Fundamentals Of Stock Analysis
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FUNDAMENTAL OF STOCK ANALYSIS
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Outline Valuation Philosophies Investors’ Understanding of Risk Premiums The Time Value of Money The Importance of Cash Flows The Tax Factor EIC Analysis
Value vs. Growth Investing The Value Approach to Investing The Growth Approach to Investing How Price Relates to Value Value Stocks and Growth Stocks: How to Tell by Looking
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Outline
The
Price-to-Book Ratio
The
Price-Earnings Ratio Differences between Industries
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Outline
Some Analytical Factors Growth Rates The Dividend Discount Model The Importance of Hitting the Earnings Estimate The Multistage DDM Caveats about the DDM False Growth A Firm’s Cash Flows Small-Cap, Mid-Cap, and Large-Cap Stocks Ratio Analysis Cooking the Books
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Valuation Philosophies
Fundamental analysts believe securities are priced according to fundamental economic data.
Technical analysts think investor behavior and supply and demand factors play the most important role.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Valuation Philosophies
Investors’ understanding of risk premiums: Investors are almost always risk-averse.
The time value of money: Everyone agrees on this basic principle.
The importance of cash flows: Most investment research deals with predicting future corporate earnings.
The tax factor: The tax code is complicated and not all investments are taxed equally. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Valuation Philosophies
Economy, Industry and Company (EIC) analysis:
The analyst first considers conditions in the overall economy (market risk),
then determines which industries are the most attractive in light of the economic conditions (using Porter’s competitive strategy analysis framework, for example),
and finally identifies the most attractive companies within the attractive industries. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Valuation Philosophies
Insert Figure 7-1 here.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Value vs. Growth Investing The Value Approach to Investing
A value investor believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm’s financial statements) justify the purchase.
Value investors believe in a regression to the mean.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Regression to the Mean
Cumulative Return
+
Overvalued stock: Sell
x
xx
Most of the time a security’s longterm return is consistent with its risk.
x x x x xx x x Undervalued stock: Buy x x x x 0
Over the long run, a security cannot survive with a cumulative return that is negative.
Time in the Long Term AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Value vs. Growth Investing The Growth Approach to Investing
Growth investors seek steadily growing companies. There are two factions:
Information traders are in a hurry; they
believe information differentials in the marketplace can be profitably exploited. True growth investors are more willing to
wait, but they share the belief that good investment managers can earn aboveaverage returns for their clients. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Value vs. Growth Investing How Price Relates to Value
In the early days of the market, before the Great Crash of 1929, price played a minor role: “A stock with good long-term prospects is always a good investment.”
8 7 . Rs
The modern perspective is that value is inextricably intertwined with price.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Value vs. Growth Investing Value Stocks and Growth Stocks: How to Tell by Looking
No precise definition exists.
Classification by Morningstar Mutual Funds:
relative relative < 1.75 price-to-book + price-earnings > 2.25 otherwise ratio ratio
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
- value - growth - blend
The Price-to-Book Ratio
Book value per share is an accounting concept synonymous with equity per share or net asset value.
Share price is not normally equal to book value because of
depreciation, uncollectible debts, goodwill, etc. economic obsolescence intangible assets
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
The Price-to-Book Ratio
The price-earnings ratio (PE) is computed by dividing the current stock price by the firm’s earnings per share.
Because of differences among industries, relative ratios are commonly computed.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Growth Rates
Growth rates from historical data: 1
ending value n − 1 growth rate geometric mean = beginning value where n = number of compounding periods
Growth rates from earnings retention: growth rate = ( 1- payout ratio ) × return on equity using arithmetic averages AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Growth Rates Choosing a Growth Rate
Financial analysts typically calculate a number of growth rates using different ways to determine a likely range for the statistic.
Recent data may be more reliable than data from the more distant past.
Company statements regarding company targets may be considered too. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Growth Rates
Insert Table 7-5 here.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
The Dividend Discount Model (DDM)
Also called Gordon’s growth model. D0 ( 1 + g ) D1 current price P0 = = k −g k −g where D0 is the current dividend D1 is the dividend to be paid next year g is the expected dividend growth rate k is the discount factor according to the riskiness of the stock
The model assumes that the dividend stream is perpetual and that the longterm growth rate is constant. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
The Dividend Discount Model (DDM)
The variable k is sometimes called the shareholders’ required rate of return. D0 ( 1 + g ) k= +g P0
Note that the shareholder’s required rate of return is the sum of the expected dividend yield and the expected stock price appreciation. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
The Importance of Hitting the Earnings Estimate
• The market often penalizes a company’s stock substantially when the earnings report is disappointing. • This is especially true when the required rate of return and the estimated growth rate are high.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
The Multistage DDM
Often, initial high growth levels cannot be sustained.
