NDAMENTAL ANALYSIS FUNDAMENTAL ANALYSIS
Top-down vs. Bottom-up Top-down approach: economy analysis and industry analysis Bottom-up approach: Technical analysis and security analysis Security analysis - Traditional fundamental analysis - Value based metrics analysis - Quantitative fundamental analysis Traditional fundamental analysis - Sources of information - COMPANY ANALYSIS Financial ratio analysis Fund flow statement analysis Cash flow statement analysis Break-even analysis and contribution analysis Financial Analysis and measures of risk Interviewing company representatives Quality of management, brand image etc. - Estimation of intrinsic value Value based metric analysis - EVA and selection of company
Fundamental Analysis Top down Bottom up
Top-down Relies heavily on the analysis and forecasting of trends in the economy and industry Evaluates the expected impact of changes in the world economy on the macro economy of the country. Evaluates the expected influence of these changes on the domestic industry. Identifies the stocks which are expected to outperform the market. Thus, the expected market changes are the driving force behind this particular investment strategy.
Bottom-up Places greater emphasis on individual stock selection. Picks up stock which are undervalued and have the potential to outperform. Despite its weakness, this approach is very popular primarily because of their inability - to forecast long-term economic and market trends or - to undertake low-cost stock selection, as well as their inherent tendency to speculate.
Fundamental Analysis Top-down approach Economy Analysis Industry Analysis
Economy Analysis Growth Rate of National Income (GDP Growth Rate): Growth Rate in Industry Growth Rate in Service Growth Rate in Agriculture
Economy Analysis Inflation: Higher rates of inflation upset business plans, lead to cost escalation and reduce profit margin. It leads to erosion of purchasing power.
Economy Analysis Interest Rates: High Interest Payment Lower Profitability Lower Interest rate stimulates Investment Activity
Economy Analysis Government Revenue, Expenditure, Deficit: High Fiscal Deficit High Inflation High Growth Expenditure (i) To stimulate Economy; and (ii) Expenditure to a particular sector i. e. , infrastructure , cement , IT etc.
Economy Analysis Foreign Trade, BOP and Exchange Rate: BOT = Imports – Exports Balance on Current account = BOT + Invisible Items BOP Deficit = Balance on Current A/C + Loan Receipt /Repaid High BOP Deficit Rupee will depreciate Improves the competitive position of Indian product.
Economy Analysis Demographic Data (Monsoon) Economic and political stability
Industry Analysis Profit 1 2 3 Industry Life Cycle 4
Industry Analysis Industry Life Cycle: Pioneering Stage (Sunrise industries) [Bio-con, Sulzon (wind energy)] Risky Investment Expansion Stage (Tele communication, IT. Etc. ) High Return at low risk Maturity Stage [FMCG, Leasing industry (during 80, s it was in pioneering stage )] Decay Stage (Type writer, Jute Industry, B&W TV) get out from the company before the onset of the decay stage
Industry Analysis INDUSTRY CHARACTERISTIC Demand Supply Gap Competitive Conditions in the Industry Barriers to Entry: Product Differentiate (Buyers Preference for established firm) Absolute Cost Advance Economy of Scale
Industry Analysis Attitude of Government - Alcoholic Drinks Cost structure Proportion of fixed cost to variable cost Higher fixed cost, higher B/E point
Bottom-Up Approaches An investor who follows a bottom-up approach to investing focuses either on (1) technical aspects of the market or (2) the economic and financial analysis of individual companies, giving relatively less weight to the significance of economic and market cycles. The investor who pursues a bottom-up strategy based on certain technical aspects of the market is said to be basing stock selection on technical analysis. The primary research tool used for investing based on economic and financial analysis of companies is called security analysis.
Three types of security analysis Traditional fundamental analysis Value based metrics analysis Quantitative fundamental analysis
Traditional fundamental analysis begins with the financial statement analysis to evaluate the financial solvency and profitability of the firm. The investor also looks at - the firm’s product lines - the economic outlook for the products (including existing and potential competitors), and - the industries in which the company operates. - the quality of management, brand image etc. Based on the growth prospects of earnings (or cash flows), the fundamental analysts attempts to determine the fair value or intrinsic value using P/E ratio (or DCF Technique).
