Stock Pitch Primer (Nov 2007)

©2007 Linda Vincent 1

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Kellogg School of ManagementNorthwestern University

Investment Management Primer:Stock Pitching for Success

Investment Management ClubNovember 8, 2007

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Pitching a Stock_____________________________________________________________________________________________________________________________

• What are the “types” of stock pitches?– Job interview– Classroom– Professional (e.g., to portfolio manager)– Your money

• What are the respective goals?– Get the job– Get the ‘A’– Get the investment

– Need I articulate??


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Pitching a Stock_____________________________________________________________________________________________________________________________

• What are the recommendations?– Buy the stock

• Stock is underpriced• Target price and estimated time frame

– Hold the stock• Stock fairly priced• Expect continued “market” returns

– Sell the stock• Stock overpriced

– Short the stock

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Pitching a Stock_____________________________________________________________________________________________________________________________

• What is shorting a stock?– Sell a stock that you do not own – Betting the share price will go down– “Borrow” the stock from the broker– Collateralize the position (50%)– Maximum gain on trade?– Maximum loss on trade?

• Target price and time frame• Stop loss


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Pitching a Stock_____________________________________________________________________________________________________________________________

• How to find a stock to pitch– Read– Read– Read

• Personal interest / experience– Something you know– Something you have learned about

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Pitching a Stock_____________________________________________________________________________________________________________________________

• Pitching a stock for a job interview– The story is key

• Growth• Asset play• Turnaround• Other……

– Make the pitch a buy or a sell (short)• Why?

– Keep it simple and short


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Pitching a Stock_____________________________________________________________________________________________________________________________

• Pitching a stock for a class or professionally

– Both story and analysis are key– More in depth analysis reviewed

• By professor or portfolio manager– Most stocks are fairly priced

• Why?Most stocks are a hold

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Pitching a Stock_____________________________________________________________________________________________________________________________

• “Pitching a stock” for your own portfolio (your money)

– The analysis is key (driven by the story)

– Most stocks are fairly priced– Key is to understand the risks (and

your risk preferences)– Target prices for buys and shorts


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Pitching a Stock – The Analysis_____________________________________________________________________________________________________________________________

• Types of valuation analysis– Technical– Fundamental– Relative– Comparable transactions

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Technical Analysis_____________________________________________________________________________________________________________________________

Technical Analysis – Example

June 23


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Fundamental Analysis___________________________________________________________________________________________________________________________________________

Five steps:1) Overview of firm and its strategies2) Evaluate structure of industry3) Evaluate firm’s economic position4) Predict future course of firm5) Valuation of firm

Goal: Estimate intrinsic value of the firm.

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Fundamental Analysis___________________________________________________________________________________________________________________________________________

What is intrinsic value of the firm?Per Warren Buffett of Berkshire Hathaway:

Intrinsic value is an all-important concept that offers the only logical approach to evaluating investments: it is simply the discounted value of the cash that can be taken out of a business during its remaining life.


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1) Overview of Firm and its Strategies___________________________________________________________________________________________________________________________________________

A) Key lines of business- Number of lines of business?- Is the firm diversified?

B) Major products/services- Characteristics of products/services

• Commodity?• Specialized, quality?

C) Primary markets- Number of major customers?- Dependence on a few customers?- Diversified markets?

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1) Overview of Firm and its Strategies___________________________________________________________________________________________________________________________________________

D) Age of firm- Firm’s economic life cycle

[Start up, emerging growth, established growth, maturity, decline]

E) Current operating strategy- Growth (organic or via acquisition)- Restructuring- Downsizing- Diversifying- Steady state

F) Management (quality, strengths, experience, reputation)

G) Corporate governance (quality, red flags)


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2) Evaluate Structure of Industry____________________________________________________________________________________________________________________________________________

A) Number of firms and concentration- What percentage of industry sales captured by

industry leaders?B) Level of competitiveness

- Barriers to entry?- Relative market shares of firms in industry?- Competition - domestic, foreign, both?- Characteristics of major competitors?

• Strengths, weaknesses, strategies

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C) Growth profile- Historical, current and projected rates of growth

D) Seasonal or cyclical patterns- Sensitivity to business cycle?

E) Regulatory environment- Established agencies

• FDA, EPA, FDIC, NRC, FAA, etc.- SEC, Sarbanes-Oxley, the next Eliott Spitzer, etc.