Suppose the growth rate g is expected to persist from the third year: D1 D2 D2 ( 1 + g ) ( k − g ) P0 = + + ( 1+ k) ( 1+ k)2 ( 1+ k)2
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors
Caveats about the DDM: The DDM is at most a useful tool in security analysis - it requires certain assumptions and it has shortcomings.
False growth: False growth occurs when a firm acquires another firm with a lower price-earnings ratio - historical data should always be scrutinized carefully when used to determine a growth rate. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors
A firm’s cash flow: The statement of cash flows is a useful analytical tool - the cash flow from operations figures are widely used as a check on a firm’s earnings quality.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors
Small-cap, mid-cap, and large-cap stocks: Another consideration in fundamental stock analysis relates to the size of the firm - for example, the small firm effect.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Ratio Analysis
The fundamental analyst is necessarily interested in the firm’s accounting statements and in the prevailing general economic conditions.
To assist in the analysis, several organizations publish comparative statistics for industry groups. which includes solvency, efficiency and profitability ratios.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Ratio Analysis 14 Key Business Ratios Solvency Ratios •
Quick Ratio = (Cash + Accounts Receivable)/Current Liabilities Measures ability to raise cash quickly, ignores inventory
3. Current Ratio = Current Assets/Current Liabilities General measure of liquidity 5. Current Liabilities to Net Worth = Current Liabilities/Net Worth Compares short-term liabilities to permanent invested capital 7. Current Liabilities to Inventory = Current Liabilities/Inventory Measures extent to which payment of current debts relies on sale of inventory 9. Total Liabilities to Net Worth = Total Liabilities/Net Worth Measures firm’s reliance on debt financing 11. Fixed Assets to Net Worth = Fixed Assets/Net Worth Vijay equity Kumar, Faculty-Finance & Control, IIPMB Measures proportion of AN firm’s tied up in long-term assets
Some Analytical Factors: Ratio Analysis 14 Key Business Ratios Efficiency Ratios 2. Collection Period = Accounts Receivable/Credit Sales per Day Measures firm’s efficiency in turning credit sales into cash 4. Sales to Inventory = Annual Net Sales/Inventory Measures speed that inventory moves from shelf to customer 6. Assets to Sales = Total Assets/Net Sales Measures efficiency with which assets are used to produce sales 8. Sales to Net Working Capital = Sales/Net Working Capital Measures aggressiveness or conservatism in financing sales 10. Accounts Payable to Sales = Accounts Payable/Annual Net Sales Measures how rapidly company pays its suppliers AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Ratio Analysis 14 Key Business Ratios Profitability Ratios 2. Return on Sales (Profit Margin) = Net Profit after Taxes/Annual Net Sales Measures profit per dollar of net sales 4. Return on Assets = Net Profit after Taxes/Total Assets Measures company’s efficiency in using assets to produce operating profit 6. Return on New Worth (Return on Equity) = Net Profit after Taxes/Net Worth Measures return to the suppliers of equity capital
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
• Return on investment (Net profit/ capital employed) * 100 Capital employed = Total SH Funds, loans, minority interest and deferred taxation, preliminary expenses, P& L Ac.(Dr)
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
• PE Ratio Current market price/EPS
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
• Book value = • Equity capital + Reserves – P&L A/c (Dr.)/ • Total number of equity shares • Debt equity Ratio • Debt/equity
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
• Dividend payout Ratio= • Dividend per share/ • EPS • Dividend yield = • Dividend per share/ • Market price AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Technical Vs. Fundamental • STM • Internal market data • Quick money
• LTM • Economy, industry • Long term basis
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
• Dividend cover = • Profit after tax/ • Market price • • • •
*100
Interest cover = Profit before interest, depreciation & tax/ Interest 2:1 AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Cooking the Books
All publicly traded firms in the India must have their financial statements audited to ensure they fairly present the company’s financial position.
Still, every year, there is at least one story of accounting fraud at a major firm. Unfortunately, there is not much the analyst can do about fraud.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Review Valuation Philosophies Investors’ Understanding of Risk Premiums The Time Value of Money The Importance of Cash Flows The Tax Factor EIC Analysis
Value vs. Growth Investing The Value Approach to Investing The Growth Approach to Investing How Price Relates to Value Value Stocks and Growth Stocks: How to Tell by Looking
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Review
The
Price-to-Book Ratio
The
Price-Earnings Ratio Differences between Industries
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Review
Some Analytical Factors Growth Rates The Dividend Discount Model The Importance of Hitting the Earnings Estimate The Multistage DDM Caveats about the DDM False Growth A Firm’s Cash Flows Small-Cap, Mid-Cap, and Large-Cap Stocks Ratio Analysis Cooking the Books
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Outline Valuation Philosophies Investors’ Understanding of Risk Premiums The Time Value of Money The Importance of Cash Flows The Tax Factor EIC Analysis
Value vs. Growth Investing The Value Approach to Investing The Growth Approach to Investing How Price Relates to Value Value Stocks and Growth Stocks: How to Tell by Looking
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Outline
The
Price-to-Book Ratio
The
Price-Earnings Ratio Differences between Industries
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Outline
Some Analytical Factors Growth Rates The Dividend Discount Model The Importance of Hitting the Earnings Estimate The Multistage DDM Caveats about the DDM False Growth A Firm’s Cash Flows Small-Cap, Mid-Cap, and Large-Cap Stocks Ratio Analysis Cooking the Books
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Valuation Philosophies
Fundamental analysts believe securities are priced according to fundamental economic data.
