Module 6
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12/14/2008
Investment Analysis and Management - BU Module 6: Fundamental Analysis
Agenda • Pointer. • Economic Analysis. • Steps in Fundamental Analysis. • Key Macroeconomic factors analysed. • Industry Analysis. • Company Analysis.
• Estimation of Intrinsic value • Obstacles in the way of Analyst. • Empirical evidence of P/E.
1
12/14/2008
Pointer • Key determinants of intrinsic value: • Earnings per share • Payout ratio • Discount rate • Growth rate
• Explain the impact of above factors on the intrinsic value. • Explain the impact of growth and discount rates on P/E multiple.
Economic Analysis • The IV of a equity share is a function of earnings level, growth rate and risk exposure of the company. • The above factors to a great extent depend upon the prospects of the industry to which the company belongs. • The prospects of various industries, in turn are largely influenced by the developments in macro-economic env.
2
12/14/2008
Economic Analysis • Empirically, researchers have found the stock price changes can be attributed to the following factors: • Economic wide factors:
30 – 35 percent.
• Industry factors:
15 – 20 percent.
• Company factors:
30 – 35 percent.
• Other factors:
15 – 25 percent.
• Based on the above evidence a three pronged procedure is adopted for fundamental analysis.
Steps in Fundamental Analysis • Understanding of the macro-economic environment and developments. • Analyzing the prospects of the industry to which the firm belongs; and • Assessing the projected performance of the company.
3
12/14/2008
Key Macroeconomic Factors – Analyzed. • Gross National Product. • Savings and Investment. • Price level and inflation. • Agriculture and monsoons. • Fiscal and monetary framework. • Infrastructural facilities and agreements.
Fiscal and Monetary Policy • Favourable Budget: • A reasonably balanced budget (no high surplus / deficit). • A level of internal and external debt that can be serviced comfortably. • A satisfactory balance of payment situation. • A tax structure which provides incentive for savings and investment. • A rate of increase in money supply which ensures that inflation is within permissible limit. • A credit policy which accommodates reasonable business demands.
4
12/14/2008
Industry Analysis • Objective of this analysis is to assess the prospects of various industrial groupings. • It is almost impossible to forecast exactly which industrial groups will appreciate the most. • Most careful analysis can suggest which industries have a brighter future than others. • Industry analysis can be performed: • Industry life cycle analysis. • Study of the structure and characteristics of an industry.
Industry Life Cycle Analysis • Industrial economists believe that the development of almost every industry may be analyzed in terms of LCA. • The four well-defined stages are • Pioneering stage. • Rapid growth stage. • Maturity and stabilisation stage. • Decline stage.
• Explain the investment implications for each stage.
5
12/14/2008
Industry Structure and Characteristics • Since each industry is unique, • A systematic study of its specific features and characteristics is an integral part of the decision process.
• The following points are focus on the following: • a. Structure of the industry and nature of competition. • b. Nature and prospect of demand. • c. Cost, efficiency, and profitability. • d. Technology and Research
Company Analysis • This is the last leg in the economy – industry – company analysis sequence. • Company analysis is organised by three parts: • Study of financial information. • Sizing up of present situation and prospects. • Evaluation of management.
6
12/14/2008
Study of Financial Information • Study of GAIL (appended in Excel sheet)
Sizing up – Present Situation & Prospects • The analyst should question along the following lines: • Availability and cost inputs. • Order position. • Regulatory framework. • Technological and production capabilities. • Marketing and distribution. • Finance and accounting. • Product Portfolio. • Human resource and personnel.
7
12/14/2008
Evaluation of Management • The analyst should ask the following questions: • What is the grand design of the management? (Conglomerate or close knit). • What is the caliber, motivation, integrity, dynamism and commitment of the top management personnel? • Does the management have specific objectives, plans and timebound programmes? • What emphasis is accorded to research and development?
Evaluation of Management • The analyst should ask the following questions: • How effective is the organisational structure? • How sound are the management systems of the company? • What is the importance assigned to management development? • How investor friendly is the management?
8
12/14/2008
Estimation of Intrinsic Value • Commonly adopted procedure by investment analysts: • Estimate the earnings per share for the current year. • Forecast the growth rate in earnings per share. • Assess the risk. • Establish a P/E ratio. • Develop a value anchor and value range.
