Professional Documents
Culture Documents
Valuationofshares-Fa 2943
Valuationofshares-Fa 2943
By-
Aishwarya Pant (2011009), Nikita Agrawal (2011069),
Rohan Garg (2011089), Romil Bhardwaj (2011092)
and Sanchit Saini (2011097)
List of topics
● Introduction to Fundamental Analysis
● Review of basics
● Understanding Financial Statements
● Valuation Methodologies
Fundamental Analysis
An Introduction
What is Financial Analysis ?
● A stock valuation methodology that uses financial
and economic analysis to predict the movement
of stock prices.
● The outcome is a value (or a range of values) of
the firm’s stock called its ‘intrinsic value’.
○ This stock’s price tend to revert towards this value.
Why is Fundamental Analysis
relevant for investing ?
● The Efficient Markets Hypothesis says that it is
impossible to ‘beat the market’ because stock
market efficiency causes existing share prices to
always incorporate and reflect all relevant
information.
Why is Fundamental Analysis
relevant for investing ?
● Recent research shows that prices could deviate
from their equilibrium values due to psychological
factors, fads, and noise trading.
• Macroeconomic analysis
• Industry analysis
• Valuation
• Situational analysis of a company
Brushing up the basics
Time Value of Money
● Given a rate of return on an asset, the current or
future value of that asset can be evaluated by
going ahead or back in time respectively
Interest Rate / Discount Factor
● We need to find out the discount factor to be
used while calculating the present value of future
cash flows
● For that, it is important to understand
Opportunity Cost first
Opportunity Cost
● The cost of selecting an activity is the value of the
most expensive alternative not chosen.
● For example : If a person invests in stocks with 6%
return annually instead of a fixed deposit which
yields an 8% return, then the opportunity cost is
8% - 6% = 2%
Calculating WACC
Calculating Cost of Equity (Ke)
● The cost of equity for a stock is given by
Ke = Rf + β * ( Rm - Rf )
where,
Rf = risk free rate
β = the risk signifying the firm
Rm - Rf = equity risk premium
WACC Calculation Example
•Question: Company λ has a 1 million shares of
common stock currently trading at $30 per share.
Current risk free rate is 4%, market risk premium is
8% and the company has a beta of 1.2. It also has
50,000 bonds with of $1,000 par paying 10%
coupon annually maturing in 20
WACC Calculation Example
•Question (contd.): years currently trading at $950.
The tax rate is 30%.
And finally,
WACC = 38.71% × 13.6% + 61.29% × 7.427%
WACC = 9.8166%
Risk Free Rate (Rf)
● It represents the interest that an investor would
expect from an absolutely risk-free investment
over a period of time.
● Though such an investment is theoretical, in
practice, most professionals use short-dated
government bonds of the currency in question.
Equity Risk Premium (Rm- Rf)
● It is the premium that investors demand for the
average risk investment that they apply to
expected cash flows with average risk.
● When it rises, investors are charging a higher
price for risk and will therefore pay lower prices
for the same set of risky expected cash flows.
Beta (β)
● A measure of the systematic risk of a security that
cannot be avoided through diversification.
● It indicates the volatility of a stock’s price relative
to the price movement of the overall market.
● The risk associated with a stock is proportional to
its beta value.
Beta (β)
● Beta can be calculated using the following
formula:
Beta (β) Calculation Example
Question: Suppose a company uses only debt and
internal equity to finance its capital budget and uses
CAPM to compute its cost of equity. Company
estimates that its WACC is12%. The capital structure
is 75% debt and 25% internal equity. Before tax cost
of debt is 12.5 % and tax rate is 20%. Risk (cont.d)
Beta (β) Calculation Example
re = 18%
18% = 6% + β(8%)
β = 1.5
Problems with Beta (β)
● Though Beta is a good measure of risk, still it is not
infallible.
○ It looks backward, and hence, is not always an
accurate predictor of future. Stocks with β<1 may
actually do better when the market is down
○ It doesn’t account for changes that are in the works,
such as new lines of business or industry shifts.
Understanding Financial
Statements
Why Financial Statements
•Understanding financial reports of companies most
important part of fundamental analysis.
•Constant assets: Assets that are purchased and sold without any
add-ons or conversions
•Cash & Bank Balances– Cash in hand in petty cash boxes, safes
and balances in bank accounts.
•Cash in when capital is raised, and cash out when dividends are
paid.
Parentheses indicate
negative values.
Financial Ratios
● Can be categorized into:
o Liquidity Measurement Ratios
o Debt Ratios
dependent on inventory.
Cash Ratio
● Even more conservative as it counts only cash, cash
equivalents and invested funds as current assets.
Calculate the Current Ratio, Quick Ratio and Cash Ratio (of Mar’10) for XYZ.
Liquidity Measurement Ratios - QnA
Answer:
• Current Ratio = 13041/4030 (figures from balance sheet) = 3.24
• Quick Ratio = 13041/4030 (figures from balance sheet) = 3.24
Here, the ratios have the same value as being from a services
sector, XYZ doesn’t have any inventory on its balance sheet
profitability is headed.
