Download Fundamental Analysis Module

Fundamental Analysis Module
ByAishwarya Pant (2011009), Nikita Agrawal (2011069),
Rohan Garg (2011089), Romil Bhardwaj (2011092)
and Sanchit Saini (2011097)
List of topics
● Introduction to Fundamental Analysis
● Review of basics
● Understanding Financial Statements
● Valuation Methodologies
Fundamental Analysis
An Introduction
What is Financial Analysis ?
● A stock valuation methodology that uses financial
and economic analysis to predict the movement
of stock prices.
● The outcome is a value (or a range of values) of
the firm’s stock called its ‘intrinsic value’.
○ This stock’s price tend to revert towards this value.
Why is Fundamental Analysis
relevant for investing ?
● The Efficient Markets Hypothesis says that it is
impossible to ‘beat the market’ because stock
market efficiency causes existing share prices to
always incorporate and reflect all relevant
information.
Why is Fundamental Analysis
relevant for investing ?
● Recent research shows that prices could deviate
from their equilibrium values due to psychological
factors, fads, and noise trading.
● Thus, investors through fundamental analysis & a
sound investment objective can ‘beat the market’.
Steps in Fundamental Analysis
● Fundamental analysis consists of a systematic
series of steps to examine the investment
environment of a company and then identify
opportunities. Some of these are :
○ Financial analysis of the company
Steps in Fundamental Analysis
• Macroeconomic analysis
• Industry analysis
• Valuation
• Situational analysis of a company
Brushing up the basics
Time Value of Money
● Given a rate of return on an asset, the current or
future value of that asset can be evaluated by
going ahead or back in time respectively
Interest Rate / Discount Factor
● We need to find out the discount factor to be
used while calculating the present value of future
cash flows
● For that, it is important to understand
Opportunity Cost first
Opportunity Cost
● The cost of selecting an activity is the value of the
most expensive alternative not chosen.
● For example : If a person invests in stocks with 6%
return annually instead of a fixed deposit which
yields an 8% return, then the opportunity cost is
8% - 6% = 2%
Calculating WACC
Calculating Cost of Equity (Ke)
● The cost of equity for a stock is given by
Ke = Rf + β * ( Rm - Rf )
where,
Rf = risk free rate
β = the risk signifying the firm
Rm - Rf = equity risk premium
WACC Calculation Example
•Question: Company λ has a 1 million shares of
common stock currently trading at $30 per share.
Current risk free rate is 4%, market risk premium is
8% and the company has a beta of 1.2. It also has
50,000 bonds with of $1,000 par paying 10%
coupon annually maturing in 20
WACC Calculation Example
•Question (contd.): years currently trading at $950.
The tax rate is 30%.
Calculate the weighted average cost of capital.
WACC Calculation Example
•Answer: Calculating the weights of debt and equity.
Market Value of Equity = 1,000,000 × $30 =
$30,000,000
Market Value of Debt = 50,000 × $950 =
$47,500,000
WACC Calculation Example
•Answer (contd.): Total Market Value of Debt and
Equity = $77,500,000
Weight of Equity = $30,000,000 / $77,500,000 =
38.71%
Weight of Debt = $47,500,000 / $77,500,000 =
61.29%
WACC Calculation Example
Answer (contd.): Second step in our solution is to
calculate the cost of equity. With the given data we
can use capital asset pricing model (CAPM) to
calculate cost of equity as follows:
Cost of Equity = Risk Free Rate + Beta × Market
Risk Premium
WACC Calculation Example
Answer (contd.): Cost of Equity = 4% + 1.2 × 8%
Hence, Cost of Equity = 13.6%
We also, need to find the cost of debt. Cost of debt
is equal to the yield to maturity of the bonds. With
the given data, we can find that yield to maturity is
10.61%.
WACC Calculation Example
Answer (contd.): After tax cost of debt is hence
10.61% × ( 1 − 30% ) = 7.427%
And finally,
WACC = 38.71% × 13.6% + 61.29% × 7.427%
WACC = 9.8166%
Risk Free Rate (Rf)
● It represents the interest that an investor would
expect from an absolutely risk-free investment
over a period of time.
● Though such an investment is theoretical, in
practice, most professionals use short-dated
government bonds of the currency in question.
Equity Risk Premium (Rm- Rf)
● It is the premium that investors demand for the
average risk investment that they apply to
expected cash flows with average risk.
● When it rises, investors are charging a higher
price for risk and will therefore pay lower prices
for the same set of risky expected cash flows.
Beta (β)
● A measure of the systematic risk of a security that
cannot be avoided through diversification.
● It indicates the volatility of a stock’s price relative
to the price movement of the overall market.
● The risk associated with a stock is proportional to
its beta value.
Beta (β)
● Beta can be calculated using the following
formula:
Beta (β) Calculation Example
Question: Suppose a company uses only debt and
internal equity to finance its capital budget and uses
CAPM to compute its cost of equity. Company
estimates that its WACC is12%. The capital structure
is 75% debt and 25% internal equity. Before tax cost
of debt is 12.5 % and tax rate is 20%. Risk (cont.d)
Beta (β) Calculation Example
• Question (contd.) : free tax is rRF = 6% and market
risk premium (rm - rrf) is 8%.
What is the beta of the company?
Beta (β) Calculation Example
•Answer:
WACC = wd*rd*(1-T) + we*re
0.12 = 0.75*(0.125)*(1-0.20) + 0.25re
0.12 = 0.075 + 0.25re
Beta (β) Calculation Example
• Answer (contd.) :
re = 18%
re = 18% = rrf + β(rm-rrf)
18% = 6% + β(8%)
β = 1.5
Problems with Beta (β)
● Though Beta is a good measure of risk, still it is not
infallible.
○ It looks backward, and hence, is not always an
accurate predictor of future. Stocks with β<1 may
actually do better when the market is down
○ It doesn’t account for changes that are in the works,
such as new lines of business or industry shifts.
Understanding Financial
Statements
Why Financial Statements
•Understanding financial reports of companies most
important part of fundamental analysis.
•To ensure that all investors have basic facts about an
investment prior to buying it, the SEBI requires public
companies to disclose meaningful financial
information.
Where can one find financial
statements?
•Listed companies send all their shareholders annual
reports.
•Quarterly financials of the company – stock
exchanges' websites and website of the company.
