L3 Fundamental Analysis

7/30/2019 L3 Fundamental Analysis

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Fundamental Analysis

Dr Mahesh Halale;

Professor

SIOM Pune


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L3: Fundamental Analysis

Main principle - Is to find profitable companies to invest in by comparingrevenues, sales, management, and other factors etc.

Fundamental analysis is the practice of evaluating a company's stock

price by comparing base elements in the company's balance

sheets as well as general market factors.

Look at internal drivers and external drivers of business.Internal drivers are company specific (e.g. revenue, net income, assets,

debts etc.).

Analysis of internal factors is objective such as Finding PE multiple, Beta

etc

External drivers are things that can affect the company's profitability butare not company specific (e.g. the economy, industry averages,

etc.).

The analysis of external drivers is more subjective, as it is concerned with

future industry growth, politics, economy, etc.


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Companies are a part of the industrial and business sector,which in turn is a part of the overall economy.

Economic Analysis

1. State of economy

2. Govt. Economic Policies

3. Money Policy and Trends in Money Supply

4. Business Cycle, power, agriculture,

infrastructure growth etc

5. Economic and Political Stability


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Fundamental AnalysisIndustry Analysis -At any stage in the economy,

there are some industries which are growing while others

are declining. Particular industry can be studied with a

view to assess the problems, prospects, etc. of the

company in that industry.

1.Raw Material & Input2. Product Line - position of the industry in the life cycle of its growth

3. Capacity Installed and Utilized

4. Industry Characteristics Cyclical, Fluctuating, Stable

5. Demand & Market6. Government Policy wrt that industry

7. Future Prospects

8. Labor & Industrial Problems

9. Management


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Company AnalysisCompanys Strengths

weaknesses. In the case of company analysis

Analyze balance sheet data for:

Use of Assets

1. Efficient use of capital;2. Leverage enjoyed in the use of capital;

3. Return on net worth; and

4. Return on equity.

SIZE of the Company - Expansion and growth of the company -

1. Growth of sales,

2. Assets - gross block and net block

3. Installed capacity & capacity utilization


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Company AnalysisThe profitability of the company -

Net profits (PAT) or cash profits in relation to sales, equity or net

worth, dividend distributed, etc.

Companys share in industry-its capacity utilization vis--vis the

utilization in the whole industry.Modernization and expansion plans - reflected in tax planning,

retention policy, bonus policy, etc.

Earnings per share, cash earnings per share and P/E ratios.

Compare companys with competitors on following heads:

1. Cost per unit;

2. Profit margins;

3. Earnings per share and P/E ratio;

4. Bonus payments;

5. Dividend distribution policy; etc.


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Thanks


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Family snap-shot

Return on net worth = profit after tax / net worth

Return on capital employed = net operating profit less adjusted taxes / total

capital employedReturn on assets = net profit /total average assets

Total average assets are what the company has had working

for it during the course of its business. (Do you notice that total

assets is also a reflection of the total capital that has been

employed in the business?) It is more prudent to take an averageof assets of two years since the balance sheet gives a snapshot

of the financials as on a particular date. What we are interested

in is getting to know of the assets that have been in use for the

entire year. Sherakhan


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Company Analysis and Stock

SelectionGood companies are not necessarily goodinvestments

In the end, we want to compare the

intrinsic value of a stock to its marketvalue

Stock of a great company may be overpriced

Stock of a lesser company may be a superiorinvestment since it is undervalued


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Companies that consistently experience above-

average increases in sales and earnings have

traditionally been thought of as growth

companies Limitations to this definition

Financial theorists define a growth company as

one with management and opportunities that

yield rates of return greater than the firmsrequired rate of return

Growth Companies and Growth

Stocks


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Growth Companies and Growth

StocksGrowth stocks are not necessarily sharesin growth companies

A growth stock has a higher rate of return

than other stocks with similar risk Superior risk-adjusted rate of return occurs

because of market under-valuation comparedto other stocks

Studies indicate that growth companieshave generally not been growth stocks


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Defensive Companies and

StocksDefensive companies future earnings aremore likely to withstand an economicdownturn

Low business risk Not excessive financial risk

Defensive stocks returns are not as

susceptible to changes in the market Stocks with low systematic risk


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Cyclical Companies and Stocks

Sales and earnings heavily influenced byaggregate business activity

High business risk

Sometimes high financial risk as wellCyclical stocks experience high returns isup markets, low returns in down markets

