INTRODUCTION TO FINANCIAL

STATEMENT ANALYSIS AND Kazi Monirul Islam, CFA

VALUATION
TRY TO LEARN EVERYDAY

“Spend each day trying to be a little wiser than you

were when you woke up. Day by day, and at the
end of the day-if you live long enough-like most
people, you will get out of life what you deserve.”

– Charles T. Munger
TRY TO LEARN EVERYDAY
OPPORTUNITY OF PERSONAL
IMPROVEMENT VIA JOURNEY OF
INVESTING IN STOCK MARKET
 Charlie Munger has very aptly said the game of life is the game of everlasting learning.

 And after having successfully achieved financial freedom through my passionate pursuit of lifelong learning, I can happily say that I'm a better

investor because I'm a lifelong learner. And I'm a better lifelong learner because I'm an investor.

 Having a strong passion for lifelong learning is a durable competitive advantage for an investor. And what differentiates successful investors from

mediocre ones is passion.

 To be a truly passionate investor means you are always thinking about the future and direction of the world. It means you are always enthusiastically

observing everything around you.

 And investing is not just a process of wealth creation. It is a source of great happiness and sheer intellectual delight for the truly passionate investor.

 Successful investing is that which lets you sleep peacefully at night. It is about achieving our financial goals in a timely manner with the lowest

possible risk. And when practiced in a truly honest and sincere manner, value investing not only leads to great wealth but also makes us better human

beings. And with the passage of time we learn to recognize that value investing is not merely about stocks and business fundamentals. It is a life

discipline of everlasting learning and personal growth.

Credit: Gautam Baid

WHAT MOVES THE MARKET?
WHAT DRIVES INVESTMENT RETURN?
WHERE DOES RETURN COME?

Dividend

Growth of the company (NPAT or NPAT driver)

Valuation Level – at which price you bought the shares

ALL THREE FACTORS ARE IMPORTANT IN
SHORTER TIME HORIZON
Example of return – One Year Period

Dividend Valuation level

NPAT Growth 1 yr Return Stock Characteristics
Yield (Repricing Return)

A 7.5% 0.0% 0.0% 7.5% High dividend Yield, no growth, bought at fair price
High Dividend Yield B 7.5% 7.0% 0.0% 14.5% High dividend Yield, moderate growth, bought at fair price
Value stock C 7.5% 7.0% 15.0% 29.5% High dividend Yield, moderate growth, bought at 15% undervalued
D 7.5% 7.0% -15.0% -0.5% High dividend Yield, moderate growth, bought at 15% overvalued

E 2.5% 15.0% 0.0% 17.5% Low dividend Yield, high growth, bought at fair price
Growth stock F 2.5% 15.0% 15.0% 32.5% Low dividend Yield, high growth, bought at 15% undervalued
G 2.5% 15.0% -15.0% 2.5% Low dividend Yield, high growth, bought at 15% overvalued

In a shorter time horizon, at which price you buy shares is very much important, along with other two
sources of return
GROWTH IS THE PRIME FACTOR IN LONGER
TERM HORIZON

Investment Investment Investment

Initial
Growth Value after 10 Value after 20 Value after 30
Investment
years years years

A 1.0 0.0% 1.0 1.0 1.0

B 1.0 5.0% 1.6 2.7 4.3
C 1.0 10.0% 2.6 6.7 17.4
D 1.0 15.0% 4.0 16.4 66.2
E 1.0 20.0% 6.2 38.3 237.4
F 1.0 25.0% 9.3 86.7 807.8

Power of Compounding is impressive!

