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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