FUNDAMENTAL ANALYSIS

( Establishing the value benchmark )

Prof. Seema Chakrabarti

Suggested Steps for Company Analysis 

Strategy Analysis Accounting Analysis Financial Analysis SWOT Analysis Going beyond the numbers Estimation of intrinsic value Relative Valuation      

Strategy Analysis 

Competitive Strategy Corporate Strategy 

Accounting Analysis 

Quality check for Financial Statements can be conducted through checking for: 

Adequate disclosure of information  Noise & Bias in accounting  Forecasting errors in accounting

Financial Analysis 

Investment analysts usually analyze historical data for making an estimate of: Earnings (and dividends) Growth Risk Valuation    

FINANCIALS OF HORIZON LTD
y y y y y y y y y y y y y y y y y y y y y y y y
N et S ales C ost of goods sold Gross profit O perating expenses O perating profit N on-operating surplus/deficit Profit before interest and tax (PBIT ) Interest Profit before tax T ax Profit after tax D ividend R etained earnings Equity share capital R eserves and surplus S hareholders¶ funds L oan funds C apital employed N et fixed assets Investments N et current assets T otal assets Earnings per share Market price per share (End of the year) 20X1 475 352 123 35 88 4 92 20 72 30 42 20 22 100 65 165 150 315 252 18 45 315 20X2 542 380 162 41 121 7 128 21 107 44 63 23 40 100 105 205 161 366 283 17 66 366 20X3 605 444 161 44 117 9 126 25 101 42 59 23 36 150 91 241 157 398 304 16 78 398 20X4 623 475 148 49 99 6 105 22 83 41 42 27 15 150 106 256 156 412 322 15 75 412 21.00 20X5 701 552 149 60 89 89 21 68 34 34 28 6 150 112 262 212 474 330 15 129 474 2.27 26.50 20X6 771 580 191 60 131 -7 124 24 100 40 60 30 30 150 142 292 228 520 390 20 110 520 4.00 29.10 20X7 840 638 202 74 128 2 130 25 105 35 70 30 40 150 182 332 221 553 408 25 120 553 4.67 31.5

EARNIN S AND DIVIDEND LEVEL T :
‡ R ‡ ‡ EPS ‡ D ‡ D

,

ROE : FACTORS
PAT ROE = SALES NET PROFIT MAR IN ASSETS ASSET TURNOVER EQUITY LEVERA E SALES ASSETS

T E REAK UP OF T E RETURN ON EQUITY IN TERMS OF ITS ETERMINANTS FOR T E PERIO ± FOR ORI ON LIMITED IS IVEN ELOW:
R % % % =N = = = A % % % L

INVESTMENT ANALYSTS USE ONE MORE FORMULATION OF T E ROE W EREIN IT IS ANALYSED IN TERMS OF FIVE FACTORS :
PBIT ROE = SALES ASSETS PBIT PROFIT BEFORE TA NETWORT SALES PROFIT BEFORE TA PROFIT AFTER TA ASSETS

ROE : FACTORS
P IT ROE = SALES ASSETS P IT P T NET ORTH SALES P T PAT ASSETS

ROE = P IT EFFICIENC ASSET TURNO ER INTEREST UR EN TA UR EN LEVERA E THE ROE REA UP FOR O EGA CO PAN IS GIVEN ELO :
ROE = P IT L = = = A I T

Book V

Per S

re BVPS

Paid-up equity apital + Reserves and surplus Number of equity shares BVPS 20 262/15 = 17.47 20 292/15 = 19.47 20 332/15 = 22.13

Earnings Per Share EPS
Equity earnings Number of equity shares EPS 20 5 34/15 = 2.27 20 6 60/15 = 4.00 20 7 70/15 = 4.67

Dividend Payout Ratio

Equity dividends Equity earnings 20 5 Dividend Payout ratio 28/34 = 0.82 20 6 30/60 = 0.50 20 7 30/70 = 0.43

Dividend Per Share DPS
DPS 20 5 Rs 1.87 20 6 2.00 20 7 2.00

GRO

TH PERFORMANCE

‡ To measure the historical growth, the compound annual growth rate (CAGR) in variables like sales, net profit, earnings per share and dividend per share is calculated. ‡ To get a handle over the kind of growth that can be maintained, the sustainable growth rate is calculated.

