Process of fundamental analysis

Business analysis

Understanding Accounting analysis

the Past

Financial analysis

Forecasting

Valuation

Trading on the valuation

1. Business Analysis
· Explain the role and importance of fundamental analysis.
· Describe the process of fundamental analysis.
· Explain the role of macroeconomic factors in understanding the business.
· Describe, explain and apply the process of industry analysis.
· Describe, explain and apply the process of strategy analysis

Financial analysts are an important intermediary in the financial markets that help less
sophisticated investors to make investment decisions. By doing so they contribute to
more efficient allocation of resources. If they have good skills in identifying mispriced
companies, they can also make money for their clients. Two approaches to analysis are
common: technical and fundamental. Technical analysis seeks to predict future share
prices relying on past time-series pattern of prices.
Fundamental analysis looks at all the information available about the company and
through process of understanding the past business of the company (business analysis,
accounting analysis, financial analysis) builds expectations about the future (forecasting)
that are translated into the company’s valuation and investment recommendation. An
illustrative case of how a bad analysis can play a role in creating economic instability is
the case of high-tech led market bubble in late 1990’s.
Fundamental analysis is essentially top-bottom exercise. It is impossible to value the
company without first looking at its environment. Therefore, a starting point is to look at
the economy-wide factors (GDP growth, interest rates, inflation, commodity prices,
exchange rates, etc.) and its impact on the industry in which company operates. This is
followed by the analysis of industry structure and its growth potential (for example, by
using the tools of Porter’s 5 forces analysis) in order to assess the opportunities for value
creation. Finally, the company’s own competitive positioning and corporate strategy are
analysed. An additional tool to organise the available information is SWOT analysis.
Through business analysis analysts should understand which the main value-drivers of
the business are and how they are expected to translate into past and prospective
quantitative, financial information.

2. Financial Analysis

· Perform financial analysis using trend analysis, common size analysis, financial ratios,
non-financial indicators and cash flow analysis.
· Evaluate usefulness of financial ratios.
· Compare and evaluate differences between traditional and alternative calculations of
financial ratios.

Financial analysis should help in the summary assessment of the current financial
position and financial performance of an entity as an input in forming expectations about
the future. It involves comparing current accounting numbers and ratios with the
historical trends and competitors. Non-financial indicators and cash flow analysis are the
useful additional tools.
The most important tool in financial analysis is financial ratios. Financial ratios are
essentially financial statements summarized in a form that is useful to explain the
company’s business and to compare it with the competitors in terms of profitability,
leverage and activity. Financial ratios should be interpreted in the context of the business
and accounting analysis. The accounting policies that directly influence the magnitude of
the ratios are different across companies in a comparison group and may be different
across time for a given company. Therefore, the separation of ‘true’ effect on ratios as a
result of business activities from an effect of different accounting policies is not an easy
task. Some other limitations in the usefulness of ratios exist as well.
Ratios based on reformulated financial statements provide a clearer picture of the sources
of value than the ratios computed in the traditional way due to more precise separation of
operating and financing activities.

3. Forecasting
· Describe and apply the process of forecasting pro-forma financial statements.
· State, explain and develop most important forecasting assumptions.
Summary
Forecasts involve projecting future income statements and statements of financial
position from which inputs to valuation can be directly calculated (earnings and cash
flows). Analysis of the past (business, accounting and financial analysis) is the base on
which the future is forecasted. The analyst needs to be aware of expected changes in the
economy, industry and strategy on the future financial position and performance and the
effect of the accounting policies on future accounting numbers. Forecasting process starts
with the sales, expenses based on the expected margins, and Income Statement.
Statement of financial position is prepared on the basis of the expected activity ratios and
leverage unless there is more precise and clear way to forecast them directly.
Forecasting horizon needs to be as long as it is needed for company to reach steady state
(constant growth and constant profitability). The terminal period assumptions about
profitability and growth should be plausible and justified

Forecasting details
(summarised from Lundholm and Sloan, 2007, Chapter 8 Forecasting Details)

· Start from core/sustainable operating income to forecast margins by eliminating from

operating income all:
- Transitory, non-recurring items (e.g. loss/gain on disposals; impairment)
- Non-forecasteable items (e.g. foreign exchange currency gains/losses)

· Sales growth
- Consider the correlation of industry sales with GDP, demographic trends and sensitivity
to other macroeconomic factors
- Consider the industry-specific drivers of sales (prices, capacity usage, and book of
orders) for the firm
- Consider the competitive position of the firm and its growth prospects relative to
industry (expected to gain market share, mature, declining…)
- Any future investments? (see notes to financial statements and operating and financial
review section of Annual Report)
- Any expected change in the usage of existing assets (change in capacity usage)?
- Any expected changes in business model and strategy?

