R-B-Ch.15 Points to Refresh

Estimating Intrinsic Value

A. Present value of cash flows (PVCF)

1. Present value of dividends (DDM)
2. Present value of free cash flow to equity (FCFE)
3. Present value of free cash flow (FCFF)

B. Relative valuation techniques

1. Price earnings ratio (P/E)
2. Price cash flow ratios (P/CF)
3. Price book value ratios (P/BV)
4. Price sales ratio (P/S)

Present Value of Dividends

Simplifying assumptions help in estimating present value of future dividends
Assumption of constant growth rate
Intrinsic Value = D1/(k-g)
D1= D0(1+g)

Growth Rate Estimates

Average Dividend Growth Rate


Average Dividend Growth Rate – Calculation of Historical Value




My recommendation is log-linear regression

Sustainable Growth Rate = RR X ROE
For Walgreen
Historical Growth rate = 11.42%

Sustainable growth rate = 0.82*.183
= 15.09%
Average = 13.24%

Use a growth rate estimate of 13%

Required Rate of Return Estimate

Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the firm’s characteristic line using regression
Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the firm’s characteristic line using regression

Assumptions regarding WalGreen – page 552
NRFR = 5 percent – the current ytm for intermediate term govt. bond.
For market risk premiums the authors will use 4.50%.

Beta is estimated using return during five year period (1996-2001) 60 observations.
The beta coefficient was estimated as 0.90

Hence required rate of return = 0.5 + .9*(.045)
= 0.090 = 9%

The Present Value of Dividends Model (DDM)
Model requires k>g
With g>k, analyst must use multi-stage model
As k = 9% & g = 13%
Multistage DDM is to be used

Growth periods
G1 = 7 years (growing at 13% per year)
G2 = 5 tears during which growth will decline by 1% per year

G3 = constant perpetual growth of 8 percent

*I am not in agreement with 8%.
*8% growth estimate will mean dividend yield of 1% during maturity period. It is very low.

Share Value DDM – page 554
The share value at the start of the maturity growth comes as 0.55(1.08)/(.09-.08)
= $59
*0.55 is dividend in the first year of maturity growth period
Discounting all dividends and maturity value to present value share value now = $23.11.

CMP of Walgreen
$38



Earnings Multiple or P/E Multiple Technique

Relative Valuation Techniques

Price Earnings Ratio
Affected by two variables:
1. Required rate of return on its equity (k)
2. Expected growth rate of dividends (g)

Estimating Company Earnings per Share

An estimate of the earnings per share for the company is a function of the sales forecast and the estimated profit margin.
The sales forecast includes an analysis of the relationship of company sales to various relevant economic series and to the concerned industry sales.

These comparisons tell use how the company is performing relative to the economy and to its closest competition.

These relationships provide background to the company, and also help us to develop specific sales estimates for Walgreen.


For estimating the relationship for Walgreen’s sales to the economy, several alternative series were considered.

Personal consumption expenditure for medicine (PCE medical care) had the strongest relationship.
The scatter plot of walgreen sales and the PCE medical care expenditures indicates the strong relationship

Walgreen sales and sales per share for the RDS industry were also compared.
It did not reflect as strong a relationship and was not used subsequently.
PCE medical vs. PCE
Proportion of PCE allocated to medical care went up from 10% in 1977 to almost 15% in 2001.
The increase in percentage is because of the growing proportion of population over 65 and the rising cost of medical care.
The increase in PCE medical occurred during economic recessions in 1981-82 and in 1990-91 also

Examination of Sales growth of Walgreen

Internal sales growth for Walgreen resulted from an increase in number of stores (from 644 in 1975 to 3,520 in 2001).
An increase in the annual sales per store also occurred because of the upgrading of stores.
The net increase in stores includes number of new large stores, and the closing of many smaller stores.
As a result, the average size of stores has increased.

More important, the firm has continued to increase its sales per thousand square feet at over 4 percent a year. This is a critical statistic in the retail industry.


Estimate of Walgreen’s Sales based macroeconomic data
To estimate PCE medical care, you should initially project total PCE.
As noted in Ch.14, economists were forecasting an increase in 3 percent in PCE during 2002.
This implies a PCE 2002 estimate of $7,267.



The PCE medical was estimated to be 15% of total PCE.
Hence PCE medical 2002 will be $1,090 billion.
This means a growth of 4.4% on 2001.
Historical relationship between PCE medical care and Walgreen sales (Exhibit 15.7) implies a 7.5% increase in Walgreen sales. (Please check)
This is below the firm’s recent growth in sales.