Understanding financial statements
•An average investor is content if company makes a profit and
reasonable dividend paid, while an intelligent investor does an
in-depth analysis of annual report.
•The Annual Report is usually broken down into the following
specific parts: the Director’s Report, the Auditor’s Report, the
Financial Statements and the Schedules and Notes to the
Accounts
Director’s report
Comprises:
•Directors’ opinions on eco. & political situation w.r.t. to firm.
•Detailed performance and financial results.
•Company's plan for modernisation, expansion & diversification.
•Discusses profit earned and the dividend recommendation.
Director’s Report : Analysis
Q: Is it correct that all companies must diversify in
order to spread the risks of economic slumps?
A: No. We should question if diversification makes sense for the
company. Industry conditions, the management’s knowledge
of the new business must be considered.
Auditor’s Report
•Auditor represents the shareholders.
•An impartial report – whether the financial statements
presented do in fact present a true and fair view of the state of
the company.
•Reports any change, such as a change in accounting principles
or the non-provision of charges that result in an increase or
decrease in profits. Careful reading important for the investor.
Financial Statements
Consists:
• Balance Sheet detailing the financing condition of the company
at the end of its financial year
• Profit and Loss Account or Income Statement summarizing the
activities of the company for the accounting period and
• Statement of Cash Flows for the accounting period.
Balance Sheet
Details the financial position of a company on a particular date; the
company’s assets (that which the company owns), and liabilities (that
which the company owes), grouped logically under specific heads.
• Sources of funds – company has to source funds to purchase fixed
assets, to procure working capital and to fund its business.
• Companies raise funds from its shareholders and by borrowing.
Raising funds - Shareholders’ Funds
•Represent the stake shareholders have in the company.
•Share capital issued to public in the following ways: Private
placement (shares offered to selected individuals or
institutions), public issue (shares offered to public), rights
issues (shares issued to shareholders as a matter of right in
proportion to their holding), bonus shares (distribution of
profits amongst the shareholders in the form of bonus shares)
Raising funds - Shareholders’ Funds
Reserves - Reserves are profits or gains which are
retained and not distributed.
•Capital reserves - gains resulting from an increase in the value
of assets and are not freely distributable to the shareholders.
•Revenue reserves - profits from operations given back into the
company and not distributed as dividends to shareholders.
Raising funds – Loan funds
•Borrowing preferred as it is quicker, relatively easier and the
rules that need to be complied with are much less.
Secured loans - Loans taken by a company by pledging some of its assets or
by a floating charge on some its assets. E.g. debentures and term loans.
Unsecured loans - Companies do not pledge any assets when they take
unsecured loans. The comfort a lender has is usually only the good name and
credit worthiness of the company. E.g. fixed deposits and short term loans.
Balance Sheet - Fixed Assets
•Assets owned for use in its business and to produce goods
•Not for resale, comprises of land, building, factories, vehicles,
machinery, furniture etc. E.g. A manufacturing company’s
major fixed assets – factory and machinery, whereas that of a
shipping company would be its ships.
•Fixed assets are shown in the Balance Sheet at cost less the
accumulated depreciation.
Balance Sheet - Fixed Assets
Common methods of depreciation are:
• Straight line method - The cost of the asset is written off equally
over its life. In the end, the cost will equal the accumulated
depreciation.
• Reducing balance method - Depreciation is calculated on the written
down value, i.e. cost less depreciation. Depreciation is higher in the
beginning and lower as the years progress.
Straight Line Depreciation Calculation
Q: On Jan 1, 2011 Company A purchased a vehicle
costing $20,000. It is expected to have a value of
$5,000 at the end of 4 years. Calculate depreciation
expense on the vehicle for the year ended Dec 31,
2011.
Straight Line Depreciation Calculation
A: Depreciation =
Cost − Residual Value
Life in Number of Periods
Using the formula depreciation
=
20000−5000
4
= $3750
Reduce Balancing Depreciation
Calculation
Q: An asset has a useful life of 3 years. Cost of the asset
is $2,000. Residual Value is $500. Rate of depreciation
is 50%. Calculate depreciation expense for three years.
A: Depreciation per annum = (Net Book Value Residual Value) x Rate%
Reduce Balancing Depreciation
Calculation
Net Book Value
Residual
Value
Rate
Depreciation
Accumulated
Depreciation
Year 1
( 2000
-
500 )
x
50%
=
750
750
Year 2
( 1250
-
500 )
x
50%
=
350
1125
Year 3
( 875
-
500 )
x
50%
=
375
1500
It can be seen that depreciation expense under
reducing balance method progressively declines over
the asset's useful life.
Balance Sheet - Investments
•Companies purchase investments in the form of shares or
debentures to earn income or to utilize cash surpluses
profitably.
•Trade investments - Shares held in competitors companies.
•Subsidiary and associate companies - Shares held in subsidiary
or associate companies.
Balance Sheet - Current Assets
Any asset that is turned into cash within 12 months:
•Converting assets: Assets that are produced/generated in the
normal course of business, e.g. finished goods and debtors.
•Constant assets: Assets that are purchased and sold without any
add-ons or conversions
•Cash equivalents: Can be used to repay dues or purchase other
assets. E.g. cash in hand
Balance Sheet - Current Assets
Inventories - Stock that a company has. Stocks, in turn,
consist of:
•Raw materials
•Work in progress (goods that are in the process of manufacture
but are yet to be completed)
•Finished goods
Balance Sheet - Valuation of stocks
Stocks are valued at the lower of cost or net realizable value to
ensure that there will be no loss at the time of sale as that
would have been accounted for. Methods of valuing stocks:
•FIFO – Stocks that come in first would be sold first and those
that come in last would be sold last.
•LIFO – Goods that arrive last will be sold first. The reasoning is
that customers prefer newer materials or products.
Balance Sheet – More terms
•Prepaid Expenses– Asset resulting from business making
payments for goods & services to be received in near future.
•Cash & Bank Balances– Cash in hand in petty cash boxes, safes
and balances in bank accounts.
•Loans & Advances– Loans repayable within a certain period.
Includes amounts paid in advance for the supply of goods,
materials and services.
Balance Sheet – More terms
•Other Current Assets- Amounts due recoverable within the
next 12 months (claims receivable, etc.)
