Fundamental Analysis & Valuation & The Effect of Behavioral Finance Fundamental Analysis & Valuation...

Fundamental Analysis & Valuation & The Effect of Behavioral Finance

Dr. Assem SafieddineAssociate Dean, Suliman Olayan of Business, AUBManaging Director, Institute For Financial Analysts (IFA)

Fundamental Analysis

Fundamental analysis involves the process of:

• Looking at the basic or fundamental quantitative and financial environment of a business

• Examining key ratios to determine the financial health• Estimating the value of the stock.

Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes.

Sound fundamental analysis will help identify companies that represent a good value.

Fundamental Analysis Fundamental analysis is

the examination of the underlying forces affecting:

• Economic data to assess the present and future growth

Economy

• Supply and demand forces for the products

• Technologies• Regulations, etc Industry

• Financial data (Quantitative)

• Management• Business concept• Competition

Company Analysis

Forecast Earnings

Estimate Fair Stock

Value

Current Market Stock Price

Over-priced

Under-priced

vs.

Fundamental Analysis: Elements of Industry Analysis

I- Evaluate relationships between macroeconomic variables and industry

• Macroeconomic factors

• Technology

• Demographics

• Social influences

• Government


II- Classify industries within life-cycle stage:

• Embryonic stage

• Growth stage

• Shakeout stage

• Mature stage

• Decline stage

Limitations of Life-Cycle Analysis• Most useful during stable periods

• Stages may not be as long as anticipated or might be skipped altogether

• Some firms will experience dissimilar growth and profits due to competitive position


III. Examine forces that determine industry competition

• Barriers to Entry

• Industry Concentration

• Industry Capacity: Supply vs. Demand and influence on Pricing

• Porter’s Five Forces

1. Rivalry among existing competitors2. Threat of new entrants 3. Threat of substitute products4. Bargaining power of buyers5. Bargaining power of suppliers


IV. Evaluate Industry’s Business Cycle Sensitivity Economic Expansion

Risk in equities would be relatively low

Aggressive growth-oriented strategy

Cyclical Stocks:technology, biotech,

semiconductor, consumer discretionary, energy, financials, industrials,

materials

Economic Contraction

Risk in equities would be relatively high

Conservative/ Defensive strategy

Non- Cyclical Stocks:Consumer staples, utilities, healthcare

High sensitivity, Earnings highly

dependent on the business cycle

Low sensitivity, Earnings highly

independent of the business cycle:Defensive or

Growth

Fundamental Analysis: Elements of Company Analysis

• Firm overview

• Industry characteristics

• Qualitative Analysis• Management • Business Model• Market share, product position• Edge, be it marketing, technology, or innovation

• Product demand

• Product costs

• Pricing environment

• Competitive Strategy• Cost Leadership

• Product or service Differentiation

• Financial ratios

• Projected financial statements and firm valuation

Fundamental Analysis: Financial Company Analysis

Earnings

Earnings (or growth towards positive earnings) tell you how healthy a company is and if it may pay dividends or grow

through capital appreciation (higher stock price).

Historical

Forecasted

Fundamental Analysis Tools

Financial Ratios

1. Cross-sectional analysis: A standardized basis for comparison with industry or companies of similar:• Operations (products and services)• Markets• Size• Level of Earnings and Earnings Potential • Market Presence • Business Model • Demand drivers• Cost structure drivers• Availability of capital and Capital Structure

2. Time-series analysis (trend analysis): Comparison to a company’s past ratios


Financial Ratios

The most important are:• Activity Ratios

Cost of goods soldInventory turnover

Average inventory=

RevenuesReceivables turnover Average receivables=

RevenuesAsset turnover

Average assets=


Financial Ratios

The most important are:

• Liquidity Ratios

Current liabilities

Current assetsCurrent ratio

Current liabilities

Cash + short term marketable securities +

receivablesQuick ratio

Current liabilities

=

=

=

Cash ratio

Cash + short term marketable securities


Financial Ratios


• Solvency Ratios

Interest Payments

Total debtDebt-to-assets ratio

Total assets

Total debtDebt-to-equity ratio

Total shareholders’ equity

=

=

=

Interest coverage EBIT


Financial Ratios


• Profitability Ratios

Total Equity

Gross ProfitsGross profit margin

Net Sales

Net IncomeNet Profit margin

Net Sales

=

=

=

ROE Net Income

ROA =Net IncomeTotal Assets


Financial Ratios


• Valuation RatiosNet Income

Earnings per share(EPS)Shares Outstanding

Price per Share

Price – Earnings (PE)

=

= EPSOverpriced orHigh Potential?

