Fundamental Analysis PART II

8/8/2019 Fundamental Analysis PART II

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FUNDAMENTAL ANALYSIS

( Establishing the value benchmark )

Prof. Seema Chakrabarti


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Suggested Steps for CompanySuggested Steps for Company

AnalysisAnalysis Strategy AnalysisStrategy Analysis

Accounting AnalysisAccounting Analysis

Financial AnalysisFinancial Analysis

SWOT AnalysisSWOT Analysis

Going beyond the numbersGoing beyond the numbers

Estimation of intrinsic valueEstimation of intrinsic value

Relative ValuationRelative Valuation


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Strategy AnalysisStrategy Analysis

Competitive StrategyCompetitive Strategy

Corporate StrategyCorporate Strategy


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Accounting AnalysisAccounting Analysis

Quality check for Financial Statements can beQuality check for Financial Statements can beconducted through checking for:conducted through checking for:

Adequate disclosure of informationAdequate disclosure of information

Noise & Bias in accountingNoise & Bias in accounting

Forecasting errors in accountingForecasting errors in accounting


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Financial AnalysisFinancial Analysis

Investment analysts usually analyze historicaldata for making an estimate of:

Earnings (and dividends)

Growth

Risk

Valuation


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FINANCIALS OF HORIZON LTD20X1 20X2 20X3 20X4 20X5 20X6 20X7

y N et Sales 475 542 605 623 701 771 840

y C ost of goods sold 352 380 444 475 552 580 638

y

Gross profit 123 162 161 148 149 191 202y O perating expenses 35 41 44 49 60 60 74

y O perating profit 88 121 117 99 89 131 128

y N on-operating surplus/deficit 4 7 9 6 - -7 2

y Profit before interest and tax

(PBIT)

92 128 126 105 89 124 130

y Interest 20 21 25 22 21 24 25

y Profit before tax 72 107 101 83 68 100 105

y T ax 30 44 42 41 34 40 35

y Profit after tax 42 63 59 42 34 60 70

y D ividend 20 23 23 27 28 30 30

y R etained earnings 22 40 36 15 6 30 40

y Equity share capital 100 100 150 150 150 150 150

y R eserves and surplus 65 105 91 106 112 142 182

y Shareholders funds 165 205 241 256 262 292 332

y L oan funds 150 161 157 156 212 228 221y C apital employed 315 366 398 412 474 520 553

y N et fixed assets 252 283 304 322 330 390 408

y Investments 18 17 16 15 15 20 25

y N et current assets 45 66 78 75 129 110 120

y T otal assets 315 366 398 412 474 520 553

y Earnings per share 2.27 4.00 4.67

y Market price per share

(End of the year)

21.00 26.50 29.10 31.5


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EARNIN S AND DIVIDEND LEVEL

T ,

:

R

EPS

D

D


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BookV Per S re BVPS

Paid-upequity apital + Reservesandsurplus

Numberofequityshares

20 20 20

BVPS 262/15=17.47 292/15=19.47 332/15=22.13

EarningsPer Share EPS

Equityearnings

Numberofequityshares

20 5 20 6 20 7

EPS 34/15=2.27 60/15=4.00 70/15=4.67


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DividendPayout Ratio

Equitydividends

Equityearnings

20 5 20 6 20 7

DividendPayoutratio

DividendPer Share DPS

20 5 20 6 20 7

DPS Rs1.87 2.00 2.00

28/34=0.82 30/60=0.50 30/70=0.43


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GRO TH PERFORMANCE

To measure the historical growth, the compound annual

growth rate (CAGR) in variables like sales, net profit,

earnings per share and dividend per share is calculated.

To get a handle over the kind ofgrowth that can be

maintained, thesustainable growth rate is calculated.


