Unit 4COMPANY ANALYSISEstablishing the Value Benchmark

Outline Strategy Analysis Accounting Analysis Financial Analysis Estimation of Intrinsic Value Tools for Judging Undervaluation or Overvaluation Obstacles in the way of an Analyst Equity Research in India

Strategy Analysis

Strategy analysis seeks to explore the economics of a firm and identify its profit drivers so that the subsequent financial analysis reflects business realities. The profit potential of a firm is influenced by the industry or industries in which it participates (industry choice), by the strategy it follows to compete in its chosen industry or industries (competitive strategy), and by the way in which it exploits synergies across its business portfolio (corporate strategy). We have considered industry analysis in the previous chapter. So, the present discussion focuses on competitive strategy and corporate strategy

Competitive Strategy

Among the various frameworks of strategy formulation, the one developed by Michael E. Porter in his seminal work Competitive Strategy has been perhaps the most influential in shaping management practice. Michael Porter argues that the firm can explore two generic ways of gaining sustainable competitive advantage viz., cost leadership and product differentiation. Cost leadership can be attained by exploiting economies of scale, exercising tight cost control, minimizing costs in area like R&D and advertising, and deriving advantage from cumulative learning. Firms which follow this strategy include Bajaj Auto in two wheelers, Mittal in steel, WalMart in discount retailing, and Reliance Industries in petrochemicals. Product differentiation involves creating a product that is perceived by customers as distinctive or even unique so that they can be expected to pay a higher price. Firms which have excelled in this strategy include Mercedes in automobiles, Rolex in wristwatches, Mont Blanc in pens, and Raymond in textiles.

Exhibit 15.1 depicts the competitive position of the firm based on its relative cost and differentiation positions. The most attractive position of course is the cost-cum-differentiation advantage position.Exhibit 15.1 Competitive Position of the Firm

SuperiorRelative Differentiation PositionSuperiorInferiorInferiorRelative Cost Position

Cost-cum-differentiation advantage DifferentiationadvantageLow cost advantage Stuck-in-themiddle

Gaining Competitive Advantage

By choosing an appropriate strategy, a firm does not necessarily gain competitive advantage. To do so the firm must develop the required core competencies (the key economic assets of the firm) and structure its value chain (the set of activities required to convert inputs into outputs) appropriately. As Palepu et.al. say: The uniqueness of a firms core competencies and its value chain and the extent to which it is difficult for competitors to imitate them determines the sustainability of a firms competitive advantage.

Gaining Competitive Advantage

To assess whether a firm is likely to gain competitive advantage, the analyst should examine the following:

The key success factors and risks associated with the firms chosen competitive strategy. The resources and capabilities, current and potential, of the firm to deal with the key success factors and risks.The compatibility between the competitive strategy chosen by the firm and the manner in which it has structured its activities (R&D, design, manufacturing, marketing and distribution, and support).The sustainability of the firms competitive advantage.The potential changes in the industry structure and the adaptability of the firm to address these changes

Strategy of Cost Leadership: Dell Computer

Direct Selling

Build-to-order manufacturing

Low-cost service

Negative working capital

Corporate Strategy Analysis

When you analyse a multi-business firm, you have to evaluate not only the profit potential of individual businesses but also the economic implications (positive as well as negative) of managing different businesses under one corporate canopy. For example, General Electric has succeeded immensely in creating significant value by managing a highly diversified set of businesses ranging from light bulbs to aircraft engine, whereas Sears has not succeeded in managing retailing with financial services.

Corporate Sources of Value Creation

Thus, whether a multibusiness firm is more valuable compared to a collection of focused firms finally depends on the context. The analyst should examine the following factors to assess whether a firms corporate strategy has the potential to create value.

Imperfections in the product, labour, or financial markets in the business in which the firm operates.Existence of special resources such as brand name, proprietary knowledge, scarce distribution channels, and organisational processes that potentially create economies of scope.The degree of fit between the companys specialised resources and its portfolio of businesses.The allocation of decision rights between the corporate office and business units and its effect on the potential economies of scope.The system of performance measurement and incentive compensation and its effect on agency costs.