Lost Confidence or Underpriced, Overlooked Potential?

High P/E

LowP/E


Financial Ratios


• Valuation RatiosPrice Per share

P/ CFCash Flow Per Share

P/ SSales Per Share

=

=

P/ BV = Book Value per Share

Price Per share

Price Per share

Fundamental Analysis Tools: Valuation Types of Equity Valuation Models

1. Discounted Cash Flow Models Estimated value is the PV of:

• Future cash distributed to shareholders (dividend discount models), or

• Future cash available to shareholders (free cash flow to equity models)

2. Multiplier Models (Relative Valuation)• Price multiplier: Ratio of stock price to earnings, sales, book

value, or cash flow

• Enterprise value multiplier: Ratio of enterprise value to sales or EBITDA

3. Asset-BasedEquity value = total asset value minus liabilities and preferred stock values

Fundamental Analysis Tools: Valuation

Choice of Valuation Models

• Model should be chosen based on available inputs

• Model should be chosen based on the intended use of the valuation

• More complexity is not necessarily better

• Consider values using more than one method

• Consider uncertainty about input values

• Consider uncertainty about the appropriateness of the model

Fundamental Analysis Tools: Valuation

Conclusion

Market price < estimated value: Asset is undervalued

Market price > estimated value: Asset is overvalued

Air Arabia: Case Study

Financial Analysis: Q2, 2010

Revenues

Passenger numbers • 11% Y-o-Y increase

Continued Pressure on yields • Average revenue per passenger falling 4% Y-o-Y in 1H2010


Financial Analysis: Q2, 2010Costs & Margins

Higher Costs and Decreasing Margins due to:• Higher fuel costs Y-o-Y • Staff training costs relating to the set-up of new hub in Egypt

Performance Below Analysts Expectations


Financial Analysis: Q2, 2010Profitability

Performance Below Analysts Expectations

Non-operating loss of AED26.9 million

• Share of loss from investment in associates such as the set-up costs of the company’s third hub in Egypt which launched its operations during the quarter


Financial Ratios: Q2, 2010 Ratios Based on Actual Financial

DataAir Arabia Middle East Airlines

AverageDubai FM Airlines

Average

Period End Date 30-Jun-10 Latest LatestLiquidityA/R turnover 7.73 18.3 9.39Inventory Turnover 285.99 35.22 288.11Quick ratio 4.32 1.03 5.14Cash Ratio 2.7 0.63 3.94ProfitabilityAsset Turnover 0.34 0.73 0.34Return on Assets (%) 6.04 3.45 5.86Return on Equity (%) 6.95 9.99 6.61Operating Margin (%) 8.82 4.04 7.82Pretax Margin (%) 17.72 4.99 17.13LeverageTotal Debt/Total Assets (%) - 28.54 - Times Interest Earned (TIE) n/a 5.12 n/a Average Return on Cash & Equiv. 7.1 4.59 7.52Per Share DataEPS 0.08 n/a n/a Cashflow AnalysisPayout Ratio (%) 130.52 - - PriceP/E 10.49 7.95 10.75Dividend Yield (%) 12.44 - - Price/Book 0.73 0.72 0.71Price/ Revenues 1.86 0.6 1.84ValuationEV/Revenues 1.21 0.65 0.93

Source:

zawya

Air Arabia: Case Study Qualitative Analysis

Competitive Environment: Highly Competitive Environment for UAE-based

airlines

FlyDubai Threat: Greater than Expected • Competition for 18 of its 65 destinations (as at June 2010)

• Fast Paced Growth: Fleet, Destinations

• Air Arabia’s fares are still higher than FlyDubai’s by 22% on average

• FlyDubai's impact on Air Arabia is now more significant that previously anticipated

Other UAE Carriers• Emirates Airlines: Major Competitor

• Price differential: 50% cheaper on average

• Discounting by other national carriers is believed to be short-lived


Qualitative Analysis

SAMA’s Possible Acquisition: Attractiveness to Air Arabia:

• Access to an attractive market that is closely regulated and difficult to penetrate

• Large expat community, low income in demographic

Challenges to Consider: • Being Granted the License

• Turning around a failing carrier: Risky acquisition

• Burdened with having to fly unprofitable domestic routes

• Many Saudi Arabian's already fly into the UAE to connect to further destinations (with Emirates providing a global network)

• Different Aircrafts: Synergies, Maintenance, and Configuration challenges


Resulting Forecast Revisions


ValuationDiscounted Cash Flows (DCF)

High capex in short to medium term: fleet expansion (38 purchased planes are expected to be delivered in 2011-2015)

WACC= Company's cost of equity• risk-free rate of 5.15%• equity risk premium of 8.3%

The company has a large cash balance

The fair value (FV) declines to AED1.30/share from a previousAED1.77/share, reflecting the downgrades to EBITDA estimates in 2010 and beyond.

Perpetual growth rate of 3.5%:Above-average LT growth rates;Relatively immature and underpenetrated LCC market in the ME


Valuation: DCF

Due to the relative immaturity of the company and its high capex requirements, the free cash flows estimates remain negative until 2015.

Therefore, the terminal value provides more than 100% of the end firm value, while around 53% of the end equity comes from cash and available-for-sale investments on the company’s balance sheet.

This is believed to be the major downside risk to the valuation, as the longer-term cash flows are inherently more risky and may be subject to stronger competition in the LCC space than currently assumed.


Valuation

Discounted Cash Flows (DCF)

Sensitivity Analysis to WACC and Perpetual Growth

The value of AED 1.3/share is 65% above the current share price.


ValuationPeer Group Analysis: Relative Valuation

All of theselected

companies follow the low-cost carrier model

Discount to peers

4.2 3.2P/E (excluding cash and cash related income)


Final Decision

????


Underpenetrated nature of the LCC market in the ME

Air Arabia‘s operational strengths and multi-hub business model

Load factors of over 80%

Fair value suggesting a 65% to the current share price

Fundamentally underpinned by a large cash pile with cash providing around AED0.60/share of value alone, and as such, limits further downside for the shares.

Current multiples look undemanding compared to global peers.

Final Decision: Undervalued Stock


Appendix: Income Statement


Appendix: Balance Sheet & Cash Flow Statement

35

Behavioral FinanceHowever, not all market behavior could be explained

by pure fundamental reasoning

Investors are in many instances irrational : Recent research argues that people’s investment decisions are

influenced by their feelings, especially when the decision involves risk and uncertainty:

• Over-confidence• Self-Attribution Bias• Fear • Joy (especially around holidays and special occasions), etc

The standard finance model, in which “unemotional investors always force capital market prices to equal the rational present value of expected future cash flows,” does not

seem to offer perfect insight into asset pricing anomalies (Baker and Wurgler 2007, p. 129).

36

Behavioral Finance

Irrational Investor behavior is often manifested in the calendar effect which reflects the tendency of financial asset returns to display systematic patterns at certain times of the day, week, month or year:

• Monday Effect: General consensus amongst most academic literature that the day of the week effect holds that stocks exhibit significantly lower returns over the period between Friday’s close and Monday’s close.

• Day Effect: In Kuwait, evidence shows that the returns of the five trading week days over the period 1993-1997 follow different processes pointing to a day-of-the-week effect in the KSE. Unlike the pattern observed in more mature Western stock markets, the returns for the first day in the trading week (Saturday then) in the KSE are higher.

37

Behavioral Finance

• Weather Effect: Evidence from the Tunisian Stock Market shows that weather variables (sunshine, temperature, humidity, rain, and wind) have a significant relationship with the daily Tunisian Stock Market prices over the period ranging between 1999 and 2006 in support to the effect of investor mood on investment behavior.

• Moreover, the relationship remains still significant even after inserting some adjustments for known calendar anomalies such as the Monday and January effects.

• World Cup Effect: Evidence points to a large, highly significant, and long lasting relationship between the World Cup event and Stock prices in the US. From 1950 to 2007, the average return on the U.S. market over the World Cup’s effect days is − 2.58%, compared to +1.21%for all days over the same period length.

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