Estimate EPS – Current year • Estimate the EPS based on the current published annual reports and based on interview with management. • Apart from EPS, establish the CFPS.
9
12/14/2008
Forecast the g in EPS • If there is a stable cost and profit structure is expected in the foreseeable future: • The g in EPS may be equated with the projected growth rate in sales? • g in sales can be expressed in monetary terms as = growth rate in physical terms + inflation rate.
Assess the Risk Exposure • Investment analyst look commonly for the following aspects of risk: • Business Risk. • Financial Risk. • Market Risk (with respect to stock market).
10
12/14/2008
Establish a P/E Multiple • Growth prospects and risk exposure are the key determinants of P/E multiple. • Following factors will also have a bearing: • Dividend and bonus policy of the firm (liberal to niggardly). • The size of the firm (very large to very small). • The general image of the firm (very favourable to unfavourable).
Determine – Value Anchor & Range • The value anchor is obtained as follows: • Projected EPS * Appropriate P/E multiple.
• Practical wisdom calls for defining an intrinsic value range around the single point estimate.
11
12/14/2008
Obstacles – Way of Analyst • Inadequacies or incorrectness of data. • Future uncertainties. • Irrational market behaviour. • Fallibility of experts.
Empirical Estimation of P/E • Whitbek and Kisor in one of the earlier studies conducted in the U.S found the following relationship: • 8.2 + 1.5 * Growth rate in earnings + 6.7 Payout ratio – 0.2 * Variability in earnings.
• Obaidullah and Kalyani Ramachandran estimated the following relationship for Indian stock market in 1992: • 0.0003 + 1.153 * Growth rate in earnings – 0.392 * Required rate of return + 0.2 Growth rate in funds flowing into the securities market.
12
12/14/2008
Reasons of Lack in Success – B/S • Almost most of the variables discussed are fairly successful in explaining P/E multiples. • The models discussed are not so successful in selecting the appropriate stocks to buy or sell. • The following are the three reasons why they are not so successful: • Shift in market taste. • Change in input values • Firm effects.
Word of Caution • Update the model periodically to reflect the most current valuation mode. • Define input variables taking into account the changing corporate fortunes. • Adjust the value estimate provided by the model in the light of firm effects which the model does not capture.
13
Investment Analysis and Management - BU Module 6: Fundamental Analysis
Agenda • Pointer. • Economic Analysis. • Steps in Fundamental Analysis. • Key Macroeconomic factors analysed. • Industry Analysis. • Company Analysis.
• Estimation of Intrinsic value • Obstacles in the way of Analyst. • Empirical evidence of P/E.
1
12/14/2008
Pointer • Key determinants of intrinsic value: • Earnings per share • Payout ratio • Discount rate • Growth rate
• Explain the impact of above factors on the intrinsic value. • Explain the impact of growth and discount rates on P/E multiple.
Economic Analysis • The IV of a equity share is a function of earnings level, growth rate and risk exposure of the company. • The above factors to a great extent depend upon the prospects of the industry to which the company belongs. • The prospects of various industries, in turn are largely influenced by the developments in macro-economic env.
2
12/14/2008
Economic Analysis • Empirically, researchers have found the stock price changes can be attributed to the following factors: • Economic wide factors:
30 – 35 percent.
• Industry factors:
15 – 20 percent.
• Company factors:
30 – 35 percent.
• Other factors:
15 – 25 percent.
• Based on the above evidence a three pronged procedure is adopted for fundamental analysis.
Steps in Fundamental Analysis • Understanding of the macro-economic environment and developments. • Analyzing the prospects of the industry to which the firm belongs; and • Assessing the projected performance of the company.
3
12/14/2008
Key Macroeconomic Factors – Analyzed. • Gross National Product. • Savings and Investment. • Price level and inflation. • Agriculture and monsoons. • Fiscal and monetary framework. • Infrastructural facilities and agreements.
Fiscal and Monetary Policy • Favourable Budget: • A reasonably balanced budget (no high surplus / deficit). • A level of internal and external debt that can be serviced comfortably. • A satisfactory balance of payment situation. • A tax structure which provides incentive for savings and investment. • A rate of increase in money supply which ensures that inflation is within permissible limit. • A credit policy which accommodates reasonable business demands.
4
12/14/2008
Industry Analysis • Objective of this analysis is to assess the prospects of various industrial groupings. • It is almost impossible to forecast exactly which industrial groups will appreciate the most. • Most careful analysis can suggest which industries have a brighter future than others. • Industry analysis can be performed: • Industry life cycle analysis. • Study of the structure and characteristics of an industry.
Industry Life Cycle Analysis • Industrial economists believe that the development of almost every industry may be analyzed in terms of LCA. • The four well-defined stages are • Pioneering stage. • Rapid growth stage. • Maturity and stabilisation stage. • Decline stage.
• Explain the investment implications for each stage.
5
12/14/2008
Industry Structure and Characteristics • Since each industry is unique, • A systematic study of its specific features and characteristics is an integral part of the decision process.
• The following points are focus on the following: • a. Structure of the industry and nature of competition. • b. Nature and prospect of demand. • c. Cost, efficiency, and profitability. • d. Technology and Research
Company Analysis • This is the last leg in the economy – industry – company analysis sequence. • Company analysis is organised by three parts: • Study of financial information. • Sizing up of present situation and prospects. • Evaluation of management.
6
12/14/2008
Study of Financial Information • Study of GAIL (appended in Excel sheet)
Sizing up – Present Situation & Prospects • The analyst should question along the following lines: • Availability and cost inputs. • Order position. • Regulatory framework. • Technological and production capabilities. • Marketing and distribution. • Finance and accounting. • Product Portfolio. • Human resource and personnel.
7
12/14/2008
Evaluation of Management • The analyst should ask the following questions: • What is the grand design of the management? (Conglomerate or close knit). • What is the caliber, motivation, integrity, dynamism and commitment of the top management personnel? • Does the management have specific objectives, plans and timebound programmes? • What emphasis is accorded to research and development?
Evaluation of Management • The analyst should ask the following questions: • How effective is the organisational structure? • How sound are the management systems of the company? • What is the importance assigned to management development? • How investor friendly is the management?
8
12/14/2008
Estimation of Intrinsic Value • Commonly adopted procedure by investment analysts: • Estimate the earnings per share for the current year. • Forecast the growth rate in earnings per share. • Assess the risk. • Establish a P/E ratio. • Develop a value anchor and value range.
Estimate EPS – Current year • Estimate the EPS based on the current published annual reports and based on interview with management. • Apart from EPS, establish the CFPS.
9
12/14/2008
Forecast the g in EPS • If there is a stable cost and profit structure is expected in the foreseeable future: • The g in EPS may be equated with the projected growth rate in sales? • g in sales can be expressed in monetary terms as = growth rate in physical terms + inflation rate.
Assess the Risk Exposure • Investment analyst look commonly for the following aspects of risk: • Business Risk. • Financial Risk. • Market Risk (with respect to stock market).
10
12/14/2008
Establish a P/E Multiple • Growth prospects and risk exposure are the key determinants of P/E multiple. • Following factors will also have a bearing: • Dividend and bonus policy of the firm (liberal to niggardly). • The size of the firm (very large to very small). • The general image of the firm (very favourable to unfavourable).
Determine – Value Anchor & Range • The value anchor is obtained as follows: • Projected EPS * Appropriate P/E multiple.
• Practical wisdom calls for defining an intrinsic value range around the single point estimate.
11
12/14/2008
Obstacles – Way of Analyst • Inadequacies or incorrectness of data. • Future uncertainties. • Irrational market behaviour. • Fallibility of experts.
Empirical Estimation of P/E • Whitbek and Kisor in one of the earlier studies conducted in the U.S found the following relationship: • 8.2 + 1.5 * Growth rate in earnings + 6.7 Payout ratio – 0.2 * Variability in earnings.
• Obaidullah and Kalyani Ramachandran estimated the following relationship for Indian stock market in 1992: • 0.0003 + 1.153 * Growth rate in earnings – 0.392 * Required rate of return + 0.2 Growth rate in funds flowing into the securities market.
12
12/14/2008
Reasons of Lack in Success – B/S • Almost most of the variables discussed are fairly successful in explaining P/E multiples. • The models discussed are not so successful in selecting the appropriate stocks to buy or sell. • The following are the three reasons why they are not so successful: • Shift in market taste. • Change in input values • Firm effects.
Word of Caution • Update the model periodically to reflect the most current valuation mode. • Define input variables taking into account the changing corporate fortunes. • Adjust the value estimate provided by the model in the light of firm effects which the model does not capture.
13