Value based metrics analysis Based on Economic Value Added (EVA) method developed by Stern Stewart & Company during the early 80’s. Fair market value should be equal to book value of assets plus present value of future EVA (MVA) i. e. , Fair market value =Book value of assets + PV of future EVA (MVA)
Quantitative fundamental analysis seeks to assess the value of securities using a statistical model derived from historical information about security return. The most commonly used model is the fundamental multifactor risk model which may be as follows; E(R) = α + βM (market return) + β 1(equity capitalisation) + β 2 (book-to-price ratio) + β 3(dividend yield) + β 4(industrial) + β 5(non-industrial)
Traditional Fundamental Analysis: Sources of information The basic information about a company can be gleaned from publication (both print and Internet), annual reports, sources such as the commercial financial information providers [CMIE, Prowess data base, Indian Quotation Systems Pvt. Ltd. (Moneyline Telerate), RBI bulletin].
The basic information about a company consists of the following Type of business (e. g. , manufacturer, retailer, service, utility) Primary products Strategic objectives Financial condition and operating performance Major competitors (domestic and foreign) Competitiveness of the industry Position of the company in the industry (e. g. , market share) Industry trend Regulatory issues Economic environment
COMPANY ANALYSIS Important Financial Statements Income Statement (P&L Account) Statement of Financial position (Balance Sheet) Fund Flow Statement Cash Flow Statement
FINANCIAL RATIO ANALYSIS: Liquidity Ratios Leverage/Capital Structure Ratio Turnover Ratio Profitability Ratio (Net Profit, Operating Profit, Non-Operating Profit) Common Stock Ratio (DPS, EPS, etc. )
FINANCIAL RATIO ANALYSIS can not tell the whole story So many assumptions. Other areas of concern - selection of an appropriate benchmark firm or firms for comparison purposes - interpretation of ratio. - pitfalls in forecasting future operating performance and financial condition based on past trends
ACCOUNTING POLICY AND NOTES Depreciation Policy: WDM, SLM Inventory Valuation: FIFO, LIFO, etc. Before comparing two companies, you must recast their comparison on the basis of uniform accounting policy.
FUND FLOW STATEMENT ANALYSIS Sources of funds Fund flow from operation Fund flow from financing Activities Decrease in W. capital Application of funds Acquisition of Assets Increasing in W. capital
Fund Flow ANALYSIS What is the fund from operation (FFO)? Whether acquisition is from FFO. Whether the firm has used short term sources of funds to finance long-term investments. Level of Increase/Decrease in Working Capital. Is it justified? What is existing Current Ratio? Excessive Liquidity is bad.
CASH FLOW STATEMENT 1. Cash Flow from Operating Activities is expected to be positive. 2. Cash Flow from Investment Activities is expected to be negative. 3. Cash Flow from Financial Activities is expected to be positive.
CASH FLOW STATEMENT ANALYSIS Checking the Power of Cash Flow Engine (CF from operating activity): Whether it is increasing? Is it increasing at the cost of Working Capital? What is the qualities of Net Profit? Correlation between net profit and cash flow from operation. Whether cash flow from financing activity is now for investment activities or it is used to meet daily expense. Whether CFOP Activity is negative?
BREAK-EVEN ANALYSIS AND CONTRIBUTION ANALYSIS EBIT = TR – TC = PQ – (Va + F) = Q (p – v) – F At Break-even point EBIT = 0, Or QB/E = [F/(p – v)] = Fixed Cost/Contribution
Margin of Safety = Actual Sale – Break-even sale Suppose B/E sale is 80% of actual sale. Margin of safety is 20%. Its sales can drop by 20% before it shows loss.
Contribution Margin = contribution / sale Suppose sale = Rs 50 per unit Variable cost =Rs 20 per unit Contribution margin = (50 -20) / 50 = 60 i. e. , 60%. This means that every rupee of additional sales will increase the pretax profit by 60 paise. The traditional financial ratio does not provide this information at all. Suppose we have got PBT to sales = 20%. Will profit increase by 20 paise for every rupee increase in sales?