Accounting Analysis

Accounting analysis seeks to evaluate the extent to which the firms accounting reports capture its business reality. As an analyst you must be familiar with.

The institutional framework for financial reporting

Sources of noise and bias in accounting

Differences between good and bad accounting quality.

The Institutional Framework for Financial Reporting

The salient features of the institutional framework for financial reporting are:Corporate financial reports are prepared on the basis of accrual accounting and not cash accounting.Preparation of financial statements involves complex judgments by management.GAAP regulates managerial judgementExternal auditing is now a near universal requirement.

Sources of Noise and Bias in Accounting

There are several sources of potential noise and bias in accounting data.Accounting rules themselves introduce noise and bias as it is often not possible to restrict managerial discretion without diminishing the informational content of accounting reports.

Forecasting errors are practically unavoidable.

Managers may introduce noise and bias in accounting reports, while making their accounting decisions.

Good and Bad Accounting Quality

Good Accounting QualityBad Accounting QualityThe accounting data focuses on key success factors and risksThe accounting data fails to highlight key success factors and risksManagers use their accounting discretion to make accounting numbers more informativeManagers use their accounting discretion to disguise realityThe firm provides adequate disclosures to describe its strategy, its current performance, and future prospectsThe firm just fulfills the minimal disclosure requirements prescribed by accounting regulationsThere are no red flagsThere are serious red flags2

Financials Analysis

The key questions to be addressed in applying the earnings multiplier approach, the most popular method in practice, are:

What is the expected eps for the forthcoming year? What is a reasonable pe ratio?

To answer these questions, investment analysts start with a historical analysis of earnings (and dividends), growth, risk, and valuation and use this as a foundation for developing the forecasts required for estimating the intrinsic value.

Earnings And Dividend Level

To assess the earnings and dividend level, investment analysts look at metrics like the return on equity, book value per share, EPS, dividend payout ratio, and dividend per share.

Financials Of Horizon Ltd

20X1

20X2

20X3

20X4

20X5

20X6

20X7

Net Sales

475

542

605

623

701

771

840

Cost of goods sold

352

380

444

475

552

580

638

Gross profit

123

162

161

148

149

191

202

Operating expenses

35

41

44

49

60

60

74

Operating profit

88

121

117

99

89

131

128

Non-operating surplus/deficit

4

7

9

6

-

-7

2

Profit before interest and tax (PBIT)

92

128

126

105

89

124

130

Interest

20

21

25

22

21

24

25

Profit before tax

72

107

101

83

68

100

105

Tax

30

44

42

41

34

40

35

Profit after tax

42

63

59

42

34

60

70

Dividend

20

23

23

27

28

30

30

Retained earnings

22

40

36

15

6

30

40

Equity share capital (Rs. 10 par)

100

100

150

150

150

150

150

Reserves and surplus

65

105

91

106

112

142

182

Shareholders funds

165

205

241

256

262

292

332

Loan funds

150

161

157

156

212

228

221

Capital employed

315

366

398

412

474

520

553

Net fixed assets

252

283

304

322

330

390

408

Investments

18

17

16

15

15

20

25

Net current assets

45

66

78

75

129

110

120

Total assets

315

366

398

412

474

520

553

Earnings per share

2.27

4.00

4.67

Market price per share (End of the year)

21.00

26.50

29.10

31.5

ROE : 3 FactorsPATSales Assets ROE= x x SalesAssets Equity Net Profit Asset Leverage MarginTurnover

THE BREAK-UP OF THE RETURN ON EQUITY IN TERMS OF ITS DETERMINANTS FOR THE PERIOD 20X5 20X7 FOR HORIZON LIMITED IS GIVEN BELOW:

Return on equity = Net profit margin x Asset turnover x Leverage multiplier

20X5

13.0 % = 4.85% x 1.48 x 1.81

20X6

20.5% = 7.78% x 1.48 x 1.78

20X7

21.1% = 8.33% x 1.52 x 1.67

INVESTMENT ANALYSTS USE ONE MORE FORMULATION OF THE ROE WHEREIN IT IS ANALYSED IN TERMS OF FIVE FACTORS :