Profit Margins
● Net Profit Margin
o Often mentioned while discussing a firm’s profitability.
o The higher the ratio %age, the more efficient use of the
firm. The lower the %age, the less leverage a firm is using
and the stronger its equity position (large companies can
push liabilities to higher %ages without much trouble)
o Problem: Liabilities such as operational liabilities are also
structure.
o While the RIGHT ratio varies acc. to industries, business
on outstanding debt.
o The lower the ratio, the more is a firm burdened by debt
expense.
Debt Ratios
● Cash Flow to Debt Ratio
A: Here, the firm’s profitability is higher than the IT industry (as 22.92 > 20),
while asset utilization is roughly in line with the industry.
● Note: We can compare the leverage of the firm and the industry on the
whole.
Du-Pont Analysis - Extension
● The analysis can sometimes overlook factors that
the decomposition doesn’t readily identify; eg a
low-gross margin and a very high operating margin.
+
Calculated by dividing
Days Sales Outstanding
= DSO (Days taken by a firm to collect on
sales going into accounts receivable)
avg. accounts
receivable figure by net
sales per day
-
Calculated by dividing
Days Payables Outstanding
avg. accounts payable
DPO (Days taken by a firm to pay its figure by net sales per
obligations to its suppliers) day
Cash Conversion Cycle (Example)
Q: Calculate the Cash Conversion Cycle value for the
XYZ (whose financial statements have been given in the
Financial Ratios segment).
Cash Conversion Cycle (Example)
Cost of Sales per day = 13771/365 = 37.73
•DIO is given by: Average Inventory = (0+0)/2 = 0
Days Inventory Outstanding = 0/37.73 = 0
Sector
Economy
Economy
To understand the impact of economy on Stock prices, we
need to
● Have a sound economic understanding.
● Interpret the impact of important economic indicators.
● Understand economy and capital flows, interest rate
cycles and currency fluctuation.
Economic Indicators
● Allow analysis of economic performance and
prediction of future performance.
● Include - various indices, earning reports and
economic summaries.
● Can have 3 relationships to the economy.
Relationship of EI and Economy
● Procyclic
○ Moves in the same direction as the economy.
○ If economy does well - this number is increasing.
○ If recession - this number is decreasing.
○ Example - GDP
Relationship of EI and Economy
● Counter Cyclic
○ Moves in the opposite direction as the economy.
○ If economy does well - this number is decreasing.
○ If recession - this number is increasing.
○ Example - unemployment rate - gets larger as
economy gets worse.
Relationship of EI and Economy
● Acyclic
○ Not related to health of economy.
○ Generally of little use as they have no correlation to
the business cycle.
○ May rise or fall even if economy is doing well.
Categories of EI
● Leading EI
● Lagging EI
● Coincidental EI
Leading EI
○ Change before the economy changes.
○ Used to predict changes in economy but are not always
accurate.
○ Bond yields are typically a good leading indicator of the
market because traders anticipate and speculate trends
in the economy.
○ Other Examples - Stock market return, Baltic Dry Index
Lagging EI
○ Changes after the economy has already begun to
follow a particular pattern or trend.
○ Confirm long-term trends, but they do not predict
them.
○ Example - unemployment rate - tends to increase for
2-3 quarters after economy starts to improve.
Coincidental EI
○ Shows the current state of economic activity within a
particular area.
○ Important because it shows economists and
policymakers the current state of the economy.
○ Example - Personal Income, GDP, industrial
production and retail sales.
7 Broad Categories where EIs fall
● Total Output, Income, and Spending
○ Broadest measures of economic performance.
○ includes GDP - used to measure economic activity.
○ Thus is both procyclical & a coincident economic indicator.
○ Implicit Price Deflator is a measure of inflation.
○ Inflation is procyclical and also coincident indicators.
○ Consumption and consumer spending are also procyclical
and coincident.
● Employment, Unemployment, and Wages
○ Unemployment rate is a lagged, countercyclical
statistic.
○ Level of civilian employment measures how many
people are working - hence procyclic.
○ Unlike the unemployment rate it is a coincident
economic indicator.
● Production and Business Activity
○ Cover how much businesses are producing and the
level of new construction in the economy.
○ Changes in business inventories, an important leading
economic indicator - indicate changes in consumer
demands.
○ New construction including new home construction -
another procyclical leading indicator.
● Prices
Includes both the prices consumers pay as well as the prices
businesses pay for raw materials and include
○ Producer Prices
○ Consumer Prices
○ Prices Received And Paid By Farmers
They measure changes in the price level and thus measure
inflation.
● Money, Credit, and Security Markets
Measure the amount of money in the economy as well as
interest rates and include
○ Money stock (M1, M2, and M3)
○ Bank Credit at all commercial banks
○ Consumer credit
○ Interest rates and bond yields
○ Stock prices and yields
They tend to be procyclical and a coincident economic indicator.