IMPRESSIVE RETURNS OF STOCKS EVEN
WHEN MARKET COULDN’T GENERATE
SUFFICIENT RETURN Annual Return (CAGR) till 2021

15 Yrs from 12 Yrs from 10 Yrs from 5 Yrs from

Stocks Dec 2006 Dec 2009 Dec 2011 Dec 2016
SQUARE 20.2% 14.2% 13.0% 4.0%
Renata 31.3% 19.8% 18.5% 17.4%
Marico * 21.8% 28.6% 25.0%
Reckit 29.0% 14.8% 25.6% 33.2%
GP * 12.1% 15.2% 11.2%
Berger * 18.2% 23.0% 10.9%
BATBC 35.8% 27.6% 28.1% 21.3%
*No data available or yet to calculate

DSE Index 9.6% 3.6% 2.7% 6.1%

Dividend Yield 3.3% 3.4% 3.8% 3.9%

Total 13.0% 6.9% 6.5% 9.9%

*Dividend Yield rough assumption
 AND THE REASON WAS EARNINGS
GROWTH…
NPAT Growth

NPAT mn 2009 2021Times CAGR

SQUARE 2,116 15,947 7.5 18.3%

Renata 604 5,062 8.4 19.4%

Marico 471 3,447 7.3 18.0%

Reckit 198 804 4.1 12.5%

GP 14,968 34,129 2.3 7.1%

Berger 580 2,692 4.6 14.3%

BATBC 2,069 14,958 7.2 17.9%

“Time is on your side when you own shares of superior companies .“ - Peter Lynch
 …THEN THERE WAS FLIPSIDE AS WELL
Decline in NPAT and share price (2010-2019)
0%

-20%

-40%
-40%
-60%
-60%
-80%
-76%
-84% -84%
-100% -88% -91%
-97% -97% -95%
-120%
PREMIERLEA ABBANK NBL ILFSL^ PRIMEFIN^

NPAT Decline Market Cap Decline

^ ILFSL & PRIMEFIN NPAT till 2018

“In the short run, the market is a voting machine but in the long run, it is a weighing machine."
− Benjamin Graham, American investor and economist
SO, WE NEED TO FIND OUT HIGH POTENTIAL
STOCKS AND AVOID THE VALUE
DESTROYERS
ON’T HAVE TO BE EXPERT ON EVERY COMPANY
THE MAJOR PARAMETERS FOR
UNDERSTANDING GROWTH…
Growth trajectory (NPAT and Revenue) – look for fast growers

 Track record of Growth and its drivers

 Likelihood of continuation/change in the historical growth trajectory

 Future growth drivers –

 Industry growth – income level, growing customer base, development of support factors/ Changes in regulatory regime/ ease of doing business/business ecosystem,

change in demography, customers habits, Under penetration/reach/coverage, changes in raw material and finished product price in local and global market ,

Impact of currency depreciation/appreciation

 Market share gain - competitive forces, company positioning – products, distribution channel, HR quality, Competitive positioning or economic moat

 Expansion plan – new products, new location, higher usage of existing products

 New growth initiative and its % impact from it

 Margin increase – price raise, cost cut or increase in efficiency through process improvement

Sustainable growth rate = ROE * retention rate

THE MAJOR PARAMETERS FOR
UNDERSTANDING GROWTH…

 Profitability – look for higher or improving

 Profit Margin and
 Return - ROA and ROE
 Sustainability

 Financial Condition – look for solid balance sheet

 Leverage - Cash, debt, debt to equity and equity multiplier
 Investment in Working capital
 Cash flow generation capacity

 Efficiency - Asset turnover ratio etc

Corporate Governance – Owners, boards and Management – Prime Factor

MEASURE OF PROFITABILITY: RETURN ON
EQUITY (ROE)
What rate of return has the firm earned on the
shareholders’ equity it had available during the year?
The general form of the rate of return computation:
Amount of return
Rate of return =
Amount invested

Applied to shareholders’ equity:

Net income
ROE =
Average equity

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DECOMPOSE ROE
Net income
ROE =
Average equity

Net income Average assets

= ×
Average assets Average equity

= ROA × Leverage

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DECOMPOSE ROE

ROE = ROA × Leverage

A company can increase its ROE

With a business strategy, by increasing its ROA and/or

With a financial strategy, by increasing its use of leverage as long

as returns on the incremental investment exceed the cost of
borrowing.