PBIT SALES PROFIT BEFORE TAX PROFIT AFTER TAX ASSETS

ROE =

X X

X

X

SALES ASSETS PBIT PROFIT BEFORE TAX NETWORTH

ROE : 5 Factors

PBIT Sales PBT PAT Assets ROE= x x x x Sales Assets PBIT PBT Net Worth

ROE = PBIT EFFICIENCY X ASSET TURNOVER X INTEREST BURDEN X TAX BURDEN X LEVERAGE

THE ROE BREAK-UP FOR OMEGA COMPANY IS GIVEN BELOW :

ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x Leverage

20X513.0%= 12.70% x 1.48 x 0.764 x 0.50 x 1.81

20X620.5% = 16.08% x 1.48 x 0.81 x 0.60 x 1.78

20X721.1% = 15.48% x 1.52 x 0.81 x 0.67 x 1.67

Book Value Per Share And Earnings Per Share

Book Value Per Share (BVPS)Paid-up equity capital + Reserves and surplusNumber of equity shares 20 x 520 x 6 20 x 7BVPS 262/15 = 17.47 292/15 = 19.47332/15 = 22.13

Earnings Per Share (EPS)Equity earningsNumber of equity shares 20 x 5 20 x 6 20 x 7EPS 34/15 = 2.27 60/15 = 4.00 70/15 = 4.67

Dividend Payout Ratio And Dividend Per ShareDividend Payout Ratio

Equity dividendsEquity earnings20 x 5 20 x 620 x 7Dividend Payout ratio

Dividend Per Share (DPS)

20 x 520 x 620 x 7DPS Rs 1.86 2.00 2.00

28/34 = 0.82 30/60 = 0.50 30/70 = 0.43

Growth Performance

To measure the historical growth, the compound annual growth rate (CAGR) in variables like sales, net profit, earnings per share and dividend per share is calculated. To get a handle over the kind of growth that can be maintained, the sustainable growth rate is calculated.

Compound Annual Growth Rate (CAGR)The compound annual growth rate (CAGR) of sales, earnings per share, and dividend per share for a period of five years 20x2 20x7 for Horizon Limited is calculated below: Sales of 20 x 7 1/ 5 840 1/ 5 CAGR of Sales : 1 = 1 = 9.2% Sales for 20 x 2 542

CAGR of earningsEPS for 20 x 7 1/ 5 7.00 1/ 5 per share (EPS) : EPS for 20 x 2 6.30

CAGR of dividend : DPS for 20 x 7 1/ 5 3.00 1/ 5 per share (DPS) DPS for 20 x 2 2.301 =1 = 2.1%1 =1 = 5.5%

Sustainable Growth Rate

The sustainable growth rate is defined as :Sustanable growth rate = Retention ratio x Return on equity Based on the average retention ratio and the average return on equity of the three year period (20x5 20x7) the sustainable growth rate of Horizon Limited is:

Sustainable growth rate = 0.417 x 18.2% = 7.58%

Risk Exposure

BetaBeta represents volatility relative to the marketVolatility of Return on equityRange of return on Equity over n yearsAverage return on equity over n years

Favourable & Unfavorable Factors Favourable Unfavorable Factors FactorsEarnings Level High book value per share Low book value per share Growth Level High return on equity Low return on equity High CAGR in sales and EPS Low CAGR in sales and EPS High sustainable growth Rate Low sustainable Growth Rate RISK EXPOSURE Low volatility of return on High volatility of Return on equity equity Low beta High beta

Valuation MultiplesThe most commonly used valuation multiples are : Price to earnings (PE) ratio Price to book value (PBV) ratio

PE Ratio (Prospective)Price per share at the beginning of year nEarnings per share for year n20 x 520 x 620 x 7PE ratio 9.25 6.63 6.23

PBV Ratio (Retrospective)Price per share at the end of year nBook value per share at the end of year n20 x 520 x 620 x 7PBV ratio 1.52 1.49 1.42

Going Beyond the Numbers

Sizing up the present situation and prospects Availability and Cost of Inputs Order Position Regulatory Framework Technological and Production Capabilities Marketing and Distribution Finance and Accounting Human Resources and Personnel

