Fundamental Equity

Analysis
Submitted By:
Anubha Mathur
Laxmi Narsimha Boddhu
Yuki Jain
Outline
Introduction
Qualitative and Quantitative Analysis
The Concept of Company's Intrinsic Value
Top-down and bottom-up
Procedure
DuPont Analysis
DCF Models
Gordon Growth Model
One and two stage dividend growth models
FCFE & FCFF models
Theoretical underpinnings of P/E ratio
Appropriate sector ratio analysis
Introduction
Fundamental analysis consists of analyzing financial
statements like
Balance sheet,
Income statement
Cash flow statement, looking at revenues,
expenses, profits, assets and debts of a company
Basics:
to conduct a company stock valuation and
predict its probable price evolution,
to make a projection on its business
performance,
to evaluate its management and make
internal business decisions,
to calculate its credit risk.

It answers questions like:
is the company business profitable,
are their revenues growing,
how is the company controlling costs,
what are company's competitive advantages and
will they last in the future, what are the
prospects of the industry in which company
operates,
has the company a valuable trademark,
is the management trust worded, has the
company to much debt, and similar.


Qualitative and Quantitative
Fundamental Analysis
Fundamental analysis includes
Quantitative research like analyzing
company statements and market share
(things that can be measured and
expressed in numerical terms)
Qualitative research like evaluating quality
of the management or the value of
company's trade mark or patents for
example (things that are difficult or
impossible to measure).
Example
Fundamental analysis of McDonalds' company
Quantitative part of research would examine
its revenues, profit, price earnings ratio, price
book ratio, growth, debt to equity ratio, price
sales ratio and many other ratios.
But the analysis would be incomplete without
taking into account the value of the
McDonalds' brand, which is recognized all
over the world by millions of people. Still, it is
very difficult to say how much is the brand
exactly worth, we can only say that it is
essential for ongoing success of selling
hamburgers.
The Concept of Company's Intrinsic Value
Two most important assumptions for
Fundamental Stock Analysis
Stock market does not reflect the true value of the
stock in every moment. That means, that stock is
most often undervalued or overvalued in relation to
its true - fair value, know as intrinsic value.
Stock market will price fairly the company on the
long run. Therefore it makes sense to buy
undervalued stock and wait for the market to
realize its real worth. Sooner or later you will profit
when stock market price will equal its intrinsic
value.
The Concept of Company's Intrinsic
Value contd
Two major unknowns with Fundamental
Analysis
The first problem is when you estimate the
companys intrinsic value, you can't be sure, if
your evaluation is correct
The second problem is that you never know
when the market will realize the true value of
the stock.
Top-down and bottom-up
When analyzing a stock using fundamental
analysis there are two basic approaches:
The top-down investor starts his analysis with global
economics, including both international and
national economic indicators, such as GDP growth
rates, inflation, interest rates, exchange rates,
productivity, and energy prices. He narrows his search
down to regional/industry analysis of total sales, price
levels, the effects of competing products, foreign
competition, and entry or exit from the industry. Only
then he narrows his search to the specific company.
The bottom-up investor starts with specific businesses,
regardless of their industry/region.

Procedure
Step1:
Financial Statement Analysis
Analysis of Ratios, dividends paid, operating cash flow, new equity
issues and capital financing, the earnings estimates and growth rate
projections
Step2:
Input to Models
The determined growth rates (of income and cash) and risk levels (to
determine the discount rate) are used in various valuation models.
Step3:
Models :
Discounted Cash Flow
Du Point
PE Models
DuPont Analysis
DuPont analysis helps analysts glean insight
from return on equity (ROE) by breaking ROE
into several components
Equity rs Shareholde
Income Net
ROE =
DuPont Analysis
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Assets Total
Assets Total
Sales
Sales
Equtiy rs Shareholde
Income Net
ROE
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Equtiy rs Shareholde
Assets Total
Assets Total
Sales
Sales
Income Net
ROE
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Multiplier
Equity
Turnover
TotalAsset
Margin
Profit
ROE
DuPont Analysis
By breaking ROE into its components, analysts can
pinpoint where returns are being generated, or lost

DuPont analysis also allows analysts to view trends
in the components of ROE
For example, whether or not profit margins are improving
or if financial leverage has changed
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Multiplier
Equity
Turnover
TotalAsset
Margin
Profit
ROE
Discounted Cash Flow Models
DCF models value expected cash flows by
assigning discount rates composed of a
combination of factors including risk premiums
and interest rates


n
n
3
3
2
2
1
1
o
R) (1
C
R) (1
C
R) (1
C
R) (1
C
V
+

+
+
+
+
+
=
Dividend Discount Models
Like a bond, equity can be valued as the present value of
a stream of cash flows, with dividends as our cash flows
The equation below illustrates that V
0
can be calculated as a
series of cash flows in future periods that are discounted at
r, where r is the required rate of return for an equity
investor
n
n n
3
3
2
2
1
1
o
r) (1
D V
r) (1
D
r) (1
D
r) (1
D
V
+
+
- - -
+
+
+
+
+
=
n
n
n t
n
n
o
) 1 (
V
r) (1
D
V
r +
+
+
=

=
Dividend Discount Models
If dividends were to remain constant forever,
then we would value equity as a perpetuity




r
D
V
o
=
Use this model to value equity with constant
dividends like preferred stock
Dividend Discount Models
Example of a constant dividend model with
D = $3 and r = 12%



$25 V
.12
$3
V
0
0
=
=
r
D
V
o
=
20 $
15 .
3 $
0
0
=
=
V
V
What happens if
my required return
on equity increases
to 15%?



