Fundamental Equity Analysis

8/3/2019 Fundamental Equity Analysis

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Fundamental EquityAnalysis

Submitted By:

Anubha Mathur

Laxmi Narsimha Boddhu

Yuki Jain


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Outline

Introduction

Qualitative and Quantitative Analysis

The Concept of Company's Intrinsic Value

Top-down and bottom-up

Procedure

DuPont Analysis

DCF Models

Gordon Growth Model

One and two stage dividend growth models

FCFE & FCFF models

Theoretical underpinnings of P/E ratio

Appropriate sector ratio analysis


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Introduction

Fundamental analysis consists of analyzing financialstatements like

Balance sheet,

Income statement

Cash flow statement, looking at revenues,expenses, profits, assets and debts of a company


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Basics:

to conduct a company stock valuation andpredict its probable price evolution,

to make a projection on its business

performance, to evaluate its management and make

internal business decisions,

to calculate its credit risk.


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It answers questions like:

is the company business profitable,

are their revenues growing,

how is the company controlling costs,

what are company's competitive advantages and will they last in the future, what are the

prospects of the industry in which companyoperates,

has the company a valuable trademark, is the management trust worded, has the

company to much debt, and similar.


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Qualitative and Quantitative

Fundamental Analysis

Fundamental analysis includes

Quantitative research like analyzingcompany statements and market share

(things that can be measured andexpressed in numerical terms)

Qualitative research like evaluating qualityof the management or the value ofcompany's trade mark or patents forexample (things that are difficult orimpossible to measure).


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ExampleFundamental analysis of McDonalds' company

Quantitative part of research would examineits revenues, profit, price earnings ratio, pricebook ratio, growth, debt to equity ratio, price

sales ratio and many other ratios. But the analysis would be incomplete without

taking into account the value of theMcDonalds' brand, which is recognized all

over the world by millions of people. Still, it isvery difficult to say how much is the brandexactly worth, we can only say that it isessential for ongoing success of selling

hamburgers.


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The Concept of Company's Intrinsic Value

Two most important assumptions forFundamental Stock Analysis

Stock market does not reflect the true value of thestock in every moment. That means, that stock is

most often undervalued or overvalued in relation toits true - fair value, know as intrinsic value.

Stock market will price fairly the company on thelong run. Therefore it makes sense to buy

undervalued stock and wait for the market torealize its real worth. Sooner or later you will profitwhen stock market price will equal its intrinsicvalue.


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The Concept of Company's Intrinsic

Value contd

Two major unknowns with FundamentalAnalysis

The first problem is when you estimate the

companys intrinsic value, you can't be sure, ifyour evaluation is correct

The second problem is that you never knowwhen the market will realize the true value of

the stock.


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Top-down and bottom-up

When analyzing a stock using fundamentalanalysis there are two basic approaches: The top-down investor starts his analysis with global

economics, including both international andnational economic indicators, such as GDP growthrates, inflation, interest rates, exchange rates,productivity, and energy prices. He narrows his searchdown to regional/industry analysis of total sales, pricelevels, the effects of competing products, foreign

competition, and entry or exit from the industry. Onlythen he narrows his search to the specific company.

The bottom-up investor starts with specific businesses,regardless of their industry/region.


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Procedure

Step1:

Financial Statement Analysis

Analysis of Ratios, dividends paid, operating cash flow, new equityissues and capital financing, the earnings estimates and growth rateprojections

Step2:

Input to Models

The determined growth rates (of income and cash) and risk levels (todetermine the discount rate) are used in various valuation models.

Step3:

Models :

Discounted Cash FlowDu Point

PE Models


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DuPont Analysis

DuPont analysis helps analysts glean insightfrom return on equity (ROE) by breaking ROEinto several components

EquityrsShareholde

IncomeNetROE


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DuPont Analysis

AssetsTotal

AssetsTotal

Sales

Sales

EqutiyrsShareholde

IncomeNetROE

EqutiyrsShareholde

AssetsTotal

AssetsTotal

Sales

Sales

IncomeNetROE

MultiplierEquity

TurnoverTotalAsset

MarginProfitROE


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DuPont Analysis

By breaking ROE into its components, analysts canpinpoint where returns are being generated, or lost

DuPont analysis also allows analysts to view trendsin the components of ROE

For example, whether or not profit margins are improvingor if financial leverage has changed

Multiplier

Equity

Turnover

TotalAsset

Margin

ProfitROE


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Discounted Cash Flow Models

DCF models value expected cash flows byassigning discount rates composed of acombination of factors including risk premiumsand interest rates

n

n

3

3

2

2

1

1o

R)(1

C

R)(1

C

R)(1

C

R)(1

CV


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Dividend Discount Models

Like a bond, equity can be valued as the present value ofa stream of cash flows, with dividends as our cash flows

The equation below illustrates that V0 can be calculated as aseries of cash flows in future periods that are discounted atr, where r is the required rate of return for an equity

investor

n

nn

3

3

2

2

1

1o

r)(1

DV

r)(1

D

r)(1

D

r)(1

DV

n

n

ntn

no

)1(

V

r)(1

DV

r


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If dividends were to remain constant forever,then we would value equity as a perpetuity

rDVo

Use this model to value equity with constant

dividends like preferred stock


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Example of a constant dividend model withD = $3 and r = 12%

$25V

.12

$3V

0

0

r

D

Vo

20$

15.