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PROFITABILITY, COMPETITION,
AND BUSINESS STRATEGY
Net income
ROA =
Average assets
Net income Revenue
ROA = ×
Revenue Average assets

In other words,
ROA can
be thought
of as: Profit margin × Turnover (efficiency)

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DECOMPOSE ROE

 A company can improve its ROE by improving ROA or making more effective use
of leverage.
 Leverage is measured as average total assets divided by average shareholders’
equity.
 If a company had no leverage (no liabilities), its leverage ratio would equal 1.0 and
ROE would exactly equal ROA.
 As a company takes on liabilities, its leverage increases.
 As long as a company is able to borrow at a rate lower than the marginal rate it can
earn investing the borrowed money in its business, the company is making an
effective use of leverage and ROE would increase as leverage increases. If a
company’s borrowing cost exceeds the marginal rate it can earn on investing in the
business, ROE would decline as leverage increased because the effect of borrowing
would be to depress ROA.
RETURN ON ASSETS
What rate of return has the firm earned on the assets it had available to use during
the year?
The general form of this computation is the same:
Amount of return
Rate of Return =
Amount invested
Two variants of ROA computation:
Net income
(1) ROA =
Average assets

Net income adjusted for interest

(2) ROA =
Average assets

Net income + [Interest expense × (1 – Tax rate)]

=
Average assets
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RETURN ON ASSETS

 ROA measures the return earned by a company on its assets.

 The higher the ratio, the more income is generated by a given level of assets.
 Most databases compute this ratio as net income/average assets (Equation 1).
 An alternative (Equation 2) is to use net income adjusted for interest as the
numerator.
 This form of the ratio reflects that net income plus after-tax interest is the amount
of earnings applicable to both equity holders and creditors, consistent with assets
being financed by both equity holders and creditors.
 Net income (after the deduction of interest) is the return solely to equity holders.
 In general, whichever form of ROA is chosen, the analyst must use it consistently
in comparison with other companies or time periods.
 For simplicity, the DuPont analysis will use the first variant (Equation 1).
DECOMPOSING RETURN ON EQUITY

ROE = Profit margin × Turnover × Leverage

Net income Revenue Average assets

ROE = × ×
Revenue Average assets Average equity

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DECOMPOSING RETURN ON EQUITY

What was the source of the firm’s return on equity?

To what extent
. . . was it derived from selling a high margin product or keeping expenses low—
deriving more profits from each $1 of sales? (return on sales, net profit margin)
. . . was it derived from generating higher sales from a lower investment in assets?
(efficient use of assets, also known as turnover or efficiency)
. . . was it derived from investing a lower amount of equity—by using more debt in its
capital structure? (financial leverage)

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DECOMPOSING RETURN ON EQUITY:
STYLIZED COMPARATIVE ANALYSIS MINI-
CASE Co. A Co. B Co. C Average
Sales ($) 2,000 4,000 6,675 4,225
Net income (NI) ($) 200 200 200 200
Average assets ($) 1,000 2,000 1,500 1,500
Average equity ($) 1,000 1,000 1,000 1,000
Average liabilities ($) 0 1,000 500 500
ROE (NI/Equity)
Net profit margin
(NI/Sales)
Turnover
(Sales/Assets)
Leverage
(Assets/Equity)
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DECOMPOSING RETURN ON EQUITY:
STYLIZED COMPARATIVE ANALYSIS MINI-
CASE
Co. A Co. B Co. C Average
Sales ($) 2,000 4,000 6,675 4,225
NI ($) 200 200 200 200
Average assets ($) 1,000 2,000 1,500 1,500
Average equity ($) 1,000 1,000 1,000 1,000
Average liabilities ($) 0 1,000 500 500
ROE (NI/Equity) 20.0% 20.0% 20.0% 20.0%
Net profit margin
(NI/Sales) 10.0% 5.0% 3.0% 4.7%
Turnover (Sales/Assets) 2 2 4.45 2.82

Leverage (Assets/Equity) 1 2 1.5 1.50

EXPLANATION

 All three companies have the same ROE.

