Fundamental Analysis

Chapter 6 Fundamental Analysis

OUTLINE • The Economy-Industry-Company (E-I-C) Framework • The Global Economy • Central Government Policy • Macroeconomic Analysis • Industry Analysis •Company Analysis

Steps Understanding of the macro-economic environment and developments Analysing the prospects of the industry to which the firm belongs Assessing the projected performance of the company and the intrinsic value of its shares

Step- 1 -- THE GLOBAL ECONOMY IN A GLOBALISED BUSINESS ENVIRONMENT, THE TOP DOWN ANALYSIS OF THE PROSPECTS OF A FIRM MUST BEGIN WITH THE GLOBAL ECONOMY. THE GLOBAL ECONOMY HAS A BEARING ON THE EXPORT PROSPECTS OF THE FIRM, THE COMPETITION IT FACES FROM INTERNATIONAL

COMPETITORS,

AND

PROFITABILITY OF ITS OVERSEAS INVESTORS.

THE

THE GLOBAL ECONOMY WHILE MONITORING THE GLOBAL ECONOMY BEAR IN MIND THE FOLLOWING: • ALTHOUGH THE ECONOMIES OF MOST COUNTRIES ARE LINKED, ECONOMIC PERFORMANCE VARIES WIDELY ACROSS COUNTRIES AT ANY TIME. • FROM TIME TO TIME COUNTRIES MAY EXPERIENCE TURMOIL DUE TO A COMPLEX INTERPLAY BETWEEN POLITICAL AND ECONOMIC FACTORS. • THE EXCHANGE RATE IS A KEY FACTOR AFFECTING THE INTERNATIONAL COMPETITIVENESS OF A COUNTRY’S INDUSTRIES.

CENTRAL GOVT. POLICIES • THE GOVERNMENT EMPLOYS TWO BROAD CLASSES OF MACROECONOMIC POLICIES, VIZ. DEMAND SIDE POLICIES AND SUPPLY SIDE POLICIES. • TRADITIONALLY, THE FOCUS WAS MOSTLY ON FISCAL AND MONETARY POLICIES, THE TWO MAJOR TOOLS OF DEMAND-SIDE ECONOMICS. FROM 1980s ONWARD, HOWEVER, SUPPLY-SIDE ECONOMICS HAS RECEIVED A LOT OF ATTENTION.

FISCAL POLICY • FISCAL POLICY IS CONCERNED WITH THE SPENDING AND TAX INITIATIVES OF THE GOVERNMENT. IT IS THE MOST DIRECT TOOL TO STIMULATE OR DAMPEN THE ECONOMY. • AN INCREASE IN GOVERNMENT SPENDING STIMULATES THE DEMAND FOR GOODS AND SERVICES, WHEREAS A DECREASE DEFLATES THE DEMAND FOR GOODS AND SERVICES. • BY THE SAME TOKEN, A DECREASE IN TAX RATES INCREASES THE CONSUMPTION OF GOODS AND SERVICES AND AN INCREASE IN TAX RATES DECREASES THE CONSUMPTION OF GOODS AND SERVICES.

MONETARY POLICY MONETARY POLICY IS CONCERNED WITH THE MANIPULATION OF MONEY SUPPLY IN THE ECONOMY. MONETARY POLICY AFFECTS THE ECONOMY MAINLY THROUGH ITS IMPACT ON INTEREST RATES. THE MAIN TOOLS OF MONETARY POLICY ARE: • OPEN MARKET OPERATION • BANK RATE • RESERVE REQUIREMENTS • DIRECT CREDIT CONTROLS

MACRO ECONOMIC ANALYSIS THE MACROECONOMY IS THE OVERALL ECONOMIC ENVIRONMENT IN WHICH ALL FIRMS OPERATE. THE KEY VARIABLES COMMONLY USED TO DESCRIBE THE STATE OF THE MACROECONOMY ARE : • • • • • • • •