•Current Liabilities- Amounts due payable within the next 12
months.
•Creditors- Trade creditors are those to whom the company
owes money for raw materials and other articles.
Balance Sheet – More terms
•Accrued Expenses- Expenses such as interest on bank
overdrafts, telephone costs, and overtime paid after they have
been incurred as they fluctuate.
•Provisions- Amounts set aside from profits for an estimated
expense or loss.
•Sundry Creditors- Any other amounts. include unclaimed
dividends and dues payable to third parties
Income Statement
•Measures a firm's financial performance over a specific
accounting period.
•Financial performance is assessed by giving a summary of how
the business incurs its revenues and expenses through both
operating and non-operating activities.
•Shows the net profit or loss incurred over a specific accounting
period, typically over a fiscal quarter or year.
Income Statement – Sales
•Sales include the amount received/receivable from customers
arising from the sales of goods and services.
•As companies give trade discounts to customers, sales should
be accounted for after deducting these discounts.
•Cash discounts for early payment are a finance expense, and
hence, should be shown as an expense.
Income Statement – Other Income
•Income that firms receive from sources other than
from product sales or provision of services.
oProfit from the sale of assets
oDividends - from the firm’s investments in other firms’ shares
oRent - received on commercial buildings leased from company
oInterest - received on deposits made and loans given
Income Statement
•Raw Materials and other items used in the manufacture of a
company’s products, also called the Cost of Goods Sold.
•Employee Costs include wages, salaries, bonus, gratuity, and
other funds, and other employee related expenditure.
•Transfer to Reserves - Profit given back into the company. May
be done to finance working capital, expansion etc. or can be
distributed to shareholders as dividends.
Income Statement
Operating & Other Expenses: All other costs incurred
in running a company, include:
•Selling expenses - Cost of advertising, sales commissions, etc.
•Administration expenses - Rent of offices and factories,
stationery, insurance, motor maintenance etc.
•Others - Costs that are not strictly administration or selling
expenses.
Income Statement
•Interest & Finance Charges - A company has to pay
interest on money it borrows.
The normal borrowings that a company pays interest
on are: bank overdrafts, term loans taken for the
purchase of machinery, fixed deposits from the public,
debentures, Inter-corporate loans.
Income Statement
•Contingent Liabilities – Liabilities that may arise up on
the happening of an event. It is uncertain however
whether the event itself may happen. The contingent
liabilities one normally encounters are bills discounted
with banks, gratuity to employees not provided for,
etc..
Annual Report - Schedules and Notes to
the Accounts
Schedules detail pertinent information about the items
of Balance Sheet and P&L Account.
•Information about sales, manufacturing costs, administration
costs, interest, and other income and expenses.
•Vital for the analysis of financial statements as it enables
investor to determine what expenses increased and why.
Annual Report - Schedules and Notes to
the Accounts
Notes to the accounts contain important information
related to the company.
•Accounting policies- Companies have also been known to
change their profit by changing the accounting policies.
•Contingent liabilities - All contingent liabilities are detailed in
the notes to the accounts and it would be wise to read these as
they give valuable insights.
Cash Flow Statement
•Allows investors to understand how a company’s operations
are running, where its money is coming from and how it is
being spent.
•Structure of the CFS: It doesn’t include the amount of future
incoming and outgoing cash that has been recorded on credit.
•A company can use a cash flow statement to predict future
cash flow, which helps with matters in budgeting.
CFS Component #1:
Cash Flow From Operations
•An accounting item indicating the money a company brings in
from ongoing, regular business activities.
•Doesn’t include long-term capital or investment costs.
•Also called operating cash flow, can be calculated as follows:
•Cash Flow From Operating Activities = EBIT + Depreciation Taxes
CFS Component #2:
Cash Flow From Investing
•Changes in equipment, assets or investments in it.
•Usually cash changes from investing are a cash out item,
because cash is used to buy new equipment, buildings or shortterm assets such as marketable securities.
•When a company divests of an asset, the transaction is
considered cash in for calculating cash from investing.
CFS Component #3:
Cash Flow From Financing
•Changes in debt, loans or dividends are accounted for in this.
•Cash in when capital is raised, and cash out when dividends are
paid.
•Thus, if a company issues a bond to the public, the company
receives cash financing; however, when interest is paid to
bondholders, the company is reducing its cash.
Cash Flow Statement Example
Net increase/decrease in cash
=
Cash flow from operating
activities + Cash flow from
investing activities + Cash flow
from financing activities
Parentheses indicate
negative values.
Financial Ratios
● Can be categorized into:
o Liquidity Measurement Ratios
o Profitability Measurement Ratios
o Debt Ratios
o Operating Performance Ratios
Liquidity Measurement Ratios
● Try measuring a firm’s short-term debt obligations
(its most liquid assets vs. its short-term liabilities)
● Rule of thumb: Greater the coverage of such
obligations, the better it is.
● Differences arise in the ratios due to the assets
assumed to be liquid.
Current Ratio (most popular ratio)
● Idea: A firm’s short-term assets (cash, cash
equivalents, securities, receivables and inventory)
can readily pay-off its short-term liabilities
● Rule of thumb: The higher, the better
● Problem: Assumption of liquidity may be flawed.
Current Ratio - Why it fails?
● This ratio assumes liquidity of all the current assets,
but all of them may not be easily converted to cash.
● Example: If the curr. liabilities are paid monthly, but
the receivable collection and inventory turnover
requires 6 months, the firm is cash-tight.
● Understanding the cash-conversion cycle helps.
Quick Ratio
● More conservative than the former as it excludes
inventory and other assets that can’t be easily
converted to cash
● Rule of thumb: Higher ratio => More liquid position
Quick Ratio w.r.t Current Ratio
● Though more conservative, the Quick. R. still
assumes liquidity of some assets.
● In general, a comparison of Quick R. to Current R. is
helpful too. For example:
o If Curr. R. > Quick R., the company’s current assets are
dependent on inventory.
Cash Ratio
● Even more conservative as it counts only cash, cash
equivalents and invested funds as current assets.
● Rarely used in reporting as firms don’t keep high
levels of cash assets to cover current liabilities.
o Excess can be returned to shareholders or used
elsewhere to generate higher returns.
