COMPANY ANALYSIS

MBA FINANCE- INVEATMENT ANALYSIS

Fundamental analysis at Company level

• Involves analysis the following 1.Firms competitive position in the industry2.Labour relations 3.Management 4.Technological changes5.Financial analysis of which the variables

include sales, profitability, tax rate,sources of financing,asset utilization and other factors

Company analysis

• Fundamental analysis expects an invest analyst to derive an understanding of a company in terms of

i. its strengths and risksii. computing the fundamental intrinsic value of

the firm’s stock iii. comparing the intrinsic value of a stock to its market value to determine if the company’s

stock should be purchased

Company analysis

• The stock of a firm with superior management and strong performance measured by

i. sales ii. earnings growth• can be priced so high that the intrinsic value

of the stock is below its current market price and should not be acquired.

Company analysis

• In contrast, the stock of a company with less success based on its sales and earnings growth may have a stock market price that is below its intrinsic value.

• In this case, although the company is not as good, its stock could be the better investment

Company analysis

• Growth Companies and Growth Stocks• financial theorists define a growth company as

a firm with the management ability and the opportunities to make investments

that yield rates of return greater than the firm’s required rate of return

• This required rate of return is the firm’s weighted average cost of capital (WACC).

Growth Companies and Growth Stocks

1. for example, a growth company might be able to acquire capital at an average cost of 10 percent

2. This growth company has the management ability and the opportunity to invest those funds at rates of return of 15 to 20 percent.

3. As a result of these investment opportunities, the firm’s sales and earnings grow faster than those of similar risk

firms and the overall economy. 4. In addition, a growth company that has above-average

investment opportunities i. retains a large portion of its earnings to fund these

superior investment projects (i.e., they have low dividend payout ratios).

A Growth stock • A growth stock is a stock with a higher rate of return

than other stocks in the market with similar risk characteristics

• The growth stock achieves this superior risk-adjusted rate of return because at some point in time the market undervalued it compared to other stocks

• Growth stocks are not necessarily shares in growth companies

• Although the stock market adjusts stock prices relatively quickly and accurately to reflect new information, available information is not always perfect or complete

• Therefore, imperfect or incomplete information may cause a given stock to be undervalued or overvalued at a point in time

Defensive Companies and Stocks

• Defensive companies are those whose future earnings are likely to withstand an economic downturn.

• Defensive stocks have relatively low business risk and not excessive financial risk.

• Typical examples are public utilities or grocery chains firms that supply basic consumer necessities

Defensive stock• There are two closely related concepts of a defensive stock• First, a defensive stock’s rate of return is not expected to decline

during an overall market decline, or decline less than the overall market.

• Second, THE CAPM(capital asset pricing model ) topic to be discussed later under technical analysis and portfolio theory indicates that an asset’s relevant risk is its covariance with the market portfolio of risky assets—that is, an asset’s systematic risk.

• A stock with low or negative systematic risk (a small positive or negative beta) may be considered a defensive stock according

to CAPM theory because its returns are unlikely to be harmed significantly in a bear market.

Cyclical Company• A cyclical company’s sales and earnings will be

heavily influenced by aggregate business activity• Examples would be firms in the steel, auto, or

heavy machinery industries• Such companies will do well during economic

expansions and poorly during economic contractions

• This volatile earnings pattern is typically a function of the firm’s business risk (both sales volatility and operating leverage) and can be compounded by financial risk.

A cyclical stock

• A cyclical stock will experience changes in its rates of return greater than changes in overall market rates of return.

• In terms of the CAPM, these would be stocks that have high betas.

• The stock of a cyclical company, however, is not necessarily cyclical.

• A cyclical stock is the stock of any company that has returns that are more volatile than the overall market

• that is, high-beta stocks that have high correlation with the aggregate market and greater volatility.

Speculative Companies and Stocks• A speculative company is one whose assets involve great

risk but that also has a possibility of great gain.• A good example of a speculative firm is one involved in oil

exploration• A speculative stocki. possesses a high probability of low or negative rates of

return ii. a low probability of normal or high rates of return• A speculative stock is one that is overpriced, leading to a

high probability that during the future period when the market adjusts the stock price to its true value, it will experience either low or possibly negative rates of return.

Value versus Growth Investing• Investment Analysts divide stocks into “growth”

stocks and “value” stocks• As we have discussed, growth stocks are

companies that will have positive earnings surprises and above-average risk adjusted

rates of return because the stocks are undervalued.• If the analyst does a good job in identifying such

companies, investors in these stocks will reap the benefits of seeing their stock prices rise after other investors identify their earnings growth potential.

Value stocks• Value stocks are those that appear to be undervalued

for reasons other than earnings growth potential• Value stocks are usually identified by analysts as

having low price-earning or price-book value ratios• A Growth stock is generally specified as a stock of a

company that is experiencing rapid growth of sales and earnings (e.g., Intel and Microsoft).