Limitation of contribution margin analysis Since an investor is interested only on the profit of the firm, the forecasted sale or growth in sale can be translated into earnings growth with the help of contribution analysis. Two notes of caution are, however, in order. First, the contribution analysis is valid only as long as the existing capacity is adequate to meet the forecasted demand growth. Second, the traditional accounting statements do not provide adequate information about variable and fixed costs.
FINANCIAL ANALYSIS AND MEASURES OF RISK
FINANCIAL ANALYSIS AND MEASURES OF RISK
FINANCIAL ANALYSIS AND MEASURES OF RISK
Interviewing company representatives Interviewing representatives of company may produce additional information and insight into the company’s business. Because the analyst comes armed with knowledge of the company’s financial statements, the questions should focus on taking a closer look at the information provided by these disclosures: - Extraordinary or unusual revenues and expenses - Large differences between earnings and Cash Flows from operating activities. - Changes in accounting policy - How the company values itself versus the market’s valuation
Other company specific factors Age of Plant Quality of Management Brand Image Labour-Management relation
ESTIMATION OF INTRINSIC VALUE Earning Analysis, dividend and dividend discount models Value of a firm =expected value of a future cash flow of the firm As an alternative, what is typically done is to examine the historical and current relation between stock prices and some fundamental values, such as earnings, dividends, using this relation to estimate the value of a share.
ESTIMATION OF INTRINSIC VALUE 1. 2. 3. Estimate the expected earnings per share (EPS). Establish a P/E Ratio. Develop a value anchor and a value range.
1. Estimate the expected earnings per share. P&L account Actual Projected Net Sale Cost of Goods sold G/Profit Operating Expenditure Operating Profit Non-Operating profit PBT Tax PAT No. of Shares EPS - -
Can earnings be managed? There is a possibility that reported financial information may be managed or manipulated by the judicious choice of accounting methods and timing. Earnings can be manipulated using a number of devices including the selection of Depreciation Policy: WDM, SLM Inventory Valuation: FIFO, LIFO, etc.
There are many pressures that a company may face that affect the likelihood of manipulation. These pressures include: - Reporting ever-increasing earnings, especially when the business is subject to variations in the business cycle - Meeting or beating analyst forecasts - Executive compensation based on earnings targets
Earnings Per Share EPS = EAT / Number of common shares outstanding What is there to interpret? EAT is the net income available to shareholders. It is pretty clear. What about the number of common shares outstanding? Can that change during the period of time under consideration? Diluted shares. Basic EPS vs. Diluted EPS
Establish a P/E Ratio. The P/E ratio may be derived from 1. The constant growth dividend model, or 2. Historical analysis
1. DIVIDEND GROWTH MODEL
Calculate P/E ratio on the basis of above formula. ……(1) Historical P/E ratio for 5 year (average). . (2) Weighted Average P/E ratio = (1+2)/2
DETERMINE A VALUE ANCHOR AND A VALUE RANGE Projected EPS x Appropriate P/E Ratio Suppose it is = 5 x 6. 8 = Rs. 34 Intrinsic Value Range = Rs. 32 – Rs. 36
Buy-hold and sale decision Market Price Decision Less than Rs. 32 Buy Between Rs. 32 -36 Hold More than Rs. 36 Sell
Some Tools for judging undervaluation or overvaluation ROE Low PBV ratio Undervalued Low ROE Low PBV High ROE Low PBV Overvalued High Low ROE High PBV High ROE High PBV
Value Based Metric Analysis ECONOMIC VALUE ADDED
Economic Value Added (EVA) is a residual income that subtracts the cost of capital from the operating profits generated by a business. The term EVA is a registered trademark of a New York based consulting firm Stern Stewart & Co.
One of the earliest to define residual income was Alfred Marshall way back in 1890. Marshall defined economic profit as total net gains less the interest on invested capital at the current rate (A Marshall, 1890, Principles of Economics, The Mac. Millan Press Ltd. )
DEFINING EVA essentially seeks to measure a company’s actual rate of return as against the required rate of return. To put it simply, EVA is the difference between Net Operating Profit after Tax (NOPAT) and the capital charge for both debt and equity (overall cost of capital). If NOPAT > the capital charge, EVA is positive If NOPAT < the capital charge, EVA is negative.
