Fundamental analysis

Inter Connected StockExchange of India

Khalsa College18 th April 2007By Anil Harolikar

anilharolikar@rediffmail.com

Structure

Interpretation of Financial Statements Ratio Analysis Fundamental Analysis

Valuation Ratios Price Target and Projections Summary

Balance sheet

Structure of Balance SheetFinancial StatementsRatio Analysis

Structure of a Balance Sheet

Balance Sheet as at 31 st March 2006

Profit and Loss Account for the Year / Period ended 31 st March 2006

Schedules Cash Flow Ratios

Notice of AGM Chairman’s Statement Directors Report Management

Discussion and Analysis Corporate Governance Auditor’s Report Notes on Accounts

Definition

  Ratio is relationship between two amounts

Proportion that one amount bears to another

Different forms

   Pure Ratio – DER

   Related to Time period- Working capital turnover

   Percentage – NP / Sales

IMPORTANCE

Helps analyse relationships Helps prepare budgets and formulate

policy Trend analysis Inter company comparison Liquidity position

For whom

  Analysts Portfolio Managers    Creditors / Lenders    Suppliers    Government    Management Investors / Shareholders Public at large

Different classes of Ratios

Based on Balance Sheet ( or Financial)

Based on Revenue Statement ( or Operational)

Based on Combination of both statements

Working capital cycle Current Assets = Cash / Bank > Raw materials > Work in process > Finished Goods stock > Receivables (if sold on credit) > Cash / Bank.

Current Liabilities Unpaid Expenses like salaries / wages, power bills, telephone bills, Materials purchased on credit, Interest due on Working Capital and

Term loans.

Financial RatiosI. Liquidity / Solvency ratios

II. Gear ratio III. Asset cover ratios

a. Current a.Debentures

b. Liquid b.Creditors

c. Absolute liquidity

c. Pref. shareholders

d. Proprietary d.Equity

e. Fixed asset e. Security cover

f. Debt Equity

Financial Ratios

LIQUIDITY Ratios Current Ratio = Current Assets /

Current Liabilities

Acid Test or Quick Ratio = CA minus Inventories / short

term Liabilities

LEVERAGE

RATIOS

Total DER = Total Debt / NW

LT DER = LT Loans / NW

COVERAGE Ratios

Security Cover = Assets to TL

Operational Ratios

REVENUE STATEMENT RATIOS

Operational RatiosI. Expense ratios

II. Earnings ratios

III. Profit cover ratios

a. Fixed cost / Total cost

a.GP ratio orTurnover ratio

a. Dividend cover

b. RM / sales b. NP ratio b. Interest cover

c. Wages / sales

c. Operating profit ratio

c. Total coverage ratio

d. Office & admin.exp /sales

e. Selling & distrib. / sales

REVENUE STATEMENT RATIOS

EXPENSE RATIOS

EARNINGS RATIOS

PROFIT COVER

EXPENSE RATIOS

FC to Total Cost = Power + Employee + Others + Depreciation +

Interest charges

/ Total Cost

Wages / Sales

Concept of Breakeven Contribution = Sale consideration − Variable cost. The higher the contribution, better. Breakeven point = the level of

activity at which revenues and costs are equal.

The lower the fixed cost, the earlier will the company reach breakeven.

EARNINGS RATIOS

GP Margin = Gross Profit / Sales

OP Margin = Operating Profit / Sales

NP Margin = Net Profit / Sales

Gross Profit Gross profit = Net Sales minus cost of Goods

sold Cost of goods sold = costs incurred

for manufacturing the goods sold. Includes Direct material cost, Direct

labour cost and factory overheads.

Operating profit Operating profit = Gross profit minus Operating

Expenses. Operating Expenses = General

Administrative expenses + Selling and Distribution expenses + Depreciation.

EBITA margin Profit before Interest and taxes =

EBITA = Operating profit + Non – operating surplus / deficit.

