Fundamental Analysis

Learning ObjectivesElements of Top-Down Fundamental AnalysisMacroeconomic FactorsClassification of IndustriesTechniques for industry analysis Techniques for company analysis

Three Steps of Top-Down Fundamental AnalysisMacroeconomic analysis: evaluates current economic environment and its effect on industry and company fundamentalsIndustry analysis: evaluates outlook for particular industriesCompany analysis: evaluates companys strengths and weaknesses within industry

Macroeconomic AnalysisBusiness CyclesExpansion, Peak, Contraction, TroughImpact of Inventory and Final SalesEconomic Indicators GDPMonetary policy and liquidityInflationInterest ratesInternational influencesConsumer sentimentsFiscal policy

Industry AnalysisClassifying industriesCyclical industry - performance is positively related to economic activity for eg. FMCGDefensive industry - performance is insensitive to economic activity for eg.- Healthcare , EducationGrowth industry - characterized by rapid growth in sales, independent of the business cycle for eg- ITES

Industry AnalysisIndustry Life Cycle Theory: Birth (heavy R&D, large losses - low revenues)Growth (building market share and economies of scale)Mature growth (maximum profitability)Stabilization (increase in unit sales may be achieved by decreasing prices) Decline (demand shifts lead to declining sales and profitability - losses)

Industry AnalysisLife Cycle of an Industry (Marketing view)Start-up stage: many new firms; grows rapidly (example: genetic engineering)Consolidation stage: shakeout period; growth slows (example: video games)Maturity stage: grows with economy (example: automobile industry)Decline stage: grows slower than economy (example: railroads)

Industry AnalysisQualitative IssuesCompetitive StructurePermanence (probability of product obsolescence)Vulnerability to external shocks (foreign competition)Regulatory and tax conditions (adverse changes)Labor conditions (unionization)

Industry AnalysisEnd use analysis identify demand for industrys productsestimates of future demandidentification of substitutesRatio analysisexamining data over time identifying favorable/unfavorable trendsRegression analysis determining the relationship between variables

Company Analysis: Qualitative IssuesSales Revenue (growth)Profitability (trend)Product line (turnover, age)Output rate of new productsProduct innovation strategiesR&D budgetsPricing StrategyPatents and technology

Company Analysis: Qualitative IssuesOrganizational performanceEffective application of company resourcesEfficient accomplishment of company goalsManagement functionsPlanning - setting goals/resourcesOrganizing - assigning tasks/resourcesLeading - motivating achievementControlling - monitoring performance

Company Analysis: Qualitative IssuesEvaluating Management QualityAge and experience of managementStrategic planningUnderstanding of the global environmentAdaptability to external changesMarketing strategyTrack record of the competitive positionSustainable growthPublic imageFinance Strategy - adequate and appropriateEmployee/union relationsEffectiveness of board of directors

Company Analysis: Quantitative IssuesOperating efficiencyProductivityProduction functionImportance of Q.A.Understanding a companys risksFinancial, operating, and business risksFinancial Ratio AnalysisPast financial ratios With industry, competitors, and Regression analysisForecast Revenues, Expenses, Net IncomeForecast Assets, Liabilities, External Capital Requirements

An AdageFinancial statements are like fine perfume;To be sniffed but not swallowed.

Dr. Abraham J Briloff, Ph.D. CPAEmmanuel Saxe Distinguished Professor of Accountancy Emeritus, Baruch College, CCNY

Company Analysis: Quantitative IssuesBalance SheetSnapshot of companys Assets, Liabilities and Equity.Income statementSales, expenses, and taxes incurred to operateEarnings per shareCash flow statementSources and Uses of fundsAre financial statements reliable?G.A.A.P. vs Cleverly Rigged Accounting Ploys

Company Analysis: Quantitative IssuesFinancial Ratio AnalysisLiquidity (ability to pay bills)Debt (financial leverage)Profitability (cost controls)Efficiency (asset management)DuPont AnalysisTop-down analysis of company operationsObjective: increase ROE

Liquidity RatiosMeasure ability to pay maturing obligationsCurrent ratioCurrent assets / current liabilitiesQuick ratio(Current assets less inventories) / current liabilities

Debt RatiosMeasure extent to which firm uses debt to finance asset investment (risk attribute)Debt-equity ratioTotal long-term debt / total equityTotal debt - total assets ratio(Current liabilities + long-term debt) / total assetsTimes interest earnedEBIT / interest chargesFixed charge coverage ratio(EBIT + Lease Exp.) / (Int. Exp. + Lease Exp.)

Profitability RatiosMeasure profits relative to salesGross profit margin ( % ) = Gross profit / salesOperating Profit Margin = Operating profits / salesNet profit margin = Net profit after taxes / salesROA = Net Profit / Total AssetsROE = Net Profit / Stockholder Equity*

* Excludes preferred stock balances

Efficiency RatiosMeasure effectiveness of asset managementAverage collection period (in days)Average receivables / Sales per dayInventory turnover (times per year)Cost of Goods Sold / average inventoryTotal asset turnoverSales / average total assetsFixed asset turnoverSales / average net fixed assets

Other RatiosEarnings per share (EPS): (Net income after taxes preferred dividends)/ number of sharesPrice-earnings (P/E): Price per share/expected EPSDividend yield: Indicated annual dividend/price per shareDividend payout: Dividends per share/EPSCash flow per share: (After-tax profits + depreciation and other noncash expenses)/number of sharesBook value per share: Net worth attributable to common shareholders/number of shares

DuPont Analysis of ROERatio 1 = NPM Ratio 2 = TATO Ratio 3 = Equity Kicker

The DuPont System suggests that ROE (which drives stock price) is a functionof cost control, asset management, and debt management.

Estimating Earnings and Fair Market Value for EquityFive Steps

1. Estimate next years sales revenues2. Estimate next years expenses3. Earnings = Revenue - Expenses4. Estimate next years dividend per share = Earnings Per Share * dividend payout ratio

5. Estimate the fair market value of stock given next years earnings, dividend, ROE, and growth rate for dividends.Using Gordon Growth model or P/E Model

Woerheides ConclusionsFundamental Analysis vs. Market EfficiencyFundamental analysis critical when dealing with private companiesNecessary condition for market efficiency of publicly traded companies (although worthless at the margin)Earnings surprises major component of performanceHow much is real?How much is C. R. A. P.?