Fundamental Analysis

Fundamental AnalysisThe process of gathering information,

organising it into a logical framework and then using it to determine the underlying value of a share.

Intrinsic ValueThe underlying or inherent value of a

stock as determined through fundamental analysis. The entire concept of stock valuation is

based on the belief that all securities possess an intrinsic value that their current market or trading value must approach over time.

Intrinsic Value Depends On:Estimates of the share’s future cash-

flowsThe discount rate used to translate

these future cash flows into a present value

The amount of risk embedded in achieving the forecasted level of performance

Fundamental Analysis Intended to help investors formulate

expectations about the future performance of the company and its shares By analysing its past performance and

current situation to determine how well it is situated to meet future challenges

Fundamental Data Defined

We will define ‘fundamental’ data to include ; company financial reports (and their analysis), earnings forecasts, directors dealings, announcements, broker’s research / tips,

and attempt to answer the following questionsand attempt to answer the following questions..

Fundamental Questions 1 of 3

Is the firm financially sound This will involve checking the company’s

accounts, to establish profitability liquidity gearing fixed asset values sufficient resources to sustain profitability

and cope with setbacks

Fundamental Questions 2 of 3

Does the firm have anything going for it ? A really impressive product superior marketing skilled management built -in growth

Based on all of the above - what profits will the firm make this year ?

Fundamental Questions 3 of 3

Do I have enough information to estimate the picture into the future too ?

Based on my profits forecast, what will earnings per share (EPS) be ?

Based on EPS, what is the price/earnings ratio (P/E) ? Also referred to as ‘PER’, ‘PE’, ‘p/e’ or ‘rating’. Beware of comparing historic to forecast PE.

Can I work out PE ratios for future years ?

Significance of P/E (1 of 2)

Example Present share price 750p

(2003) actual (2004) forecast (2005) forecast

eps 50p 75p (a rise of 50%)

90p

P/E 15 10

If the earnings grow by 50% ! The P/E falls by 33% (if the

price stays the same). This would further imply a forecast P/E of 8.3 for 2005 -

nearly half of its 2003 figure.

Significance of P/E (2 of 2)

Given we have a growing earnings stream the market may be willing to pay 15 or more years earnings to buy this share.

This would produce two ‘target prices’ 2004 2005

75p x 15 1,125p 90p x 15 1,350

Representing a gain of 600p per share or 80% over two years

Estimating EPSCan be derived from the normal formula

EPS (yr.t) = Earnings (yr.t)

No. of Shares (yr.t)

Or an alternative approach would be EPS = ROE x Book Value per Share

Thus focussing on the key aspects the

firms success – particularly when the

ROE is broken down

ROE broken down

Dupont Ratios

Profitability can go further!

Dupont Ratios

Factors affecting P/EThe future P/E tends to be the most

difficult to estimate, being a function of ; State of the market Current and projected inflation Growth rate in earnings Amount of debt Level of dividends

General Rules Regarding P/E Higher P/E ratios can be expected with higher

An optimistic market outlook Rising inflation translates into falling P/E’s Growth rates in earnings Lower debt levels Lower levels of dividend payout

A good starting point can be the average market multiple and establish a Relative P/E Multiple.

Valuation - Definitions

The process by which an investor uses risk and return concepts to determine the worth of a security Or

The process by which the underlying value of a stock is established on the basis of its forecasted risk and return performance

Forecasts - based on FundamentalsFundamental analysis is intended to

help investors formulate expectations about the future performance of the company and its shares By analysing its past performance and

current situation to determine how well it is situated to meet future challenges

Valuation BasesGenerally based on the required rate of

return (CAPM)Starting point in establishing value –

forecast - sales and profit marginsWhich would be used to establish

Forecast – earnings and P/E ratios

Valuation Models (common)

DCF PV of Dividend

(DDM) Zero, Constant, Variable

PV of Free Cash Flow

PV of Dividends and Earnings (D&E)

RELATIVE Price Earnings

Approach (P/E) Price to Cash Flow Price to Book Value Price to Sales

Summary of Data Required Required rate of return (associated discount factors)

Risk free rate Market return Beta value

Current share price and number of issued shares P/E and P/E projections EPS and EPS projections DPS and DPS projections Either historic DPS figures or ROE and dividend payout ratio

Levels of provision

In considering how this information can In considering how this information can be obtained, it may be useful to be obtained, it may be useful to categorise it into the following types:categorise it into the following types:

Basic historic Analysed historic Current Combined

Basic - Fundamental Data Consists of Annual Corporate

Reports for analysis which can be obtained from:

icibinc (by ordering for postage)

CAROL UK, (online - and as well as UK,

companies, European

& Asian are now included)

EDGAR, (US ‘standard’. Equivalent

to an electronic

Companies House)

Analysed - Fundamental Data

The ‘Bible’ for fundamentalists has The ‘Bible’ for fundamentalists has traditionally been :traditionally been : Hemmington Scott - ‘REFS’

Really Essential Financial Statistics

Access to parts of REFS is increasingly appearing online but the searchable CD Rom version is a must for those attempting to carry out frequent search and analysis.

Current - Fundamental Data

Consider the links (in red) and articles suggested on the database for this session.

ACTIVITY: Go to at least 3 of the sites listed and

extract and compare fundamental information relating to one or more of your investment decisions.

IC DatabaseIC Database

Combined - Fundamental Data

Many software providers are now Many software providers are now attempting to include fundamental data attempting to include fundamental data downloads with their price updates.downloads with their price updates.

Indications of the ‘fundamental’ events Indications of the ‘fundamental’ events can then be viewed on the price charts.can then be viewed on the price charts.

Synergy’s Synergy’s - Portfolio Advantage- Portfolio Advantage Ionic’s Ionic’s - Sharescope- Sharescope

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