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COMPOUND ANNUAL GRO TH RATE CAGR

The compound annual growth rate (CAGR of sales,

earnings per share, and dividend per share for a period offive years 20x2 20x7 for Horizon Limited is calculated

below:

Salesof20x7 1/5 840 1/5

CAGRofSales : 1= 1= 9.2%Salesfor20x2 542

CAGRofearnings EPS for20x7 1/5 7.00 1/5

pershare(EPS : EPS for20x2 6.30

CAGRofdividend : DPS for20x7 1/5 3.00 1/5

pershare(DPS DPS for20x2 2.30

1 = 1= 2.1%

1 = 1= 5.5%


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SUSTAINABLEGRO TH RATE

Thesustainablegrowthrateisdefinedas :

Sustainablegrowthrate=Retentionratio xReturnonequity

Based on the average retention ratio and the average

return on equity of the three year period (20x5 20x7) the

sustainable growth rate ofHorizon Limited is:

Sustainablegrowthrate=0.417x18.2%=7.58%


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RIS EXPOSURE

Beta

Betarepresentsvolatilityrelativetothemarket

VolatilityofReturnonequity

RangeofreturnonEquityovern years

Averagereturnonequityovern years


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VALUATION MULTIPLES

The most commonly used valuation multiples are :

Price to Earnings (PE) ratio

Price to Book Value (PBV) ratio

Price to Cash Flow Ratio

Price to sales Ratio


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VALUATION MULTIPLES

PE Ratio(Prospective)

PricepershareatthebeginningofyearnEarningspershareforyearn

20x5 20x6 20x7

PEratio 9.25 6.63 6.23

PBV Ratio(Retrospective)

Pricepershareattheendofyearn

Bookvaluepershareattheendofyearn

20x5 20x6 20x7

PBV ratio 1.52 1.49 1.42


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FAVOURABLE & UNFAVOURABLE

FACTORS

FAVOURABLE UNFAVOURABLE

FACTORS FACTORS

EARNINGS LEVEL HIGH BOO VALUEPER LO BOO VALUE

SHARE PER SHARE

GRO TH LEVEL HIGH RETURN ON LO R ETURN ON

EQUITY EQUITY

HIGH CAGR IN SALES LO CAGR IN SALES

AND EPS AND EPS

HIGH SUSTAINABLE LO SUSTAINABLE

GRO TH RATE GRO TH RATE

RIS EXPOSURE LO VOLATILITY OF HIGH VOLATILITY OF

RETURN ON EQUITY R ETURN ON EQUITY

LO BETA HIGH BETA


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SWOT AnalysisSWOT Analysis

Examination of a firms:Examination of a firms:

SStrengthstrengthsWWeaknesseseaknesses

OOpportunitiespportunities

TThreatshreats


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GOINGBEYOND THE NUMBERS

SIZING UP THE PRESENTSITUATIONAND PROSPECTS

Availabilityand CostofInputs OrderPosition

Regulatory Framework

TechnologicalandProduction Capabilities

Marketingand Distribution Financeand Accounting

Human ResourcesandPersonnel

EVALUATIONOFMANAGEMENT

Strategy Calibre, Integrity, Dynamism

Organisational Structure

Execution Capability

Investor- friendliness


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Estimating Intrinsic ValueEstimating Intrinsic Value

A) Present value of cash flows (PVCF)A) Present value of cash flows (PVCF)

Present value of dividends (DDM)Present value of dividends (DDM)

Present value of Free cash flow to equityPresent value of Free cash flow to equityholders (FCFE)holders (FCFE)

Present value of free cash flow to firm (FCFF)Present value of free cash flow to firm (FCFF)

B) Earnings Multiplier ApproachB) Earnings Multiplier Approach

C) Measures of Value AddedC) Measures of Value Added


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CalculatingCalculating

Free Cash Flow to EquityFree Cash Flow to Equity

FCFE =FCFE =

Net Income (EAT)Net Income (EAT)

+ Depreciation Expense+ Depreciation Expense

-- Capital ExpendituresCapital Expenditures

-- (( in Working Capitalin Working Capital

-- Principal Debt RepaymentsPrincipal Debt Repayments+ New Debt Issues+ New Debt Issues


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CalculatingCalculating


When the firm maintains a fixed debt equity ratio:When the firm maintains a fixed debt equity ratio:

FCFE = Net IncomeFCFE = Net Income

(1(1--d) * (Capital Expendituresd) * (Capital Expenditures -- Depreciation)Depreciation)

-- (1(1--d) * (d) * ((( in Working Capital )in Working Capital )


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Present Value ofPresent Value of


where,where,

FCFEFCFE11 = the expected free cash flow in period 1= the expected free cash flow in period 1i.e FCFE (1+g)i.e FCFE (1+g)

k = the required rate of return on equity for the firmk = the required rate of return on equity for the firm

ggFCFEFCFE = the expected= the expected constantconstant growth rate of free cashgrowth rate of free cashflow to equity for the firmflow to equity for the firm

FCFEgk

FCFEValue

!