Liquidity Measurement Ratios - QnA
Q: Suppose an IT firm XYZ’s financial statements are:
Liquidity Measurement Ratios - QnA
Calculate the Current Ratio, Quick Ratio and Cash Ratio (of Mar’10) for XYZ.
Liquidity Measurement Ratios - QnA
Answer:
• Current Ratio = 13041/4030 (figures from balance sheet) = 3.24
• Quick Ratio = 13041/4030 (figures from balance sheet) = 3.24
Here, the ratios have the same value as being from a services
sector, XYZ doesn’t have any inventory on its balance sheet
• Cash Ratio = 9797/4030 (figures from balance sheet) = 2.43
Profitability Indicator Ratios
● Give good understanding on how effectively a firm
utilizes its resources in generating profit and
shareholder value.
● Next, we cover profit margins, which are usually
taken as percentages to show effective changes
over a period of time, rather than absolute changes.
Profit Margins
● Gross Profit Margin
o Shows efficiency of a firm in using its raw materials,
labour and fixed assets to generate profits.
o Rule of thumb: Higher margin, favourable indication
o Weight of this margin varies between the company
types. Eg.: Retailers don’t have a “cost of sales”.
Profit Margins
● Operating Profit Margin
o Since the management can control the operating
expenses, +ve/-ve trends are directly related to their
decisions.
o Hence, this is preferred over net-income for making
inter-company projections and financial projections.
Profit Margins
● Pre-tax Profit Margin
o A firm can use various tax-management techniques to
manipulate the timing and magnitude of its taxable
income. Hence, the pre-tax income is useful.
o Rule of thumb: Higher margin => more profitable the firm
o This margin’s trend gives an insight of where the firm’s
profitability is headed.
Profit Margins
● Net Profit Margin
o Often mentioned while discussing a firm’s profitability.
o However, investors must also look at the income
elements and expense operating elements in the Balance
Sheet that determine this margin.
Effective Tax Rate
● Gives an understanding of the tax rate a firm faces.
For example: XYZ’s effective tax rate for Mar’10 is
= 1717 / 7520 = 23%
● Differs from firm’s stated rate due to accounting factors,
such an forex provisions.
● While companies can lessen their tax burdens smartly, a
relatively stable eff. rate is a good sign.
Return on Assets (ROA)
● Shows profitability of a firm w.r.t. its total assets
o Intuitively, higher the return, more efficient use of asset
base. But capital-intensive firms have a higher
denominator, & non-capital-intensive firms have a higher
numerator.
o Hence, for comparisons, companies being reviewed
should be similar in product line and business type
Return on Equity (ROE)
● Measures how much the shareholders earn for their
investment in the firm
o The higher the ratio %age, the more efficient use of the
equity base & the better return to its investors
o Weakness: disproportionate amount of debt => smaller
equity base. Thus, the debt-equity relation is imp. too!
Return On Capital Employed (ROCE)
● Complements the ROE by adding the firm’s debt
liabilities to equity to give the total capital
employed.
● Gives a picture of how the use of leverage impacts a
company’s profitability.
Debt Ratios
● Used to determine the overall level of financial risk
the firm and its shareholders face.
● Generally, the greater the amount the amount of
debt, the greater the financial risk of bankruptcy.
Debt Ratios
● Debt Ratio
o Gives an idea of the amount of leverage being used by a
firm. The lower the %age, the less leverage a firm is using
and the stronger its equity position (large companies can
push liabilities to higher %ages without much trouble)
o Problem: Liabilities such as operational liabilities are also
counted as debt, but they aren’t really debts.
Debt Ratios
● Debt-Equity Ratio
o Measures how much the suppliers, lenders, creditors and
obligors have committed vs. the shareholders.
o Lower %age => Less leverage & stronger equity position
o Problem: Even this includes operational liabilities in debt.
o As with Debt Ratio, large companies can push the liability
comp. to higher %ages, without getting into trouble.
Debt Ratios
● Capitalization Ratio
o Measures the debt component of a firm’s capital
structure.
o While the RIGHT ratio varies acc. to industries, business
line and development stage, a low debt and high equity
in this ratio generally denotes high investment quality.
Debt Ratios
● Interest Coverage Ratio
o Determines how easily a firm can pay interest expenses
on outstanding debt.
o The lower the ratio, the more is a firm burdened by debt
expense.
Debt Ratios
● Cash Flow to Debt Ratio
o Determines how easily a firm can cover total debt with
its yearly cash flow from projections.
o The higher the ratio, the better the firm’s ability to carry
its total debt.
Operating Performance Ratios
● Give insights into the firm’s performance and management
during the period being measured.
o
Fixed-Asset Turnover gives a measure of the productivity of the
firm’s fixed assets to generating sales
o
Sales/Revenue per Employee gives a measure of personnel
productivity of a firm. The industry and product-line influence this
indicator.
Du-Pont Analysis
● Can be used in assessing the financial performance
of a firm.
● The ratio incorporates profitability, operating
efficiency and leverage to aid an investor to
understand a firm’s strengths and weaknesses.
Du-Pont Analysis - Breakup
● Formula:
o Net Income/Sales = Net Profit Margin (Profitability)
o Sales / Avg. Assets = Tot. Asset Turnover (Asset Util.n)

{Avg. Assets = (Assets at beg. + Assets at end)/2}
o Avg. Assets / Avg. Equity = Leverage Multiplier
Du-Pont Analysis – Analysis Example
Q: If an IT firm’s Du-Pont Ratio is: ROE = 22.92 * 1.06 * 1 = 24.3, while that
of the IT industry ratio is: ROE = 20 * 1.01 * 1.1 = 22.2. What can you say
about the profitability and asset utilization of the firm?
A: Here, the firm’s profitability is higher than the IT industry (as 22.92 > 20),
while asset utilization is roughly in line with the industry.
● Note: We can compare the leverage of the firm and the industry on the
whole.
Du-Pont Analysis - Extension
● The analysis can sometimes overlook factors that
the decomposition doesn’t readily identify; eg a
low-gross margin and a very high operating margin.
● To avoid this, we can extend the formula to
incorporate more components:
Cash Conversion Cycle
● Our liquidity measurement ratios assume the
liquidity of certain assets, hence, not fully capturing
the liquidity of the firm.
● The CCC gives us the duration that a firm uses to sell
inventory, collect receivables and pay its accounts
payable. The shorter this cycle, the more liquidity.
