Vade Mecum - Fundamental Analysis

Vade mecum – Fundamental Analysis Financial Report  Management Discussion and Analysis (MD&A) – is everything that is vital mentioned?  Auditors Report  Responsibilities of auditors and company  How the GAAP is applied  Opinion, not guarantee of FS accuarcy  Balance Sheet - snapshot  Income Statement – the earnings revelation  Cash Flow Statement – does it generate cash?  Footnotes – the fineprint matters

GAAP  Reliable, Relevant and Useful information for people  Conflict – Relevance v Reliability – Market Value v Historical Value

The System  Equity (SE) and Debt (Liability) supplied as Capital  Assest acquired with the Capital supplied  Inventory is stocked Epili Sagar ©

Vade mecum – Fundamental Analysis  Sales made from inventory  Cash generated  Pay taxes  Pay interest, Give out Dividend or Retain

Statement of CASH FLOWS SCF Natural CF Sell Equity

classification CFF

Issue Debt Buy Assets

Issue Debt CFI

Buy Inventory

CFO

Pay Taxes Pay Dividend Pay Interest

CFF

Pay Dividend Buy Assets Make Sales

Make Sales Pay Costs

Sell Equity

CFI

Buy Inventory Pay Costs

CFO

Pay Taxes Pay Interest NET CASH FLOW

Useful CF Measures FCFE – Free Cash Flow to

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FCFE = Net Income - Net Capital Expenditure -

Vade mecum – Fundamental Analysis Equity

Change in Net Working Capital + New Debt - Debt

- to Shareholders

Repayment

PCF – Price to CF Ratio

FCFE = CFO - CFI PCF = (Price per share / CF per share)

- mkt expectation of a firm’s future value FCFF – Free CF to Firm

FCFF = Operating Income – Taxes – Expenses –

- profitability measure, same as

Changes in NWC – investments

cash measure NOPAT used in

FCFF = CFO + After tax interest – CFI

EVA

= CFO + Interest paid (1-Tax Rate) - CFI

Taxes – no need to subtract taxes separately from CFO, CFI or CFF.  CFO already accounts for it  If taxes abnormal – then after tax measure to be adjusted for “normal” figures

Ajustments to CFO  General Adjustments made  Net Income  Add/Subtract Non-Cash expenses – Depreciation etc.  Add/Subtract Cash from Operating Assets/Liabilities – AR, AP, Accrued L, Inven  Adjusting for Non Recurring CF  Tax Benefits from ESO Epili Sagar ©

Vade mecum – Fundamental Analysis  Unusual Changes in WC 

AP delayed to show extra cash might be nonre curring

 Costs – Capital expenditure (reduce CFI) or Expenses (reduce CFO)  Dividend received or Trading Gains – sustainable or not?

Cash

Theory  Diff appropriate cash lvl for each firm

Good  Signals strong company performance

 Extra Cash

Bad  Not put to good use  Opportunity Cost of holding cash

 Dividends

 Risk of carelessness

 Share buybacks

 Helps to avoid Capital

 Extra investments

Mkts – avoid scrutiny

 Capital Mkts

CONSUMER CONFIDENCE

CASH CONVERSION CYCLE  Inventory processing period + Receivables Collection period – Payables Period  Shorter the better

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Vade mecum – Fundamental Analysis  Decrease Inven Period and Receivables Period  Increase Payable period

DEBT  Leverage is good – too much is bad  Ratios to help assess debt  Debt Ratio = 

Total Liabilities / Total Assets

Lower the better

 Debt-Equity Ratio =

Total Liabilites / Total Shareholder’s Equity



how much debt in addition to $1 of SE is being taken to finance operations



lower the better

 Current Ratio =

Current Assets / Current Liabilities



How equipped to pay off debts in short term



Higher the better

DIVIDENDS  Dividend payment shows the future is bright for the company  Dividend payments  YES – if not possible to grow much through reinvesting in business

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Vade mecum – Fundamental Analysis  NO – if helps growth of company more than value that shareholder would get by investing the dividends  Measures  Dividend Yield = 



Annual Dividend Income PS / Price PS

Low if •

Company doing GOOD – hence Share Price is very high

•

Company doing BAD – hence Low Annual Dividend

Little importance for growth companies

 Dividend Coverage Ratio =

Earnings PS / Dividend PS



How its earnings can cover for the dividends paid



Higher the better



Too high = BAD witholding too much earnings

 Discipline heightened  More retained earnings – more exec compensation, extravagance, higher prices paid for acquisitions etc  Helps Valuation  Discounting all future dividends gives stock value today

GOODWILL  All factors that contribute to value of firm over and above Book Value  Intangible asset

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Vade mecum – Fundamental Analysis  Very hard to arrive at an accurate figure.  Not depreciated as other assets  Every year its value is reassessed  If value of goodwill falls the it is reduced ot written off completely  Writing down goodwill – sign of poor mgmt decisions  Negative goodwill – if business acquired for price below the fair value of tangible assets  PTN – look for it in Balance Sheet or Footnotes – assess it carefully