Technical analysts think investor behavior and supply and demand factors play the most important role.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Valuation Philosophies
Investors’ understanding of risk premiums: Investors are almost always risk-averse.
The time value of money: Everyone agrees on this basic principle.
The importance of cash flows: Most investment research deals with predicting future corporate earnings.
The tax factor: The tax code is complicated and not all investments are taxed equally. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Valuation Philosophies
Economy, Industry and Company (EIC) analysis:
The analyst first considers conditions in the overall economy (market risk),
then determines which industries are the most attractive in light of the economic conditions (using Porter’s competitive strategy analysis framework, for example),
and finally identifies the most attractive companies within the attractive industries. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Valuation Philosophies
Insert Figure 7-1 here.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Value vs. Growth Investing The Value Approach to Investing
A value investor believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm’s financial statements) justify the purchase.
Value investors believe in a regression to the mean.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Regression to the Mean
Cumulative Return
+
Overvalued stock: Sell
x
xx
Most of the time a security’s longterm return is consistent with its risk.
x x x x xx x x Undervalued stock: Buy x x x x 0
Over the long run, a security cannot survive with a cumulative return that is negative.
Time in the Long Term AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Value vs. Growth Investing The Growth Approach to Investing
Growth investors seek steadily growing companies. There are two factions:
Information traders are in a hurry; they
believe information differentials in the marketplace can be profitably exploited. True growth investors are more willing to
wait, but they share the belief that good investment managers can earn aboveaverage returns for their clients. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Value vs. Growth Investing How Price Relates to Value
In the early days of the market, before the Great Crash of 1929, price played a minor role: “A stock with good long-term prospects is always a good investment.”
8 7 . Rs
The modern perspective is that value is inextricably intertwined with price.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Value vs. Growth Investing Value Stocks and Growth Stocks: How to Tell by Looking
No precise definition exists.
Classification by Morningstar Mutual Funds:
relative relative < 1.75 price-to-book + price-earnings > 2.25 otherwise ratio ratio
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
- value - growth - blend
The Price-to-Book Ratio
Book value per share is an accounting concept synonymous with equity per share or net asset value.
Share price is not normally equal to book value because of
depreciation, uncollectible debts, goodwill, etc. economic obsolescence intangible assets
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
The Price-to-Book Ratio
The price-earnings ratio (PE) is computed by dividing the current stock price by the firm’s earnings per share.
Because of differences among industries, relative ratios are commonly computed.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Growth Rates
Growth rates from historical data: 1
ending value n − 1 growth rate geometric mean = beginning value where n = number of compounding periods
Growth rates from earnings retention: growth rate = ( 1- payout ratio ) × return on equity using arithmetic averages AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Growth Rates Choosing a Growth Rate
Financial analysts typically calculate a number of growth rates using different ways to determine a likely range for the statistic.
Recent data may be more reliable than data from the more distant past.
Company statements regarding company targets may be considered too. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Growth Rates
Insert Table 7-5 here.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
The Dividend Discount Model (DDM)
Also called Gordon’s growth model. D0 ( 1 + g ) D1 current price P0 = = k −g k −g where D0 is the current dividend D1 is the dividend to be paid next year g is the expected dividend growth rate k is the discount factor according to the riskiness of the stock
The model assumes that the dividend stream is perpetual and that the longterm growth rate is constant. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
The Dividend Discount Model (DDM)
The variable k is sometimes called the shareholders’ required rate of return. D0 ( 1 + g ) k= +g P0
Note that the shareholder’s required rate of return is the sum of the expected dividend yield and the expected stock price appreciation. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
The Importance of Hitting the Earnings Estimate
• The market often penalizes a company’s stock substantially when the earnings report is disappointing. • This is especially true when the required rate of return and the estimated growth rate are high.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
The Multistage DDM
Often, initial high growth levels cannot be sustained.
Suppose the growth rate g is expected to persist from the third year: D1 D2 D2 ( 1 + g ) ( k − g ) P0 = + + ( 1+ k) ( 1+ k)2 ( 1+ k)2
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors
Caveats about the DDM: The DDM is at most a useful tool in security analysis - it requires certain assumptions and it has shortcomings.
False growth: False growth occurs when a firm acquires another firm with a lower price-earnings ratio - historical data should always be scrutinized carefully when used to determine a growth rate. AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors
A firm’s cash flow: The statement of cash flows is a useful analytical tool - the cash flow from operations figures are widely used as a check on a firm’s earnings quality.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors
Small-cap, mid-cap, and large-cap stocks: Another consideration in fundamental stock analysis relates to the size of the firm - for example, the small firm effect.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Ratio Analysis
The fundamental analyst is necessarily interested in the firm’s accounting statements and in the prevailing general economic conditions.
To assist in the analysis, several organizations publish comparative statistics for industry groups. which includes solvency, efficiency and profitability ratios.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Ratio Analysis 14 Key Business Ratios Solvency Ratios •
Quick Ratio = (Cash + Accounts Receivable)/Current Liabilities Measures ability to raise cash quickly, ignores inventory
3. Current Ratio = Current Assets/Current Liabilities General measure of liquidity 5. Current Liabilities to Net Worth = Current Liabilities/Net Worth Compares short-term liabilities to permanent invested capital 7. Current Liabilities to Inventory = Current Liabilities/Inventory Measures extent to which payment of current debts relies on sale of inventory 9. Total Liabilities to Net Worth = Total Liabilities/Net Worth Measures firm’s reliance on debt financing 11. Fixed Assets to Net Worth = Fixed Assets/Net Worth Vijay equity Kumar, Faculty-Finance & Control, IIPMB Measures proportion of AN firm’s tied up in long-term assets
Some Analytical Factors: Ratio Analysis 14 Key Business Ratios Efficiency Ratios 2. Collection Period = Accounts Receivable/Credit Sales per Day Measures firm’s efficiency in turning credit sales into cash 4. Sales to Inventory = Annual Net Sales/Inventory Measures speed that inventory moves from shelf to customer 6. Assets to Sales = Total Assets/Net Sales Measures efficiency with which assets are used to produce sales 8. Sales to Net Working Capital = Sales/Net Working Capital Measures aggressiveness or conservatism in financing sales 10. Accounts Payable to Sales = Accounts Payable/Annual Net Sales Measures how rapidly company pays its suppliers AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Ratio Analysis 14 Key Business Ratios Profitability Ratios 2. Return on Sales (Profit Margin) = Net Profit after Taxes/Annual Net Sales Measures profit per dollar of net sales 4. Return on Assets = Net Profit after Taxes/Total Assets Measures company’s efficiency in using assets to produce operating profit 6. Return on New Worth (Return on Equity) = Net Profit after Taxes/Net Worth Measures return to the suppliers of equity capital
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
• Return on investment (Net profit/ capital employed) * 100 Capital employed = Total SH Funds, loans, minority interest and deferred taxation, preliminary expenses, P& L Ac.(Dr)
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
• PE Ratio Current market price/EPS
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
• Book value = • Equity capital + Reserves – P&L A/c (Dr.)/ • Total number of equity shares • Debt equity Ratio • Debt/equity
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
• Dividend payout Ratio= • Dividend per share/ • EPS • Dividend yield = • Dividend per share/ • Market price AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Technical Vs. Fundamental • STM • Internal market data • Quick money
• LTM • Economy, industry • Long term basis
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
• Dividend cover = • Profit after tax/ • Market price • • • •
*100
Interest cover = Profit before interest, depreciation & tax/ Interest 2:1 AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Some Analytical Factors: Cooking the Books
All publicly traded firms in the India must have their financial statements audited to ensure they fairly present the company’s financial position.
Still, every year, there is at least one story of accounting fraud at a major firm. Unfortunately, there is not much the analyst can do about fraud.
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Review Valuation Philosophies Investors’ Understanding of Risk Premiums The Time Value of Money The Importance of Cash Flows The Tax Factor EIC Analysis
Value vs. Growth Investing The Value Approach to Investing The Growth Approach to Investing How Price Relates to Value Value Stocks and Growth Stocks: How to Tell by Looking
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Review
The
Price-to-Book Ratio
The
Price-Earnings Ratio Differences between Industries
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
Review
Some Analytical Factors Growth Rates The Dividend Discount Model The Importance of Hitting the Earnings Estimate The Multistage DDM Caveats about the DDM False Growth A Firm’s Cash Flows Small-Cap, Mid-Cap, and Large-Cap Stocks Ratio Analysis Cooking the Books
AN Vijay Kumar, Faculty-Finance & Control, IIPMB
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