Cash Conversion Cycle (CCC)
Cash Conversion Cycle (Formula)
DIO
Days Inventory Outstanding
(Days taken by a firm to turn over)
Calculated by dividing
avg. inventory figure by
cost of sales per day
+
=
Days Sales Outstanding
DSO
(Days taken by a firm to collect on
sales going into accounts receivable)
Calculated by dividing
avg. accounts
receivable figure by net
sales per day
Days Payables Outstanding
DPO
(Days taken by a firm to pay its
obligations to its suppliers)
Calculated by dividing
avg. accounts payable
figure by net sales per
day
Cash Conversion Cycle (Example)
Q: Calculate the Cash Conversion Cycle value for the
XYZ (whose financial statements have been given in the
Financial Ratios segment).
Cash Conversion Cycle (Example)
•DIO is given by:
•DSO is given by:
•DPO is given by:
Cost of Sales per day
= 13771/365 = 37.73
Average Inventory
= (0+0)/2 = 0
Days Inventory Outstanding
= 0/37.73 = 0
Net Sales per day
= 21140/365 = 57.92
Average Accounts receivables
= (3390+3244)/2 = 3317
Days Sales Outstanding
= 3317/57.92 = 57.27
Cost of Sales per day
= 13771/365 = 37.73
Average Payables
= (1544+1995)/2 = 1769.5
Days Payables Outstanding
= 1769.5/37.73 = 46.90
• Therefore, XYZ’s CCC = DIO + DSO – DPO = 10.37
Valuation Methodologies
Top Down Approach/ EIC Analysis
Company
Sector
Economy
Economy
To understand the impact of economy on Stock prices, we
need to
● Have a sound economic understanding.
● Interpret the impact of important economic indicators.
● Understand economy and capital flows, interest rate
cycles and currency fluctuation.
Economic Indicators
● Allow analysis of economic performance and
prediction of future performance.
● Include - various indices, earning reports and
economic summaries.
● Can have 3 relationships to the economy.
Relationship of EI and Economy
● Procyclic
○ Moves in the same direction as the economy.
○ If economy does well - this number is increasing.
○ If recession - this number is decreasing.
○ Example - GDP
Relationship of EI and Economy
● Counter Cyclic
○ Moves in the opposite direction as the economy.
○ If economy does well - this number is decreasing.
○ If recession - this number is increasing.
○ Example - unemployment rate - gets larger as
economy gets worse.
Relationship of EI and Economy
● Acyclic
○ Not related to health of economy.
○ Generally of little use as they have no correlation to
the business cycle.
○ May rise or fall even if economy is doing well.
Categories of EI
● Leading EI
● Lagging EI
● Coincidental EI
Leading EI
○ Change before the economy changes.
○ Used to predict changes in economy but are not always
accurate.
○ Bond yields are typically a good leading indicator of the
market because traders anticipate and speculate trends
in the economy.
○ Other Examples - Stock market return, Baltic Dry Index
Lagging EI
○ Changes after the economy has already begun to
follow a particular pattern or trend.
○ Confirm long-term trends, but they do not predict
them.
○ Example - unemployment rate - tends to increase for
2-3 quarters after economy starts to improve.
Coincidental EI
○ Shows the current state of economic activity within a
particular area.
○ Important because it shows economists and
policymakers the current state of the economy.
○ Example - Personal Income, GDP, industrial
production and retail sales.
7 Broad Categories where EIs fall
● Total Output, Income, and Spending
○ Broadest measures of economic performance.
○ includes GDP - used to measure economic activity.
○ Thus is both procyclical & a coincident economic indicator.
○ Implicit Price Deflator is a measure of inflation.
○ Inflation is procyclical and also coincident indicators.
○ Consumption and consumer spending are also procyclical
and coincident.
● Employment, Unemployment, and Wages
○ Unemployment rate is a lagged, countercyclical
statistic.
○ Level of civilian employment measures how many
people are working - hence procyclic.
○ Unlike the unemployment rate it is a coincident
economic indicator.
● Production and Business Activity
○ Cover how much businesses are producing and the
level of new construction in the economy.
○ Changes in business inventories, an important leading
economic indicator - indicate changes in consumer
demands.
○ New construction including new home construction another procyclical leading indicator.
● Prices
Includes both the prices consumers pay as well as the prices
businesses pay for raw materials and include
○ Producer Prices
○ Consumer Prices
○ Prices Received And Paid By Farmers
They measure changes in the price level and thus measure
inflation.
● Money, Credit, and Security Markets
Measure the amount of money in the economy as well as
interest rates and include
○ Money stock (M1, M2, and M3)
○ Bank Credit at all commercial banks
○ Consumer credit
○ Interest rates and bond yields
○ Stock prices and yields
They tend to be procyclical and a coincident economic indicator.
● Government Finance
Measures of government spending and government deficits and debts:
○ Budget Receipts
○ Budget Outlays
○ Union Government Debt
During recessions, govt. stimulate economy by increasing spendings
without raising taxes, causes govt. spendings and
government debt to rise during a recession - countercyclical indicator.
They tend to be coincident to the business cycle.
● International Trade
○ Measures country’s exports and imports.
○ level of exports tends not to change much during the
business cycle. So net exports is countercyclical as imports
outweigh exports during boom periods.
○ Measures of international trade tend to be coincident
economic indicators.
Industry
● Detailed analysis of a specific industry.
● Purpose: to identify those industries with a
potential for future growth and to invest in
equity shares of companies selected from such
industries.
Company
● Final stage - Analyse the company.
● This analysis has two thrusts:
○ How the company has performed vis-à-vis other
similar companies
○ How the company has performed in comparison to
earlier years
Issues to be examined
● The Management
● The Company
● The Annual Report
● Cash flow
● Ratios
The Management
● A very important factor.
● It is upon the quality, competence and vision of the management
that the future of company rests.
● Under good, competent management, company grows.
Examples: Sunil Mittal of Bharti Airtel, Azim Premji of
Wipro, Deepak Parekh of HDFC, are few such examples where the
management of the companies headed by strong leadership have
helped companies create significant wealth for their investors.
Two types of Management
● Family Management
○ a member of the owner or controlling family, at the helm.
○ all policies determined by controlling family.
○ some may be good, some may not neccessarily be in
shareholder’s interests.