GROWTH RATE OF GROSS DOMESTIC PRODUCT INDUSTRIAL GROWTH RATE AGRICULTURE AND MONSOONS SAVINGS AND INVESTMENTS GOVERNMENT BUDGET AND DEFICIT PRICE LEVEL AND INFLATION INTEREST RATES BALANCE OF PAYMENT, FOREX RESERVES, AND EXCHA RATE • INFRASTRUCTURAL FACILITIES AND ARRANGEMENTS • SENTIMENTS

Step 2--INDUSTRY ANALYSIS ∗SENSITIVITY TO THE BUSINESS CYCLE ∗ INDUSTRY LIFE CYCLE ANALYSIS • PIONEERING STAGE • RAPID GROWTH STAGE • MATURITY & STABILIZ’N STAGE • DECLINE STAGE ∗STUDY OF THE STRUCTURE AND CHARACTERISTICS OF AN INDUSTRY

* PROFIT POTENTIAL OF INDUSTRIES

Profit potential of industries – Porter Model : As per Michel Porter, the profit potential of an industry depends upon five basic competitive forcesThreat of new Entrants Rivalry among the existing firms Pressure from substitute products Bargaining power of Buyers Bargaining power of Sellers POTENTIAL ENTRANTS BARGAINING SUPPLIERS POWER OF SUPPLIERS

TREAT OF NEW ENTRANTS INDUSTRY BARGAINING RIVALRY AMONG POWER OF FIRMS BUYERS

THREAT OF SUBSTITUTE PRODUCTS SUBSTITUTES

BUYERS

Step 3 – Company Analysis

• Study of Financials

• Going Beyond the Numbers

• Estimation of Intrinsic Value

STUDY OF FINANCIALS

THIS INCLUDES A HISTORICAL ANALYSIS OF EARNINGS (AND DIVIDENDS), GROWTH, RISK, AND VALUATION AND USE THIS AS A FOUNDATION FOR DEVELOPING THE FORECASTS REQUIRED FOR FINDING OUT FUTURE OUTCOME AND THUS THE INTRINSIC VALUE

FINANCIALS OF X-PRO INDIA LTD 20X3

20X4

20X5

20X6

20X7

20X8

20X9

Net Sales

475

542

605

623

701

771

840

Cost of goods sold

352

380

444

475

552

580

638

Gross profit

123

162

161

148

149

191

202

Operating expenses

35

41

44

49

60

60

74

Operating profit

88

121

117

99

89

131

128

4

7

9

6

-

-7

2

Profit before interest and tax (PBIT)

92

128

126

105

89

124

130

Interest

20

21

25

22

21

24

25

Profit before tax

72

107

101

83

68

100

105

Tax

30

44

42

41

34

40

35

Profit after tax

42

63

59

42

34

60

70

Dividend

20

23

23

27

28

30

30

Retained earnings

22

40

36

15

6

30

40

Equity share capital

100

100

150

150

150

150

150

Reserves and surplus

65

105

91

106

112

142

182

Shareholders’ funds

165

205

241

256

262

292

332

Loan funds

150

161

157

156

212

228

221

Capital employed

315

366

398

412

474

520

553

Net fixed assets

252

283

304

322

330

390

408

Investments

18

17

16

15

15

20

25

Net current assets

45

66

78

75

129

110

120

315

366

398

412

474

520

553

Earnings per share

2.8

2.27

4.00

4.67

Market price per share (End of the year)

21.00

26.50

29.10

31.5

Non-operating surplus/deficit

Total assets

ROE : 3 FACTORS PAT ROE

=

SALES x

SALES NET PROFIT MARGIN

ASSETS x

ASSETS

EQUITY

ASSET TURNOVER

Equity Multiplier

The break-up of the return on equity in terms of its determinants for the period 20x7 – 20x9 for X-PRO Ltd. is given below: 20X7 20X8 20X9

Return on equity = Net profit margin x Asset turnover x Eq. Multiplier 13.0 % = 4.85% x 1.48 x 1.81 20.5% = 7.78% x 1.48 x 1.78 21.1% = 8.33% x 1.52 x 1.67

Investment analysts use one more formulation of the ROE wherein it is analysed in terms of five factors :

