Fundamental Analysis – The bottom up approach · 2012-01-29 · • Leverage ratios, also...

Fundamental Analysis –The bottom up approach

Elio D’AmatoChief Executive Officer

AIA Conference - Sydney1 September 2011

Important informationThis presentation is provided for educational purposes only and has been prepared without taking into account your personal circumstances, and you should therefore consider its appropriateness in light of your objectives, financial situation and needs, before acting on it. Investments can go up and down.

Information in this presentation is current as at date of presentation unless otherwise stated. However, please bear in mind that shares or other investments may go up or down in value, that past performance may not be repeated and that such information is no guarantee of future performance.

For further ‘Important Information’ (e.g. relating to the Lincoln Australian Share Fund, Testimonials, Disclosures of Interest and other disclaimers), please refer to the “Important Information” section at the end of this presentation.

Two approaches:• Top down

• Start with the big picture (e.g. favourable markets)• Drill down multiple levels to individual stock

selection that meets all the above criteria• Bottom up

• Assess quality companies first and foremost• Consider broader factors secondary to core

company’s business

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How do you ‘fundamental’?

Bottom up analysis

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”

Warren Buffett

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• So how do we apply this analysis?• Financial Health – examine the financial structure of

the business• Performance – consider management’s historical

performance and its drivers• Company assessment – understand how the

business works, the sector it operates within and assess its future going forward

• Valuation – quantify the value of the company, accommodating for growth prospects going forward

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Bottom up analysis

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Financial Health

Understanding financial statements

To be able to assess the Financial Health of a company, it is first necessary to understand the different financial statements

• Profit and Loss statement

• Balance Sheet

• Cash Flow statement

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• The Profit and Loss statement (P&L) is also referred to as the ‘Income Statement’

• It gives a summary of a company’s revenues and expenses for a specified period of time

• The most important figure generated is the Net Income and Earnings Per Share (EPS)

• Remove significant items and focus only on recurring items to get a better picture

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Profit and Loss statement

• The Balance Sheet is also referred to as a ‘Statement of Financial Position’

• It lists a company’s Assets, Liabilities and Shareholders’ Equity as at a particular point in time

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Balance Sheet

• The Cash Flow statement shows the movements of cash and cash equivalents as affected by changes in a company’s income and balance sheet accounts

• It is usually divided into three parts:• Cash flows from Operations• Cash flows from Investing Activities• Cash flows from Financing Activities

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Cash Flow statement

• The task of determining the health of a listed company by looking at financial statements seems daunting

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• But it doesn’t really require special training or countless hours of research!

• Even the novice investor can make sense of a listed company’s Balance Sheet, Profit and Loss and Cash Flow statement by using financial ratios

Financial ratios

What is financial ratio analysis?• When we take a financial figure and look at it relative to another

financial figure

• These ratios simplify the process of determining the health of a listed company and make reported financial information more meaningful and useful for investors

• It allows for comparison with previous years, other companies and the industry sector

• First popularised by Benjamin Graham (considered by many as the ‘Father of fundamental analysis’)

• Ratios can measure many factors of a business12

Financial ratio analysis

• Liquidity ratios indicate whether a company has the ability to pay off short-term debt obligations (debts due to be paid within one year) as they fall due

• Generally, a higher value is desired as this indicates greater capacity to meet debt obligations

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Liquidity ratios

Operating Cash Flow to Current Liabilities (OCFCL)• Operating cash flow to current liabilities pertains to the

cash generated from the operations of a company (revenues less all operating expenses, plus depreciation), in relation to short-term debt obligations

• Operating cash flow is a more accurate measure of a company’s profitability than net income because it only deducts actual cash expenses and therefore demonstrates the strength of a company’s operations

• Consistently negative operating cash flow implies a business is going backwards in relation to the cost to conduct ordinary operations

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Liquidity ratios

OCFCL ratioFormula:

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OCFCL Ratio =Operating Cash Flow

Current Liabilities

• The higher the value of the OCFCL ratio, the lower the level of risk

• A high value indicates that the company generates sufficient cash from its operations to cover short- term liabilities

Liquidity ratios

OCFCL ratioExample: RCG Corporation Limited (RCG) – Rounded to ‘000s

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OCFCL Ratio =

OCFCL Ratio =

Financial Health exercise

$7,690$9,409

0.82

Cash Balance to Total Liabilities (CBTL)• Measures a company’s ability to meet total debt commitments

using its current cash balance

• This measures the company’s ability to absorb liquidity shocks should profitability drop or debt covenants breached

