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Streetsmart Guide to Valuing a Stock Other Books in the Streetsmart Series Streetsmart Guide to Managing Your Portfolio Streetsmart Guide to Short Selling Streetsmart Guide to Timing the Stock Market Streetsmart Guide to Valuing a Stock The Savvy Investor’s Key to Beating the Market Second Edition Gary Gray, Patrick J. Cusatis, and J. Randall Woolridge McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2004 by The McGraw-HIll Companies, Inc. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-143623-5 The material in this eBook also appears in the print version of this title: 0-07-141666-8. 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DOI: 10.1036/0071436235 To Katie O’Toole, a great writer, a terrific editor, and a wonderful wife and mother. G.G. To my wife, Deborah, my children, Jacob and Julia, and my parents. P.J.C. To my daughters, Jillian, Ainsley, and Ginger. J.R.W. This page intentionally left blank. For more information about this title, click here. Contents Preface Acknowledgments CHAPTER 1 CHAPTER 2 xi xv INTRODUCTION AND OVERVIEW 1 Financial Flameout Good Companies—Hot Stocks—Ridiculous Prices The Investment Decision The 10 Principles of Finance Overview of the Book 1 THE 10 PRINCIPLES OF FINANCE AND HOW TO USE THEM Principle 1: Higher Returns Require Taking More Risk Principle 2: Efficient Capital Markets Are Tough to Beat Principle 3: Rational Investors Are Risk Averse Principle 4: Supply and Demand Drive Stock Prices in the Short-run Principle 5: When Analyzing Returns, Simple Averages Are Never Simple 2 4 5 7 13 14 21 29 31 34 Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use. vii viii CONTENTS Principle 6: Transaction Costs, Taxes, and Inflation Are Your Enemies Principle 7: Time and the Value of Money Are Closely Related Principle 8: Asset Allocation Is a Very Important Decision Principle 9: Asset Diversification Will Reduce Risk Principle 10: An Asset Pricing Model Should be Used to Value Investments Summary CHAPTER 3 CHAPTER 4 40 43 48 54 56 STOCK VALUATION: SOME PRELIMINARIES 61 Introduction to Valuation DCF Stock Valuation We Caused the High-Tech Bubble Return to Stockholders Stock Price—Too High?—Too Low?—Just Right? Stock Valuation—Art, Science, or Magic? Stock Valuation Approaches: Fundamental, Technical, and MPT Stock Value, Stock Price, and Emotions Stock Value, Stock Price, and Analyst Recommendations When to Buy, When to Sell: Our Recommendation Where Do We Go Next? 61 63 69 72 77 82 HOW TO VALUE A STOCK Some Definitions Relating to Cash Flow The Free Cash Flow to the Firm Approach Why DCF and Not EPS? The Discounted FCFF Valuation Approach Microsoft—A Simple DCF Example Valuation—Growth versus Value, Large Cap versus Small Cap Valuation—The Next Step CHAPTER 5 36 83 88 90 92 94 97 97 102 108 110 115 123 124 FORECASTING EXPECTED CASH FLOW 127 The Five Chinese Brothers Growth Rates and the Excess Return Period Net Operating Profit Margin and NOP Income Tax Rate and Adjusted Taxes Net Investment Incremental Working Capital 127 128 138 141 143 147