Stock Valuation Basics



I. Careers in FinanceA career in finance can be separated into three areas – corporate finance, investment management, and retail financial services. A career in corporate finance involves analyzing, selecting, and funding investments for financial and non-financial corporations. Positions in corporate finance include financial analysts, reporting analysts, budget analysts, and planners. A career in corporate finance requires extensive knowledge of accounting and the business and industry environment.A career in retail financial services involves direct interaction with the public in their need to save, invest, and borrow. Areas include retail banking, financial advising, mortgage lending, credit cards, and stock brokerage services. Starting positions include bank representatives, stock brokers, financial advisors, credit analysts, and financial analysts and consultants at banks and other financial institutions. A career in investment management involves analyzing and selecting securities and managing the overall return and risk profile of a portfolio. Positions in investment management are often categorized and from office, middle office, and back office. The front office includes portfolio managers, traders, researchers, and sales representatives. The middle office includes risk managers, reporting analysts, and information systems analysts. The back office includes compliance analysts and general support staff of other offices. The BS in finance prepares students for all three areas. Positions in the front office are very competitive and often require excellent grades and summer internships. II. COMMON Stock Selection MethodsSelect products (consumer goods, technology, retail, services, restaurants, etc.) you like and find its stock (if it is publicly traded). You can start at the company website and look for “investor” or “about us” link. Event/News Trading: see what stocks are in the news and take a view on the outcome of some uncertain event or the market’s reaction to an announced event. Activity: What are today’s top stock events or stories and how have their prices reacted? What is your bet?Technical Analysis: Use of price and volume graphs to predict stock changes.Key Terms: Momentum: Belief that stocks will continue in current price direction (up, down, sideways) because the market price does not fully reflect current events (products, profits, news). Reversal: Belief that stock price will change its current direction because market has overreacted to current events.Support: stock price that you belief that stock cannot fall below. Some graph support levels by connecting previous lows (see graph below).Resistance: stock price that you belief that stock cannot exceed. Some graph support levels by connecting previous highs.Volume is the number of shares traded over a particular time period. Some suggest that increasing volumes is an indicator of momentum (continuation) and decreasing volumes is an indicator of reversal.SupportResistanceActivity: Look up WMT and TGT stock quotes on finance.. What are the support and resistance levels? Which would you buy? The problem with technical analysis is that there is little evidence that trading based on these principles is profitable.Price Multiples: A price multiple is the stock price divided by a per share value of earnings, sales, or book “Accounting” value.Example: The Price-Earnings Ratio (PE) is the stock price divided by the earnings per share (EPS)EPS = Net Income (a.k.a. Net Profit) / Shares Outstanding Net Income = Revenues – Costs – Interest Expense - TaxesActivity: Compute WMT and TGT PEs by finding Net Income, Shares Outstanding, and stock price. What are WMT and TGT current PE (finance.) and which would you buy? Compare key statistics for both stocks. Do any of these influence your recommendation.The problem with multiples is that it is difficult to compare stock multiples because stocks have different characteristics such as growth and risk.Discounted Free Cash Flow Method: A belief that stock value should be the sum of all its expected cashflows (adjusted for time) divided by the current number of sharesFree cash flows (FCF) are the amount of cash that a company generates after all production costs and capital good expenditures (such as property, plant, equipment). One such measure of FCF for companies with no debt is:Free Cash Flow (FCF) = Net Income – Capital Expenditure + DepreciationDepreciation is the accounting recognition of prior year capital expenditures (CAPEX). Depreciation is added to avoid the double counting of capital expenditures.Stock Value per share is:If you assume FCFs grow at some constant rate, g, then the formula for growth perpetuity isWhere g is the perpetual growth rate and r is the discount rate that should account for the riskiness of the company.Where get g? often between -5% and long-term growth of the economy (4%)Where get r? at least the return on a risk-free long term security (such as the 10-year treasury which is about 4%, see finance.bonds), plus 2 – 10%.r estimate: 10-yr Treasury yield plus 4% for average risk stock, 8% for high risk, and 2% for low riskValuation Exercise for Companies with Low and Stable Growth, and No DebtBBBYDebt: 0 Net Income: Depreciation: CAPEX: Shares: g = ? (=< 4%)r = ? V = Buy Sell of hold?What if r off by +/- 2%The problem with this method is that g, r, and FCF are often difficult to calculate and it does not work if g > r. Other companies with little or no debt, positive cashflows, and growth between 1 – 5%: Yahoo StockScreen: Low Growth Firms with No debt and Positive Cash FlowsTry to value one of these to see if it’s a good buy?(Another way to get the discount rate = 10-year Treasury + Beta * 5%)Beta: Measure of stock riskiness (see key stats), 5% is the average stocks riskIII. Free Cash Flow MODEL FOR companies with debt and low/Stable growth A. Forecasting FREE CASH FLOWS with DebtFCF=Net Income –CAPEX +Depr. +Interest Expense(1-Tax Rate)andNote: Interest is added to FCF and debt subtracted from the valuation to value the stockholders claim to the firm. Tax is subtracted because interest payments are tax deductible.Data Sources:NI: Annual Income Statement or Cash Flow StatementCAPEX: Annual Cash Flow StatementDepreciation: Annual Income Statement or Cash Flow StatementDebt: Short-term + Long-term debt from Balance Sheet or Yahoo Key StatisticsInterest Expense: Annual Income StatementTax: 40% is a good estimate of the sum of local, state, and federal taxes.r: 10-year Treasury Yield (finance.yahoo/bonds) + 2 – 10 depending on riskg: estimate of long-term perpetual growth (often between -2% to 4.5%), look at prior.Shares: Shares Outstanding from Yahoo Key StatisticsExercise: Value WMTIV. Free Cash Flow Estimation MODEL FOR companies with debt and low/Stable growth (Version 2)FCF=Net Income –CAPEX +Depr. +Interest Expense(1-Tax Rate)V. building a general “Multi-STAGE” Valuation model VI. Valuation assignment and pitchEach group of 3 students will analyze and value a group of stocks.Rank the following industry groups from the best to the worst performer in the next couple years. Think about what global, economic, social or industry trends favor or hurt these industries.Restaurants/Specialty Eateries (in Services Sector)Apparel Stores (in Services Sector)Department/Discount Stores (in Services Sector)Grocery/Drug Stores (in Services Sector)Broadcasting/CATV Systems (in Services Sector)Consumer Goods SectorHealth Care SectorTechnology SectorValue at least one stock per team member in your top ranked industry using the multistage growth model. Select the best buy and sell recommendation using the valuation and an insight about the company or industry.Create a stock pitch Finding Stocks using Yahoo Stock Screener:Restaurants (FCF, Profit Margin, and Sales Growth > 0)Presentation Essentials:State Your Thesis Clearly (“XYZ stock is A Buy because of 1, 2, 3”)Support: Support your thesis with logical arguments, evidence, models, etc.Know your Audience: Anticipate concerns or questions Automated Valuation ModelNote: In this valuation model, FCF = NI + Net CAPEX (CAPEX + Depr + working capital) + Interest Expense. ................
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