• A lower value indicates a company may be susceptible to failing to meet its commitments due to low cash reserves

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Liquidity ratios

CBTL ratioFormula:

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CBTL =Cash Balance

Total Liabilities

• A ratio of 1 is usually considered the benchmark, but could vary across industries

• A ratio of less than 1 suggests the company may not have sufficient resources to settle its debt obligations if they fell due today

Liquidity ratios

CBTL ratioExample: RCG Corporation Limited (RCG) – Rounded to ‘000s

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CBTL =

Current Ratio =


$17,172$10,067

1.70

• Leverage ratios, also referred to as gearing ratios, measure the extent to which a company utilises debt to finance growth

• Can provide an indication of a company’s long- term solvency

• While most financial experts will acknowledge that debt is a cheaper form of financing than equity, debt carries risks and investors need to be aware of the extent of this risk

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Leverage ratios

Total Liabilities to Total Tangible Assets (TLTAI)• Provides an indication of a company’s capital

structure and whether the company is more reliant on borrowings (debt) or shareholder capital (equity) to fund assets and activities

• Contrary to what many believe, debt is not necessarily a bad thing. Debt can be positive, provided it is used for productive purposes such as purchasing assets and improving processes to increase net profits

• Acceptable TLTAI ratios may also vary across industries

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Leverage ratios

TLTAI ratioFormula:

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TLTAI Ratio =Total Liabilities

Total Assets - Intangibles

• A higher ratio generally indicates greater risk• Greater debt can result in volatile earnings due to

additional interest expense as well as increased vulnerability to business downturns

Leverage ratios

TLTAI ratioExample: RCG Corporation Limited (RCG)

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TLTAI Ratio =

TLTAI Ratio = 0.29


$10,067($53,215 – $18,642)

Interest Cover ratio • A company’s interest cover ratio measures its ability

to meet interest expenses on debt using profits• Generally, a ratio of greater than two is regarded as a

healthy position to cover interest

Formula:

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Interest Cover Ratio =

Net Profit Before Tax + Interest

(EBIT)Interest

Leverage ratios

Interest Cover ratioExample: RCG Corporation Limited (RCG) – Rounded to ‘000s

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$13,024 - $97

$97

133.27

• Summary RCG Corporation Limited (RCG)• OCFCL ratio: 0.82• CBTL ratio: 1.70• TLTAI ratio: 0.29• Interest Cover ratio: 133.27

• What does this tell us about RCG as a whole?The company is a profit-making that has little interest bearing debt. RCG generates sufficient cash flow in a year to repay short term obligations. RCG has excellent debt-serving ability on the back of its very strong interest cover (ie no debt)

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Performance

• Also an assessment of management performance• Can be carried out by reviewing some profitability

ratios• Should be compared across time and against

industry peers• May also be compared against companies globally

within the same industry

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Assessing company performance

Return on Assets (ROA)• ROA is a measurement of management performance • It tells the investor how well a company uses its

assets to generate income • Technically, a company should produce an ROA

higher than the risk free rate of return to be rewarded for the additional risks involved in operating the business. If a company’s ROA is equal or even less than the risk free rate, investors should think twice as they would be better off just purchasing a bond with a guaranteed yield

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Management assessment

Return on AssetsFormula:

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Return on Assets =Net Income

Average Total Assets

• A higher ROA denotes a higher level of management performance but must still be compared with peers

• A rising ROA may initially appear good but can turn out to be unimpressive if other companies in its industry have been posting higher returns and greater improvements in ROA


Return on AssetsExample: RCG Corporation Limited (RCG) – Rounded to ‘000s

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Return on Assets =

Return on Assets =


$8,937($53,215 + $49,453) / 2

17.5%

Return on Equity (ROE)• ROE is another measurement of management

performance

• It tells the investor how well a company has used capital from shareholders to generate profits

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Return on EquityFormula:

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Return on Equity =Net Income

Average Shareholders’ Equity

• Similar to the ROA ratio, a higher ROE denotes a higher level of management performance


Return on EquityExample: RCG Corporation Limited (RCG) – Rounded to ‘000s

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Return on Equity =

Return on Equity =


$8,937($43,148 + $42,152) / 2

21%

Earnings growth• Another way to gauge management’s performance is

to look at a company earnings growth• Net profit after tax may be used but a better indicator

would be Earnings Per Share (EPS) as this would take into account any increases in the number of shares

• Look for an increasing trend as this would indicate improvement in shareholder value

• Can apply a minimum target e.g. EPS growth > 8%

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EPS growthFormula:

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EPS growth =EPS Present - EPS Previous

EPS Previous

• Should be observed over several periods• Look for companies with consistent EPS growth• Prefer increasing EPS growth trend


Earnings GrowthExample: RCG Corporation Limited (RCG)

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EPS Growth =

EPS Growth =


(3.65 – 2.84 cents)2.84 cents

29%

Gross Profit margin• Gross profit margin tells us what percentage of a

company's sales revenue would remain after deducting the cost of goods sold

• This is important as it helps to determine whether the company would still have enough funds to cover operating expenses such as employee benefits, lease payments, advertising, and so on

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Profitability ratios

Gross Profit margin Formula:

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Gross Profit margin =Sales – Cost of Sales

Sales

• A company’s gross profit margin may also be viewed as a measurement of production efficiency

• A company with a gross profit margin higher than that of its competitors, or the industry average, is deemed to be more efficient and is therefore, all things being equal, preferred

Profitability ratios

Gross Profit margin Example: RCG Corporation Limited (RCG) – Rounded to ‘000s

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Gross Profit margin =

Gross Profit margin =

Management assessment exercise

($42,339 – $14,876)$42,339

64.9%

• Summary: RCG Corporation Limited (RCG)• Return on Assets: 17.5%• Return on Equity: 21%• EPS Growth: 29%• Gross Profit Margin: 64.9%

• What does this tell us about RCG’s performance?The company has been performing strongly. The high ROA and ROE is reflective of efficient operations. High EPS growth indicates the company’s operations continue to grow strongly and gross profit margins are indicative of high profitability of the business

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Management assessment exercise

See you shortly

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Let’s take a break

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Company assessment

• Understand how a company operates and generates its profits

• Determine the company’s key competitive advantage

• Identify key risks in the company’s business model• Assess the attractiveness of the sector the

company operates within

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Deconstructing a company

• Advantages of understanding a company’s business model and how its profits are made:• The ability to comprehend the company’s

announcements and its impact on performance• The foresight to apply broader economic news and

views when gauging a company’s prospects• Identify key risk exposures of the company and your

overall portfolio • Confidence in making investment decisions for your

portfolio

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Company operations

• Crucial when comparing a company to its peers• The three generic competitive strategies are:

• Cost leadership – the lowest cost producer of a substitutable product

• Differentiation – product perception that it is not easily substituted and a resulting premium can be charged

• Niche focus – provides a product aimed for a sub- category of the market

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Key competitive advantage

• A company’s key competitive advantage can be distilled from the generic strategies • e.g. cost leadership due to economies of scale, efficient

distribution networks or vertical integration• The more difficult it is for competitors to replicate

this advantage the stronger the long term impact of this advantage• e.g. through strong branding, Coca-Cola Amatil Limited

(CCL) has been able to differentiate their product from generic cola beverages to charge higher prices over the long term

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Key competitive advantage

• Unfortunately, no business model is perfect and key risks for a business have to be identified

• This is related to both understanding a business and its sector

• Some risks will be specific to the business and others apply to the overall sector

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Identifying key risks

• Like competitive advantages, there are numerous risks to running a business

• Key is to identify the risks which would be the most pertinent to a business:• Magnitude of failure – e.g. for a wheat farmer, the price of

wheat is a key risk and substantially impacts the profitability of the business

• Likelihood of failure – e.g. likelihood for a fall in the price of wheat is reasonable as global crop yields can vary significantly but global demand is relatively stable

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Key risks

• This process is similar to applying a top down approach

• Examine country and macroeconomic impacts• e.g. the recent carbon tax proposal will significantly

impact the profitability of energy intensive industries in Australia if legislated. This creates uncertainty making Australian industries like aluminum, agriculture, steel and manufacturing less attractive

• Assess the attractiveness of the sector via ‘Porter’s five forces’

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Understanding the sector

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Porter’s five forces

• An attractive sector will exhibit a combination of these characteristics:• low threat of new entrants, thanks to high barriers to

entry, including government regulations and high start up costs

• low power of suppliers, thanks to available substitutes and a large number of suppliers

• low power of buyers, due to a large number of buyers• low threat of substitutes due to absence of similar

products or services

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Porter’s five forces

• What does RCG Corporation do?• Investment holding company which owns and operates

a number of footwear businesses• Businesses include The Athlete’s Foot, Shoe Superstore

and RCG Brands Pty Ltd• How does it generate its profits?

• Sale of the footwear and apparel through its specialty stores, and through its wholesale and distribution subsidiary, RCG Brands

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Company assessment exercise

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• What is RCG Corporation Limited’s (RCG) key competitive advantage?

• RCG is a niche retailer with unique market position• RCG differentiates itself on utilitarian and comfort

shoes, hence it is less susceptible to fashion trends• RCG has a strong and capable management team

who have been successful at turning the company around and positioning it for growth


• What are the key business specific risks for RCG?• Management has been instrumental in turning the

business around, hence key personnel risk• Execution risk of new stores rollout for the Athlete’s Foot

and Shoe Superstore• What are the key sector risks that impact RCG?

• Cost pressure – rising raw material costs will increase the cost of goods sold (COGS)

• Weak consumer sentiment – higher interest rates and rising petrol costs may force consumers to trim discretionary spending

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• What country or macroeconomic factors are affecting RCG?• Rising labor cost – wages in China have been increased

significantly over the past 12 months• Currency headwind – Chinese Yuan is a highly undervalued

currency, expected to appreciate strongly over time

• Using ‘Porter’s five forces’ what makes RCG’s sector attractive?• Power of suppliers is low due to the large number of manufacturers• High power of buyers as demand for footwear is relatively elastic• Unfortunately, there is a high threat of new entrants and substitutes,

due to low startup costs and the wide variety of footwear available

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Valuations

• Investors should determine an intrinsic valuation

when making investment decisions

• Purchase undervalued shares

• Dispose overvalued shares

• Warren Buffett says

“Price is what you pay, value is what you get”

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Valuations

• There are several widely accepted methods utilised to do this

• Each has their strengths and weaknesses

• However, all methodologies will rely on assumptions and estimates

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How is a valuation determined?

• Ratio valuation – historical or relative• Price / Earnings ratio (P/E)• P/E / Earnings Growth ratio (PEG)• Price / Cash Flow ratio (P/CF)• Price / Book Value ratio (P/BV)

• Enterprise Value• Dividend Discount model (Gordon Growth model)• Discounted Cash Flow model

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Valuation methodologies

• Ratio valuations are the mostly widely used valuation tool due to the simplicity of their calculation

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P/E ratio =Current Price

Estimated Annual Earnings

PEG ratio =P/E Ratio

Estimated Annual Earnings Growth

Ratio valuation calculation

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P/BV ratio =Current Price

Estimated Book Value

P/CF ratio =Current Price

Estimated Annual Cash Flows

Ratio valuation calculation

• Historical ratio valuation assumes that the relationship between the company’s share price and earnings (cash flow or book value respectively) should be constant over time

• In other words, each dollar invested should be worth a fixed percentage of earnings e.g.• Company A’s historical P/E is 15• Company A’s current P/E is 20• Investors should sell Company A as the current

market price is high relative to its earnings

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Ratio valuation - Historical

• Relative ratio valuation is used to compare different companies with similar operations. e.g.• Assume Company A and B are identical• Company A’s P/E is 20, Company B’s P/E is 15• Investors should purchase Company B• Reasoning – Company B’s earnings cost comparatively

less than Company A• Note that the P/E ratio is calculated in the same

way as a historical ratio valuation

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Ratio valuation - Relative

• P/E ratios are the most widely used, as the relationship between a company’s earnings performance and stock returns are well documented

• Other ratios were derived in response to limitations of the P/E ratio:• PEG ratio allowed comparison of companies different growth profiles.

Traditional P/E assumes companies have similar growth• P/CF ratio catered for the argument that company’s will use creative

accounting to boost nominal profits. Cash flow is hard to manipulate and P/CF is used for companies with consistent cash flows

• P/BV was created for similar reasons as P/CF. This ratio is used to determine the value of a company if it liquidated immediately. This ratio is more useful for asset heavy companies. Book value is also commonly referred to as Net Tangible Assets (NTA)

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When do we use different ratios?

• RCG Corporation Limited (RCG)• Current share price is $0.50• Expected earnings is 4.5 cents per share• Historical P/E of 17• Average retail sector P/E of 12

• What is RCG’s current P/E?• P/E = $0.50 / $0.045 = 11

• Is RCG cheap compared to its historical P/E?• Is RCG cheap compared to its sector’s P/E?

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Valuation exercise

• RCG Corporation Limited (RCG)• Current P/E is 11• Expected earnings growth is 23%• Oroton Group Limited (ORL) PEG is 4.36

• What is RCG’s PEG?• PEG = 11 / 23 = 0.48

• Is RCG cheap compared to ORL?