Stocks with high betas


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Speculative Companies and

StocksSpeculative companies invest in assets

involving great risk, but with the possibility

of great gain

Very high business risk

Speculative stocks have the potential for

great percentage gains and losses

May be firms whose current price-earnings

ratios are very high


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Value versus Growth Investing

Growth stocks will have positive earningssurprises and above-average risk adjustedrates of return because the stocks are

undervaluedValue stocks appear to be undervalued forreasons besides earnings growth potential

Value stocks usually have low P/E ratio or lowratios of price to book value


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The Search for True Growth

StocksTo find undervalued

stocks, we must

understand the theory

of valuation itself


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Company Analysis

Competitive forces necessitate competitive

strategies.

Competitive Forces:

1. Current rivalry2. Threat of new entrants

3. Potential substitutes

4. Bargaining power of suppliers

5. Bargaining power of buyers

SWOT analysis is another useful tool


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Firm Competitive Strategies

Defensive or offensive

Defensive strategy deflects competitiveforces in the industry

Offensive competitive strategy affectscompetitive force in the industry toimprove the firms relative position

Porter suggests two major strategies: low-cost leadership and differentiation


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Low-Cost Strategy

Seeks to be the low cost leader in its

industry

Must still command prices near industry

average, so still must differentiate

Discounting too much erodes superior

rates of return


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Differentiation Strategy

Seeks to be identifiedas unique in itsindustry in an areathat is important tobuyers

Above average rate ofreturn only comes ifthe price premiumexceeds the extracost of being unique


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Focusing a Strategy

Firms with focused strategies:

Select segments in the industry

Tailor the strategy to serve those specific

groups

Determine which strategy a firm is pursuing

and its success

Evaluate the firms competitive strategy overtime


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SWOT Analysis

Examination of a firms:

StrengthsCompetitive advantages in the marketplace

WeaknessesCompetitors have exploitable advantages of some kind

OpportunitiesExternal factors that make favor firm growth over time

ThreatsExternal factors that hinder the firms success


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Favorable Attributes of Firms

Peter Lynchs list of favorable attributes:

1. Firms product is not faddish

2. Company has competitive advantage over rivals

3. Industry or product has potential for market stability4. Firm can benefit from cost reductions

5. Firm is buying back its own shares or managers

(insiders) are buying


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Categorizing Companies

Lynch further recommends the followingcategorization of firms:

1. Slow growers

2. Stalwart3. Fast growers

4. Cyclicals

5. Turnarounds6. Asset plays


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Specific Valuation with the P/E

RatioEarnings per share estimates Time series use statistical analysis

Sales - profit margin approachEPS = (Sales Forecast x Profit Margin)/ Number of Shares

Outstanding

Judgmental approaches to estimating earningsLast years income plus judgmental evaluations

Using the consensus of analysts earnings estimates

Once annual estimates are obtained, do quarterlyestimates and interpret announcements accordingly


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Site Visits, Interviews, and Fair

DisclosureFair Disclosure (FD) requires that all disclosureof material information be made public to allinterested parties at the same time Many firms will not allow interviews with individuals,

only provide information during large publicpresentations

Analysts now talk to people other than topmanagers

Customers, suppliers


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Making the Investment Decision

If the estimate of the stocks intrinsic value isgreater than or equal to the current market price,buy the stock

If your estimate of the stocks future intrinsicvalue would yield a return greater than yourrequired rate of return (based on currentinvestment price), then buy the stock

If the value is less than its current price, or itsreturn would be less than your required rate ofreturn, do not buy the stock


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When to Sell

Hold on or move on?

If stocks decline right after purchase, is that afurther buying opportunity or a signal of amistaken investment?

Continuously monitor key assumptions that ledto the purchase of the investment Know why you bought, and see if conditions have

changed

Evaluate when market value approachesestimated intrinsic value


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Influences on Analysts

Several factors make it difficult for analysts tooutperform the market

Efficient Markets

Markets tend to price securities correctly, soopportunities are rare

Most opportunities are likely in small, less followedcompanies

Paralysis of Analysis Must see the forest (the appropriate recommendation)

despite all of the trees (data) that complicate thedecision


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Influences on Analysts

Investment bankers may push forfavorable evaluations of securities whenthe same firm does (or wants to do)

underwriting business with the firm inquestion

Are analysts independent and unbiased intheir recommendations?

Ideally, analysts will remain independent andshow confidence in their analyses

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L3 Fundamental Analysis

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