● Government Finance
Measures of government spending and government deficits and debts:
○ Budget Receipts
○ Budget Outlays
○ Union Government Debt
During recessions, govt. stimulate economy by increasing spendings
without raising taxes, causes govt. spendings and
government debt to rise during a recession - countercyclical indicator.
They tend to be coincident to the business cycle.
● International Trade
○ Measures country’s exports and imports.
○ level of exports tends not to change much during the
business cycle. So net exports is countercyclical as imports
outweigh exports during boom periods.
○ Measures of international trade tend to be coincident
economic indicators.
Industry
● Detailed analysis of a specific industry.
● Purpose: to identify those industries with a
potential for future growth and to invest in
equity shares of companies selected from such
industries.
Company
● Final stage - Analyse the company.
● This analysis has two thrusts:
○ How the company has performed vis-à-vis other
similar companies
○ How the company has performed in comparison to
earlier years
Issues to be examined
● The Management
● The Company
● The Annual Report
● Cash flow
● Ratios
The Management
● A very important factor.
● It is upon the quality, competence and vision of the management
that the future of company rests.
● Under good, competent management, company grows.
Examples: Sunil Mittal of Bharti Airtel, Azim Premji of
Wipro, Deepak Parekh of HDFC, are few such examples where the
management of the companies headed by strong leadership have
helped companies create significant wealth for their investors.
Two types of Management
● Family Management
○ a member of the owner or controlling family, at the helm.
○ all policies determined by controlling family.
○ some may be good, some may not neccessarily be in
shareholder’s interests.
○ Advantage: Loyal family members.
Two types of Management
● Professional Management
○ managed by professionals who are company’s employees.
○ The CEO often does not even have a financial stake.
○ His aim: meeting the annual budget and business targets.
○ Disadvantage: professional managers may leave the company
for better pay and perquisites offered by another company.
○ Would be unfair to say to invest only in professional ones.
What factors to look for while
investing in companies?
Integrity of Management
○ Most important aspect.
○ A determined employee can perpetrate a
fraud, despite good systems and controls.
○ Similarly, the management can juggle figures,
causing harm and financial loss to a company.
○ Tracking integrity may not be easy.
Past record of management
○ Another point to consider: proven competence.
○ How has the management managed the affairs over the
last few years?
○ Has the company grown?
○ Has it become more profitable?
○ Wise to be a little wary of new management.
○ Wait until the company shows signs of success.
How highly is the management rated by its peers in
the same industry?
○ A very telling factor.
○ Competitors are aware of nearly all the strengths and
weaknesses of management of their rivals.
○ If they hold the management in high esteem it is truly
worthy of respect.
How the management fares in adversity?
○ Inherent strength of a management tested.
○ How well the management does in times of recession.
■ Did it streamline its operations?
■ Did it close down its factories?
■ Was it able to sell its products?
■ How did sales fare?
○ A management that can steer its company in difficult days
will normally always do well.
The depth of knowledge of the management
○ Knowledge of its products, its markets and the industry.
○ Often the management sits back thinking that it will
always be the dominant company. The reality sinks in only
when it is too late.
○ Must be in touch with the industry and customers at all
times.
○ Be aware of the latest techniques and innovations
The management must be open, innovative and
must also have a strategy
○ Must be prepared to change when required.
○ Must essentially know where it is going and how to go
there.
○ Must be receptive to ideas.
○ Be dynamic.
Non-professionalised Management
○ Not recommended to invest in a company - yet to
professionalize.
○ As decisions are made on the whims of the chief
executive.
○ The most competent are not given the positions of
power.
○ There may be nepotism because of blood ties.
Valuation Models
Valuation Models
DCF DDM
DCF
• Valuation of corporates
Expected
cashflow
`
Year
Discount rate
Illustration of DCF
Expected cash-flow
Year
Discount rate
What if we were to calculate the
risk?
Weighted average cost of capital (WACC) is one of the useful tools to do this. Here’s how…
Expected
cashflow
Year
‘r’ will be Discount rate
replaced by
WACC now in our
formula
This also makes sense as the WACC the cost of capital that the firm has to pay on an average,
which essentially is the weighted average risk that the project bears, or the effective return
which the debt + equity holders of the company expect from the company in return
What if we were to value a financial institution?
• The DCF doesn’t really work there – Banks/FIs are run on the
balance sheets; hence we do not look at cash flows in their
case – they are usually driven by the dividends paid.
Expected cash-
flow → this is
the dividend
paid
indefinitely
Year
Discount rate → cost
of equity here
Estimating the Discount Rate
Discount rate = Risk-free rate + (Stock beta x Market risk
premium)
Risk-free rate = U.S. T-bill rate, which is the wait
component or time value of money.
Stock beta measures the individual stock’s risk relative to
the market.
Market risk premium measures the difference in return
between investing in the market and investing in T-bills
Discount Rate Example
Assume T-bills yield 4.5%; ABC’s beta is 1.15; and the market
risk premium = 8%
What if g = 7%?
Constant Growth
Two stage DDM
Model
Constant/Gordon Growth model
If dividends are expected to grow at a constant rate,
say g, then the current value of the stock is given by
rate
o Historical relationships between free cash flow and