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8.5 Company Analysis and Stock Selection

In this topic we use the same method used in the valuation of a stock market index covered earlier. To value individual stocks, we estimate the earnings multiplier (P/E) and earnings in order to arrive at an estimate for the future price of the stock.

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It is important to differentiate between company analysis and stock selection. Company analysis may identify a company that is highly attractive in terms of growth and management. However, when it comes to looking at the valuation of the stock it may be that the market has already discounted the favourable prospects in the share price and the shares are trading above their intrinsic value. In this case the stock should probably be avoided. On the other hand, there may be a company with less attractive prospects where the stock price is trading below its intrinsic value, which makes it a more attractive investment.

Growth companies and growth stocks

Growth companies – these are traditionally companies that have shown above average growth in sales and earnings, although they can also be defined as companies that have the potential to earn a rate of return that is above the required rate of return or cost of capital.

Growth stock – A growth stock is one that has achieved a higher risk-adjusted return than other stocks in the market. Growth stocks are not limited to being stocks of growth companies. They are stocks that at some stage were undervalued by the market but during the adjustment to a fair value exhibited superior performance.

It should be noted that growth companies’ share prices have not generally provided superior performance in the past, meaning they are not always growth stocks.

A defensive company is one whose earnings are resilient to economic downturn. A defensive stock is one that has a low or negative beta so the stock price is expected to fall by less than the market in a downturn.

Similarly a cyclical company is heavily influenced by the business cycle whereas a cyclical stock has a high beta and is expected to rise or fall by more than the market.

A speculative company is one where the business is risky but there is the potential for a large gain. A speculative stock is one with a high probability of poor returns and a small probability of spectacular returns.

Value versus growth investing

Value stocks are ones which are undervalued on some measure other than their growth potential, such as a low price/book or price/earnings value. In this comparison we are looking at growth stocks to mean something different to the definition above; in this case we are looking at growth stocks as ones which have above average sales or earnings growth. They will often trade at high price/earnings and price/book values.

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