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Valuation exercise

• Enterprise Value is an economic measure used to determine the market value of a business

• Enterprise Value is commonly known as the theoretical takeover price. An acquirer would have to take on the company’s debt but will be able to pocket its cash

• It is used as an alternative to Market Capitalisation when valuing a company as a whole

• It is also used as an alternative to Price for ratio valuation. e.g. EV/EBITDA as an alternative to P/E

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Enterprise value

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Enterprise value

Enterprise Value

Market Value of Ordinary Shares+

Market Value of Preference Shares +

Market Value of Debt+

Market Value of Minority Interest-

Market Value of Associate Company-

Cash and Cash Equivalents

=

• The dividend discount model (DDM) values companies based on their return to shareholders in the form of dividends

• A simple example of a dividend discount model is the Gordon Growth model, which values a security based on a constant dividend growth and a constant required rate of return

• This can be expanded to a two-stage model where an initial level of growth is assumed and then another after time

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Dividend discount model

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Valuation =Expected Dividend Amount

Required Rate of Return

-Expected Dividend Growth

• Note that even a simple dividend discount model like the Gordon Growth model requires a number of assumptions and estimates

Gordon Growth model

• RCG Corporation Limited (RCG):• Is expected to pay 3 cents of dividends• This dividend is expected to grow 6% going forward• Our current required rate of return for a company of

RCG’s risk profile is 10%

• How much is RCG worth according to a Gordon Growth model?• RCG’s valuation = $0.03 / ( 0.1 – 0.06 ) = $0.75

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Valuation exercise

• The discounted cash flow (DCF) model is based on a similar premise as the dividend growth model

• This valuation model examines the cash flows a company is expected to generate in future periods

• These individual cash flows are ‘discounted’ back to the current period to determine the intrinsic value of the company

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Discounted cash flow model

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Bringing it all together

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• Check the Financial Health• Use liquidity, leverage and profitability ratios

• Review past performance• Tells you about the efficiency and effectiveness of

management

• Assess the company• Understand the company – its operations, strengths,

weaknesses and risks

• Determine the Valuation• Use price multiples, EV, DDM, and DCF

Things to remember

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Fundamental checklist

Nine Golden Rules Your intellectual framework

1. Financial Health2. Management Assessment3. Outlook / Forecast4. Share Price Value5. Share Price Trend/Sentiment6. Liquidity and size7. Company Activities8. News/Announcements9. Follow the above rules

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Thank you for your attendance

Important informationLincoln Indicators Pty Ltd (Lincoln) makes no representation and gives no warranty as to the accuracy of the information contained in this presentation, and does not accept any responsibility for any errors or inaccuracies in, or omissions from, this presentation (whether negligent or otherwise), and Lincoln shall not be liable for any loss or damage howsoever arising as a result of any person acting or refraining from acting in reliance on any information contained herein. No reader should rely on this presentation, as it does not purport to be comprehensive or to render personal advice. This disclaimer does not purport to exclude any warranties implied by law which may not be lawfully excluded.

Information in this presentation is current as at date of presentation unless otherwise stated. It is provided for educational purposes only and may not reflect current market data or opinion. It should not be relied upon in respect to any current investment decision. Investments can go up and down. Past performance is not a reliable indicator of future performance.

Economic and other information taken into account in forming any opinions are subject to change and therefore opinions expressed as to future matters may no longer be reliable.

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Our advice has been prepared without taking into account your personal circumstances, and you should therefore consider its appropriateness in light of your objectives, financial situation and needs, before acting on it.

Where we refer to the Lincoln Australian Share Fund (the ‘Fund’), information and advice provided should be considered in conjunction with the Product Disclosure Statement (PDS) of the Fund, which is available on request and from our website. You should read and consider the PDS before making any decision about whether to acquire or continue to hold the product. Responsible Entity/ Issuer of the Fund is Equity Trustees Limited ABN 46 004 031 298 AFSL 240975. Lincoln and its Authorised Representatives will be remunerated on the basis of monies invested in the Fund. You should read and consider our Financial Services Guide (FSG) provided to you, which sets out key information about the services we provide. The FSG is also available at www.lincolnindicators.com.au. Testimonials are provided by third parties for information purposes only and are not intended to be financial product advice. They do not represent opinion or advice from Lincoln. The information provided may not be appropriate to your particular circumstances. You should consider obtaining your own independent advice before making any decision.

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Important information

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Fundamental Analysis – The bottom up approach · 2012-01-29 · • Leverage ratios, also...

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