Welcome to professional development workshop

Fundamentals of Stock Market

Jointly organized by LankaBangla Securities Ltd (LBSL) and Bdjobs Training

Fundamental Analysis

Conductor: Md. Ashaduzaman Riadh

Efficient Capital market

An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and, therefore , the current prices of securities reflect all information about the security. Assumptions are: I) A large number of profit-maximizing participants analyze and value the securities II) New information regarding securities comes to the market in a random fashion and the timing of one information is generally independent of others.

Efficient Capital market

III) Profit maximizing investors adjust security prices rapidly to reflect the effect of new information. III) In an efficient market ,the expected returns implicit in the current price of the security should reflect its risk.

Form of hypothesis
Weak-form EMH- assumes that current stock prices fully reflect all security market information. Semi strong -form EMH- asserts that security prices adjust rapidly to the release of all public information apart from public information. Strong-Form EMH- contends that stock prices fully reflect all information from public and private sources. That means that no group of investor has monopolistic information relevant to the formation of prices.

In what Form we belong?

studies: I ) Stock split II ) The size effect III) Neglected Firm effect IV) Book Value-Market Value Ratio V) P/E ratio VI) Announcement of Accounting changes

Efficient Market and Fundamental Analysis

Fundamental analysis believe that , at any point of time , there is a basic intrinsic value for the individual securities and these value depends on the underlying economic factors. Therefore the investor should determine the intrinsic value of an investment asset at a point in time by examining the variables that determine the value such as : I) Economic Factors II) Industry Factors III) Sales and Cost structure IV) Current and Future earnings , Cash Flow and Risk factors.

Efficient Market and Fundamental Analysis

If the prevailing market price differs from the estimated intrinsic value by enough to cover the transactions cost , you should take appropriate action:  Buy if the market price is substantially below intrinsic value  Sell or dont buy- if market price is above the intrinsic Value. Fundamental analyst believe that, occasionally , market price and intrinsic value differ but eventually investors recognize the discrepancy and correct it. An investor who can do a superior job of estimating intrinsic value can consistently make superior market timing ( asset allocation ) decisions or acquire undervalued securities and generate above-average returns.

Fundamental Analysis
Fundamental Analysis involves: I) II) III) IV) aggregate market analysis , industry analysis , company analysis , and portfolio management.

Intrinsic value and equity valuation

A critical assumption in equity valuation, as applied to publicly traded securities , is that the market price of a security can differ from its intrinsic value. The intrinsic value of any asset is the value of the asset given its hypothetically complete understanding of the assets investment characteristics. If one assumed that the market price of an equity security perfectly reflected its intrinsic value , Valuation would simply require looking at the market price.

Valuation Process
1. Understanding the Business- industry and competitive analysis, together with an analysis of financial statements and other company disclosures, provides a basis for forecasting company performance. 2. Forecasting company performance- forecasts of sales, earnings, dividends , and financial position (pro forma analysis) provide the inputs for most valuation models. 3. Selecting the appropriate valuation model: Depending on the characteristics of the company and the context of valuation , some valuation models will be more appropriate than others.

Valuation Process
4. Converting forecasts to a valuation- Beyond mechanically obtaining the output of valuation models, estimating value involves judgment. 5. Applying the valuation conclusion

1) Understanding the Business:

Industry and competitive analysis, together with an analysis of the companys financial reports, provides a basis for forecasting performance.

1.1 Economic Analysis

Economic Indicators Primary economic variables that are used to determine the position on the business cycle. Leading Indicators - may indicate where the economy will be in the next 3 to 6 months. Money Supply Interest Rate Spread Lagging Indicators - Economic indicators that usually change direction after business conditions have changed. Average duration of unemployment (in weeks) Change in labor cost per unit of output in manufacturing Average Prime Rate charged by Banks Commercial and Industrial Loans Outstanding Changes in Consumer Price Index for services

1.2) Industry Analysis: Business cycle

Recovery : The Economy picks up from its slowdown or recession. Good investments to have are the countrys cyclical stocks and commodities and riskier assets. Early uprising: confidence is up. Good investments to have are the countrys stocks and also commercial and residential property Late upswing: Boom mentality has taken hold . This is not usually a good time to buy the countrys stocks. The countrys commodity and property prices will also be peaking . This is time to purchase the countrys bonds and interest sensitive stocks.

