Stockmarket. Valuation

and Analysis

Alexander Gilles, CFA

Part 1

Valuation and Discount Factors

Concerned about valuation

Board

Management

Marketing Production

OperationsBuyers Suppliers

Finance

Equity Analyst Credit analyst

Strategist Rating agency

Stockholders Lenders

Equity funds, VC funds, raiders

Potential stockholders

Potential lenders

Bond funds, high-yield (junk) bonds

Financial statements

Investment bankers

4

Value of a building Dividends on a building = rent paymentsex. IF Rent: 2million, and required return is

25%, then 2 million / .25 = ………… If required return is 0.15: 2 / 0.15 = ….. If required return is 0.08: 2 / 0.15 = …..Observation: ……………………………………… ex. Rent of 1 bn, required 12%, value of the

building is: ……………………

5

Value of a business Stable business, generates P20m a year Earnings / “r” = Value. PER 20 / .15 = 133m 1/.15 = 6.6x 20 / .20 = 100m 1/.20 = 5.0x 20 / .30 = 66m 1/.30 = 3.3x

PER multiple = 1/ required return Value of 133/earnings of 20 = 6.6x Earnings of 20/Value of 133 = 15%

6

Value of a business Stock PeR multiple= Price /

EarningsEarnings x multiple = value.

Definitions: • Net income x multiple = value• Sales x multiple = value• Cash flow x multiple = value

This business earns 30,000 a year. Other businesses of this same type are valued at a multiple of 15x. This business must be worth P…………

This business earns 4 million a year. Other businesses of this same type are valued at a multiple of 12x. This business must be worth P…………

7

Value of a businessEarnings300,000 a year

Take the same earnings of 300,000at 15x = 4.5m

discounted using 0.066667 =……. at 12x = 3.6m

discounted using 0.08333 =……. at 8x = 2.4m

discounted using 0.125 =…….

Part 2

Company analysis

Understanding a Company

• How elastic is the demand for the company’s products/services?• Is the demand seasonal?• What is the raw material situation?

• What are the key products for the company and what is their contribution?• How is the company competitively placed in that product segment?

• Which geographies are key revenue contributors to the company revenues?• How competitively poised is the company in that geography?• How risk free is the geography?

• Which product contributes maximum to the company’s profits• Which geographies contribute the maximum to the company’s profits

• Does the company have a unique selling proposition (USP)?• How strong/sustainable is the company’s USP?• Does the company enjoy an important position in the market (like largest player etc)?

Business

Product Segments

Geographic Segment

Key Profit Contributors

USP

Raw Material 1

Raw Material 2

Raw Material 3

Manufacturer(Production Processes)

Distributor/Wholesaler

Retailer

Allied Components

Allied Services like Transportation;

security etc

Exclusive Showrooms

Intermediaries in Raw Material Procurement

Value Chain Analysis• Quality of Components• Cost of components• Speed of Delivery• Time for scaling up• Factory location (near RM or

customer) • Production time/rate• Error Rate/Quality• Ability to scale up• Wastages

• Transportation Time• Efficiency of routing and

scheduling

• Cost-Benefit of having exclusive show rooms

• Benefit of additional visibility through showrooms

• Margins/incentives to dealers• Timely distribution (wh salers)• Competition from local products• Retail level promotions

• Cost of Raw Mat • Procurement time• Adequacy of supply• Long term supply

contracts• Cost of Transport

11

Value chain’s impact

Cost of Raw materials

Warehousing

Trucking

Cost of Goods Sales Other

income

Workers salaries

Selling Gen Admin

expenses

Tax savings

Lower Interest

expenses

Making money or saving money, from manufacturing process or from any other process.

Value

12

Interpreting News Items/Developments

• What will be the impact of the news/development on the company’s business?

• Is the news/development a positive or a negative aspect about the company?

• Why will a particular development/news affect the business of the company?

• In case of a threat, can the company escape it?

• How profound will be the impact of a news/development on the company’s business

What?

Why?

How Much?

Part 3

Financial statement analysis

Growth in Prices

Growth in Volumes

REV

ENU

E G

RO

WTH

Volume Growth Because of:• Better marketing/brand promotion by the company• Improved/enhanced distribution by the co.• Expansion into new region/product/variant• Take over of a competitor• Industry wide demand increase• One time increase because of a special order

Is the Price Growth Sustainable• Price increase is industry wide/individual initiative?• How elastic is the demand for the product?• What is the competition scenario (fragmented?)• Does the industry operate on a premium concept?• Is there scope for another price increase?