Evaluation of management Strategy Calibre, Integrity, Dynamism Organisational Structure Execution Capability Investor - friendliness

Estimation of Intrinsic Value Estimate the expected EPS Establish a p / e ratio Develop a value anchor and a value range

EPS Forecast 20 x 7 20 x 8Assumption (ACTUAL) (PROJECTED) Net Sales 840924 Increase by 10 Percent Cost of Goods sold 638708 Increase by 11 Percent Gross profit 202216 Operating Expns 74 81 Increase by 9.5 Percent Depreciation 30 34 Sellin & gen. Admn. Expns 44 47 Operating Profit 128135 Non-operating Surplus/Deficit 2 2 No Change Profit before INT. & Tax (PBIT) 130 137 Interest 25 24 Decrease by 4 Percent Profit before Tax 105113 Tax 35 38 Increase by 8.57 Percent Profit after Tax 70 75 Number of Equity Shares 15 MLN 15 Earnings per Share RS 4.67 RS 5.00

Different PE Ratios

Note that different PE ratios can be calculated for the same stock at any given point in time.

PE ratio based on last years reported earnings PE ratio based on trailing 12 months earnings PE ratio based on current years expected earnings PE ratio based on the following years expected earnings

P / E Ratio Constant Growth Dividend Model Dividend payout ratio P / E RATIO = Required Expected return on -growth rate equityin dividends Cross Section Analysis P / E = a1 + a2 Growth Rate in + a3 dividend earnings payout ratio + a3 Variability in earnings + a4 company sizeHistorical analysis

Weighted P /E ratio

Ratio

Historical Analysis

20 x 520 x 620 x 7PE ratio 9.25 6.63 6.23The average PE ratio is : 9.25 + 6.63 + 6.23 3

Weighted PE Ratio

PE ratio based on the constant growth dividend discount modelPE ratio based on historical analysis : 7.376.36 + 7.37 2= 7.37 = 6.87 : 6.36

Value Anchor and Value Range

Value Anchor

Projected EPS x Appropriate PE ratio 5.00 x 6.87 = Rs. 34.35

Value Range Rs.30 Rs.38Market Price Decision < Rs.30 Buy Rs.30 Rs.38 Hold > Rs.38 Sell

Tools for Judging Undervaluation or Overvaluation

PBV-ROE Matrix

Growth-Duration Matrix

Expectations Risk Index

Quality at a Reasonable Price (VRE)

PEG: Growth at a Reasonable Price

PBV-ROE Matrix

Overvalued High ROE

HIGH Low ROE High PBV

High PBV

Low ROE Undervalued

LOW Low PBV High ROE

Low PBV

LOW HIGH

ROE

PBV Ratio

Growth-Duration Matrix

UndervaluedPromises of growthDividend cowsOvervaluedHigh LowHigh LowExpected 5-YrEPS GrowthDuration (1/Dividend Yield)

Expectations Risk Index (ERI)

Developed by Al Rappaport, the ERI reflects the risk in realising the expectations embedded in the current market price

Proportion of stock Ratio of expected future price depending on growth to recent growth expected future growth (Acceleration ratio)ERI = X

ERI Illustration

Omegas price per share = Rs.150

Omegas operating cash flow (before growth investment)

Omegas cost of equity = 15 percent

Growth rate in after-tax cash operating earnings over the past three years

Market expectation of the growth in after-tax cash operating earnings over the next three years = Rs.10 per share = 20 percent = 50 percent

ERI Illustration

Omegas base line value = = Rs.66.7

Proportion of the stock price coming from investors expectations of future = = 0.56 growth opportunities

Acceleration ratio = = 1.25 ERI = 0.56 x 1.25 = 0.70

In general, the lower (higher) the ERI, the greater (smaller) the chance of achieving expectations and the higher (lower) the expected return for investors.150 66.7150Rs.100.151.501.20

Quality at a Reasonable Price

Determining whether a stock is overvalued or undervalued is often difficult. To deal with this issue, some value investors use a metric called the value of ROE or VRE for short. The VRE is defined as the return on equity (ROE) percentage divided by the PE(price-earning) ratio. For example, if a company has an expected ROE of 18 percent and a PE ratio of 15, its VRE is 1.2 (18/15). According to value investors who use VRE: A stock is considered overvalued if the VRE is less than 1.A stock is worthy of being considered for investment, if the VRE is greater than 1.A stock represents a very attractive investment proposition if the VRE > 2A stock represents an extremely attractive investment proposition if the VRE > 3

