Fundamental Analysis

Dr Mahesh Halale; Professor SIOM Pune

L3: Fundamental Analysis

Main principle - Is to find profitable companies to invest in by comparing revenues, sales, management, and other factors etc. Fundamental analysis is the practice of evaluating a company's stock price by comparing base elements in the company's balance sheets as well as general market factors. Look at internal drivers and external drivers of business. Internal drivers are company specific (e.g. revenue, net income, assets, debts etc.). Analysis of internal factors is objective such as Finding PE multiple, Beta etc External drivers are things that can affect the company's profitability but are not company specific (e.g. the economy, industry averages, etc.). The analysis of external drivers is more subjective, as it is concerned with future industry growth, politics, economy, etc.

Fundamental Analysis
Companies are a part of the industrial and business sector, which in turn is a part of the overall economy. Economic Analysis 1. State of economy 2. Govt. Economic Policies 3. Money Policy and Trends in Money Supply 4. Business Cycle, power, agriculture, infrastructure growth etc 5. Economic and Political Stability

Fundamental Analysis
Industry Analysis - At any stage in the economy,
there are some industries which are growing while others are declining. Particular industry can be studied with a view to assess the problems, prospects, etc. of the company in that industry.
1. Raw Material & Input
2. Product Line - position of the industry in the life cycle of its growth
3. Capacity Installed and Utilized 4. Industry Characteristics Cyclical, Fluctuating, Stable 5. Demand & Market

6. Government Policy wrt that industry

7. Future Prospects 8. Labor & Industrial Problems 9. Management

Fundamental Analysis
Company Analysis Companys Strengths weaknesses. In the case of company analysis
Analyze balance sheet data for: Use of Assets
1.
Efficient use of capital; 2. Leverage enjoyed in the use of capital; 3. Return on net worth; and 4. Return on equity. SIZE of the Company - Expansion and growth of the company 1. Growth of sales, 2. Assets - gross block and net block 3. Installed capacity & capacity utilization

Fundamental Analysis
Company Analysis
The profitability of the company Net profits (PAT) or cash profits in relation to sales, equity or net worth, dividend distributed, etc. Companys share in industry-its capacity utilization vis--vis the utilization in the whole industry. Modernization and expansion plans - reflected in tax planning, retention policy, bonus policy, etc. Earnings per share, cash earnings per share and P/E ratios.

Compare companys with competitors on following heads:

1. 2. 3. 4. 5.

Cost per unit; Profit margins; Earnings per share and P/E ratio; Bonus payments; Dividend distribution policy; etc.

Thanks

Family snap-shot Return on net worth = profit after tax / net worth Return on capital employed = net operating profit less adjusted taxes / total capital employed Return on assets = net profit /total average assets

Total average assets are what the company has had working for it during the course of its business. (Do you notice that total assets is also a reflection of the total capital that has been employed in the business?) It is more prudent to take an average of assets of two years since the balance sheet gives a snapshot of the financials as on a particular date. What we are interested in is getting to know of the assets that have been in use for the entire year. Sherakhan

Company Analysis and Stock Selection

Good companies are not necessarily good investments In the end, we want to compare the intrinsic value of a stock to its market value
Stock of a great company may be overpriced Stock of a lesser company may be a superior investment since it is undervalued

Growth Companies and Growth Stocks

Companies that consistently experience aboveaverage increases in sales and earnings have traditionally been thought of as growth companies
Limitations to this definition

Financial theorists define a growth company as one with management and opportunities that yield rates of return greater than the firms required rate of return

Growth Companies and 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 under-valuation compared to other stocks

Studies indicate that growth companies have generally not been growth stocks

Defensive Companies and Stocks

Defensive companies future earnings are more likely to withstand an economic downturn
Low business risk Not excessive financial risk

Defensive stocks returns are not as susceptible to changes in the market

Stocks with low systematic risk

Cyclical Companies and Stocks

Sales and earnings heavily influenced by aggregate business activity
High business risk Sometimes high financial risk as well