1


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Present Value ofPresent Value of


Two Stage Model:Two Stage Model:

=PV of FCFE discounted@reqd rate of retn. + PV of=PV of FCFE discounted@reqd rate of retn. + PV ofterminal Valueterminal ValueWhere,Where,PV of terminal ValuePV of terminal Value= 1/(1+r)= 1/(1+r)nn*FCFE in n+1 year / r*FCFE in n+1 year / r -- gg

LL

(in long run)(in long run)Also,Also,FCFE in n+1 year = FCFE in nth year * (1 + gFCFE in n+1 year = FCFE in nth year * (1 + gLL i.e growth ratei.e growth rate

in long run)in long run)N = Number of years of supernormal growthN = Number of years of supernormal growth


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Operating Free Cash Flow to the FirmOperating Free Cash Flow to the Firm

Discount the firms operating free cash flow toDiscount the firms operating free cash flow tothe firm (FCFF) at the firms weighted averagethe firm (FCFF) at the firms weighted averagecost of capital (WACC) rather than its cost ofcost of capital (WACC) rather than its cost ofequityequity

FCFF = EBIT (1FCFF = EBIT (1--Tax Rate)Tax Rate)+ Depreciation Expense+ Depreciation Expense-- Capital SpendingCapital Spending-- (( in Working Capitalin Working Capital-- (( in other assetsin other assets


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Present Value ofPresent Value ofOperating Free Cash FlowOperating Free Cash Flow

where,where,FCFFFCFF11 = the free cash flow in period 1= the free cash flow in period 1

WACC = the firms weighted average cost of capitalWACC = the firms weighted average cost of capital

ggFCFFFCFF = the firms constant growth rate of free cash flow= the firms constant growth rate of free cash flow

FCFFgWACC

FCFFValueFirm

!1


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DIVIDEND DISCOUNT MODEL

SINGLEPERIOD VALUATION MODEL

D1 P1P0 = +

(1+r) (1+r)

MULTI - PERIOD VALUATION MODEL ( Infinite Duration)

g Dt

P0 = 7t=1 (1+r)t

ZERO GRO TH MODELD

P0 =

r

CONSTANT GRO TH MODEL

D1

P0 =

r-g


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T O - STAGEGRO TH MODEL

1- 1+g1 n1+r Pn

P0 = D1 +

r-g1 (1+r)n

WHERE

Pn D1 (1+g1)n-1 (1+g2) 1

=

(1+r)n r-g2 (1+r)n


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TWO - STAGEGROWTH MODEL : EXAMPLE

E X A M P L E T H E R RE NT D D E ND O N A N E IT S H A R E O

E R T IG O L IM IT E D IS R S E R T IG O IS E X P E CT E D T O E NJO A N

A O E -NO RM A L G R O W T H R A T E O P E RCE NT O R A P E RIO D O

E A RS T H E RE A T E R T H E G R O W T H R A T E W IL L A L L A ND S T A IL IS E A T P E RCE NT E IT IN E S T O R S R E IRE A RE T RN O

P E RCE NT W H A T IS T H E INT RINS IC A L E O T H E E IT S H A R E O

E R T IG O ?