3$

0

0

V

V What happens if

my required returnon equity increases

to 15%?


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Dividend Discount Models In practice, dividends are not constant forever.

Hopefully, dividends grow and not decline, but the point isdividends change

If the growth rate is assumed to be a constant, g, wecan use the following equation

g)-(r

DV 1o

Note: r > g, or wehave a negative

denominator and

D1 = D0(1+g)

This equation is known as the Gordon GrowthModel and is often used to value equity inmature, stable industries like utilities


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Example of a Gordon Growth Model (constant dividendgrowth) with D0=$3, r = 12%, and g = 4%

g)-(r

DV 1o

$39V

0.08

$3.12V

.04)(.12

.04)$3(1V

0

0

0

Note that V0 is sensitive to

changes in r and g. Thus, we

must take care when estimatingthese values for our analysis.

$28.36V.04)(.15

$3(1.04)V

0

0

00.53$)06.12(.

)06.1(3$

0

0

V

V


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Dividends like the economy and single stocks donot tend to grow at stable rates forever

If one identifies a company with two defined stages ofgrowth, use the following two-stage DDM

T

T

3

3

10

2

2

10100

)r1(

P

)r1(

)g1(D

)r1(

)g1(D

)r1(

)g1(DV

)g(r

)g(1DP

2

2TT

Where


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We can re-write a two stage DDM as

T

TT

1tt

t

100

1Ttt

t

2

T

10T

1tt

t

10

0

r)(1

P

r)(1

)g(1DP

r)(1

)g(1)g(1D

r)(1

)g(1D

P

)g(r

)g(1DP

2

2TT

Where


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Example of a two stage DDM Lets assume for a moment that our company has just

discovered the cure to sleep deprivation and has obtained athree year patent. That would change our estimation of g for aperiod of 3 years. We will say that our company will now grow

at 10% for three years and then return to our normalized 4%growth rate thereafter.

First stage is 3yrs with high growth rate of 10% and long-term growth or stable growth rate is 4% indefinitely

D0 = $3, g1 = 10%, t=3, g2 = 4%, T=4, r=12%


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Lets look at the equation with our variables

T

T

3

3

10

2

2

10100

)r1(

P

)r1(

)g1(D

)r1(

)g1(D

)r1(

)g1(DV

4

3

3

3

2

2

1

1

0)12.1()04.12(.

)04.1()1.1(3($

.12)(1.1)$3(1

.12)(1.1)$3(1

.12)(1.1)$3(1V


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Lets look at the equation with our variables

1.57

(.08)

04)($3.99)(1.

1.40

$3.99

1.25

$3.63

1.12

$3.3V

0

1.57

$51.87

1.40

$3.99

1.25

$3.63

1.12

$3.3V0

$33.04$2.85$2.90$2.94V0

$41.72V0


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Discounted Cash Flow Models What if a company does not pay a dividend?

Analysts can use free cash flow to the firm and free cash flowto equity models as a substitute

FCF models are created in the same fashion as DDMs

When estimating the value of equity, use free cash flow toequity as the appropriate cash flow and the required return onequity as the discount rate

When estimating the value of an entire firm, use free cash flowto the firm and WACC as the discount rate


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P/E rational

g)-(r

DV 1o

g)(r

g)(1DV 00

1

D

g)(r

g)(1V 00

1

0

1

0

E

1

1

D

g)(r

g)(1

E

V

1

0

1

0

E

D

g)(r

g)(1

E

V


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Appropriate ratios for different sectors

Financials P/B

Retail P/E

Industrials P/E

Healthcare

Biotech start-up P/discounted future earnings

Mature pharmaceutical P/E Services P/E

Tech

High growth & no earnings P/S & a function of cash burn rate

Mature firms in stable sector P/E


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Advantages

Intuitive Appeal:Cause Effect Relationship

Using fundamental analysis to predict futuresprices has that precept as its foundation, and

attempts to identify the "causing" factors. In thissense, the approach is intuitively appealing.

Objectivity:Fundamental analysis is objective in that

relationships are tested by sound mathematicaland statistical methods.


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Disadvantages

Data Intensive:Fundamental analysis relies on a considerableamount of data to test the significance ofvariables. Such data are often not easy to acquire

and, moreover, are seldom available withoutcharge.

Labor Intensive:Fundamental analysis also requires a

considerable amount of human labor - time andenergy. As well, methods have become socomplex that few individuals short of a trainedeconomist can properly apply the availabletechnology.

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Fundamental Equity Analysis

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