GROWTH  Good indicator  Has to be realistic and sustainable  Management must control efforts for growth when it does not add value  Rather make dividend payments for higher returns for shareholders

NET OPERATING INCOME (NOI)  NOI often as NOPAT  NOI =

Operating Income * (1 – Tax Rate) EBIT *( 1 – Tax Rate)

 Why a GOOD measure? Epili Sagar ©

Vade mecum – Fundamental Analysis  Difficult to manipulate  Net Income is manipulate by altering below the line items like 

Accounting principles



Sales of Discontinued operations



Special Items

 Used for valuation purposes

R&D  R & D expenditure shows brighter future and strong financials for the firm  Measuring R & D  Price to Research Ratio (PRR) = Markt Value of firm / R&D in past 12 mths 

Between 5 and 10 = GOOD



Above 15 = BAD



Smaller the better

 Price Growth Flow Model = (R&D PS + Earnings PS) / Share price 

To identify companies with strong current earnings and investing in R&D

 Measuring EFFECTIVENESS of R&D  Patent output per R&D dollar spent  Proficiency of R&D = Net Pdt Sales (past 3 yrs) / Total Sales (3 yrs)

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Vade mecum – Fundamental Analysis RELATIVE VALUATION  Steps  Create a list of comparable companies and collect their market values  Calculate multiples from the market values 

P/E Ratio



Enterprise-Value-to-Sales Multiple

 Compare these multiples with those of peers to see if it is over or undervalued  BUT – Companies may be have low multiples because of  Inherent problem with the company’s performance, or  IF it is an undervalued firm in an overvalued peer market  Hence difficult to decide if it is indeed undervalued  Use relative valuation coupled with close examination of fundamentals

R O A – Return on Assets  How well the company extracts profits from the assets it owns  ROA = Net income / TotalAssets  Sometimes ROA = EBIT / Total Assets  Compare ROA with  Interest – if profits made out of assets is less than payments to finance assets then negative sign

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Vade mecum – Fundamental Analysis  Cost of Capital – if new project does not help squeeze enough profits to offset cost of capital then investing in them might not be that good an idea  Alternative ROA calculation  ROA =

Profit Margin

x

Net Income/Revenues

Total Assets Turnover Revenues/Total Assets

 Vs ROE – better – because ROE does not tell us extent of leverage  BUT  Numerator (Net Income) is suspect – given deficiencies of accrual based earnings and managed earnings  Assets –do not include intangibles and hence ROA may get a boost for companies that are “light”

R O E – Return on Equity  Measure of how well company generates profits from its equity  ROE = Net Income / Average Common Equity *  * = Total Assets - Total Liabilities  A firm cannot increase earnings faster than its ROE without raising additional cash  BUT, it is not perfect  Write downs – reduce NI for that one year but depresses SE for few years hence artificially boosting ROE  Share buybacks – depresses SE proportionately more than it depresses earnings Epili Sagar ©

Vade mecum – Fundamental Analysis  Leverage – does not reveal how much debt is being taken for financing activities  Intangible Assets ignored  ROIC may be a better measure

BOOK VALUE  Price-Book (P/B) Ratio – Market Price of Company Shares / Book Value of Equity  Book Value of Equity

= Value of assets as expressed in BS = Book Value of Assets – Book Value of Liabilities

 If P/B < 1  The asset value is overstated  Company earning a very poor return on Assets  BUT,  Helpful only in capital intensive businesses, because intangibles are not accounted for.  Not helpful in high debt firms – high debt reduces book value and artificially boosts P/B ratio  Book Value can be not a good indicator 

Book value of asset reflects its original cost.



Easy to boost BV of assets by increasing cahs reserves or vice versa

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Vade mecum – Fundamental Analysis

WACC  Weighted Average Cost of Capital – return that both debtors and owners should expect  Weighted average of the cost of equity and the cost of debt  Used as discount rate in DCF calculations for arriving at NPV  Cost of Equity – required return for an owner or investor – CAPM model  Required return = Risk free rate + Beta(Market Risk Premium)  Cost of debt – simply the interest paid for the debt taken  Weights given to each cost by proportion of total capital in equity or debt

Z-Score  By Edward Altman for looking for impending bankruptcy

>3 1.8
Where: Z = score Epili Sagar ©

No fear of bankruptcy Gray Zone Danger Zone

Vade mecum – Fundamental Analysis A = Working Capital/Total Assets

financing current needs

B = Retained Earnings/Total Assets

using earnings to pump in or debt

C = Earnings Before Interest & Tax/Total Assets

extracting profits from assets

D = Market Value of Equity/Total Liabilities

accounting for effect of MV

E = Sales/Total Assets

how assets used to generate sales

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