Dividend Discount Models
In practice, dividends are not constant forever.
Hopefully, dividends grow and not decline, but the point is
dividends change
If the growth rate is assumed to be a constant, g, we
can use the following equation
g) - (r
D
V
1
o
=
Note: r > g, or we
have a negative
denominator and
D
1
= D
0
(1+g)
This equation is known as the Gordon Growth
Model and is often used to value equity in
mature, stable industries like utilities
Dividend Discount Models
Example of a Gordon Growth Model (constant dividend
growth) with D
0
=$3, r = 12%, and g = 4%



g) - (r
D
V
1
o
=
$39 V
0.08
$3.12
V
.04) (.12
.04) $3(1
V
0
0
0
=
=

+
=
Note that V
0
is sensitive to
changes in r and g. Thus, we
must take care when estimating
these values for our analysis.
$28.36 V
.04) (.15
$3(1.04)
V
0
0
=

=
00 . 53 $
) 06 . 12 (.
) 06 . 1 ( 3 $
0
0
=

=
V
V
Dividend Discount Models
Dividends like the economy and single stocks do
not tend to grow at stable rates forever
If one identifies a company with two defined stages of
growth, use the following two-stage DDM
T
T
3
3
1 0
2
2
1 0 1 0
0
) r 1 (
P
) r 1 (
) g 1 ( D
) r 1 (
) g 1 ( D
) r 1 (
) g 1 ( D
V
+

+
+
+
+
+
+
+
+
=
) g (r
) g (1 D
P
2
2 T
T

+
=
Where
Dividend Discount Models
We can re-write a two stage DDM as
T
T
T
1 t
t
t
1 0
0
1 T t
t
t
2
T
1 0
T
1 t
t
t
1 0
0
r) (1
P
r) (1
) g (1 D
P
r) (1
) g (1 ) g (1 D
r) (1
) g (1 D
P
+
+
+
+
=
+
+ +
+
+
+
=

+ = =
) g (r
) g (1 D
P
2
2 T
T

+
= Where
Dividend Discount Models
Example of a two stage DDM
Lets assume for a moment that our company has just
discovered the cure to sleep deprivation and has obtained a
three year patent. That would change our estimation of g for a
period of 3 years. We will say that our company will now grow
at 10% for three years and then return to our normalized 4%
growth rate thereafter.
First stage is 3yrs with high growth rate of 10% and long-
term growth or stable growth rate is 4% indefinitely
D
0
= $3, g
1
= 10%, t=3, g
2
= 4%, T=4, r=12%

Dividend Discount Models
Lets look at the equation with our variables
T
T
3
3
1 0
2
2
1 0 1 0
0
) r 1 (
P
) r 1 (
) g 1 ( D
) r 1 (
) g 1 ( D
) r 1 (
) g 1 ( D
V
+

+
+
+
+
+
+
+
+
=
|
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|
.
|

\
|
+

+ +
+
+
+
+
+
+
+
+
+
=
4
3
3
3
2
2
1
1
0
) 12 . 1 (
) 04 . 12 (.
) 04 . 1 ( ) 1 . 1 ( 3 ($
.12) (1
.1) $3(1
.12) (1
.1) $3(1
.12) (1
.1) $3(1
V
Dividend Discount Models
Lets look at the equation with our variables
1.57
(.08)
04) ($3.99)(1.
1.40
$3.99
1.25
$3.63
1.12
$3.3
V
0
|
|
.
|

\
|
+ + + =
1.57
$51.87
1.40
$3.99
1.25
$3.63
1.12
$3.3
V
0
+ + + =
$33.04 $2.85 $2.90 $2.94 V
0
+ + + =
$41.72 V
0
=
Discounted Cash Flow Models
What if a company does not pay a dividend?
Analysts can use free cash flow to the firm and free cash flow
to equity models as a substitute
FCF models are created in the same fashion as DDMs
When estimating the value of equity, use free cash flow to
equity as the appropriate cash flow and the required return on
equity as the discount rate
When estimating the value of an entire firm, use free cash flow
to the firm and WACC as the discount rate
P/E rational
g) - (r
D
V
1
o
=
|
|
.
|

\
|

+
=
g) (r
g) (1 D
V
0
0
1
D
g) (r
g) (1
V
0
0
|
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.
|

\
|

+
=
|
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|

\
|
|
.
|

\
|
|
|
.
|

\
|

+
=
1
0
1
0
E
1
1
D
g) (r
g) (1
E
V
|
|
.
|

\
|
|
|
.
|

\
|

+
=
1
0
1
0
E
D
g) (r
g) (1
E
V
Appropriate ratios for different sectors
Financials P/B
Retail P/E
Industrials P/E
Healthcare
Biotech start-up P/discounted future earnings
Mature pharmaceutical P/E
Services P/E
Tech
High growth & no earnings P/S & a function of cash burn rate
Mature firms in stable sector P/E

Advantages
Intuitive Appeal:
Cause Effect Relationship
Using fundamental analysis to predict futures
prices has that precept as its foundation, and
attempts to identify the "causing" factors. In this
sense, the approach is intuitively appealing.
Objectivity:
Fundamental analysis is objective in that
relationships are tested by sound mathematical
and statistical methods.

Disadvantages
Data Intensive:
Fundamental analysis relies on a considerable
amount of data to test the significance of
variables. Such data are often not easy to acquire
and, moreover, are seldom available without
charge.
Labor Intensive:
Fundamental analysis also requires a
considerable amount of human labor - time and
energy. As well, methods have become so
complex that few individuals short of a trained
economist can properly apply the available
technology.