· Margins
- Distinguish between fixed and variable costs (economy of scale, operating leverage)
- Distinguish between discretionary variable and fixed costs
- Variable may vary with sales so expense margins constant, e.g. costs of material
- May change as a result of successful cost management program, increase in productivity
and changes in technology (e.g. lower energy consumption per unit of sale)
- May change if sales growth driven by changes in prices, not volumes
- Discretionary variable: behave as variable
- Discretionary fixed: because they are fixed, margins are increasing with increase in
sales
- Discretionary fixed: RD costs highly discretionary: may vary with sales, but they are
easy to cut; Advertising; Other general and selling expenses
- Discretionary fixed: increase in good times following sales growth (constant margins),
but not immediate decrease in bad times (falling margins); look in the past to gauge the
behavior.
· Depreciation (fixed cost)
- Depreciation rates and useful lives given in accounting policies section of financial
statements
- Forecast depreciation in relation to the PPE in BS, not sales
- Have in mind composition of future assets (e.g. is company investing in plants or
building a new premises?)

· Interest rate (Borrowing costs)

- Past interest rate a good indicator of future rates
- Forecast in relation to financial obligations in BS, not in relation to sales
- Note that investment and cash balances are more variable than long-term debt, as
components of net financial obligations

· Unusual items
- Zero
- However, if impairment and asset-write downs show continually in the past, think if
they are worth forecasting
· Other operating income
- Usually income from associates and joint ventures. This income needs to be forecasted
separately

· Tax rate
- Use notes to financial statements where differences between effective tax rate (tax
expense/profit before tax) and statutory tax rate are reconciled
- Gauge the effective tax rate by forecasting these differences
- Deferred tax issue

For Statement of Financial position items, ratios are usually defined in terms of
ending (or beginning) assets and liabilities (not average!) for the purpose of easier
calculation.
· Working capital (inventories, receivables, prepayments, operating cash, payables,
accruals)
- Driven by operating cycle
- Cash: usually treated as financial assets, but if operating than usually around
3% of sales
- Receivables: depend on the collection period and credit risk; bargaining power
important (e.g. small suppliers of large retailers)
- Inventories: usually stable, decrease as a result of slow sales (recession?) or fast growth;
increase as a result of changes in logistics (just-in-time inventory system)
- Trade payables: mirror image of receivables
- Other: small or stable
· Property, plant and equipment
- Future investment plans – look at the notes to financial statements
- Investment is lumpy, so capacity usage is increasing, effects of economy of scale, and
consequently Sales/PPE ratio decreases
- However, the capacity usage of PPE (and economy of scale) depends on the nature of
industry; in services PPE tend to grow with sales (e.g. restaurants)
- Technology changes: increase in turnover
- Note: unlike for other items PPE is first forecasted (since we usually know investment
plans in a near-term), and then turnover Sales/PPE ratio calculated

· Intangibles
- One-off event, usually as a result of acquisition (purchased brand, goodwill);
- Keep the amount fixed or write it off if you think that the benefits do not exist
· Equity holdings classified as operating assets
- Measured at cost or fair value, or cost+share of profits
- If fair value, then keep constant; same for cost
- Associates (cost+share of profits), should be looked in more details at the level of that
company

· Provisions
- Deferred taxes: if firms are rapidly growing, liabilities will grow as a % of assets; if
shrinking, it will go down as a % of assets; in steady-state constant % of assets
- Other (warranty, pensions, restoration liability) depend on the nature of provision

Sales/Ending Net operating assets should be relatively stable over time since it is a
function of technology; big changes are extremely rare. Consequently, sales growth
and margin forecasting are more important for the accuracy of valuation.
· Net financial obligations
- Consider target long-term capital structure
- Stable over time
- Investments in debt (financial assets), treat as a part of overall capital structure policy
- If leverage is increasing, it is likely that borrowing costs will increase as well.
Changes in equity are residual when all other balance sheet items are forecasted
Dividend payout needs to be balanced against potential equity issuance (given that net
change in equity is already defined as a residual)
Check if your DuPont decomposition for forecasted ratios makes sense. (Note that
DuPont analysis is based on the beginning of the year assets, to be consistent with
valuation models)

4. Valuation Models
· Explain main principles behind the forecasting-based valuation.
· State simplified forms of forecasting-based valuation models and explain under what
assumptions simple models can be used.
· State general forms of discounted cash flow models, residual income model
· Calculate cost of capital using CAPM.
· Adjust valuation for the period from the financial year-end to the time of the valuation.
· Describe and evaluate asset-based valuation.
· Describe and explain determinants of price-to-book and price-to-earnings ratios.
· Understand how price-to-book and price-to-earnings ratio articulate.
· Use price-to-book and price-to-earnings ratio for a quick analysis of the company’s
performance and expected prospects.