PEG: Growth at a Reasonable Price

What price should one pay for growth? To answer this difficult question, Peter Lynch, the legendary mutual fund manager, developed the so-called PE-to-growth ratio, or PEG ratio. The PEG ratio is simply the PE ratio divided by the expected EPS growth rate (in percent). For example, if a company has a PE ratio of 20 and its EPS is expected to grow at 25 percent, its PEG ratio is 0.8 (20/25).

PEG: Growth at a Reasonable Price

Proponents of PEG ratio believe that: A PEG of 1 or more suggests that the stock is fully valued.A PEG of less than 1 implies that the stock is worthy of being considered for investment.A PEG of less than 0.5 means that the stock possibly is a very attractive investment proposition.A PEG of less than 0.33 suggests that the stock is an unusually attractive investment proposition. Thus, the lower the PEG ratio, the greater the investment attractiveness of the stock. Growth-at-a-reasonable price (GARP) investors generally shun stocks with PEG ratios significantly greater than 1.

Obstacles in the Way of an Analyst Inadequacies or incorrectness of data Future uncertainties Irrational market behaviour

Excellent Versus Unexcellent Companies

In general, it appears that financial performance of excellent companies deteriorates whereas financial performance of non-excellent companies improves.

Empirical evidence of this kind reflects the phenomenon of reversion to the mean which says that, over time, financial performance of companies tends to converge to the average value of the group as a whole. Thanks to this tendency, good past performers are likely to produce inferior investment results and poor past performers are likely to produce superior investment results.

Equity Research in India

Traditionally, lip sympathy was paid to equity research. Financial institutions (mutual funds, in particular) had a research cell because it was in good form to have one. Likewise, large brokers set up equity research cells to satisfy their institutional clients. In the mid-1980s more progressive firms like Enam Financial, DSP Financial Consultants, and Motilal Oswal Securities Limited set up research divisions to exploit the opportunities in the equity market. With the entry of foreign institutional investors and the emergence of more discerning investors, the need for equity research is felt more widely. Indeed, currently equity research is a growing area.

Future

Equity researchers who are able to do their job well have bright prospects. The future belongs to those who will:

Have a clear understanding of what their research is supposed to do and how they should go about doing it.

Learn to interpret financial numbers and assess qualitative factors which may not be immediately reflected in numbers.

Develop a medium-term or long-term perspective based on an incisive understanding of the dynamics of the companies analysed.

How to Make Most of Stock Research Reports

To make the most of stock research reports, follow these guidelines: Dont trust a research report naively. Use it as a starting point and do your own due diligence before acting on it.

Check the credibility of the brokerage house by reading its reports over a period of time.

Be wary of unscrupulous brokerage houses which prepare biased research reports with ulterior motives.

Often a buy recommendation is given, when promoters or some other investors want to exit a stock.

Summing Up

In practice, the earnings multiplier method is the most popular method. The key questions to be addressed in this method are: what is the expected EPS for the forthcoming year? What is a reasonable PE ratio given the growth prospects, risk exposure, and other characteristics? Historical financial analysis serves as a foundation for answering these questions. The ROE, perhaps the most important metric of financial performance, is decomposed in two ways for analytical purposes. ROE = Net profit margin x Asset turnover x Leverage ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x Leverage

To measure the historical growth, the CAGR in variables like sales, net profit, EPS and DPS is calculated.

To get a handle over the kind of growth that can be maintained, the sustainable growth rate is calculated.

Beta and volatility of ROE may be used as risk measures.

An estimate of EPS is an educated guess about the future profitability of the company.

The PE ratio may be derived from the constant growth dividend model, or cross-section analysis, or historical analysis.

The value anchor is : Projected EPS x Appropriate PE ratio

PBV-ROE matrix, growth-duration matrix, and expectation risk index are some of the tools to judge undervaluation or overvaluation.