COMPOUND ANNUAL GRO

TH RATE CAGR

The compound annual growth rate (CAGR of sales, earnings per share, and dividend per share for a period of five years 20x2 ± 20x7 for Horizon Limited is calculated below:
Sales of 20 x 7 CAGR of Sales : Sales for 20 x 2 CAGR of earnings per share (EPS : EPS for 20 x 7 EPS for 20 x 2
1/ 5 1/ 5

840 ±1= 542 ±1 =

1/ 5

± 1 = 9.2%

7.00 6.30

1/ 5

±1 = 2.1%

CAGR of dividend : DPS for 20 x 7 per share (DPS DPS for 20 x 2

1/ 5

±1 = 3.00 2.30

1/ 5

±1 = 5.5%

SUSTAINABLE GRO

TH RATE

The sustainable growth rate is defined as :
Sustainable growth rate=Retention ratio x Return on equity

Based on the average retention ratio and the average return on equity of the three year period (20x5 ± 20x7) the sustainable growth rate of Horizon Limited is: Sustainable growth rate = 0.417 x 18.2% = 7.58%

RIS

EXPOSURE Beta

Beta represents volatility relative to the market Volatility of Return on equity Range of return on Equity over n years Average return on equity over n years

VALUATION MULTIPLES The most commonly used valuation multiples are : Price to Earnings (PE) ratio Price to Book Value (PBV) ratio  Price to Cash Flow Ratio  Price to sales Ratio

VALUATION MULTIPLES
PE Ratio (Prospective)
Price per share at the beginning of year n Earnings per share for year n PE ratio 20 x 5 9.25 20 x 6 6.63 20 x 7 6.23

PBV Ratio (Retrospective)
Price per share at the end of year n Book value per share at the end of year n PBV ratio 20 x 5 1.52 20 x 6 1.49 20 x 7 1.42

FAVOURABLE & UNFAVOURABLE FACTORS
FAVOURABLE FACTORS EARNINGS LEVEL GRO TH LEVEL ‡ HIGH BOO VALUE PER SHARE ‡ HIGH RETURN ON EQUITY ‡ HIGH CAGR IN SALES AND EPS ‡ HIGH SUSTAINABLE GRO TH RATE ‡ LO VOLATILITY OF RETURN ON EQUITY ‡ LO BETA UNFAVOURABLE FACTORS ‡ LO BOO VALUE PER SHARE ‡ LO RETURN ON EQUITY ‡ LO CAGR IN SALES AND EPS ‡ LO SUSTAINABLE GRO TH RATE ‡ HIGH VOLATILITY OF RETURN ON EQUITY ‡ HIGH BETA

RIS

EXPOSURE

SWOT Analysis 

Examination of a firm s: 
Strengths  Weaknesses  Opportunities  Threats

GOING BEYOND THE NUMBERS
‡ SIZING UP THE PRESENT SITUATION AND PROSPECTS ‡ Availability and Cost of Inputs ‡ Order Position ‡ Regulatory Framework ‡ Technological and Production Capabilities ‡ Marketing and Distribution ‡ Finance and Accounting ‡ Human Resources and Personnel ‡ EVALUATION OF MANAGEMENT ‡ Strategy ‡ Calibre, Integrity, Dynamism ‡ Organisational Structure ‡ Execution Capability ‡ Investor - friendliness

Estimating Intrinsic Value
A) Present value of cash flows (PVCF) 
 

Present value of dividends (DDM) Present value of Free cash flow to equity holders (FCFE) Present value of free cash flow to firm (FCFF)

B) Earnings Multiplier Approach C) Measures of Value Added

Calculating Free Cash Flow to Equity
FCFE =
Net Income (EAT) + Depreciation Expense - Capital Expenditures - ( in Working Capital - Principal Debt Repayments + New Debt Issues

Calculating Free Cash Flow to Equity
When the firm maintains a fixed debt equity ratio:

FCFE = Net Income
(1-d) * (Capital Expenditures - Depreciation) (1-

- (1-d) * (( in Working Capital ) (1((

Present Value of Free Cash Flow to Equity

FCFE1 Value ! k  g FCFE
where, FCFE1 = the expected free cash flow in period 1 i.e FCFE (1+g) k = the required rate of return on equity for the firm gFCFE = the expected constant growth rate of free cash flow to equity for the firm

Present Value of Free Cash Flow to Equity 

Two Stage Model:

=PV of FCFE discounted@reqd rate of retn. + PV of terminal Value Where, PV of terminal Value
= 1/(1+r)n*FCFE in n+1 year / r - gL (in long run) Also, FCFE in n+1 year = FCFE in nth year * (1 + gL i.e growth rate in long run) N = Number of years of supernormal growth

Operating Free Cash Flow to the Firm
Discount the firm s operating free cash flow to the firm (FCFF) at the firm s weighted average cost of capital (WACC) rather than its cost of equity FCFF = EBIT (1-Tax Rate) (1+ Depreciation Expense - Capital Spending - ( in Working Capital - ( in other assets

Present Value of Operating Free Cash Flow

FCFF1 Firm Value ! WACC  g FCFF
where, FCFF1 = the free cash flow in period 1 WACC = the firm s weighted average cost of capital gFCFF = the firm s constant growth rate of free cash flow