F) Sensitivity to macroeconomic conditions- Interest rates, inflation, consumer confidence


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G) Technological change and innovation- Importance – history, resources

H) Production profile- Labor or capital intensive?- Unionized?

• History of labor relations- Constraints on availability of raw materials,

labor, other production inputs?

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I) Drivers of business- What drives success in industry?- What drives stock price/returns of firms

in industry?


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Value drivers______________________________________________________________________________________________________________________________________________

Share price

Value driver

ExamplesRetail: Gross margin (sales less cost of goods sold)

Same store sales per square footHomebuilders: Interest rates

Demographics (e.g., household formation)Credit availabilityConsumer confidence

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Value drivers______________________________________________________________________________________________________________________________________________

OperatingMargins

29%

27%

25%

23% $60 / share

21% $55 / share

19% $50 / share

17%4% 6% 8% 10% 12%

Sales Growth


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Industry Analysis - Airlines__________________________________________________________________________________

Industry Characteristics:- Protracted downturn (2001 – 2005 )- Top 10 carriers’ losses (5 consecutive years):

• 2005: $ 27 billion loss on $ 97 billion revenues• 2004: $ 10 billion loss on $ 91 billion revenues

- Heavily regulated- Highly unionized

• Poor labor relations common- Major cost components

• Labor ( 25 – 32 % of total costs in 2006)• Fuel ( 26 % of total costs in 2006)

- Capital intensive- Highly levered

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Industry Analysis - Airlines________________________________________________________________________

Key value drivers:• Revenue per revenue-paying passenger mile

(RPM or yield - measure of fare levels)▪ Revenue per available seat mile (RASM)• Cost per available seat mile (CASM)• Passenger load factor:

Revenue passenger miles / available seat miles• Break-even analysis based on load factor

- Load factor in US YTD 2007 = 79.2% - Load factor in 2006 = 77.6%- Break-even load factor in 2007 = 76%


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Industry Analysis - Airlines__________________________________________________________________________

Example of Value Drivers

Airlines: Domestic cost per available seat mile (CASM)Domestic operating revenue per ASM (RASM)

2nd Qtr 2005(in cents/mile) Cost/ASM Rev/ASM

US Airways 15.3 > 15.2Northwest 15.7 > 15.0Continental 15.7 > 14.9United 13.8 > 13.7 American 11.5 < 11.6America West 11.4 = 11.4 Frontier 10.7 = 10.7 Southwest 7.1 < 8.0 JetBlue 6.7 < 7.4

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Industry Analysis - Airlines__________________________________________________________________________


2nd Qtr 2006

(in cents/mile) Cost/ASM Rev/ASM

US Airways 16.1 < 18.4 Northwest 13.8 < 15.2 Continental 13.6 < 14.6United 13.4 < 14.1American 12.4 < 13.4America West 12.7 < 13.5 Frontier 11.0 < 11.4 Southwest 8.9 < 10.7 JetBlue 7.8 < 8.5


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Industry Analysis - Airlines___________________________________________________________________________


2nd Qtr 2007

(in cents/mile) Cost/ASM Rev/ASM

US Airways 16.3 < 19.0 Northwest 13.0 < 14.7 Continental 13.5 < 14.5United 13.0 < 14.5American 12.8 < 13.7America West 13.1 > 12.8 Frontier 10.7 = 10.7 Southwest 9.0 < 10.3 JetBlue 8.0 < 9.0

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Industry Analysis - Airlines_____________________________________________________________________________________________________________________________

Continental Airlines Nov. 2005 – Nov. 2007


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Industry Analysis - Airlines__________________________________________________________________________________

Additional considerations for airline analysis:• Market share (share of available seat miles)• Barriers to entry

GatesTake-off and landing slotsRoutes

• Aircraft fleetAverage ageStandardizationFuel efficiencyAircraft orders and options

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3) Evaluate Firm’s Current Economic Position_____________________________________________________________________________________________________________________________

A) Financial position- Balance sheet analysis

• Types of assets (tangible, intangible, current, long term)• Nature of liabilities (maturity structure, off-balance-sheet)• Capital structure (leverage)• Components of residual equity

B) Profitability- Income statement analysis

• Operating revenues and expenses• Profit margins• Nonrecurring or unusual items


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3) Evaluate Firm’s Current Economic Position_____________________________________________________________________________________________________________________________