Alternative estimate using square footage

Industry/companies provide data on square footage and the number of stores.
If we estimate the increase in store area of Walgreen during 2002 as 4.5 million square feet (which is less than in most years), the firm’s total sales area would be about 42.7 million square feet.

As noted, sales per square foot have likewise increased.
Assuming a conservative increase of $650 of sales per thousand square feet implies a sales forecast of about $27.75 billion for 2002, a 12.7 percent increase over 2001 sales of $24.62 billion.

Alternative estimate using number of stores

Walgreen is expected to open 475 stores during 2002.
Assuming it closes 60, this would be a net addition of 415 stores. Total stores will reach 3,935 stores at the end of 2002.
Assuming sales per store to reach $7.25 million, will an estimate of $28.53 billion (3,935*7.25 million) .
This will mean an increase of 16 percent over 2001.

Final estimate

Given the three estimates, the preference is for an estimate close to the high value because of the positive economic environment and the company’s ability to increase sales between 16 and 18 percent a year during 2001 and 2000.
Therefore we will assume 15 percent increase, which implies a final sales forecast for 2002 of $28 billion.

Estimating the Company Profit Margin

Projection of earnings per share should include three considerations.
1. Identifaction and evaluation of the firm’s specific competitive strategy – that is either, low-cost or differentiation.
2. Firm’s internal performance, including general company trends and consideration of any problems that might affect its future performance.

And (3) the firm’s relationship with its industry, which should indicate whether the company’s past performance is attributable to its industry or if it is unique to the firm.
These examinations should help us understand the firm’s past performance and should also provide the background to make meaningful estimate for the future.
Walgreen’s competitive Strategies ( No value implication found)
Based on annual reports, walgreen has pursued both strategies with different segments of its business.
The firm’s size and buying power allow it to be a cost leader for some its nonprescriptive products such liquor, icecream, candy and softdrinks.
These items are advertised heavily to attract customer traffic and to build customer loyalty.

At the same time Walgreen has attempted to build a strong franchise in the medical prescription business based on differentiation in service.
The Internal performance
Exhibit 15.9
The profit margins for Walgreen increased from 1977 to the mid-1980s followed by a decline through 1988 and a recovery beginning in 1991.
In contrast, the margins for the RDS industry experienced a relatively steady decline after a peak in 1983.

Overall, Walgreen experienced a positive trend in its operating and net profit margins over the past 24 years.
To predict future values, you need to determine the reason for the overall decline in the industry profit margin and, more important, what factors have contributed to Walgreen’s strong positive performance.

Internal Performance - Industry Factors

Industry profit margins have declined over the last two decades due to price discounting by aggressive regional chains.
Ch.14 suggested this as one of the competitive structure conditions that affect long-run profitability.
Industry analysts have observed that price cutting has subsided, and they foresee relative price stability.

In addition, drugstores have tended toward a more profitable product mix featuring high-profit-margin items, such as cosmetics, and this has had a positive influence on profit margins.
Company - Performance
Walgreen’s profit margin has shown consistent improvement.
The outlook for profit margin is good because the firm has developed a strong position in the pharmacy business and has invested in service including mail-order prescriptions and inventory-control technology that will help the firm experience strong margins on this business.

The firm also emphasized high-profit margin items, such as greeting cards, photofinishing, and cosmetics.

Specific Estimate for Walgreens

Specific estimates for Walgreen’s future margins typically would begin with an analysis of the firm’s relationship with drugstore industry margins using time-series plots (Ex. 15.10)
This time series (1977-2000) showed good results for Walgreen versus its industry prior to 1997 followed by Walgreen outperforming through 2000.
You should consider any unique factors that would influence this long run relationship,such as price wars or an abnormal number of store openings or closings by the firm

Following a consideration of the long-run company-industry profit-margin relationship, you should analyse the firm’s common-size income statement for several years.
The breakdown of the income statement depends on the consistent detail provided by the firm

Analysis of cost of goods sold and SG&A expenditure is encouraging.
The cost of goods sold increased slightly less than 1%.
There was a larger decline in the percentage of SGA expense through 2000.
As a result, the operating profit margin increased from 5.46% to 5.68%.
Interest expense was not a factor.

Tax rate remained between 38 and 40 percent during the last several years.

Net Profit Margin Estimate

The overall industry outlook is encouraging because of stable prices, an increase in mechanization within the industry, and the inclusion of more high-profit-margin items.
Therefore, the industry profit margin is expected to increase slightly during 2002.


