALUATING RISK
Any discussion of risk in investment finance must focus on an
assessment of the required rate of return (i.e., the rate of return that is
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0 (1 + )
1
=
Where:
P0 = Price today (i.e., the value of the stock)
DIVt = Dividend at time t (e.g., t of 0 = today, t of 1 = next year)
k = Required rate of return calculated using CAPM
g = Growth rate (of dividends, free cash flow, etc.)
As its name implies, this model assumes one, constant growth
rate for the entire projection period. This makes it easy to calculate,
but also fairly unrealistic in practice. How many companies grow at
one rate for their entire lifetime?
H-Model
0 =
0 (1 + ) 0 ()( )
+
Where:
P0 = Price today
D0 = Todays value of dividends
ga =Abnormally high growth rate
gn = Long-run growth rate
H = Number of years it is expected that the abnormally high
growth rate will last
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as many years as the analyst sees fit, from three years to 300 years. In
practice, a five- to ten-year period is usually used (as in this example,
which has a five-year period for Stage 1).
In Stage 2, a simplified calculation based on a long-term
growth rate is incorporated. Notice that the value of P5 in Stage 2
simply utilizes the constant growth method that we reviewed in
method #1 above. The idea behind the multistage model is that growth
can be explicitly forecast for a few years, but beyond that, it is
impossible to predict the future with a high degree of accuracy, so a
simplified assumption is more appropriate. The Stage 2 value is
sometimes known as the terminal value or exit value, since it is the
value of all the cash flows that accrue at the end of the explicit
assumption period (i.e., after Stage 1). It can also be thought of as the
price at which the asset could be sold at that point in time.
Where:
5 (1 + )
6
5 =
=
P0 = Price today
DIVt = Value of dividend at time t (1, 2, 3 . . .)
k = Required rate of return calculated using CAPM
glong = Long-run growth rate
The multistage model allows for the most customized or
explicit cash flow projections. In Stage 1, the cash flows are
projected individually, on a year-by-year basis. There is no single,
specific growth rate chosengrowth could be 5 percent in year one,
10 percent in year two, 15 percent in year three, - 10 percent in year
four, 7 percent in year five, and so on. In addition, Stage 1 can last for
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MARKOWITZ
THEORY
AND
THE
PORTFOLIO
SELECTION
For the individual investor, however, the growth in the number of mutual
funds provides solid footing to achieve this all-important diversification benefit.
10 | P a g e
E(Rm) = The expected rate of return for the market portfolio (the
index portfolio)
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=
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