• As a result of intel and microsoft high performance due to the rapid growth in personal computers industry which required the chips from intel and software from microsoft , the stock s of these two companies typically had and have high P/E and price-book-value ratio

Economic and Industry Influences on a company

• If economic trends are favorable for an industry, the company analysis should focus on firms in that industry that are well positioned to benefit from the economic trends

• Research analysts should become familiar with the cash flow and risk attributes of the firms they are studying

• Firms in an industry will have varying sensitivities to economic variables, such as economic growth, interest rates, input costs, and exchange rates.

• Because each firm is different, an investor must determine the best candidates for purchase under expected economic conditions.

Structural Influences• Factors such as social trends, technology, and political

and regulatory influences, can have a major effect on some firms in an industry

• Some firms in the industry can try to take advantage of ;

a) demographic changesb) shifts in consumer tastesc) lifestyles, or invest in technology to lower costs and

better serve their customers• Such firms may be able to grow and succeed despite

unfavorable industry or economic conditions.

Structural Influences• For example, Wal-Mart became the leading retailer in

the 1990s in usa because it benefited from i. smart management.ii. The geographic location of many of its stores allowed

it to benefit from rising regional population and lower labor costs.

• Its strategy, which emphasized everyday low prices, was appealing to consumers who had become concerned about the price and value of purchases

• Wal-Mart’s technologically advanced inventory and ordering systems and the logistics of its distribution system gave the retailer a competitive advantage.

Structural Influences

• Even if the economy plays a major role in determining overall market trends and industry groups display sensitivity to economic variables.

• other structural changes may counterbalance the economic effects, or company management may be able to minimize the impact of economic events on a company

COMPANY ANALYSIS- Firm CompetitiveStrategies

• In describing competition within industries, we identified five competitive forces that could

affect the competitive structure and profit potential of an industry.

(1) current rivalry,(2) threat of new entrants(3) potential substitutes,(4) bargaining power of suppliers(5) bargaining power of buyers

competitive strategy

• After you have determined the competitive structure of an industry,

• An investment analyst should attempt to identify the specific competitive strategy employed by each firm

• evaluate these strategies in terms of the overall competitive structure of the industry

Company’s competitive strategy

• A company’s competitive strategy can either be defensive or offensive

• A defensive competitive strategy involves positioning the firm so that its capabilities provide the best means to deflect the effect of the competitive forces in the industry.

• Examples may include investing in fixed assets and technology to lower production costs or creating a strong brand image with increased advertising expenditures

A company’s competitive strategy• An offensive competitive strategy is one in which the firm attempts

to use its strengths to affect the competitive forces in the industry• For example, Microsoft dominated the personal computer

software market by preempting, rivals and its early affiliation with IBM because it became the writer of operating system software for a large portion of the PC market

• Wal-Mart used its buying power to obtain price concessions from its suppliers. This cost advantage, coupled with a superior delivery system to its stores, allowed Wal-Mart to grow against larger competitors until it became the leading U.S. retailer.

• Shoprite is doing the same strategy in Zambia , this is reflected by the inability by SPUR to compete against shoprite in terms of lowering prices for goods and services . Spurs prices are very high compared to shoprite

Porters competitive strategy

• Porter suggests two major competitive strategies: low-cost leadership and differentiation.

• These two competitive strategies dictate how a firm has decided to cope with the five competitive conditions that define an industry’s environment.

• The strategies available and the ways of implementing them differ within each industry.

Low-Cost Strategy

• The firm that pursues the low-cost strategy is determined to become the low-cost producer and the cost leader in its industry

• Cost advantages vary by industry and might include

i. economies of scaleii. proprietary technologyiii. preferential access to raw materials.

Low-Cost Strategy• In order to benefit from cost leadership, the firm must

command prices near the industry average, which means that it must differentiate itself about as well as other firms.

• If the firm discounts price too much, it could erode the superior rates of return available because of its low cost.

• Wal-Mart was considered a low-cost source. The firm achieved this

i. by volume purchasing of merchandise ii. lower-cost operations.• As a result, the firm charged less but still enjoyed higher

profit margins and returns on capital than many of its competitors.

Differentiation Strategy• With the differentiation strategy, a firm seeks to

identify itself as unique in its industry in an area that is important to buyers

• the possibilities for differentiation vary widely by industry

• A company can attempt to differentiate itself based on its distribution system (selling in stores, by mail order, or door-to-door) or some unique marketing approach

• A firm employing the differentiation strategy will enjoy above-average rates of return only if the price premium attributable to its differentiation exceeds the extra cost of being unique.

SWOT Analysis

• Strengths, Weaknesses, Opportunities and Threats (SWOT) analysis is a strategy development tool that matches internal organizational strengths and weaknesses with external opportunities and threats

• SWOT analysis helps you balance idealism and pragmatism, and obtain a balanced perspective of your internal strengths and weaknesses and external opportunities and threats to develop an effective strategy.

SWOT Analysis

• Strengths and weaknesses involve identifying the firm’s internal abilities or lack thereof

• Opportunities and threats include external situations, such as competitive forces, discovery and development of new technologies, government regulations, and

domestic and international economic trends

The strengths of a company• The strengths of a company give the firm a comparative advantage

in the marketplace• Perceived strengths can includei. good customer serviceii. high-quality productsiii. strong brand image,iv. customer loyaltyv. innovative R&Dvi. market leadershipvii. strong financial resources.• To continue having strengths, a firm must continue to be

developed, maintained, and defended through prudent capital investment policies

Weaknesses

• Once weaknesses are identified, the firm can select strategies to mitigate or correct the weaknesses.

• For example, a firm that is only a domestic producer in a global market can make investments that will allow it to export or produce its product overseas.

• Another example would be a firm with poor financial resources that would form joint ventures with financially stronger firms

Opportunities• Opportunities, or environmental factors that

favor the firm, can include;i. a growing market for the firm’s products

(domestic and international),ii. shrinking competition,iii. favorable exchange rate shifts, iv.a financial community that has confidence in the

outlook for the industry or firm, v. or identification of a new market or product

segment.

Threats• Threats are environmental factors that can hinder the firm in

achieving its goals.• Examples would includei. a slowing domestic economy (or sluggish overseas economies for

exporters), ii. additional government regulation,iii. an increase in industry competition, iv. threats of entry, v. buyers or suppliers seeking to increase their bargaining power, vi. or new technology that can obsolete the industry’s product• By recognizing and understanding opportunities and threats, an

investor can make informed decisions about how the firm can exploit opportunities and mitigate threats

Quality of management

• Board of directors – who are the members of the board of directors

• Quality of management • Market share • Industrial relations • Corporate governance • Type of technology used by the firm

Financial analysis

Analyzing Key Ratios – Valuation• P/E• PEG• P/S• P/B

Financial analysis

– Analyzing Key Ratios– Financial Ratios• Profit Margin• ROA• ROE• EPS• Debt/Equity• Current Ratio• Dividend Rate

Valuation1. Understanding Price to Earnings Ratio –P/E• The P/E looks at the relationship between the stock price and the company’s earnings• You calculate the P/E by taking the share price and dividing it by the company’s EPS.

(earnings per share )• P/E = Stock Price / EPS • For example, a company with a share price of $40 and an EPS of 8 would have a P/E of

5 ($40 / 8 = 5). • What does P/E tell you? • The P/E gives you an idea of what the market is willing to pay for the company’s

earnings.• The higher the P/E the more the market is willing to pay for the company’s earnings.• Conversely, a low P/E may indicate a “vote of no confidence” by the market or it

could mean this is a sleeper that the market has overlooked.• What is the “right” P/E? There is no correct answer to this question, because part of

the answer depends on your willingness to pay for earnings

Understanding the PEG• Price to Earnings Ratio or P/E• The P/E is the most popular way to compare the relative value of stocks

based on earnings because you calculate it by taking the current price of the stock and divide it by the Earnings Per Share (EPS).

• This tells you whether a stock’s price is high or low relative to its earnings

• Some investors may consider a company with a high P/E overpriced and they may be correct.

• A high P/E may be a signal that traders have pushed a stock’s price beyond the point where any reasonable near term growth is probable.

• However, a high P/E may also be a strong vote of confidence that the company still has strong growth prospects in the future, which should mean an even higher stock price

Understanding the PEG (PROJECTED GROWTH IN EARNINGS)

• The market is usually more concerned about the future than the present, it is always looking for some way to project out.

• Another ratio you can use will help you look at future earnings growth is called the PEG ratio.

• You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings

• PEG = P/E / (projected growth in earnings• For example, a stock with a P/E of 30 and projected earning growth next year of

15% would have a PEG of 2 (30 / 15 = 2).• What does the “2” mean? Like all ratios, it simply shows you a relationship• In this case, the lower the number the less you pay for each unit of future earnings

growth. So even a stock with a high P/E, but high projected earning growth may be a good value.

•

• investors looking for hot stocks aren’t the only ones trolling the markets• A group of investors called value investors go about their business looking for

companies that the market has passed by.• Some of these investors become quite wealthy finding sleepers, holding on to

them for the long term as the companies go about their business without much attention from the market, until one day they pop up on the screen, and some analyst “discovers” them and bids up the stock.

• Meanwhile, the value investor pockets a hefty profit.• Value investors look for some other indicators besides earnings growth and so

on. One of the metrics they look for is the Price to Book ratio or P/B • .You calculate the P/S by dividing the market cap of the stock by the total

revenues of the company.

Price to Book Ratio

Price to Book Ratio

• You calculate the P/B by taking the current price per share and dividing by the book value per share.

• P/B = Share Price / Book Value Per Share

What is Dividend Yield

• Dividend yield is an easy way to compare the relative attractiveness of various dividend-paying stocks

• . It tells an investor the yield he / she can expect by purchasing a stock.

• This allows a basis of comparison between other investments such as bonds, certificates of deposit, etc.