○ Advantage: Loyal family members.
Two types of Management
● Professional Management
○ managed by professionals who are company’s employees.
○ The CEO often does not even have a financial stake.
○ His aim: meeting the annual budget and business targets.
○ Disadvantage: professional managers may leave the company
for better pay and perquisites offered by another company.
○ Would be unfair to say to invest only in professional ones.
What factors to look for while
investing in companies?
Integrity of Management
○ Most important aspect.
○ A determined employee can perpetrate a
fraud, despite good systems and controls.
○ Similarly, the management can juggle figures,
causing harm and financial loss to a company.
○ Tracking integrity may not be easy.
Past record of management
○ Another point to consider: proven competence.
○ How has the management managed the affairs over the
last few years?
○ Has the company grown?
○ Has it become more profitable?
○ Wise to be a little wary of new management.
○ Wait until the company shows signs of success.
How highly is the management rated by its peers in
the same industry?
○ A very telling factor.
○ Competitors are aware of nearly all the strengths and
weaknesses of management of their rivals.
○ If they hold the management in high esteem it is truly
worthy of respect.
How the management fares in adversity?
○ Inherent strength of a management tested.
○ How well the management does in times of recession.
■ Did it streamline its operations?
■ Did it close down its factories?
■ Was it able to sell its products?
■ How did sales fare?
○ A management that can steer its company in difficult days
will normally always do well.
The depth of knowledge of the management
○ Knowledge of its products, its markets and the industry.
○ Often the management sits back thinking that it will
always be the dominant company. The reality sinks in only
when it is too late.
○ Must be in touch with the industry and customers at all
times.
○ Be aware of the latest techniques and innovations
The management must be open, innovative and
must also have a strategy
○ Must be prepared to change when required.
○ Must essentially know where it is going and how to go
there.
○ Must be receptive to ideas.
○ Be dynamic.
Non-professionalised Management
○ Not recommended to invest in a company - yet to
professionalize.
○ As decisions are made on the whims of the chief
executive.
○ The most competent are not given the positions of
power.
○ There may be nepotism because of blood ties.
Valuation Models
Valuation Models
DCF
DDM
DCF
• Valuation of corporates
• Basis of Fundamental Analysis - Intrinsic value of a company
• Uses expected future Cash flows to calculate the present value
• The single most powerful tool to value anything in the world
of finance
DCF
• Not just corporates, if we take a closer look at project
financing, it also uses DCF for valuing whether a project is
worth pursuing or not
• Gives an investor the power to see how much would the
money become in years to come. Time value of money –
power of compounding
Deep-diving into DCF
• What is it: In discounted cash flow valuation, the value of an
asset/corporate is the present value of the expected cash
flow on the asset
• Principle: Every asset has an intrinsic value that can be
estimated, based upon its characteristics in terms of cash
flows, growth and risk. This risk is captured by the rate of
return we expect or the discounting rate we sue in the DCF.
Deep-diving into DCF
• Information needed:
• Expected life of asset/project, which is also our ‘n’ in the
formula
• Expected cash flows during the life of the asset at various
times. For simplicity, take cash flows at year end for now
• Discount rate to be used for the valuation – this captures
the expected risk
Fundamentals of a DCF model
Expected
cashflow
`
Year
Discount rate
Illustration of DCF
How much is an infinite stream of
INR 15 million/year worth?
Assume 10% discount rate.
Expected cash-flow
Discount rate
Year
What if we were to calculate the
risk?
Weighted average cost of capital (WACC) is one of the useful tools to do this. Here’s how…
Cost of Debt (Kd)
➢
Risk Free Rate (e.g. 10 year government bond) Nominal or real
➢
Appropriate Credit Risk Premium to capture for the risk specific to the asset/project under
valuation
Cost of Equity (Ke)
➢
Equity risk premium is an estimate of the premium investors require in excess of risk-free assets for owning
equities (4-7% most typically used)
➢
Beta is a measurement of firm's/similar firms volatility compared to the market (if higher than 1
company/sector
is riskier than market in average)
➢
CAPM is the most frequently used model to calculate cost of equity
Fundamentals of a DCF model
Expected
cashflow
Year
‘r’ will be
replaced by
WACC now in our
formula
Discount rate
This also makes sense as the WACC the cost of capital that the firm has to pay on an average,
which essentially is the weighted average risk that the project bears, or the effective return
which the debt + equity holders of the company expect from the company in return
What if we were to value a financial institution?
• The DCF doesn’t really work there – Banks/FIs are run on the
balance sheets; hence we do not look at cash flows in their
case – they are usually driven by the dividends paid.
• DDM comes to rescue us in that case
• We use cost of equity instead of WACC in case of a dividend
discount model
What if we were to value a financial institution?
• Another way to think about this is that Free Cash flows are usually
arrived at post changes in WC and capex – FIs/ Banks are not capex
oriented like a corporate; thus, it would make sense to use
something which really captures their business model for the
purpose of true valuation – isn’t that what the world of investing is
all about.
The magical science behind valuation is evident
yet again
Ct = the expected cash flow
t = time
k = the discount rate
DDM is an extended application of this concept
And how is that?
Here’s
how
Expected cashflow → this is
the dividend
paid
indefinitely
Year
Discount rate → cost
of equity here
But this assumes
dividends are paid
indefinitely, which
takes us to our next
important point
Estimating the Discount Rate
Discount rate = Risk-free rate + (Stock beta x Market risk
premium)
Risk-free rate = U.S. T-bill rate, which is the wait
component or time value of money.
Stock beta measures the individual stock’s risk relative to
the market.
Market risk premium measures the difference in return
between investing in the market and investing in T-bills
Discount Rate Example
Assume T-bills yield 4.5%; ABC’s beta is 1.15; and the market
risk premium = 8%
Discount rate = 4.5% + (1.15 x 8%) = 13.70%
Using the CPGM with D(0) = ₹2 and g = 6%:
V(0) = ₹2(1.06)/(.1370 - .06) = $27.53
Discount Rate Example
What if the MRP were 9%?
DR = 4.5% + (1.15 x 9%) = 14.85%
V(0) = ₹2(1.06)/(.1485 - .06) = ₹23.95
What if g = 7%?