Decline in Prices

Decline in Volumes

REV

ENU

E D

ECLI

NE

Volume Decline Because of:• Better brand promotion by competitors• Obsolete/outdated technology; quality issues• Problems in supply chain management• Failing relationships with workers/distributors

Reasons for Price Decline:• Competition induced price decline. not always sustainable)• Product un-sellable (forced to reduce price)• Regulatory price fixing (my force out small players)• More efficient production (should reflect positively in volumes)• Favorable tax policy (should reflect positively in volumes)

Analysing Revenue Changes: Growth/Decline in Revenues

Cost of Goods Sold (COGS)

Selling, General & Admin Expenses (Includes

Marketing Expenses)

Salaries & Wages

Interest Income/Expenses

COGS Increase :• Increase in RM prices (is this rise more than revenue increase?)• Increase in production/take over of new company (should reflect positively in revenues)COGS Decline:• COGS decline – More efficient raw material procurement/ use of alternative RM• COGS decline – More cost efficient production process

SG&A Increase: • Intensive Marketing and Promotion Campaign (should reflect in revenues)• Acquisition/expansion activity going on (check whether earlier acquisitions were compatible)• Company caught in litigations/legal activity (this cost is also categorized as Professional Exp)

Increase in Salaries and Wages:• Increase in average wage rate (check whether this is a because company is doing good?)• Additional hiring in marketing/production/legal departments (does it reflect in co performance)• Payment of performance oriented bonus/ bonus for employee retention (is labor mkt stressed)

Interest Expense Increase:• Additional debt taken by the company (check how company expects to use this debt)• Earlier default by company, new interest is penal interest• New liabilities taken over due to new acquisitions (check whether acquisition was profitable,

i.e assets greater than liabilities)• If new acquisition not profitable, did company get a government aid for acquisition

Analysing Cost Changes

Note: Also check reasons for increase in depreciation & amortisation; unusual expenses and use of deferred tax asset/liability

16

Understanding the Balance Sheet

A balance sheet indicates all sources of funds for a company and where it applies those funds

Liabilities reflect the various ways in which a company has raised short term and long term funds

Assets are where such funds are utilised

All sources of funds come at a cost.

All application of funds should come at a profit

A balance sheet analysis involves analysing efficiency of use of funds, measuring solvency (asset-liability matching) and operational efficiency

17

Analysing a Balance Sheet Analysis of solvency of the company

Current Ratio Quick Ratio Gearing Ratio (Long term Liabilities/Net Worth) Working Capital should be positive (current assets - current

liabilities) Long term assets should be backed by long term liabilities only

• Analysis of Operational Efficiency Inventory Days of Handling A/c Receivables Days of Handling A/c Payables Days of Handling Working Capital Turnover (Sales/Working capital *100)

Analysis of Efficiency in use of capital/assets Return on Equity Return on Capital Employed Return on Assets

Compare Ratios with Peers to get Industry view

18

Ratios: what they mean for business

Solvency Ratios

Ratio for measuring operational efficiency

Ratio’s for measuring efficient use of capital/assets

• An adverse short term solvency ratio (current ratio/quick ratio) indicates a short term liquidity crunch

• A high gearing ratio means that much more interest expenses• A high gearing ratio may also make it difficult for the company to raise new debt• Long term assets backed by short term liabilities (current liabilities) is a potential liquidity

problem

• High inventory days of handling (especially as compared to peers) may indicate problems with inventory management.

• This ratio say that either demand is low for products or company is producing more than needed. Both will affect profits

• High A/c receivables days of handling means receivables are not quickly converted to cash. Hence operating cash flow will not grow in sync with profits

• Low a/c payable days of handling means credit period from suppliers is very low. This will reflect into greater requirement of working capital, hence more short term loans

• Adverse ratio (in comparison to competitors) means company is not utilizing its capital/assets as well as its competitors

• Adverse ratio could reflect problems with low revenues or high costs. High costs may also reflect in to problems with pricing of products

Also Check:

• Maintenance CAPEX: Is maintenance CAPEX as a percentage of revenues going up. Check why and is that rational

• Expansion CAPEX: Expansion capex drains out cash reserves. Check whether expenditure will help company

• Additional Debt: Additional Debt means more interest costs. Check how company expects to use new debt.

• Debt substitution: debt substitution means taking low cost debt to pay off high cost debt. This is a positive sign