 Company A’s ROE is driven by its net profit margin (10% versus 4.7%
average for the three companies).
 Company B’s ROE is driven by its leverage (2× versus 1.5× average for the
three companies). Its turnover is below average, and its profit margin is
very slightly above average.
 Company C’s ROE is driven by its turnover (4.45× versus 2.82× average).
STOCK CLASSIFICATION Kazi Monirul Islam, CFA
 DEFINE THE NATURE OF STOCK/INDUSTRY

 Cyclical vs Non-Cyclical

 Basic Consumption Vs Luxury

 Struggling …..Temporary vs Permanent

 High Margin vs Low Margin

 High Turnover vs Low Turnover

 High Leverage vs Low Leverage

 High Capital Intensive Vs Low Capital Intensive

 High Growth stage Vs Moderate Growth Vs Low Growth

 GROWTH DRIVER

 Under penetration / reach / coverage

 Demographics – Age of the population

 Changes in regulatory regime/ ease of doing business / business ecosystem

 Changes in raw material and finished product price in local and global market – supply
shock

 Impact of currency depreciation/appreciation

CLASSIFY STOCK BASED ON NATURE

 Slow growers: Large Mature companies, pays a high dividend yield

 Stalwart: Moderate growth (8%-12%)
 Fast growers: have very high growth (near 20%)
 Cyclical: very much related to the economic cycle
 Turnaround: Very high return when clicks but failure ratio could be high
 Asset Play: Buy a hidden Gem, not discovered by market
CLASSIFY STOCK BASED ON NATURE

 Slow Growers: Low-risk and low-gain

 Stalwart: Low-risk and moderate-gain
 Fast growers: High-risk and high-gain
 Cyclical: May be low-risk and high-gain or high-risk and low-gain, depending on how
adept you are at anticipating cycles
 Turnaround: High-risk and high-gain
 Asset Play: Low-risk and high-gain

Allocation in each class depends on your risk tolerance level and return target.
DIFFERENT STRATEGIES FOR DIFFERENT
CLASSES
 Slow Growers: Hold for stability and regular income from dividend

 Stalwart: Buy at a bargain and sell when there is a 20-50% return, repeat the process

 Fast growers: Hold and enjoy the compounding effect as long as the story is intact, sell when
the story falters or you find a better story,
 Cyclical: Buy in the down cycle and sell in upcycle

 Turnaround: Buy at the worst time/ showing signs of a turnaround, Sell when it turns around

 Asset Play: Buy for a hidden Gem, not discovered by the market, and sell when it is priced

Different exit strategies for different classes of stock

VALUATION Kazi Monirul Islam, CFA
VALUATION

“What you pay for an investment is the single biggest determinant for how successful that
investment will be. When equity prices are high, your returns will be lower. When they are cheap,
your returns will be higher.

Barry Ritholtz - American equities analyst

VALUATION PRINCIPLES
 Valuation means valuing the cash flow you are going to receive from an investment.

 No cash flow = no value

 Riskiness of cash flow should be reflected in discount rate; high risk = high discount rate and vice versa

 Reaching a valuation conclusion requires consideration of both Quantitative and Qualitative factors
TWO MOST IMPORTANT FACTORS IN
VALUATION

 Growth – Positive relation with value

 Risk – Negative relation with value
 UNDERSTANDING RISK

 The size of the Company - Small vs Big Companies

 Quality of Management & Board

 Financial leverage (High vs Low) – Impact of interest

 Operating Leverage (High vs Low) – Capacity to absorb fluctuation from economic cycle

 Cyclical vs Non-Cyclical

 Basic Consumption Vs Luxury

 High Margin vs Low Margin

Risk free Rate + Risk Premium
METHOD OF COMPARABLES

Benchmark Value of the

Multiple Choices

Firm’s
Industry or Broad market
Industry peers historical
sector index index
values
PRICE AND EARNING MULTIPLES