V(0) = ₹2(1.07)/(.1370 - .07) = ₹31.94
Based on the assumptions on growth rates
and dividends we have variations in DDM
Constant Growth
Model
Two stage DDM
Constant/Gordon Growth model
If dividends are expected to grow at a constant rate,
say g, then the current value of the stock is given by
D1 = next year's dividend
kce = required rate of return on common equity
g = firm's expected constant growth rate
Constant/Gordon Growth model
Assumptions
• Growth rate in dividends is constant
• Earnings per share is constant
• Payout ratio is constant
Constant/Gordon Growth model
In order to use this model, we have to estimate the
expected growth rate, g, which can be done by
• Using the growth rate as projected by security
analysts
• Using 𝑔 = 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
= (1 – 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑒)(𝑅𝑂𝐸)
Constant Growth Model Example
Suppose D(0) = ₹ 200; k = 12%; g = 6%.
D(1) = (₹ 200 x 1.06) = ₹ 212
V(0) = ₹ 212 / (.12 - .06) = ₹ 3533
Merits and Caveats
Merits
✓Easy to
compute
Caveats
o Not usable for firms paying no dividends
o Not usable when g > k
o Sensitive to choice of g and k
o K and g may be very difficult to estimate
o Constant perpetual growth is often
unrealistic
Two stage DDM
Two stage DDM
Early growth phase –
usually high growth
phase
Two stage DDM essentially is a SOTP
concept
Constant growth
phase
Terminal Value and
much like the
constant growth
model
Two-Stage (any number) Dividend Growth
Model
If we have two different growth rates, one for an early period and one
for a later period, you would use the two-stage model
➢ASSUMPTION:
• future dividend growth is not constant
➢Model Methodology
• to find present value of forecast stream
of dividends
• divide stream into parts (lifecycle stage)
• each representing a different value for g
➢ Advantage
▪ Allows for two different growth rates
▪ g can be greater than k during period 1
➢ Disadvantages
▪ Not usable for firms paying no
dividends
▪ Sensitive to choice of g and k
▪ k and g may be difficult to estimate
FCFF based DCF
● FCFF (Free Cash Flow to Firm) is the cash available to bond
holders and stock holders after all expenses and investments
have taken place
● Positive value - Good sign, shows firm has cash after expenses
● Negative value - Not enough revenue generated to cover its
costs and investments. Investor should dig deeper for
reasons.
FCFF based DCF
FCFF = NI + NCC + I(1-T) - FC - WC
or
FCFF = CFO - FC + I(1-T)
NCC= non-cash charges such as
FC = Change in fixed capital investments.
depreciation and amortization
WC = Change in working capital
NI = Net income.
investments.
I (1-T) = After-tax interest expense.
CFO = cash flow from operations
Example: Calculating FCFF
EBITDA
$1,000
Depreciation expense
$400
Interest expense
$150
Tax rate
30%
Purchases of fixed assets
$500
Change in working capital
$50
Net borrowing
$80
Common dividends
$200
Example: Calculating FCFF from Net Income
NI = (EBITDA – Dep – Int)(1-Tax Rate)
NI = ($1000 - $400 - $150)(1 - 0.3) = $315
FCFF = NI + NCC + Int(1-Tax Rate)-FCInv-WCInv
FCFF = $315 + $400 + $150 (1-0.3) - $500 - $50 = $270
Example: Calculating FCFF from EBIT and EBITDA
EBIT = EBITDA – Dep = $1000 - $400 = $600
FCFF = EBIT (1 – Tax Rate) + Dep – FCInv – WCInv
FCFF = $600(1-0.30) + $400 - $500 - $50 = $270
FCFF = EBITDA(1 – Tax Rate) + Dep(Tax Rate) – FCInv – WCInv
FCFF = $1000(1-0.30) + $400 (0.3) - $500 - $50 = $270
Example: Calculating FCFF from CFO
CFO = NI + Dep – WCInv
CFO = $315 + $400 - $50 = $665
FCFF = CFO + Int(1-Tax Rate) – FCInv
FCFF = $665 + $150(1-0.30) - $500 = $270
FCFE based DCF
● Free cash flow to equity (FCFE) is the cash flow available to
the firm’s equity holders after all operating expenses,
interest and principal payments have been paid, and
necessary investments in working and fixed capital have
been made.
FCFE = FCFF + Net Borrowing - I(1+T)
FCFE based DCF
FCFE = Cash Flow from Operations
+ Net Borrowing
- Change in Fixed Capital Investments
● Given discount rate Ke and growth rate of FCFE is g:
Previous Example: Calculating FCFE from
FCFF, Net Income, & CFO
FCFE = FCFF – Int(1- Tax Rate) + Net Borrowing
FCFE = $270 - $150(1-0.3) + $80 = $245
FCFE = NI + NCC - FCInv – WCInv + Net Borrowing
FCFE = $315 + $400 - $500 - $50 + $80 = $245
FCFE = CFO – FCInv + Net Borrowing
FCFE = $665 - $500 + $80 = $245
Forecasting Free Cash Flows
● To forecast free Cash Flows, compute historical free cash flow
and apply some constant growth rate
● Appropriate if:
o Free cash flow for the firm tended to grow at a constant
rate
o Historical relationships between free cash flow and
fundamental factors are expected to be maintained
FCFF and FCFE based DCF
FCFF and FCFE used when
• The firm is not dividend paying
• The firm is dividend paying but dividends differ significantly
from the firm’s capacity to pay dividends
• Free cash flows align with profitability within a reasonable
forecast period with which the analyst is comfortable
• The investor takes a control perspective
Sum of the Parts (SOTP) Evaluation
● Each business unit is valued based on either
discounted free cash flows (DCF) or peer multiples.
● Sum of these parts gives the Enterprise Value
● Good for companies with diverse business interests
Sum of the Parts (SOTP) Evaluation
● Evaluates each unit separately - also includes
ventures which are not currently generating
revenues
● SOTP can indicate if the value of the company
would increase if it was split
SOTP Example
Q. Using DCF, the valuations of the following divisions
of Microsoft was as follows. Find the SOTP of
Microsoft, assuming these are the only divisions.
Cloud and Enterprise
14.1 Million USD
Devices and Services
31 Million USD
Windows and Office
24 Million USD
SOTP Example
A. SOTP Enterprise Value will simply be the sum of all
the divisions’ DCF valuations:
SOTP = 14.1 + 31 + 24
= 69.1 Million USD
Relative Valuation
● In relative valuation, the value of an asset is compared to the
values assessed by the market for similar or comparable
assets.