DIVIDEND DISCOUNT MODEL
‡ SINGLE PERIOD VALUATION MODEL D1 P1 P0 = + (1+r) (1+r) ‡ MULTI - PERIOD VALUATION MODEL ( Infinite Duration) g Dt P0 = 7 t=1 (1+r)t ‡ ZERO GRO TH MODEL D P0 = r ‡ CONSTANT GRO TH MODEL D1 P0 = r-g

T O - STAGE GRO 1 - 1+g1 1+r P0 = WHERE Pn = (1+r)n r - g2 D1 r - g1
n

TH MODEL

Pn + (1+r)n

D1 (1+g1)n-1 (1+g2) (1+r)n

1

TWO - STAGE GROWTH MODEL : EXAMPLE
EX A M PLE THE R R E NT D D E ND O N A N E IT SH ARE O E R T IG O L IM IT E D IS R S E R T IG O IS E X P E CT E D T O E NJO AN A O E -NO R M A L G R O W T H R A T E O P E R CE NT O R A P E R IO D O E A R S T H E R E A T E R T H E G R O W T H R A T E W IL L A L L A ND S T A IL IS E P E R CE NT E IT IN E S T O R S R E IR E A R E T R N O AT P E R CE NT W H A T IS T H E INT R INS IC A L E O T H E E IT SH ARE O E R T IG O ? T H E INP T S R E IR E D O R A P P L ING T H E T W O -S T A G E M O D E L A R E : g1 = 20 PERCENT g2 = 10 PERCENT n = 6 YEARS r = 15 YEARS D1 = D0 (1+g1) = RS.2(1.20) = 2.40 PLU IN THESE INPUTS IN THE TWO STA E MO EL, WE INTRINSIC VALUE ESTIMATE AS FOLLOWS :
6

ET THE

1.20 1 1.15

2.40 (1.20)5 (1.10) + .15 - .10 2.40 (2.488)(1.10) + [0.497] .05

1 (1.15)6

P0 = 2.40
.15 - .20 1 - 1.291 = 2.40 -0.05 = 13.968 + 65.289 = RS.79.597

H MODEL
ga gn

H D0 PO = r - gn D0 (1+gn) = r - gn

2H

[(1+gn) + H (ga + gn)] D0 H (ga + gn) + r - gn PREMIUM DUE TO ABNORMAL GROWH RATE VALUE BASED ON NORMAL GROWTH RATE

ILLUSTRATION: H LTD D0 = 1 ga = 25% gn = 15% + 0.18 - 0.15 = 38.33 0.18 - 0.15 + 16.67 = 55.00 P/E = 27.5 H=5 r = 18% 1 x 5(.25 - .15)

1 (1.15) P0 =

IF E = 2

IMPACT OF GROWTH ON PRICE, RETURNS, AND P/E RATIO
PRICE D1 PO = r-g RS. 2.00 LOW GROWTH FIRM PO = 0.20 - 0.05 RS. 2.00 NORMALGROWTH FIRM PO = 0.20 - 0.10 RS. 2.00 SUPERNORMAL GROWTH FIRM PO = 0.20 - 0.15 = RS.40.00 5.0% 15.0% 13.33 = RS.20.00 10.0% 10.0% 6.67 = RS.13.33 15.0% 5.0% 4.44 (D1 / PO) DIVIDEND YIELD CAPITAL PRICE GAINS EARNINGS YIELD RATIO (P1 - PO) / PO (P / E)

EARNINGS MULTIPLIER APPROACH
P0 = m E1

DETERMINANTS OF m i.e. (P / E)
D1 P0 = r-g E1 (1 - b) = r - ROE x b (1 - b) P 0 / E1 = r - ROE x b

FINANCIAL ANALYSIS
‡ The key questions to be addressed in applying the EARNINGS MULTIPLIER APPROACH, the most popular method in practice, are: 
What is the expected EPS for the forthcoming year?  What is a reasonable PE ratio?

‡

ESTIMATION OF INTRINSIC VALUE ‡ Estimate the expected EPS ‡ Establish a P / E ratio ‡ Develop a value anchor and a value range

EPS FORECAST
20 x 7 (ACTUAL) ‡ NET SALES ‡ COST OF GOODS SOLD ‡ GROSS PROFIT ‡ OPERATING EXPNS ‡ DEPRECIATION ‡ SELLIN & GEN. ADMN. EXPNS ‡ OPERATING PROFIT ‡ NON-OPERATING SURPLUS/DEFICIT ‡ PROFIT BEFORE INT. & TAX (PBIT) ‡ INTEREST ‡ PROFIT BEFORE TAX ‡ TAX ‡ PROFIT AFTER TAX ‡ NUMBER OF EQUIITY SHARES ‡ EARNINGS PER SHARE 840 638 202 74 30 44 128 2 130 25 105 35 70 15 MLN RS 4.67 20 x 8 (PROJECTED) 924 708 216 81 34 47 135 2 137 24 113 38 75 15 RS 5.00 NO CHANGE ASSUMPTION INCREASE BY 10 PERCENT INCREASE BY 11 PERCENT INCREASE BY 9.5 PERCENT

