FUNDAMENTAL ANALYSIS

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FUNDAMENTAL ANALYSIS

• FUNDAMENTAL ANALYSIS

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• 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

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Fundamental Analysis

• Top down
• Bottom up

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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.
  

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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.

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Fundamental AnalysisTop-down approach

• Economy Analysis
• Industry Analysis

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Economy Analysis

• Growth Rate of National Income (GDP Growth Rate)
• Growth Rate in Industry
• Growth Rate in Service
• Growth Rate in Agriculture

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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.

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Economy Analysis

• Interest Rates
• High Interest Payment ? Lower Profitability
• Lower Interest rate stimulates Investment Activity

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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.

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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.

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Economy Analysis

• Demographic Data (Monsoon)
• Economic and political stability

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Industry Analysis

• Profit
• 1
  2 3 4
• 
  Industry Life Cycle

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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, BW TV)
  ? get out from the company before the onset of
  the decay stage

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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

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Industry Analysis

• Attitude of Government
• - Alcoholic Drinks
• Cost structure
• Proportion of fixed cost to variable cost
• Higher fixed cost, higher B/E point

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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.

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Three types of security analysis

• Traditional fundamental analysis
• Value based metrics analysis
• Quantitative fundamental analysis

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Traditional 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 firms 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).

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Value based metrics analysis

• Based on Economic Value Added (EVA) method
  developed by Stern Stewart Company during the
  early 80s.
• 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)

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Quantitative fundamental analysis

• 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) a ßM (market return) ß1(equity
  capitalisation)
• ß2 (book-to-price ratio)
  ß3(dividend yield)
• ß4(industrial) ß5(non-industrial)

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Traditional Fundamental AnalysisSources 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.

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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

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COMPANY ANALYSIS

• Important Financial Statements
• Income Statement (PL Account)
• Statement of Financial position (Balance Sheet)
• Fund Flow Statement
• Cash Flow Statement

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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.)

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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

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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.

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FUND FLOW STATEMENT ANALYSIS
Sources of funds Application of funds
Fund flow from operation Fund flow from financing Activities Decrease in W. capital Acquisition of Assets Increasing in W. capital
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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.

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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.

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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?

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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

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Margin of Safety

• 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.

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Contribution Margin

• Contribution Margin contribution / sale
• Suppose sale Rs50 per unit
• Variable cost Rs20 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?

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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.

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FINANCIAL ANALYSIS AND MEASURES OF RISK
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FINANCIAL ANALYSIS AND MEASURES OF RISK
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FINANCIAL ANALYSIS AND MEASURES OF RISK
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Interviewing company representatives

• Interviewing representatives of company may
  produce additional information and insight into
  the companys business.
• Because the analyst comes armed with knowledge of
  the companys 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
  markets valuation

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Other company specific factors

• Age of Plant
• Quality of Management
• Brand Image
• Labour-Management relation

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ESTIMATION OF INTRINSIC VALUEEarning 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.

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ESTIMATION OF INTRINSIC VALUE

1. Estimate the expected earnings per share (EPS).
2. Establish a P/E Ratio.
3. Develop a value anchor and a value range.

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1. Estimate the expected earnings per share.
PL 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 - - - - - - - - - - - - - - - - - - - - - -
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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.

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• 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

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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

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Establish a P/E Ratio.

• The P/E ratio may be derived from
• 1. The constant growth dividend model, or
• 2. Historical analysis

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1. DIVIDEND GROWTH MODEL
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• 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
• (12)/2

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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

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Buy-hold and sale decision
Market Price Decision
Less than Rs.32 Buy
Between Rs.32-36 Hold
More than Rs.36 Sell
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Some Tools for judging undervaluation or
overvaluation

• ROE
• Low High
• Low
• PBV
• ratio
• High

Low ROE Low PBV Undervalued High ROE Low PBV
Overvalued Low ROE High PBV High ROE High PBV
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Value Based Metric Analysis

• ECONOMIC VALUE ADDED

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• 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.

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• 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 MacMillan Press Ltd.)

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DEFINING EVA

• EVA essentially seeks to measure a companys
  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 gt the capital charge, EVA is positive
• If NOPAT lt the capital charge, EVA is negative.

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• 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

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• 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

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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 Rs3,000. If interest is Rs1,000 and tax
  rate is 40, then PAT is Rs1200
• EBIT Rs3,000
• Interest Rs1,000
• PAIBT Rs2000
• Tax (40) Rs800
• PAT Rs1200

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NOPAT is equivalent to income available to
shareholders plus interest expenses (after tax).

• Income available to shareholders PAT Rs1200
• Interest expenses (after tax)
• effective interest interest interest
  tax shield
• Rs1,000 40 x Rs1,000
• Rs1,000 Rs400 Rs600
• NOPAT Rs1200 Rs600 Rs1,800

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• If before tax cost of debt is kd 10 ,Debt
  capital Rs1000 ,Cost of equity capital (ke)
  12 and Equity capital Rs5000
• Total capital charge
• after tax cost of debt cost of
  equity
• kd (1 t) x Rs10,000 ke x Rs5000
• 10(1 - .40) x Rs10,000 12 x Rs5000
• Rs600 Rs600 Rs1200
• Thus, EVA NOPAT capital charge
• Rs1,800 Rs1200 Rs 600

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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(Rs1200 Rs1000) actual cost of
  capital(10x Rs10,000 12 x Rs5000 Rs1000
  Rs600 Rs1600) Rs2200 Rs1600 Rs600

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• 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

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• 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
• Tobins q 1 MVA / book value of company

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Company selection using EVA

• Excess return to invested capital (EVA / book
  value of capital)
• 
  Best fitted
  line
• 
  x x x x xx
• 
  x x x x
• 
  x xx x xx x
• x x
  
• x Y
  x x
• Z x
• x
• xx Ratio of
  market value to book value or replacement cost
  (q)
• x x x x
• x x

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• 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.

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Company selection using EVA

• Excess return to invested capital
• 
  
• 4 4
  
• 2
• 1.5 2
  Ratio of market value to replacement cost (q)

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• Tobins q MV of company / book value of company
• Consider the following situations
• For firm Y , MP fair value (FV)
• For firm X, MP lt FV , the firm is under priced
• For firm Z, MP gt FV, the firm is overpriced.

Firm Excess return Tobins q
X 4 1.5
Y 4 2
Z 2 2