● Relative valuation is much more likely to reflect market
perceptions and moods than DCF valuation.
Relative Valuation
When to do relative valuation:
● Objective is to sell a security at that price today (IPO)
● Investing in “momentum” based strategies
How to do Relative Valuation
● Identify comparable assets and obtain market values
● Convert market values into standardized values. This price
multiples.
● Compare the multiple for the asset being analyzed to the
standardized values for comparable asset, controlling for any
differences between the firms that might affect the multiple,
to judge whether the asset is under or overvalued.
Price : Earnings Ratio
● The P/E ratio of a stock is a measure of the price paid for a
share relative to the annual net income or profit earned by
the firm per share.
PE = Market Price per Share / Earnings Per Share
Trailing P/E Ratio
● Earnings per share is the net income of the company for the
most recent 12 month period, divided by number of shares
outstanding.
● Most commonly used.
Forward P/E Ratio
● Instead of net income, uses estimated net earnings over next
12 months.
● Estimates are typically derived as the mean of a select group
of analysts.
● These estimates change rapidly with change in time.
Price / Book Value Ratio
● Calculated by dividing the current closing price of the stock
by the latest quarter’s book value per share.
● Also known as the “price-equity ratio”.
● Low value -> Undervalued or something wrong with
company
Enterprise Value/EBITDA Ratio
● The enterprise value to EBITDA multiple is obtained by
netting cash out against debt to arrive at enterprise value
and dividing by EBITDA.
Price/Sales Ratio
● Price/Sales looks at the current stock price relative to the
total sales per share.
● Typically, lower the P/S, the better the value.
● Suitable for growing industries but highly volatile.
Example
Q. Out of the ratios studied till now, which one would you use
to advise an investor in the dot com boom in the 90s?
A. Since all the companies are new, it may make sense for an
investor to use the price:sales ratio along with some other
multiple to take a low risk decision. Many companies don’t even
have a single sale before they go public, this may be a warning
sign.
Valuations for Financial Services
Firms
Financial Services Firms
● Incase of banks, money is the raw material as well as the
final product
● Banks need to maintain a certain percentage of their
deposits with RBI, known as Cash Reserve Ratio
● They also need to invest in Government Securities that is a
part of its statutory liquidity ratio (SLR)
Financial Services Firms
● Since money (which comes from net worth) is the
capital for banks, price to book value is important
for banks.
Ratios for Financial Services Firms
•
Non Interest Income Metric
•
Operating Profit Margins (OPM) Ratio
•
Credit to Deposit Ratio (CDR)
•
Capital Adequacy Ratio (CAR)
•
Cost to Income ratio
•
NPA (Net Non-Performing Assets to Loans) Ratio
•
Provision Coverage Ratio
Ratios for Financial Services Firms
Net Interest Income (NII) Metric
● Net Interest Income Metric is essentially the difference
between the bank’s interest revenues and its interest
expenses.
● Indicates how effectively the bank conducts its lending and
borrowing operations.
Ratios for Financial Services Firms
Net Interest Margin (NIM) Ratio
● Net interest margin is the net interest income earned by the
bank on its average earning assets.
● These assets comprises of advances, investments, balance
with the RBI and money at call.
Ratios for Financial Services Firms
Operating Profit Margins (OPM) Ratio
● Banks operating profit is calculated after deducting
administrative expenses, which mainly include salary cost
and network expansion cost.
● Negative for banks with large networks and infrastructure
Ratios for Financial Services Firms
Credit to Deposit (CD) Ratio
● Ratio of funds lent by the bank out of the total amount
raised through deposits.
● Higher ratio reflects ability of the bank to make optimal use
of the available resources.
Ratios for Financial Services Firms
Capital Adequacy Ratio (CAR)
● Ratio of qualifying capital to risk adjusted assets.
● Minimum CAR set to 10% by RBI in 2002
● A ratio below the minimum indicates that the bank is not
adequately capitalized to expand its operations.
● The ratio ensures that the bank do not expand their business
without having adequate capital.
Ratios for Financial Services Firms
NPA (Net Non-Performing Assets to Loans) Ratio
● Used as a measure of the overall quality of the bank’s loan
book.
● Higher ratio reflects rising bad quality of loans.
Ratios for Financial Services Firms
Provision Coverage Ratio
● An indicator of the asset quality of the bank is the ratio of
the cumulative provision balances of the bank as on a
particular date to gross non performing assets.
● High Ratio -> additional provisions to be made by the bank in
the coming years would be relatively low
Special Cases of Valuation
IPOs
● New companies have unsustainably high growth rates and
volatile revenues - forecasting future cash flows is not possible.
● In newer business models, comparision is also often difficult
due to lack of similar companies.
● Thus, DCF is very inaccurate for these companies.
● Use of accounting numbers and comparable multiples.
Firms with Negative Cash Flows
● Cannot use DDM and FCFE for discounting negative cash
flows. P/E and EV/EBITDA can’t be used either.
● In such cases, FCFF and P/B are used, since they work for
negative cash flows.
● Sometimes SOTP method is used for asset heavy firms (eg.
land banks)
Acquisition Valuation
● Often, acquisition of a company is strategically important for
the acquirer, which adds an intrinsic value to the company
being acquired.
● This additional intrinsic price being paid by the acruqirer is
known as the control premium.
● For example, Google may want to purchase Bing, so that it
becomes the monopoly in online search.
Acquisition Valuation
● Acquisitions also come with another premium, a noncompete clause.
● This clause makes sure that the management and promoters
of the target company do not start another such similar
businesses in direct competition with the acquirer for a
specified amount of time.
Distressed Companies
● When companies enter a period of financial distress, the
original holders often sell the debt or equity securities of the
issuer to a new set of buyers.
● Investors in distressed securities often try to influence the
process by which the issuer restructures its debt, narrows its
focus, or implements a plan to turn around its operations.
Distressed Companies
● Investors in distressed securities typically must make an
assessment not only of the issuer’s ability to improve its
operations but also whether the restructuring process might
benefit one class of securities more than another.
● Investing in distressed companies involves a fair amount of
judgement about the future path of the company, and
availability of finances and other resources.
Thank You