DECREASE BY 4 PERCENT

INCREASE BY 8.57 PERCENT

Methods of calculating P/E Ratio 

Dividend Growth Model Cross sectional Analysis Historical Analysis Weighted P/E Ratio   

CONSTANT GROWTH DIVIDEND MODEL
DIVIDEND PAYOUT RATIO(i.eD1 / E1) P / E RATIO = REQUIRED RETURN ON EQUITY EXPECTED GROWTH RATE IN DIVIDENDS

_

CROSS SECTION ANALYSIS
P/ E = a1 + a2 (GROWTH RATE IN + a3 (DIVIDEND EARNINGS) PAYOUT RATIO)

+ a4 (VARIABILITY IN EARNINGS) + a5 (COMPANY SIZE)

HISTORICAL ANALYSIS
PE ratio 20 x 5 9.25 20 x 6 6.63 20 x 7 6.23

The average PE ratio is : 9.25 + 6.63 + 6.23 = 7.37 3

WEIGHTED PE RATIO
PE ratio based on the constant growth dividend discount model : 6.36

PE ratio based on historical analysis : 7.37 6.36 + 7.37 = 6.87 2

VALUE ANCHOR AND VALUE RANGE
Value Anchor Projected EPS x Appropriate PE ratio 5.00 x 6.87 = Rs. 34.35 Value Range Rs.30 Market Price < Rs.30 Rs.30 ± Rs.38 > Rs.38 ² Rs.38 Decision Buy Hold Sell

Relative valuation techniques:

1. Price earnings ratio (P/E) 2. Price cash flow ratios (P/CF) 3. Price book value ratios (P/BV) 4. Price sales ratio (P/S)

PBV-ROE Matrix

HIGH PBV Ratio LOW

Overvalued Low ROE High PBV Low ROE Low PBV LOW ROE

High ROE High PBV Undervalued High ROE Low PBV HIGH

GROWTH-DURATION MATRIX

High Expected 5-Yr EPS Growth Low

Undervalued

Promises of growth

Dividend cows Low

Overvalued

High

Duration (1/Dividend Yield)

EXPECTATIONS RIS

INDEX (ERI)

Developed by Al Rappaport, the ERI reflects the risk in realising the expectations embedded in the current market price

Proportion of stock ERI = price depending on expected future growth X

Ratio of expected future growth to recent growth (Acceleration ratio)

ERI ILLUSTRATION
‡ Omega¶s price per share ‡ Omega¶s operating cash flow (before growth investment) ‡ Omega¶s cost of equity ‡ Growth rate in after-tax ³cash´ operating earnings over the past three years = Rs.150
= Rs.10 per share

= 15 percent = 20 percent

‡ Market expectation of the growth in after-tax ³cash´ operating earnings over the next three = 50 percent years

ERI ILLUSTRATION
Rs.10 ‡ Omega¶s base line value = = Rs.66.7 0.15 ‡ Proportion of the stock price coming from investors¶ expectations of future = 150 ± 66.7 = 0.56 150 growth opportunities 1.50 ‡ Acceleration ratio = 1.20 ERI = 0.56 x 1.25 = 0.70 = 1.25

In general, the lower (higher) the ERI, the greater (smaller) the chance of achieving expectations and the higher (lower) the expected return for investors.

OBSTACLES IN THE WAY OF AN ANALYST ‡ Inadequacies or incorrectness of data ‡ Future uncertainties ‡ Irrational market behaviour

SUMMING UP
‡ In practice, the earnings multiplier method is the most popular method. The key questions to be addressed in this method are: what is the expected EPS for the forthcoming year? What is a reasonable PE ratio given the growth prospects, risk exposure, and other characteristics? Historical financial analysis serves as a foundation for answering these questions. ‡ The ROE, perhaps the most important metric of financial performance, is decomposed in two ways for analytical purposes. ROE = Net profit margin x Asset turnover x Leverage ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x Leverage ‡ To measure the historical growth, the CAGR in variables like sales, net profit, EPS and DPS is calculated.

‡ To get a handle over the kind of growth that can be maintained, the sustainable growth rate is calculated. ‡ Beta and volatility of ROE may be used as risk measures. ‡ An estimate of EPS is an educated guess about the future profitability of the company. ‡ The PE ratio may be derived from the constant growth dividend model, or cross-section analysis, or historical analysis. ‡ The value anchor is : Projected EPS x Appropriate PE ratio ‡ PBV-ROE matrix, growth-duration matrix, and expectation risk index are some of the tools to judge undervaluation or overvaluation.

And now ..

And now ..
IT S TIME FOR ASSIGNMENT !!!

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