NOPAT is the return on capital employed. Thus, if r is the rate of return on capital employed, the NOPAT = r x capital Capital charge is the overall cost of capital. Thus, if c is the rate of cost of capital, the capital charge = c x capital
Thus EVA = NOPAT – capital charge = r x capital – c x capital = (r – c) x capital = (rate of return – cost of capital) capital If, for example, NOPAT is Rs 250, capital is Rs 1, 000, and c is 15%, then r is 25% (NOPAT/capital ) and EVA is Rs 100. EVA =(r – c) x capital = (25% - 15%) x Rs 1, 000 = Rs 100
NET OPERATING PROFIT AFTER TAX (NOPAT) NOPAT is equivalent to income available to shareholders plus interest expenses (after tax). Suppose, OPERATING PROFIT BEFORE INTEREST AND TAX = EBIT = Rs 3, 000. If interest is Rs 1, 000 and tax rate is 40%, then PAT is Rs 1200: EBIT = Rs 3, 000 Interest = Rs 1, 000 PAIBT = Rs 2000 Tax (40%)= Rs 800 PAT = Rs 1200
NOPAT is equivalent to income available to shareholders plus interest expenses (after tax). Income available to shareholders = PAT = Rs 1200 Interest expenses (after tax) = effective interest = interest – interest tax shield = Rs 1, 000 – 40% x Rs 1, 000 = Rs 1, 000 – Rs 400 = Rs 600 NOPAT = Rs 1200 + Rs 600 = Rs 1, 800
If before tax cost of debt is kd = 10% , Debt capital = Rs 1000 , Cost of equity capital (ke) = 12% and Equity capital = Rs 5000: Total capital charge = after tax cost of debt + cost of equity = kd (1 –t) x Rs 10, 000 + ke x Rs 5000 = 10%(1 -. 40) x Rs 10, 000 + 12% x Rs 5000 = Rs 600 + Rs 600 = Rs 1200 Thus, EVA = NOPAT – capital charge = Rs 1, 800 – Rs 1200 = Rs 600
Alternatively EVA can be calculated as follows: EVA = NOPAT( which is equivalent to income available to shareholders plus actual interest expenses) – actual cost of capital (which is before tax cost of debt plus after tax cost of equity capital) Or EVA = NOPAT(Rs 1200 + Rs 1000) –actual cost of capital(10%x Rs 10, 000 + 12% x Rs 5000 = Rs 1000 + Rs 600 = Rs 1600) = Rs 2200 – Rs 1600 = Rs 600
EVA = NOPAT – capital charge = r x capital – c x capital = (r – c) x capital = (rate of return – cost of capital) capital EVA / capital = rate of return – cost of capital = excess return on invested capital
MV of equity = book value of equity + MVA MV of equity + Debt = book value of equity + debt+ MVA MV of company = book value of company + MVA Or MV of company / book value of company = 1 + MVA / book value of company Tobin’s q = 1 + MVA / book value of company
Company selection using EVA Excess return to invested capital (EVA / book value of capital) Best fitted line x x xx xxxx xx x x xx Y xx Zx x xxxx xx Ratio of market value to book value or replacement cost (q)
The above figure shows the “excess return on invested capital” versus the “market Value of Invested capital-to-Replacement Cost of Invested Capital” for a number of hypothetical companies. The data points that lie above the ‘best fitted line’ represent potentially undervalued companies (or shares), while those data points that fall below the ‘best fitted line’ represent potentially overvalued companies.
Company selection using EVA Excess return to invested capital 4 4 2 1. 5 2 Ratio of market value to replacement cost (q)
Tobin’s q = MV of company / book value of company Consider the following situations: Firm X Y Z Excess return 4% 4% 2% Tobin’s q 1. 5 2 2 For firm Y , MP = fair value (FV) For firm X, MP < FV , the firm is under priced For firm Z, MP > FV, the firm is overpriced.