C) Cash flow- Statement of cash flows analysis

• Cash from operations• Cash from investing activities• Cash from financing activities

D) Time series (firm through time)E) Cross-section (firm relative to competitors)F) Risks

- Economic – macroeconomic risks- Business – risk of not earning cost of capital- Financial – risk of not meeting financial obligations

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4) Predict Future Course of Firm____________________________________________________________________________________________________________________

Build financial model - Project firm’s future operations

• Understand the firm’s business model• Understand firm’s strategy• Understand and assess sustainability of

competitive advantages

- Structure projections as pro forma financial statements• Income statement• Balance sheet• Statement of cash flows


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4) Predict Future Course of Firm____________________________________________________________________________________________________________________

Build financial model (Cont.’)

- Carefully and completely articulate assumptions- Do sensitivity analysis on value drivers

• Sales growth• Cost of goods sold• Cost of capital• Others

- Incorporate alternative strategies- Assess impact of risk

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5) Estimate the intrinsic value of the firm__________________________________________________________________________________________________________________

a) Valuation model

b)Sensitivity analysis

c) Reasonable range for intrinsic value


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Valuation__________________________________________________________________________________

This process is at least as much ART as SCIENCE.

The goal is not just the “number” (the intrinsic value) but an understanding of what drives the value and how that value could change.

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Valuation - Free Cash Flows______________________________________________________________________________________________

Free cash flows are the cash flows available for distribution to all providers of capital after providing for all short term and long term capital needs of the firm necessary to execute the firm’s strategic plan. These cash flows determine the firm’s value.


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Calculating free cash flows______________________________________________________________________________________________

START WITH STATEMENT OF CASH FLOWSCash Flow from Operations

Net income+ expenses not using cash- revenues not providing cash- increase in working capital** -OR-+ decrease in working capital**

___________________________________________________________________________________________________

Cash Flow from Operations (from St. of Cash Flows)**

** Includes changes in working capital except for:cashnotes payablecurrent portion of long term debt

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Calculating free cash flows_________________________________________________________________________________________________

Cash Flow from Operations (from St. of Cash Flows)+ interest paid in cash- interest tax shield (tax shelter from financing charges) _______________________________________________________Cash Flow from Operations of the Unlevered Firm- capital investment (including, but not limited to, capital

expenditures or “CAPEX”)_______________________________________________________Free Cash Flows of the Unlevered Firm (FCFU)====================================================


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Step 5 of Fundamental Analysis -Valuation

_________________________________________________________________________________

Discounted cash flow model:• The numerator contains the free cash flows• Estimate annual free cash flows until firm reaches

steady state – the horizon or terminal date (T)• Estimate the value of the firm from the terminal date

( )( )

( )( )T

Ttt

T

1=t0 k1

TVE+

k1FCFE

=V++

∑

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Step 5 of Fundamental Analysis_________________________________________________________________________________

Discounted cash flow model (continued):• Terminal or continuing value:

– Often estimated as a perpetuity, usually with growth– Terminal values are often filled with heroic

assumptions– Terminal value may dominate calculation of firm

value

( )( )

( )( )T

Ttt

T

1=t0 k1

TVE+

k1FCFE

=V++

∑


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Discounted cash flow model (continued):• Terminal or continuing value:

– Perpetuity with growth– g is growth rate of FCF in perpetuity

( ) ( )( )( )gk

g1FCFETVE T

T −+

=

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Discounted cash flow model (continued):

• Discount rate k:

• Weighted average cost of capital

⎟⎟⎠

⎞⎜⎜⎝

⎛+⎟⎟

⎠

⎞⎜⎜⎝

⎛==

t

tt,D

t

tt,Et V

Dk

VE

kWACCk

( )( )

( )( )T

Ttt

T

1=t0 k1

TVE+

k1FCFE

=V++

∑


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Discounted cash flow model (continued):• Weighted average cost of capital

Where:kEt = cost of equity capital at time tkDt = after tax cost of debt capital at time tEt = market value of equity at time tDt = market value of debt at time tVt = market value of the levered firm at time t = Et + Dt

⎟⎟⎠

⎞⎜⎜⎝

⎛+⎟⎟

⎠

⎞⎜⎜⎝

⎛=

t

tt,D

t

tt,Et V

Dk

VE

kWACC

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Discounted cash flow model (continued):

V0 = total value of firm (debt + equity)

V0 less market value of debt =intrinsic value of equity

Value of equity / # shares = Price / share

Compare intrinsic value to market price

RECOMMENDATION


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Multiples Analysis – An Alternative______________________________________________________________________________

• Also referred to as relative valuation• Ubiquitous• Generally not motivated by first

principles• What does relative valuation assume

about market prices?