Industry Analysis- Life cycle

When an industry is young, it is in the Introduction or Development Stage, sales or profits are not strong but developing. We all want investment that are in the Growth & Expansion phase the steep portion of the graph.
Growth Introduction Maturity Decline

Industry Life Cycle

Industry Analysis- Life cycle

As an industry matures, it's profits (sales) level off. At this point, the mature firm is making money and not expanding like the growth phase. Investors (owners) expect the firm to begin paying dividends. The act of a firm paying dividends is a signal to investors that they are (1) not able to reinvest the money into the firm profitably; (2) they are beyond growth phase
Growth Introduction Maturity Decline

Industry Life Cycle

Industry Analysis: External Factors Affecting Sales and Profitability

 Technology  Government  Social Changes  Demographics  Foreign influence

1.3) Competitive forces that shape the industry profitability

Threat of Entry: depends on I) Barrier to entry which again depends on:  Supply side economies of scale  Demand side economies of scale  Customer switching cost  Capital requirements  Incumbency advantages independent of size  Unequal access to distribution channels  Restrictive government policy

Threat of Entry: depends on II) Expected retaliation: which again depends on  How incumbents have previously responded vigorously to new entrants  Incumbents possess substantial resources to fight back  Excess capacity  Industry growth is slow so newcomers can gain volume only by taking it from incumbents.

1.3) Competitive forces that shape the industry profitability

The Power of Supplier: the company depend on a wide range of different supplier groups for inputs .a supplier group is powerful if:  It is more concentrated than the industry it sells to  The supplier group does not depend heavily on the industry for its revenue.  Industry participants face switching costs in changing suppliers.  Suppliers offer products that are differentiated.  There is no substitute for what the supplier group provides.  The supplier group can credibly threaten to integrate forward into the industry.

1.3) Competitive forces that shape the industry profitability

The power of Buyers- As with the suppliers, there may be distinct groups of customers who differ in bargaining power. Customer is powerful if There are few buyer or purchases in large volume  The industry products are standardized or undifferentiated  Buyers face few switching costs in changing vendors  Buyer can credibly threaten to integrate backward and produce the industrys product themselves if vendors are too profitable.

1.3) Competitive forces that shape the industry profitability

A Buyer group is price sensitive if:
 The product it purchases from the industry represents a significant fraction of its cost structure or procurement budget  Buyer under pressure to trim its purchase cost  The quality of buyers products or services is little affected by the industrys product.  The industry product has little effect on the buyers other cost.

1.3) Competitive forces that shape the industry profitability

The threat of a substitute is high if
 If offers an attractive price-performance trade-off to the industrys product  The buyers cost of switching to the substitute is low

1.3) Competitive forces that shape the industry profitability

Rivalry among Existing Competitors: The intensity of rivalry is greatest if:  Competitors are numerous or are roughly equal in size and power .  Industry growth is slow  Exit barriers are high  Rivals are highly committed to the business and have aspirations for leadership  Products and services of rivals are nearly identical and there are few switching costs for buyers.  Overcapacity  Products are perishable

It is especially important to avoid the common mistake : 1. Industry Growth Rate(fast growing industry is not always attractive) 2. Technology and innovation 3. Government 4. Complementary products and services

1.4) Financial Statement Analysis Understanding the Income Statement

XYZ company Income Statement For the year ended ..monthyear

Year 1
Revenue Cost of Goods Sold Gross Profit Selling& Admin Exp. Income from Operation

Year 2

Interest Expense Income before taxes Tax Expense Income after taxes Earning Per Share

Understanding the Balance Sheet

XYZ company Balance Sheet For the year ended ..monthyear

Year 1
Non Current Assets Current Asset Total Asset Non Current Liabilities Current Liabilities Total Liabilities Equity Total Liability and shareholders equity

Year 2

Understanding Cash Flow

XYZ company Statement of Cash Flow (Indirect Method) For the year ended ..monthyear

Year 1
Cash flow from operating activities Net Income Dep. Exp Gain on sale of equipment Net Cash provided by operating activities Cash flow from investing activities Cash received from sale of equipment Cash paid for purchase of equipment Net Cash used for investing activities Cash Flow from financing activities Net Cash Increase / decrase

Year 2

Common ratios used in financial analysis

Activity Ratio: Measures how efficiently company performs day to day task. Inventory turnover ratio.
Days on sales outstanding Number of days of payable Total Asset turnover.