T H E INP T S RE IRE D O R A P P L ING T H E T W O -ST A G E M O D E L A RE :

g1 = 20 PERCENT

g2 = 10 PERCENT

n = 6 YEARS

r = 15 YEARS

D1 = D0 (1+g1) = RS.2(1.20) = 2.40

PLU IN THESE INPUTS IN THE TWO STA E MO EL, WE ET THE

INTRINSIC VALUE ESTIMATE AS FOLLOWS :

1.206

1 -

1.15 2.40 (1.20)5

(1.10) 1

P0 = 2.40 +

.15 - .20 .15 - .10 (1.15)6

1 - 1.291 2.40 (2.488)(1.10)

= 2.40 + [0.497]

-0.05 .05

= 13.968 + 65.289

= RS.79.597


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H MODEL

ga

gn

H 2H

D0

PO = [(1+gn) +H(ga +gn)]

r-gn

D0 (1+gn) D0H(ga +gn)

= +

r-gn r-gn

VALUEBASED PREMIUM DUE TO

ON NORMAL ABNORMAL GROWH

GROWTH RATE RATE


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ILLUSTRATION: H LTD

D0 =1 ga =25% H=5gn =15% r=18%

1(1.15) 1x5(.25- .15)

P0 = +0.18- 0.15 0.18- 0.15

= 38.33 + 16.67 = 55.00

IF E = 2 P/E = 27.5


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IMPACT OF GROWTH ON PRICE, RETURNS,

AND P/E RATIO

PRICE DIVIDEND CAPITAL PRICE

D1 YIELD GAINS EARNINGS

PO = YIELD RATIO

r-g (D1/PO) (P1-PO)/PO (P/E)

RS.2.00LOWGROWTH FIRM PO = = RS.13.33 15.0% 5.0% 4.44

0.20- 0.05

RS.2.00

NORMALGROWTH PO = = RS.20.00 10.0% 10.0% 6.67

FIRM 0.20- 0.10

RS.2.00

SUPERNORMAL PO = = RS.40.00 5.0% 15.0% 13.33

GROWTH FIRM 0.20- 0.15


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EARNINGS MULTIPLIER

APPROACH

P0 = m E1

DETERMINANTS OF m i.e.(P/E)

D1

P0 =r-g

E1(1- b)

=

r- ROExb

(1- b)

P0/E1 =

r- ROExb


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FINANCIAL ANALYSIS

The key questions to be addressed in applying

theEARNINGSMULTIPLIER APPROACH, the most

popular method in practice, are:

What is the expected EPS for the

forthcoming year?

What is a reasonable PE ratio?


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ESTIMATION OF

INTRINSIC VALUE

EstimatetheexpectedEPS

EstablishaP/Eratio

Developavalueanchorandavalue

range


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EPS FORECAST

20x7 20x8 ASSUMPTION

(ACTUAL) (PROJECTED)

NET SALES 840 924 INCREASEBY 10PERCENT COST OF GOODS

SOLD 638 708 INCREASEBY 11PERCENT

GROSS PROFIT 202 216

OPERATINGEXPNS 74 81 INCREASEBY 9.5PERCENT

DEPRECIATION 30 34

SELLIN & GEN.

ADMN.EXPNS 44 47

OPERATINGPROFIT 128 135

NON-OPERATING

SURPLUS/DEFICIT 2 2 NO CHANGE

PROFIT BEFORE

INT. & TAX(PBIT) 130 137

INTEREST 25 24 DECREASEBY 4PERCENT

PROFIT BEFORE

TAX 105 113

TAX 35 38 INCREASEBY 8.57PERCENT

PROFIT AFTER

TAX 70 75

NUMBER OF EQUIITY

SHARES 15MLN 15

EARNINGS PER SHARE RS 4.67 RS 5.00


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Methods of calculating P/E RatioMethods of calculating P/E Ratio

Dividend Growth ModelDividend Growth Model

Cross sectional AnalysisCross sectional Analysis

Historical AnalysisHistorical Analysis

Weighted P/E RatioWeighted P/E Ratio


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CONSTANT GROWTH DIVIDEND MODEL

DIVIDEND PAYOUT RATIO(i.eD1/E1)

P/E RATIO =REQUIRED EXPECTED

RETURN ON _ GROWTH RATEEQUITY IN DIVIDENDS

CROSS SECTION ANALYSIS

P/E = a1 + a2 (GROWTH RATE IN + a3 (DIVIDEND

EARNINGS) PAYOUT RATIO)

+ a4 (VARIABILITY IN EARNINGS) + a5 (COMPANY SIZE)


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HISTORICAL ANALYSIS

20x5 20x6 20x7PEratio 9.25 6.63 6.23

TheaveragePEratiois :