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Multiples Analysis ___________________________________________________________________________________

• Procedure (to value a firm):– Select comparable firms

• Identify key characteristics of comparable firms– What are these key characteristics?

» Industry» Firm size» Growth rate» Capital structure» Profitability

• How many sample firms?– Are more firms “better”?


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Multiples Analysis__________________________________________________________________________________________________

– Choose an appropriate comparison metric • What are the criteria for choice?

– Value driver?• Examples

– Earnings per share or EPS– Earnings before interest, taxes, depreciation and

amortization or EBITDA– Book value of equity (BVE or BV)– Sales

• Industry specific – CASM, RASM, load factor (airlines)– Gross margin and same store sales (retail)

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Multiples Analysis____________________________________________________________________________________________________________________

Income Statement (for the X month period ending on date)

Operating revenues (sales)less: (Operating expenses)

Earnings before interest and taxes (EBIT)Plus: Depreciation and amortization

Earnings before interest, taxes, depreciation, and amortization or EBITDA


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– Determine “representative” multiple from the distribution of comparable firms• Analyze distribution – understand what

is high, low, “normal”• Mean, median

– Apply multiple to firm being valued to get an implied “price”• Choose appropriate numerator

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• Choice of performance metric– Share price to earnings (P / E)

• Most popular, most commonly used• “Not meaningful” for firms that report

losses– Share price to book value of equity

• Used when balance sheet reflects approximate fair value of assets in place

• Used more widely in recent years after academic research on importance of book values in predicting returns


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• Choice of performance metric– Enterprise Value (EV) to EBITDA

• Enterprise value = debt + equity• Used for firms with significant non-cash

expenditures– Enterprise Value (EV) to sales

• Used for young firms or firms with negative net income

• Why share price vs enterprise value in numerator?

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Brinker International (NYSE: EAT)__________________________________________________________________________________________________

Example – Determine appropriate price for Brinker International (a restaurant) using multiples.

Data for BrinkerPrice (MVE / share) = $ 26.90 EPS = $ 1.46EBITDA / share = $ 3.35Debt / share = $ 2.32Sales / share = $ 24.86BVE / share = $ 9.05


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Brinker International (NYSE: EAT)______________________________________________________________________________________________

68 publicly traded comparable restaurants:

P / E EV / EBITDA EV / Sales P / BVEMean 18.75 7.67 0.75 2.16Median 15.73 6.75 0.55 1.44

Brinker Implied Price (vs. $26.90 actual price)

Mean $ 27.38 $ 23.37 $ 16.33 $ 19.55 Median $ 22.97 $ 20.29 $ 11.35 $ 13.03

(computations on next slide)

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Computations (Means):

P / E $ 1.46 x 18.75 = $ 27.38EV/EBITDA $ 3.35 x 7.67 = $ 25.69 - $ 2.32 = $ 23.37EV/Sales $ 24.86 x 0.75 = $ 18.65 - $ 2.32 = $ 16.33P / BVE $ 9.05 x 2.16 = $ 19.55

(recall that EV = enterprise value = total value of firm bothdebt and equity)


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What do you conclude about Brinker’s trading price?

Too high, too low, or about “right”?

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Stock Picking/Pitching___________________________________________________________________________________________________________________________________________

• What does the “street” say about your stock?

• Why are you better than the “street”?

• What is going to make the street see things your way and move the price of the stock appropriately (what are the catalysts)?


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Stock Picking/Pitching___________________________________________________________________________________________________________________________________________

Why are you better than the “street”?• Rely on three competitive advantages:

– Better information dig deeper• Industry reports, primary diligence

– Better, more robust analysis• Accounting adjustments, business

cycles, secular shifts– Objectivity

• Take advantage of market psychology when it is wrong

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Stock Picking/Pitching __________________________________________________________________________________

• Quick overview• Importance of understanding the firm’s

story• Importance of understanding the

industry and its key value drivers• Importance of in-depth financial analysis• No quick, back of the envelope answers• Peter Lynch estimates that the top stock

pickers are right 60% of the time

Stock Pitch Primer (Nov 2007)

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