1. Which industry have greater ROE & why?
ROE (Return on equity) It measures a firm’s efficiency at generating profits from every unit of shareholders equity .Of all the fundamental ratios that investor look at, one of the most important is return on equity, and it’s a basic test of how effectively co. management uses investor’s money. It is a measure of a corporation’s profitability that reveals how much profit a co. generates with the money shareholders have invested Calculated as, ROE= Net Income Shareholder Equity
Also known as “Return on net worth (RONW)”. ROE is useful for compairing the profitability of a company to that of other firms in the same industry. What is more important than a greater singular ROE is consistency in past are far more likely to do so in the future. e.g. o Consulting firm: Some industries have high ROE because they require no assets, such as consulting firm o Manufacturing Industries: Some industries require large infrastructure builds before they generate penny of profit such as oil refiners. o Construction industry: Such industry requires are capital intensive industries, so they will have low ROE. o Software: less capital intensive assets & liabilities so high ROE o Technology Co.:This companies with low debts often post high ROE numbers due to high profit margins, not high debt levels o Service sector Co.: Have high ROE So we cannot conclude that consulting firm are better investments than refiners just because of their ROE. Generally capital intensive businesses have low ROE
Firm with small asset base have high ROE
High ROE levels may be due to a short term factors such as; o Restructuring charges & assets sales that lower equity & increase ROE o Stock buybacks that lower equity & increases ROE o One time gain that increase earnings & ROE o A strong economy or peak in the business cycle. Because it is much more difficult to maintain high ROE levels for the long term, it is also important to consider ROE over long periods of time. Drawback of ROE: As mentioned earlier, a company that takes high levels of debt will show up a high ROE. As such ‘Return on invested capital (ROIC)’ & not ROE will be a good indicator of testing the co.s efficiency levels.How, for understanding the value of co.s with nil or marginal amts of debt. ROE is of great help
2. kind of co. which would generate cash flows at an early part of their lives? Discounted cash flow:
In finance, the discounted cash flow (or DCF) approach describes a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values. The discount rate used is generally the appropriate WACC, which reflects the risk of the cash flows. The discount rate reflects two things: 1. The time value of money (risk rate) - investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay. 2. a risk premium (risk premium rate) - reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all. Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management. To discount cash flow, the objective is to find the value of assets, given their cash flow growth and risk characteristic. In relative valuation the objective is to value assets based on how similar assets are currently priced in the market.
To do relative valuation correctively, we need to understand the fundamentals of discounted cash flows valuation. Discounted cash flow valuation has its foundation in the present value, where the value of any assets is the present value of expected future cash flows on it. A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Formula to calculate DCF: Where multiple cash flows in multiple time periods are discounted, it is necessary to sum them as follows:
for each future cash flow (FV) Where, N=life of an assets CF= Cash flow in period t R=Discount rate reflecting the riskiness of the project. The cash flow will vary from assets to assets, dividends for stocks, interest rate etc. The discount rate will be a function of the riskiness of the estimated cash flow, with higher rates for riskier assets and lower rates for safer projects. Under discounted cash flow valuation, we estimate the intrinsic value of an assets based on its fundamentals. Intrinsic value is the value that would be attached to the firm by an all knowing analyst, who not only estimates the estimated cash flow for the firm correctly but also attaches the right discount rate to these cash flows and values them with absolute precision. With intrinsic valuation, one can get the value of any asset is the present value of the expected cash flow on the assets and it is determined by the magnitude of the cash flow, the expected growth rate in these cash flows and uncertainty associated with receiving these cash flow.
By looking at assets with guaranteed cash flows over a finite period and then to cover the valuation of assets when there is uncertainty about expected cash flows , as a final step we consider the valuation of the firm with the potential, at least, for an infinite life and uncertainty in cash flow. Estimation of cash flows: It is the cash that equity investors can take out of the firm after financing investment needed to sustain future growth. Capital expenditure may be greater than depreciation. The dividends can exceed the free cash flows on equity. The free cash flow to equity is after capital expenditures
In corporate finance, free cash flow (FCF) is cash flow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on. Conclusion: So that we can conclude that those industries that are in the manufacturing process, energy sector, infrastructure, real estate sector have lesser cash flow in the early start of the project. Because it is difficult to generate cash flow immediately. They start generating money after some completion of the period. But sectors like service and trading, they start generating cash flow as they start with the project. They do not need to wait as much as manufacturing companies require it.