BEST and SIMPLE method, if you can adjust limitations –

 EPS – True EPS, normalized and reflective of forward EPS

 Differences in Companies – Earnings growth, Risk, and Quality adjustments
PRICE-TO-EARNINGS MULTIPLE
DEFINITIONS

Trailing P/E Forward P/E

Preferred when Preferred when

Uses earnings of
forecasted Uses next year’s trailing earnings
last 12 m/last 4
earnings are not earnings are not reflective
quarters /last year
available of future
VALUATION
P/E and Growth Exercise
 FCFF
Expected NPAT CAGR P/E
 DDM less than 10% Max 12

 P/E – Growth 10-12% 10 to 15

12%-15% 12 to 18
 Growth usually NPAT growth 15%-17% 15 to 22

 More sophisticated formula includes dividend 17% -20% 17 to 25

yield with NPAT growth 20% - 25% 20 to 30

Not linear in upward side since it
More than 25% is difficult to sustain.
 Applicable for manufacturing companies

Lower end or higher end – depends on risk profile of the company

The ranges are for valuation exercise – expecting to help structured thinking. Not a perfect guideline since there are many factors needed to
be considered for the valuation
VALUATION

P/B and ROE

 Excess Return/Abnormal earnings/Residual Income Exercise
Expected ROE P/B
 P/B – ROE
less than 10% Max 1
 More applicable for financials 10% to 13% 1 to 1.5
13% to 16% 1.2 to 1.8
16% to 18% 1.4 to 2.3
20% to 25% 1.7 to 3.5
Above 25% 2.5+

Lower end or higher end – depends on risk profile of the company

The ranges are for valuation exercise – expecting to help structured thinking. Not a perfect guideline since there are many factors needed to
be considered for the valuation
ENTERPRISE VALUE

EV = Market Cap + Debt – Cash and Cash equivalents – value of other non-
operating investments

Market Cap = Number of shares * Share price

Don’t compare just share price, compare with market cap at least/Best way to
compare with EV
ENTERPRISE VALUATION EXERCISE WITH NP
MARGIN

Expected NP Margin EV/Revenue

10% or below 0.5 to 2
10% to 15% 2 to 3
15% to 20%  3 to 4
20%+ 4 to 5

Higher growth companies with similar margin will get higher multiples

Lower end or higher end – depends on risk profile of the company

The ranges are for valuation exercise – expecting to help structured thinking. Not a perfect guideline since there are many factors needed to
be considered for the valuation
ENTERPRISE VALUATION EXERCISE WITH
EBITDA GROWTH
EBITDA CAGR EV/EBITDA

Below 10% Max 6x

10-12% 6.0x to 8.0x
12%-15% 7.0x to 9.0x
15%-20% 9.0x to 11.0x
More than 20% Max 12.0x

Lower end or higher end – depends on risk profile of the company

Higher growth companies with similar margin will get higher multiples

The ranges are for valuation exercise – expecting to help structured thinking. Not a perfect guideline since there are many factors needed to
be considered for the valuation
 SUMMARY OF VALUATION

 P/E Multiples should be justified by the growth prospects (+) and risk profile (-)

 P/B multiples should be justified by the ROE (+) and risk profile (-)

 EV/Sales should be justified by net profit margin (+), growth (+), and risk profile (-)

 EV/EBITDA should be justified by EBITDA margin (+), growth (+), and risk profile (-)

 Dividend yield is effective if it reflects earnings capacity and it is sustainable or in good

cases if it has growth
SUMMARY OF VALUATION

 Peer/industry comparison can be done if we can adjust the differences

among the companies (growth, risk)

 All of the parameters (EPS, book value, Sales, EBITDA and Dividend)
should be adjusted for abnormal fluctuations, one-off and cyclical ups and
down.

 Need to use normalized level of EPS, book value, Sales, EBITDA and
Dividend for calculating relevant multiple
THANK YOU