Equity Valuation and Portfolio Management

KEY POINTS

• Fundamentals and valuation metrics are used in traditional and value-based approaches to equity securities analysis.
• In the traditional realm, growth rates, margins, return on equity, multiples, and the fundamental stock return are at the heart of this well-known approach to company analysis.
• The extended Dupont formula goes a long way in showing how the multiplicative combination of operating margins, asset turns, interest burden, tax burden and the equity multiplier (leverage) at the company level can impact—either positively or negatively—the shareholders' return on equity.
• Valuation measures such as price-to-sales, price-to-earnings, and price-to-book ratios can be used by investors and analysts to assess whether a company's internal growth opportunities are correctly priced in the marketplace.
• If the fundamental stock return (which includes the sustainable growth rate as measured by times return on equity) falls short of the required return—equivalently if the fundamental stock return lies below the securities market line—then the stock appears to be overvalued. Consequently, the investor should consider selling or short selling the presumably mispriced shares. In theory, the firm's common stock is priced “just right” when the fundamental stock return equals the investor's required return. In turn, a potential buy opportunity is present when the FSR exceeds the required rate. We also examined the traditional (and value-based) role of corporate debt policy.
• Investors ...