Liquidity ratio: Measures company's ability to meet its short term obligation
Current Ratio. Quick Ratio. Cash Ratio.

Common ratios used in financial analysis

Profitability Ratio: measures companys ability to generate profitable sales from its resources.
Gross profit Margin Net Profit Margin. Return on Asset . Return on Equity.

Solvency Ratio: measures company's ability to meet long term obligation.

Debt to asset ratio Financial Leverage ratio. Interest coverage ratio.

Du Pont Analysis decomposition of ROE

ROE= Net profit Margin* Asset turnover * leverage.
Year 2005 2004 2003 2002 ROE 5.92 1.66 1.62 -0.62 Net profit Margin 3.33 1.11 1.13 -0.47 Asset turnover 1.11 0.95 0.93 0.84 leverage. 1.60 1.58 1.54 1.60

Selected Quality of Earnings Indicators

Category Revenues and gain Observation Recognizing revenue early, for example bill and hold sales Classification of nonoperating income or gains as part of operations. Recognizing too much or too little reserve in the current year. Exp: restructuring reserve Deferral of expenses by capitalizing expenditures as an assets. For example: long depreciable lives Potential Interpretation Acceleration in the recognition of revenue boosts reported income masking a decline in operating performance

Expense and losses

May boost or decrease current income at the expense of future income

Selected Quality of Earnings Indicators

Category Balance Sheet Issues observation Use of off-balance sheet financing such leasing asset or securitizing receivables. Characterization of an increase in a bank overdraft as OCF Potential interpretation Asset or liability may not be properly reflected on the balance sheet. Operating cash flow may be artificially inflated.

Operating cash flow

2) Forecasting Company Performance

 top-down forecasting approach  Bottom-up forecasting approach

3) Selecting the appropriate Valuation model

3.1) Absolute valuation model: is a model that specifies an assets intrinsic value . Such models are used to produce an estimate of value that can be compared with the assets market price. Different types of absolute valuation model are Dividend Discount Model (DDM), Free Cash Flow to Firm Model , Free Cash Flow to Equity Model, Residual income models 3.2) Relative Valuation Models : estimate an assets value relative to that of another asset. Relative valuation is typically implemented by using Price multiples ( P/E, P/BV , P/cash flow) or enterprise multiple (EV/EBITDA)

Absolute valuation model (DDM)

Dividend Discount Model
DDM is the simplest and oldest present value approach to valuing stock. The dividend discount model defines cash flows as dividends. Generally , the definition of returns as dividends , and the DDM , is most suitable when:  When company is dividend paying  The board of directors has established a dividend policy that bears an understandable and consistent relationship to the companys profitability , and  The investor takes a non control perspective

Dividend Discount Model

DDM can be one of the following kinds  The Gordon Growth model  Multistage DDM  The H-Model

The Gordon Growth model

The Gordon Growth Model assumes that dividends grow indefinitely at a constant rate. This model is most appropriate for companies with earnings expected to grow at a rate comparable to or lower than the economys nominal growth rate (GDP). g= sustainable growth rate ( ROE b) b= retention ratio ( 1- dividend payout ratio) dividend payout ratio= (dividend/ net profit) r = required rate of return

How to find required rate of return (r)

r can be calculated by using  CAPM  multifactor model (FFM) r= risk free rate + Beta * equity risk premium Equity Risk Premium requires
 The equity index to represent equity market return  The time period for computing the estimate  The type of mean calculated  The proxy for risk free rate

 Multifactor model r= risk free rate+ beta*market risk premium + beta * SMB + Beta * HML

Multi stage DDM models

 Growth phase typically enjoy rapidly expanding market , abnormally high growth rate in EPS  Transition phase- transition to maturity , earning growth gets slow and about to converge economic growth rate.  Mature phase- ROE approaches to Cost of Capital and sales and earning growth stabilizes.

Free Cash Flow Valuation

Free cash flow is used under following conditions The company does not pay dividends  The company pays dividends but the dividends paid differ significantly from the companys capacity to pay dividends.  Free cash flows align with profitability within a reasonable forecast period with which the analyst is comfortable.  The investor takes a control perspective. With control comes discretion over the uses of free cash flow.