Cyclical stocks experience high returns is up markets, low returns in down markets
Stocks with high betas

Speculative Companies and Stocks

Speculative companies invest in assets involving great risk, but with the possibility of great gain
Very high business risk

Speculative stocks have the potential for great percentage gains and losses
May be firms whose current price-earnings ratios are very high

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 ratios of price to book value

The Search for True Growth Stocks

To find undervalued stocks, we must understand the theory of valuation itself

Company Analysis
Competitive forces necessitate competitive strategies.
1. 2. 3. 4. 5. Competitive Forces: Current rivalry Threat of new entrants Potential substitutes Bargaining power of suppliers Bargaining power of buyers

SWOT analysis is another useful tool

Firm Competitive Strategies

Defensive or offensive Defensive strategy deflects competitive forces in the industry Offensive competitive strategy affects competitive force in the industry to improve the firms relative position Porter suggests two major strategies: lowcost leadership and differentiation

Low-Cost Strategy
Seeks to be the low cost leader in its industry Must still command prices near industry average, so still must differentiate Discounting too much erodes superior rates of return

Differentiation Strategy
Seeks to be identified as unique in its industry in an area that is important to buyers Above average rate of return only comes if the price premium exceeds the extra cost of being unique

Focusing a Strategy
Firms with focused strategies:
Select segments in the industry Tailor the strategy to serve those specific groups Determine which strategy a firm is pursuing and its success Evaluate the firms competitive strategy over time

SWOT Analysis
Examination of a firms:

Strengths
Competitive advantages in the marketplace

Weaknesses
Competitors have exploitable advantages of some kind

Opportunities
External factors that make favor firm growth over time

Threats
External factors that hinder the firms success

Favorable Attributes of Firms

Peter Lynchs list of favorable attributes:
1. 2. 3. 4. 5. Firms product is not faddish Company has competitive advantage over rivals Industry or product has potential for market stability Firm can benefit from cost reductions Firm is buying back its own shares or managers (insiders) are buying

Categorizing Companies
Lynch further recommends the following categorization of firms:
1. 2. 3. 4. 5. 6. Slow growers Stalwart Fast growers Cyclicals Turnarounds Asset plays

Specific Valuation with the P/E Ratio

Earnings per share estimates
Time series use statistical analysis Sales - profit margin approach
EPS = (Sales Forecast x Profit Margin)/ Number of Shares Outstanding

Judgmental approaches to estimating earnings

Last years income plus judgmental evaluations Using the consensus of analysts earnings estimates

Once annual estimates are obtained, do quarterly estimates and interpret announcements accordingly

Site Visits, Interviews, and Fair Disclosure

Fair Disclosure (FD) requires that all disclosure of material information be made public to all interested parties at the same time
Many firms will not allow interviews with individuals, only provide information during large public presentations

Analysts now talk to people other than top managers

Customers, suppliers

Making the Investment Decision

If the estimate of the stocks intrinsic value is greater than or equal to the current market price, buy the stock If your estimate of the stocks future intrinsic value would yield a return greater than your required rate of return (based on current investment price), then buy the stock If the value is less than its current price, or its return would be less than your required rate of return, do not buy the stock

When to Sell
Hold on or move on? If stocks decline right after purchase, is that a further buying opportunity or a signal of a mistaken investment? Continuously monitor key assumptions that led to the purchase of the investment
Know why you bought, and see if conditions have changed

Evaluate when market value approaches estimated intrinsic value

Influences on Analysts
Several factors make it difficult for analysts to outperform the market Efficient Markets
Markets tend to price securities correctly, so opportunities are rare Most opportunities are likely in small, less followed companies

Paralysis of Analysis
Must see the forest (the appropriate recommendation) despite all of the trees (data) that complicate the decision

Influences on Analysts
Investment bankers may push for favorable evaluations of securities when the same firm does (or wants to do) underwriting business with the firm in question
Are analysts independent and unbiased in their recommendations? Ideally, analysts will remain independent and show confidence in their analyses