Investment Analysis Session 3: 10 th November 2009 Duration 1 hour 30 min.
-
Upload
lynne-daniel -
Category
Documents
-
view
212 -
download
0
Transcript of Investment Analysis Session 3: 10 th November 2009 Duration 1 hour 30 min.
Page 2
Topics to be covered
Equity Investment Analysis
Financial Distress
Types of Risk
Valuation Approaches
Page 4
Creative Accounting or Aggressive Accounting
Creative accounting and earnings management are:
Accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules
The term generally refers to, systematic misrepresentation of the true income and assets of corporations or other organizations for the purpose of pleasing investors and inflating stock prices
The main forms of earnings management are as follows: Unsuitable revenue recognition Inappropriate accruals and estimates of liabilities Excessive provisions and generous reserve accounting Intentional minor breaches of financial reporting requirements that
aggregate to a material breach
Page 5
Balance Sheet
• A documented report of your company's assets
and obligations, as well as the residual ownership
claims against your equity at any given point in
time.
Page 6
Balance Sheet
Assets Side:
Fixed assets: (plant, equipments, machinery)
Investment: (in other companies, in market)
Current assets(Stock, Debtors, prepaid expenses)
Intangible assets (Goodwill, patent, trademark)
Fictitious assets: (Preliminary expenses)
Page 7
Balance Sheet
Liabilities side:
Equity and preference shares
Reserves and surplus
Long term debt
Current liabilities (creditors, bills payables, deferred revenues)
Contingent liabilities
Page 8
Major Earnings Indicators
EBITDA: (Earnings Before Interest, Taxes, Depreciation and Amortization)
EBIT: (Earnings before interest and tax)
PAT or net income
where p is plow back ratio
Page 10
What is Financial Distress?
A situation where a firm’s operating cash flows are not
sufficient to satisfy current obligations and the firm is forced
to take corrective action
Financial distress may lead a firm to default on a contract,
and it may involve financial restructuring between the firm,
its creditors, and its equity investors
Page 11
Definition of Terms
Default
– Failure to meet an interest payment, or
– Violation of debt agreement
Financial Distress
– Includes default and bankruptcy, but also
– Threat of default or bankruptcy and its effect on the company
– Defined to capture the costs and benefits of using large amounts of debt finance
Bankruptcy
– Formal procedure for working out default
– Does not automatically follow from default
Page 12
Insolvency
Stock - base insolvency: the value of the firm’s assets is
less than the value of the debt
AssetsAssets
DebtDebt
EquityEquity
Solvent firmSolvent firm
AssetsAssets
Insolvent firmInsolvent firm
DebtDebt
Note the negative equity
Page 13
Insolvency
Flow - base insolvency: It occurs when the firms’ cash flows are
insufficient to cover contractually required payments
Contractual obligations
Insolvency
$
Firm cash flow
Cash flow shortfall
time
Page 14
Factors influencing Financial Distress
Sensitivity of the company's revenues to the general level
of economic activity
Proportion of fixed to variable costs
Liquidity and marketability of the firm's assets
Cash-generative ability of the business
Page 15
Factors influencing Financial Distress
Operating leverage:
A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs
A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged
A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said to have used more operating leverage
Degree of Operating Leverage (DOL) = % Change in EBIT
% Change in sales
Page 16
Factors influencing Financial Distress
Financial leverage:
The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt
Financial leverage involves using fixed costs to finance the firm, and will include higher expenses before interest and taxes (EBIT). The higher the degree of financial leverage, the more volatile EPS will be
Degree of financial leverage = % change In EPS
% change in EBIT
Combined leverage:
A leverage ratio that summarizes the combined effect of the degree of operating leverage (DOL), and the degree of financial leverage has on earnings per share (EPS)
Degree of combined leverage= % change in EPS = DOL*DFL
% change in sales
Page 17
What Happens in Financial Distress?
Financial distress does not usually result in the firm’s death
Firms deal with distress by:
» Selling major assets
» Merging with another firm
» Reducing capital spending and research and development
» Issuing new securities
» Negotiating with banks and other creditors
» Exchanging debt for equity
» Filing for bankruptcy
Page 18
Responses to Financial Distress
Think of the two sides of the balance sheet
Asset Restructuring: (Asset side)
» Selling major assets
» Merging with another firm
» Reducing capital spending and R&D spending
Financial Restructuring: (Liability side)
» Issuing new securities
» Negotiating with banks and other creditors
» Exchanging debt for equity
» Filing for bankruptcy
Page 20
Type of Risks
Capital Risk:
The risk an investor faces that he or she may lose all or part of the principal amount invested
The risk a company faces that it may lose value on its capital. The capital of a company can include equipment, factories and liquid securities
Liquidity Risk:
The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss
Business Risk:
The risk that a company will not have adequate cash flow to meet its operating expenses
Financial Risk:
The risk that arises from use of debt in capital structure
Page 21
Type of Risks
Currency Risk:
A form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.