9.25 + 6.63 + 6.23

3

WEIGHTED PE RATIO

PEratiobasedontheconstant

growthdividenddiscountmodel

PEratiobasedonhistoricalanalysis : 7.37

6.36 + 7.37

2

=7.37

=6.87

: 6.36


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VALUE ANCHOR AND VALUE RANGE

Value Anchor

ProjectedEPS x AppropriatePEratio

5.00x6.87= Rs.34.35

Value Range

Rs.30 Rs.38

MarketPrice Decision

< Rs.30 Buy

Rs.30Rs.38 Hold

> Rs.38 Sell


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Relative valuationtechniques:Relative valuationtechniques:

1. Price earnings ratio (P/E)1. Price earnings ratio (P/E)

2. Price cash flow ratios (P/CF)2. Price cash flow ratios (P/CF)

3. Price book value ratios (P/BV)3. Price book value ratios (P/BV)

4. Price sales ratio (P/S)4. Price sales ratio (P/S)


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Overvalued HighROE

HIGH LowROE HighPBV

HighPBV

LowROE Undervalued

LOW LowPBV HighROE

LowPBV

LOW HIGH

ROE

PBV Ratio

PBV-ROEMatrix


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GROWTH-DURATION MATRIX

UndervaluedPromisesof

growth

Dividend

cowsOvervalued

High

Low

HighLow

Expected5-YrEPS Growth

Duration(1/Dividend Yield)


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EXPECTATIONS RIS INDEX(ERI)

Developed by Al Rappaport, the ERI reflects the risk in

realising the expectations embedded in the current market

price

Proportionofstock Ratioofexpectedfuture

pricedependingon growthtorecentgrowth

expectedfuturegrowth (Accelerationratio)

ERI = X


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ERI ILLUSTRATION

Omegaspricepershare = Rs.150

Omegasoperatingcashflow

(beforegrowthinvestment)

Omegascostofequity =15percent

Growthrateinafter-tax cashoperating

earningsoverthepastthreeyears

Marketexpectationofthegrowthinafter-tax

cashoperatingearningsoverthenextthree

years

= Rs.10 pershare

=20percent

=50percent


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ERI ILLUSTRATION

Omegasbaselinevalue= = Rs.66.7

Proportionofthestockpricecoming

frominvestorsexpectationsoffuture = =0.56

growthopportunities

Accelerationratio= =1.25

ERI =0.56x1.25=0.70

In general, the lower (higher) the ERI, the greater (smaller) the

chance of achieving expectations and the higher (lower) the

expected return for investors.

150 66.7

150

Rs.10

0.15

1.50

1.20


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OBSTACLES IN THE

WAY OF AN ANALYST

Inadequaciesorincorrectnessofdata

Futureuncertainties

Irrationalmarketbehaviour

SUMMING UP


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SUMMINGUP

In practice, the earnings multiplier method is the most popular

method. The key questions to be addressed in this method are:what is the expected EPS for the forthcoming year? What is a

reasonable PE ratio given the growth prospects, riskexposure,

and other characteristics? Historical financial analysis serves as a

foundation for answering these questions.

The ROE, perhaps the most important metric of financial

performance, is decomposed in two ways for analytical purposes.

ROE = Net profit margin x Asset turnover x Leverage

ROE=PBIT efficiencyx Assetturnoverx Interestburden

x Taxburdenx Leverage

To measure the historical growth, the CAGRin variables like

sales, net profit, EPS and DPS is calculated.

T t h dl th ki d f th th t b i t i d


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To get a handle over the kind ofgrowth that can be maintained,

the sustainable growth rate is calculated.

Beta and volatility ofROE may be used as riskmeasures.

An estimate ofEPS is an educated guess about the future

profitability ofthe company.

The PE ratio may be derived from the constant growth dividendmodel, or cross-section analysis, or historical analysis.

The value anchor is :

Projected EPS x Appropriate PE ratio

PBV-ROE matrix, growth-duration matrix, and expectation risk

index are some ofthe tools to judge undervaluation or

overvaluation.


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And now..And now..


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And now..And now..

ITSTIME FOR ASSIGNMENT !!!


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Fundamental Analysis PART II

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