ROE : 5 FACTORS PBIT ROE

=

SALES x

SALES

PBT x

ASSETS

PAT x

PBIT

ASSETS x

PBT

EQUITY

ROE = PBIT efficiency x Asset Turnover x Interest Burden x Tax Burden x Leverage

The ROE break-up for X-PRO company is given below : ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x Leverage

20X7 20X8 20X9

13.0% = 20.5% = 21.1% =

12.70% 16.08% 15.48%

x x x

1.48 1.48 1.52

x x x

0.764 0.81 0.81

x x x

0.50 0.60 0.67

x 1.81 x 1.78 x 1.67

BOOK VALUE PER SHARE AND EARNINGS PER SHARE Book Value Per Share (BVPS) Paid-up equity capital + Reserves and surplus Number of equity shares BVPS

20 x 7 262/15 = 17.47

20 x 8 292/15 = 19.47

20 x 9 332/15 = 22.13

Earnings Per Share (EPS) Equity earnings Number of equity shares EPS

20 x 7 34/15 = 2.27

20 x 8 60/15 = 4.00

20 x 9 70/15 = 4.67

DIVIDEND PAYOUT RATIO AND DIVIDEND PER SHARE Dividend Payout Ratio Equity dividends Equity earnings Dividend Payout ratio

20 x 7

20 x 8

28/34 = 0.82

30/60 = 0.50

20 x 9 30/70 = 0.43

Dividend Per Share (DPS) DPS

20 x 7 Rs 1.87

20 x 8 2.00

20 x 9 2.00

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

COMPOUND ANNUAL GROWTH RATE (CAGR) The compound annual growth rate (CAGR) of sales, earnings per share, and dividend per share for a period of five years 20x4 – 20x9 for X-pro India Limited is calculated below: CAGR of Sales :

Sales of 20 x 9

1/5

Sales for 20 x 4

CAGR of earnings per share (EPS) :

EPS for 20 x 9 EPS for 20 x 4

–1=

1/5

840

1/ 5

542

4.67 –1 = 4.2

CAGR of dividend : DPS for 20 x 9 1/5 –1 = 2.00 per share (DPS) DPS for 20 x 4 1.53

– 1 = 9.2%

1/5

1/5

–1 = 2.1%

–1 = 5.5%

SUSTAINABLE GROWTH RATE The sustainable growth rate is defined as : Sustainable growth rate = Retention ratio x Return on equity

Based on the average retention ratio and the average return on equity of the three year period (20x7 – 20x9) the sustainable growth rate of X-pro India Ltd. is: Sustainable growth rate = 0.417 x 18.2% = 7.58%

FAVOURABLE & UNFAVOURABLE FACTORS

FAVOURABLE FACTORS EARNINGS LEVEL VALUE

• HIGH BOOK VALUE PER SHARE

UNFAVOURABLE FACTORS • LOW BOOK PER SHARE

GROWTH LEVEL

• HIGH RETURN ON EQUITY • HIGH CAGR IN SALES AND EPS • HIGH SUSTAINABLE GROWTH RATE

• LOW RETURN ON EQUITY • LOW CAGR IN SALES AND EPS • LOW SUSTAINABLE GROWTH RATE

RISK EXPOSURE

• LOW VOLATILITY OF RETURN ON EQUITY • LOW BETA

• HIGH VOLATILITY OF RETURN ON EQUITY • HIGH BETA

GOING BEYOND THE NUMBERS • SIZING UP THE PRESENT SITUATION AND PROSPECTS • Availability and Cost of Inputs • Order Position • Regulatory Framework • Technological and Production Capabilities • Marketing and Distribution • Finance and Accounting • Human Resources and Personnel • EVALUATION OF MANAGEMENT • Strategy • Calibre, Integrity, Dynamism • Organisational Structure • Execution Capability • Investor - friendliness

INTRINSIC VALUE In simple words Intrinsic value is nothing but the present value of future cash flows (say interest, dividend, redemption value or say liquidation proceeds) of a security. The E-I-C analysis through valuation ratios helps to determine future outcome/earnings/ value of the company and thus instrumental to discover the fair/intrinsic value of the stock. xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx