Fundamental Analysis:Company Analysis

C S MishraVGSOM, IIT Kharagpur

Overview

• Importance of Company Analysis• Company Analysis and Stock Valuation• Broad Methodology of Company Analysis

– Strategy Analysis• Defining Strategy• Levels in Organization and Strategy Decisions• Porter’s Five Forces Model Revisited• SWOT Analysis• PEST Analysis• Lessons from Select Authors

– Analysis of Financial Reports

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Importance of Company Analysis

• After analyzing the economy and stock markets for several countries, one decides about investing some portion of one’s portfolio in common stocks.

• After analyzing various industries, one identifies those industries that appear to offer above-average risk-adjusted performance over one’s investment horizon.

• Next questions that arise: – Which are the best companies?– Are they overpriced or underpriced?

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Company Analysis vs. Stock Valuation: Points to Note

• Good companies are not necessarily good investments.

• Compare the intrinsic value of a stock to its market value.

• Stock of a great company may be overpriced.• Stock of a growth company may not be a

growth stock.

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• Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earnings.

• Financial theorists define a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return.

Growth Companies

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Growth Stocks

• Growth stocks are not necessarily shares in growth companies.

• A growth stock has a higher rate of return than other stocks with similar risk.

• Superior risk-adjusted rate of return occurs because of market undervaluation compared to other stocks.

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Defensive Companies and Stocks

• Defensive companies’ future earnings are more likely to withstand an economic downturn.

• Low business risk• Not excessive financial risk• Stocks with low or negative systematic risk (β)

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Cyclical Companies and Stocks

• Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity.

• Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall market rates of return.

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Speculative Companies and Stocks

• Speculative companies are those whose assets involve great risk but that also have a possibility of great gain.

• Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return.

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Value versus Growth Investing

• Growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued.

• Value stocks appear to be undervalued for reasons besides earnings growth potential.

• Value stocks usually have low P/E ratio or low P/B ratio.

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Economic, Industry, and Structural Links to Company Analysis

• Company analysis is the final step in the top-down approach to investing.

• Macroeconomic analysis identifies industries expected to offer attractive returns in the expected future environment.

• Analysis of firms in selected industries concentrates on a stock’s intrinsic value based on growth and risk.

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Economic and Industry Influences

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

• Firms with sales or earnings particularly sensitive to macroeconomic variables should also be considered.

• Research analysts need to be familiar with the cash flow and risk of the firms.

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Structural Influences

• Social trends, technology, political, and regulatory influences can have significant influence on firms.

• Early stages in an industry’s life cycle see changes in technology which followers may imitate and benefit from.

• Politics and regulatory events can create opportunities even when economic influences are weak.

Company Analysis: Strategy Analysis

• Defining Strategy• Levels in Organization and Strategy Decisions• Porter’s Five Forces Model Revisited• PEST Analysis• SWOT Analysis

Strategy Defined

• Strategy refers to a plan of action designed to achieve a particular goal. The word is of military origin, deriving from the Greek word στρατηγός (stratēgos), which roughly translates as “general”.*

*Source: http://en.wikipedia.org/wiki/Strategy, accessed on 20 June, 2010

Importance of Strategy

• Reasons for premature death of firm– No Strategic Intent– Passive Management– New opportunities not explored– Failure to adapt to change in surroundings

Multiple Layers/ Levels of Strategy

Levels of Strategy Management DecisionCorporate Strategy Activities to enhance substantial

competitive advantage•Selecting the Business to do?•Entering New Market•Exiting/ withdrawal from market

Business Strategy •Decisions to maximize competitive position within the chosen market

Operational Strategy •Planning for execution of the goal of the strategic business unit (SBU)

All the decisions affect the cash flows of a company, hence important from analysis and valuation point of view.

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Firm Competitive Strategies:Revisiting Porter’s Five Forces Model

• Current rivalry• Threat of new entrants• Potential substitutes• Bargaining power of suppliers• Bargaining power of buyers

The Takeaways from Porter’s Analysis

• Helps in determining potential attractiveness of an industry- insight of margins.

• Helps decision about exit or entry.• Allows a systematic and structured analysis of

market structure and competitive situation.• Helps to understand strategies of the

company to reduce power of competitive forces.

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Firm Competitive Strategies, contd..

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

• Offensive strategy involves using the company’s strength to affect the competitive industry forces, thus improving the firm’s relative industry position.

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Firm Competitive Strategies, contd..

• Porter suggests two major strategies:– Low-Cost Strategy

• The firm seeks to be the low-cost producer, and hence the cost leader in its industry.

– Differentiation Strategy• Firm positions itself as unique in the industry.

• However, companies may opt for different strategies depending upon the products.

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SWOT Analysis

• Examination of a firm’s:–Strengths

–Weaknesses

–Opportunities

–Threats

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SWOT Analysis

• Examination of a firm’s:–Strengths

–Weaknesses

–Opportunities

–Threats

INTERNAL ANALYSIS

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SWOT Analysis

• Examination of a firm’s:–Strengths

–Weaknesses

–Opportunities

–ThreatsEXTERNAL ANALYSIS

Strategy Analysis- External:PEST

• P: Political &Legal Changes

• E: Economic Changes

• S: Social Changes

• T: TechnologicalChanges

A Change in Government, Policy or Law

Rising level of living standards or interest rate change

More Working Women going out to work

New Inventions and Ideas

Strategy Analysis – Internal Environment

• Review of Resources– Tangible – Intangible

• Review of Capabilities– Knowledge based capabilities– R&D– Customer Service/ Support– Global Operations– Core Competencies- The areas where firm functions

well.

Lessons from Select Authors

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Some Lessons from Peter Lynch

Favorable Attributes of Firms:1. Firm’s product should not be faddish.2. Firm should have some long-run comparative

advantage over its rivals.3. Firm’s industry or product has market stability.4. Firm can benefit from cost reductions.5. Firms that buy back shares show there are putting

money into the firm.

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Tenets of Warren Buffet*

• Business Tenets• Management Tenets• Financial Tenets• Market Tenets

* Source: Hagstorm, Robert G: The Essential Buffet, Wiley, 2001, as presented in Reilly and Brown, 2007.

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Tenets of Warren Buffet, contd..

• Business Tenets:– Is the business simple and understandable?– Does the business have a consistent operating

history?– Does the business have favorable long-term

prospects?• Management Tenets:

– Is management rational?– Is management candid with its shareholders?

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Tenets of Warren Buffet, contd..

• Financial Tenets:– Focus on return on equity, not earnings per share– Calculate “owner earnings”– Look for companies with high profit margins– For every dollar retained, make sure the company

has created at least one dollar of market value• Market Tenets:

– What is the intrinsic value of the business?– Can the business be purchased at a significant

discount to its fundamental intrinsic value?

Financial Analysis of Companies

• Estimating Intrinsic Value• Analyzing financial statements• Red flags in financial reporting• Measures of Value Addition

– Economic Value Added (EVA)*– Market Value Added (MVA)*

*Stern and Stewart, New York

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Estimating Intrinsic Value

A. Present value of cash flows (PVCF)– 1. Present value of dividends (DDM)– 2. Present value of free cash flow to equity (FCFE)– 3. Present value of free cash flow to firm (FCFF)

B. 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)

P/E and P/B RatiosPrice-Earning and Price-Book Value Ratio Sensex Companies as on 21 June 2010

# Company Name P/E P/B # Company Name P/E P/B 1A C C Ltd. 10.31 2.58 17Mahindra & Mahindra Ltd. 18.45 4.542Bharat Heavy Electricals Ltd. 28.18 7.47 18Maruti Suzuki India Ltd. 15.91 3.413Bharti Airtel Ltd. 10.66 2.74 19N T P C Ltd. 18.99 2.264Cipla Ltd. 27.66 4.47 20Oil & Natural Gas Corpn. Ltd. 15.38 2.915D L F Ltd. 63.82 3.75 21Reliance Communications Ltd. 77.47 0.746H D F C Bank Ltd. 31.17 4.27 22Reliance Industries Ltd. 21.46 2.717Hero Honda Motors Ltd. 18.11 10.53 23Reliance Infrastructure Ltd. 25.25 2.198Hindalco Industries Ltd. 16.29 1.03 24State Bank Of India 16.53 2.39Hindustan Unilever Ltd. 27.02 15.65 25Sterlite Industries (India) Ltd. 55.88 2.78

10HDFC Limited 30.68 5.6 26Tata Consultancy Services Ltd. 28.78 10.2611I C I C I Bank Ltd. 24.97 1.95 27Tata Motors Ltd. 13.24 2.4412I T C Ltd. 28.1 8.19 28Tata Power Co. Ltd. 45.46 2.7613Infosys Technologies Ltd. 27.75 7.3 29Tata Steel Ltd. 8.87 1.1914Jaiprakash Associates Ltd. 14.77 3.65 30Wipro Ltd. 20.73 6.3715Jindal Steel & Power Ltd. 43.19 9.43 Average 27.34 4.7216Larsen & Toubro Ltd. 35 6.18 Median 25.11 3.53

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Analysis of Growth Companies• Generating rates of return greater than the

firm’s cost of capital is considered to be temporary.

• Earnings higher the required rate of return are pure profits.

• How long can they earn these excess profits?• Is the stock properly valued?

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Negative Growth Model

• Firm retains earnings, but reinvestment returns are below the firm’s cost of capital

• Since growth will be positive, but slower than it should be, the value will decline when the investors discount the reinvestment stream at the cost of capital.

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Intra-Industry Analysis

• Directly compare two firms in the same industry• Factors to consider

– A major difference in the risk involved– Inaccurate growth estimates– Stock with a low P/E relative to its growth rate

is undervalued– Stock with high P/E and a low growth rate is

overvalued

Historical Financial Analysis

• Normalization and adjustments for accounting figures• Evaluation of accounting strategy• Review of accounting policies and notes to accounts• Assessing adequacy and quality of disclosures• Financial ratio analysis for

– Profitability– Asset utilization– Long term solvency– Liquidity– Market performance

Fraud and Red Flags in Financial Reporting

• Cooking the books• Financial Analysis is not expected to detect the frauds it

starts with the assumption that figures are not misrepresented

• Carefully done, financial statement analysis can reveal unusual patterns that are difficult to rationalize- questions all ‘red flags’

• Numbers on their own may not make any sense. Questioning the number can help.

• Some indications of red flags:– Assets utilization ratios that provide early warning signal.– Unexplained changes are reasons for suspicious activities– Unreasonable growth goals that can not be financed easily

Red flags in Financial Reporting

• Unexplained changes in policies & estimates especially in doom days

• Unexplained transactions to boost profit • Very consistent margin, growth rate and stable or consistent

increasing cash and bank balance• Unusual increase in debtors and inventories in relation to sales• Unusual increase in intangible assets• Reduction in managed cost- like advertisement to boost cost• One time profit from non-operating assets• Unexplained focus or shift towards non-core business• Significant changes in segment revenue & margin

• Improper method adopt in asset valuation• Increasing gap between accounting income and

taxable income• Increasing gap between reputed income and cash

from operation• Unexplained write-off• R&D partnership• Presence of special purpose vehicles/ enterprises

(SPVs/ SPEs)• Weak governance structure• Complex ownership and financial structure

Red flags in Financial Reporting

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Measures of Value-Added

• Economic Value-Added (EVA)– Compare net operating profit less adjusted taxes

(NOPLAT) to the firm’s total cost of capital in dollar terms, including the cost of equity

• EVA return on capitalEVA/Capital

• Alternative measure of EVA– Compare return on capital to cost of capital

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Measures of Value-Added

• Market Value-Added (MVA)– Measure of external performance– How the market has evaluated the firm’s

performance in terms of market value of debt and market value of equity compared to the capital invested in the firm

• Relationships between EVA and MVA– mixed results

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Site Visits and the Art of the Interview

• Focus on management’s plans, strategies, and concerns

• Restrictions on nonpublic information• “What if” questions can help gauge sensitivity of

revenues, costs, and earnings• Management may indicate appropriateness of

earnings estimates• Discuss the industry’s major issues• Review the planning process• Talk to more than just the top managers

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When to Sell• Holding a stock too long may lead to lower returns

than expected• If stocks decline right after purchase, is that a further

buying opportunity or an indication of incorrect analysis?

• Continuously monitor key assumptions• Evaluate closely when market value approaches

estimated intrinsic value• Know why you bought it and watch for that to change

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Efficient Markets• Opportunities are mostly among less well-

known companies• To outperform the market you must find

disparities between stock values and market prices - and you must be correct

• Concentrate on identifying what is wrong with the market consensus and what earning surprises may exist

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Global Company and Stock Analysis

Factors to Consider:– Availability of Data– Differential Accounting Conventions– Currency Differences (Exchange Rate Risk)– Political (Country) Risk– Transaction Costs– Valuation Differences

References• Bodie, Kane, Marcus and Mohanty: Investments, 8e, Tata

McGraw Hill, 2009• Hagstorm, Robert G: The Essential Buffet, Wiley, 2001• Lynch, Peter: One Up on Wall Street, Simon & Schuster,

1989• Lynch, Peter: Beating the Street, Simon & Schuster, 1993• Porter, Michael E.: Competitive Strategy: Techniques for

Analyzing Industries and Competitors, 1998• Reilly and Brown: Investment Management and Portfolio

Management, 8e, Thomson Learning (Now, Cengage Learning), 2007

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