Because of Walgreen’s strong performance relative to its industry profit margin and the increase in margin since 1995 (Ex.15.11) it is estimated that the firm will show a small increase during 2002 to 3.55%.

Computing Earnings per Share

This margin estimate combined with the prior sales estimate of $28 billion, indicates net income of $994 million.

Assuming about 1,030 million common shares outstanding, earnings should be about $0.97 per share for 2002.
This estimates gives an increase of 13% of EPS of $0.86 in 2001.

Importance of Quarterly Estimates

It is essential to derive quarterly estimates from annual estimates.
First it will confirm our annual estimates. Do quarterly estimates reasonable and sum up to annual figure?
Second, unless we have quarterly forecasts, we will not be able in a position to determine whether the subsequent actual results are a positive surprise, negative surprise, or not surprise.

Further, if the actual results are a surprise relative to our estimate, we will want to understand the reason for the surprise.
We have to understand whether we under- or overestimated sales growth and/or profit margin.
This understanding is needed for an estimated earnings revision that reflects the new information from the company.
We would probably revise each of our future quarterly estimates to arrive at a new annual estimate.

Estimating Company Earnings Multipliers

Two approaches
Macro analysis – starting from market and industry.
Micro analysis – Estimate a multiplier based on its three components: the dividend-payout ratio, the required rate of return, and the rate of growth
We then resolve the estimates derived from each approach and settle on one estimate.
Macro Analysis of the Earnings Multiplier p.569
Ratio for the period of 1977-2000.
After 1987 walgreen’s P/E has generally followed industry multiple with ration between 1.00 to 1.5
Walgreen multiple is also higher than market from 1994 with ratio between 1.10 and 1.40


Is the higher value for Walgreen’s P/E relative to both its industry and the market that generally prevailed since 1992 justified?
Microanalyses should provide some insights regarding this question.

Micro analyses

Div pay out ratio:
Walgreen almost always had a lower payout.
Implies lower P/e relative to market and industry
k
Walgreen should have relatively lower BR due to its stable sales growth.
Fin Risk: leverage ration less than 2.0 less than market and comparable to the industry.
The liquidity risk is low compared to its industry and average in the market.
Exchange risk and country risk very little in relation to market.

This implies overall risk for Walgreen should be lower than the market.

Beta is also 0.90
Hence based on k P/E should be higher for Walgreen.
Expected Growth Rate
Using the average of results of the last three years ROEs will approximately as follows
NPM TAT ROA Ta/Equity ROE
Wal 3.54 3.04 10.76 1.68 18.08
Ind 2.77 2.35 6.51 2.52 16.40
S&P 5.86 0.84 4.92 3.60 17.71

Exp. Growth Rates

Using the average recent retention rates

R.R. ROE Exp.Gr.Rate
Walgreens 0.79 18.08 0.1428
RDS 0.77 16.40 0.1148
S&P 0.63 17.71 0.1116

Comparing estimates of D/D, K and g to comparable values for the industry and the market, we find that Walgreen’s multiplier should be greater than the industry and market.

Assuming a market multiple of 23 for market, 26 for RDS industry Walgreen can have a multiple of 30. with range of 28-30-32

Value of Walgreen

Exp. EPS = 0.97
Value range
28*0.97 = $27.16
30*0.97 = $29.10
32*$0.97 = $31.04
The CMP of Walgreen is $38.
We cannot recommend Walgreen for buy.

Site Visits and the Art of the Interview

Focus on management’s plans, strategies, and concerns
Restrictions on nonpublic information
“What if” questions can help gauge sensitivity of revenues, costs, and earnings
Management may indicate appropriateness of earnings estimates
Discuss the industry’s major issues
Review the planning process
Talk to more than just the top managers

When to Sell

Holding a stock too long may lead to lower returns than expected
If stocks decline right after purchase, is that a further buying opportunity or an indication of incorrect analysis?
Continuously monitor key assumptions
Evaluate closely when market value approaches estimated intrinsic value
Know why you bought it and watch for that to change
Efficient Markets
Opportunities are mostly among less well-known companies
To outperform the market you must find disparities between stock values and market prices - and you must be correct
Concentrate on identifying what is wrong with the market consensus and what earning surprises may exist
Influences on Analysts
Investment bankers may push for favorable evaluations
Corporate officers may try to convince analysts
Analyst must maintain independence and have confidence in his or her analysis

Global Company and Stock Analysis

Factors to Consider:

Availability of Data
Differential Accounting Conventions
Currency Differences (Exchange Rate Risk)
Political (Country) Risk
Transaction Costs
Valuation Differences