3. What are industry sectors which have higher multiple & why co. has high & low multiples?
Price Earnings Multiple Valuation: Business Valuation / How much is my Business Worth? Price-earnings ration (P/E) is simply the price of a company's share of common stock in the public market divided by its earnings per share. By multiplying this P/E multiple by the net income, the value for the business could be determined. A valuation ratio of a company's current share price compared to its per-share earnings. Calculated as:
Also sometimes known as "price multiple" or "earnings multiple". Market value per share = Market cap (equity) Earning per share EPS = Profit After Tax No. of outstanding shares In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects. The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per Rs. of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay Rs. 20 for Rs.1 of current earnings. It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number. P/E Multiple stands for Price / Earnings multiple and is one of the most frequently used measure to value a share price. Here price stands for the current market price at which the stock is trading. Earnings stand for EPS (Earnings per share) and normally the annual profits for the last financial year are considered while calculating EPS. For arriving at the P/E Multiple you need to divide the Current market price by the EPS of the company. So if the stock is trading currently at Rs.100 and the EPS is Rs.10 then the P/E multiple is 10. A rule of thumb is that high growth stocks would trade at a higher P/E multiple and that is why investors would observe the P/E multiple P/E Multiple can really help investors to determine whether the price that an investor is paying for a stock is high or low.
P/E Multiple is a good measure to determine whether to buy a stock when you have already done your research about the fundamentals of the company and are confident that the company in itself has sound operations and that buying it would be a good idea. This is like saying that you have done your research among various car manufacturers and are confident that buying a Honda or Toyota would be a good deal. It is usually best to compare stocks within the same sector because different sectors trade at different range of multiples. For example technology stocks normally command a higher P/E than utility stocks because of the higher earnings growth potential. So the key factors to be kept in mind while using P/E ratio is to do your fundamentals research first and then to use it on companies narrowed down on the same sector.
Michael Porter’s Five Force’s Model:
The Five Forces
1. The Threat of Substitute Products The existence of close substitute products increases the propensity of customers to switch to alternatives in response to price increases (high elasticity of demand).
buyer propensity to substitute relative price performance of substitutes
buyer switching costs perceived level of product differentiation
2. The threat of the entry of new competitors Profitable markets that yield high returns will draw firms. This results in many new entrants, which will effectively decrease profitability. Unless the entry of new firms can be blocked by incumbents, the profit rate will fall towards a competitive level (perfect competition).
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The existence of barriers to entry (patents, rights, etc.) economies of product differences brand equity switching costs or sunk costs capital requirements access to distribution absolute cost advantages learning curve advantages expected retaliation by incumbents government policies
3. The intensity of competitive rivalry For most industries, this is the major determinant of the competitiveness of the industry. Sometimes rivals compete aggressively and sometimes rivals compete in non-price dimensions such as innovation, marketing, etc.
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number of competitors rate of industry growth intermittent industry overcapacity exit barriers diversity of competitors informational complexity and asymmetry fixed cost allocation per value added level of advertising expense Economies of scale Sustainable competitive advantage through improvisation
4. The bargaining power of customers Also described as the market of outputs. The ability of customers to put the firm under pressure and it also affects the customer's sensitivity to price changes.
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buyer concentration to firm concentration ratio degree of dependency upon existing channels of distribution bargaining leverage, particularly in industries with high fixed costs
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buyer volume buyer switching costs relative to firm switching costs buyer information availability ability to backward integrate availability of existing substitute products buyer price sensitivity differential advantage (uniqueness) of industry products
5. The bargaining power of suppliers Also described as market of inputs. Suppliers of raw materials, components, labor, and services (such as expertise) to the firm can be a source of power over the firm. Suppliers may refuse to work with the firm, or e.g. charge excessively high prices for unique resources.
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supplier switching costs relative to firm switching costs degree of differentiation of inputs presence of substitute inputs supplier concentration to firm concentration ratio employee solidarity (e.g. labor unions) threat of forward integration by suppliers relative to the threat of backward integration by firms cost of inputs relative to selling price of the product.