Forecasting-based valuation models are more complex, but also more accurate as they
take into account the information analysed and forecasted in previous steps of
fundamental analysis. The underlying principle behind this type of models is that the
entity is a going-concern. In this course, we also assume that Miller-Modigliani
proposition on value-irrelevance of capital structure and dividend payout holds.
Forecasting-based models are essentially present-value exercise where future payoffs
(dividends, free cash flows, residual earnings) are discounted using cost of capital. Value
of equity can be also indirectly estimated by firstly estimating value of operations and
then deducting value of debt (which is assumed to be equal to its book value).

Simplified versions of forecasting-based valuation models assume that the company is

already in steady state. These versions are useful in ‘reverse engineering’ exercise to
challenge the market assumptions about growth and expected return embedded in the
observed market share price.
There are three important caveats to remember about the determinants of value:
· Increase in financial leverage creates growth in earnings per share, but does not add
value because increase in earnings is offset by higher financial risk (and cost of equity
capital).
· Smaller (higher) dividend payout creates (more) less growth, but it adds value only in
investment is a positive NPV project (rate of return is higher than WACC).
· Accounting choice and accounting policy may result in earnings growth, but accounting
itself does not create or destroys value.

Formula
Basic EPS = (Net income – Preferred dividends)/Weighted average number of shares
outstanding
Inventory Turnover = Cost of goods sold/Average inventory
Days of Inventory on Hand = 365/Inventory turnover
Receivables Turnover = Revenue/Average receivables
Days of Sales Outstanding = 365/Receivables turnover
Payables Turnover = Purchases/Average trade payables
Number of days of payables = 365/Payables turnover
Working capital turnover = Revenue/Average working capital
Fixed asset turnover = Revenue/Average fixed assets
Total Asset Turnover = Revenue/Average total assets
Current ratio = Current assets/Current liabilities
Quick ratio = (Cash + Short-term marketable investments + Receivables)/Current
liabilities
Cash ratio = (Cash + Short-term marketable investments)/Current liabilities
Debt-to-assets ratio = Total debt/Total assets
Debt-to-capital ratio = Total debt/(Total debt + Shareholders’ equity)
Debt-to-equity ratio = Total debt/Shareholders’ equity
Financial leverage ratio = Average total assets/Average total equity
Financial leverage=Average total assets/Average shareholders funds
Financial leverage ratio=Net financing obligations/Shareholders funds

Interest coverage ratio = EBIT/Interest payments

Gross profit margin = Gross profit/Revenue
Operating profit margin = Operating profit/Revenue
Net profit margin = Net profit/Revenue
ROA = Net income/Average total assets
Return on total capital = EBIT/ (Short-term debt + Long-term debt + Equity)
Return on equity = Net income/Average total equity
Return on common equity = (Net income – Preferred dividends)/Average common
equity
ROE = ROA x Leverage
ROE = Net profit margin x Asset turnover x Leverage
P/E = Price per share/Earnings per share
P/S = Price per share/Sales per share
P/BV = Price per share/Book value per share
Dividends per share = Common dividends declared/Weighted average number of
ordinary shares
Dividend payout ratio = Common share dividends/Net income attributable to common
shares
Sustainable growth rate = Retention rate x ROE

Cash Flow Classification under U.S. GAAP

CFO
Inflows Outflows
Cash collected from customers. Cash paid to employees.
Interest and dividends received. Cash paid to suppliers.
Proceeds from sale of securities held for trading. Cash paid for other expenses.
Cash used to purchase trading securities.
Interest paid.
Taxes paid.
CFI
Inflows Outflows
Sale proceeds from fixed assets. Purchase of fixed assets.
Sale proceeds from long-term investments Cash used to acquire LT investment securities.
CFF
Inflows Outflows
Proceeds from debt issuance. Repayment of LT debt.
Proceeds from issuance of equity instruments Payments made to repurchase stock.
Dividends payments.