For example, if you are a U.S. investor and you have stocks in India, the return that you will realize is affected by both the change in the price of the stocks and the change in the value of the Indian rupee against the U.S. dollar. So, if you realize a 15% return in your India stocks but the Indian rupee depreciates 15% against the U.S. dollar, this will amount to no gain at all.
Operational Risk:
An operational risk is a risk arising from execution of a company's business functions. As such, it is a very broad concept including fraud risks, legal risks, physical or environmental risks, etc.
Page 23
Definition of Valuation
In finance, valuation is the process of estimating the potential market value of a financial and real asset or liability
The value found by such method is also called “Fair value” or “intrinsic value”
Fair value, also called fair price is a concept used in finance and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account two factors
Objective factors:
Acquisition/ production/ distribution costs, replacement costs, or costs of close substitutes
Actual utility at a given level of development of social productive capability
Supply vs. demand
Subjective Factors
Risk characteristics
Cost of and return on capital
Individually perceived utility
Page 24
Valuation Approaches
Assets value approach
Liquidation approach
Market comparable approach
Discounted cash flow approach
Page 25
Asset Value or Book Value Approach
Meaning:
In asset value approach, company‘s assets and liabilities and the company are valued on “book value” (as per accounting entries) basis
Used to value:
Stock, bonds, companies
Advantages:
No estimation required
Easy to calculate
Disadvantages:
Based on accounting values not market values
Does not show “Fair value”
Page 26
Liquidation Value Approach
Meaning:
Liquidation value is estimated amount of money that an asset or company could be sold for assuming if it were to go out from business
Used to value:
Companies, assets
Advantages:
It gives a fair idea about the worth of assets OR market value
Disadvantages:
Not useful for going concern
Liquidation value is typically lower than fair market value
Page 27
Discounted Cash Flow Methods
Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value
It is calculated as:
Used to value:
Any asset which has a cash flow (Stock, bond, company, commodity)
Advantages:
Gives better estimation
Disadvantages:Complex to calculateMethod can not be used for an asset which does not have a cash flow
Page 28
Market Comparable Approach
In market comparable approach the fair value of asset is derived by using comparable multiples
For example: P/E multiple, EV/EBITDA, EV/EBIT, EV/NOPAT
Important point is to use the right multiples for valuation
Firm having same business type, capital structure, same sales volume etc.)
Used to value:
Stock, Firm
Advantages:
Ready references are available
Can be used when cash flows are not available
Disadvantages:
Difficult to find right benchmark
Page 29
In Class Exercises
If a company's current year dividend is $ 2 and it is going to increase by 20% for two years and then 10% and then will grow forever by 5%. If cost of equity is 10%, find the price of the stock?
Step 1 : Decide which model to use
Dividend discount model
Step 2: Find out the present value of all dividends
Step 3: Find out the present value of terminal value
Step 4 : Add all of them two find value of stock
Page 30
In Class Exercises
If PVR wants to buy Fun Cinema and PVR has contacted you to value Fun Republic Ahmedabad. Following is the data of Fun Republic:
EBIT = 400
Tax rate = 40%
Depreciation = 100
Working capital requirement = 50
No capital expenditure required
It is estimated that Fun Republic‘s revenue would be 10% for two years and then it would stabilize at 5%
PVR will be buying Fun by taking a loan from ICICI at 10%
What price should PVR quote?
Page 31
Example: Fun republic
Step 1: Find out FCFF for Fun Republic
FCFF = EBIT(1 - tc) + NCC - ∆WK - Capex
Step 2: Find out the discount rate
How PVR is going to finance the purchase?
Step 3: Find out FCFF1, FCFF2, FCFF3 and terminal value
Use growth rates given in the example
Step 4: Find out discounted FCFF
Step 5: Find the price PVR should quote
Page 32
In class Exercises
Suppose Tata wants to float a public issue for financing NANO plant
Following is the financial information:
Profit after tax for 2009 = 1000 crore
No of shares outstanding = 40 crore
Following is are the price to earnings multiples for other listed companies.
What is a fair value of TATA’s stock????
Company name P/E multipleMaruti 15 timesHLL 10 timesInfosys 25 timesRanbaxy 20 times
Page 33
Example TATA
Step 1:Decide the valuation method –
Market comparables
Step 2: Decide the multiple for comparison
Price earning multiple
Step 3: Find out earning per share
Step 4: Find out comparable company
Step 5: Based on that find out the fair value