Defining the Free Cash Flow

Free cash Flow to Firm- is the cash flow available to the companys suppliers of capital ( both equity and debt holders) after all operating expenses has been paid and necessary investment in working capital and fixed capital have been made. Free cash flow to equity is the cash flow available to the companys holders of common equity after all operating expenses , interest , and principal payments have been paid and necessary investments in working capital and fixed capital have been made . FCFE is the cash flow from operations minus capital expenditures minus payments to debt holders.

Free Cash Flow

Free cash flow indicates cash available to the capital providers after proper allocation to the investment for growth.

FCFF = EBIT (1- Tax rate) + Depreciation FCInv WCInv. FCFE = FCFF Int (1- tax rate) + Net Borrowing.

Example
A company reported the following results in its fiscal year, EBIT Tax rate Depreciation Net Investment in Fixed Capital Net increase in working capital Net Borrowing Interest = 500 mil = 40% = 300 mil = 400 mil = 45 mil = 75 mil = 100 mil

Solution
FCFF = = = = 500 ( 1- .40) + 300 400 45 155 mil. 155 100 ( 1 - .40) + 75 170 mil.

FCFE

Investment Decision: A company with positive free cash flow has cash available for its investors after meeting all of its expenses including capital expenditure for growth opportunities. Hence, can be recommended as a sound company to invest in.

Relative Valuation
What is it?: The value of any asset can be estimated by looking at how the market prices similar or comparable assets. Philosophical Basis: The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics) Information Needed: To do a relative valuation, you need an identical asset, or a group of comparable or similar assets a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value) and if the assets are not perfectly comparable, variables to control for the differences Market Inefficiency: Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected

Relative Approach
Provide information about how the market is currently valuing stock at several levels Aggregate market Alternative industries Individual stocks within the industry
Individual stock

Alternative industries

Aggregate Market

Relative Approach
Relative Approach (Multiple Models) Price to Earnings Price to Cash Flow Price to Book Value Price to Sales

Equity Valuation

Relative P/E P/BV P/CF P/S

Price to Earnings Ratio P/E

A valuation ratio of a company's current share price compared to its per-share earnings. Also sometimes known as "price multiple" or "earnings multiple".

Price / Earnings Ratio =

Price of Stock Earning Per share

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay Tk. 20 for Tk.1 of current earnings For example, if a company is currently trading at Tk.43 a share and earnings over the last 12 months were Tk. 1.95 per share, the P/E ratio for the stock would be 22.05 (Tk.43/Tk.1.95). Based on EPS from the last four quarters is called trailing P/E. Based on EPS taken from the estimates of earnings expected in the next four quarters is called forward P/E.

Trailing P/E and Forward P/E

"Trailing P/E" calculates stocks P/E ratio based on Companys most recent twelve months earnings. This is used to get the Companys P/E based on its historical earning performance. Market Price of the Stock Trailing P/E =
EPS based on most recent 12 month period

Forward P/E" calculates stocks P/E ratio based on Companys Expected Earning per Share. This is used to get the Companys P/E based on its Future Earning prospects.

Market Price of the Stock Forward P/E = Expected Earning per Share

Price to Earnings Ratio P/E

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a Banks to a Manufacturing company as each industry has much different growth prospects.

Book Value or Net Asset Value (NAV)

A company's common stock equity as it appears on a balance sheet, equal to total assets minus liabilities, preferred stock, and intangible assets such as goodwill. This is how much the company would have left over in assets if it went out of business immediately. Since companies are usually expected to grow and generate more profits in the future, market capitalization is higher than book value for most companies. Since book value is a more accurate measure of valuation for companies which aren't growing quickly, book value is of more interest to value investors than growth investors.

Total Shareholders Equity NAV per share = Number of share outstanding

When relative valuation works best..

This approach is easiest to use when there are a large number of assets comparable to the one being valued these assets are priced in a market there exists some common variable that can be used to standardize the price This approach tends to work best for investors who have relatively short time horizons are judged based upon a relative benchmark (the market, other portfolio managers following the same investment style etc.) can take actions that can take advantage of the relative mispricing; for instance, a hedge fund can buy the under valued and sell the over valued assets

4. Converting forecasts to a valuation

Two important aspects of converting forecasts to valuation are:  Sensitivity Analysis  Scenario analysis

What approach would work for you?

As an investor, given your investment philosophy, time horizon and beliefs about markets (that you will be investing in), which of the approaches to valuation would you choose? Discounted Cash Flow Valuation Relative Valuation Neither. I believe that markets are efficient.

Thank you