Measure of profit not influenced by Financial leverage and Tax factor.

Considered More Suitable for inter-company comparison.

Net Profit Net profit = OP (+/– non-OP) -

financial expenses ( interest on borrowed funds).

PBT = NP PAT = PBT- tax Retained earnings = PAT -

dividends

PROFIT COVER Dividend Cover Ratio

= NP / Dividend amount Dividend pay out ratio What is the reasonable ratioGrowing companyMature companyCash strapped companyCash rich company

PROFIT COVER Interest Cover

= NP+ Interest added back / Interest

Manufacturing company Banking / Finance company

Combined Ratios

I. Turnover ratios Inventory turnover Debtors turnover Creditors turnover Turnover to assets

and liabilities

II. Profitability ratio ROCE/RONW/ROE NP to Fixed

assets /NP to Total assets

EPS / PE ratio / Div Yield ratio / DPS / Div payout ratio

Combined Ratios

TURNOVER or VELOCITY RATIOS Inventory Turnover = Sales / Inventory Debtors Turnover = Credit Sales /

Debtors Turnover to Assets = Sales / Total

Assets

PROFITABILITY RATIOS

ROCE = NP / Total Capital

RONW = NP / NW

EPS = NP / No. of Shares

DPS = Dividend amount / No. of shares

OTHER RATIOS

SPS = Sales / No. of Shares Book Value = NW (less revaluation

reserves) per share

Limitations

   Basis of valuation of stock   Depreciation methods   Authenticity of data   More meaningful if trend analysis   Past results may not help predict

future   Varies for Industry / Company /

Season

Fundamental Analysis

What we mean by FA

Definition

Fundamental analysis is the examination of the underlying forces that affect the well being of the Economy, Industry groups and Companies

Fundamental Analysis determines the worth of a business by its future expected earning potential which in turn depends on quality of company’s management, business outlook for the company, outlook for the industry in which the company operates and the overall economic backdrop.

How does it differ from Technical analysis

Technical   “Future price is based on past price trend and

current price”    Efficient market    Price discounts every thing. Fundamental    Future price can not be determined using past /

current price    Current price does not reflect fair value    It is only reflection of the past    Weak form of market efficiency

What is the Goal or Objective

Derive a forecast for the future Profit from future price movements

How do we achieve this

     Value

     What is value

The intrinsic value of a company depends on the underlying business strength of the company

     Price

     What is price

General Steps

“TOP DOWN” Approach Economy Industry groups Specific Company

INDICATORS

GDP growth rateIndex of Industrial Production ( IIP )Inflation indices –WPI / CPI.Growth rate of Money supply Growth rate of PopulationGrowth rate of Agriculture

Indicators -- contd

Growth rate of per capita income Growth rate of Imports and Exports Interest rates. Stock Market Indices Foreign Exchange Reserves

The Political Equation

The political stability of the country is of paramount importance. No industry or company can grow and prosper in the midst of political turmoil.

Contribution of different Sectors to Economy

Last Year Expected in Future

Agriculture 54 ?

Industry 24 ?

Services 22 ?

Total 100 100

INDUSTRY

   Overall growth rate

   Market size

Importance to economy

Industry AnalysisIndustry Life Cycle

Product Demand

Profitability

Embryonic phase Low- Educating Buyers

Low-High Fixed cost, Low capacity

Growth phase Approaching Saturation level

Good, decreasing

Shake out phase Approaching Saturation level

Good, decreasing

Maturity phase Stagnant, Replacement

Low, steady

Decline phase Declining Declining, Rivalry

Steps

1. Demand Supply Analysis2. Profitability Analysis3. Level of Competition

Michael Porter’s Analysis

Threat of New Entrants

Bargaining Powerof Suppliers

Rivalry amongExisting Competitors

Bargaining Powerof Buyers

Threat of Substitute Products or Services

  Right Industry or Right Company

Stocks move in groups More important to be in right industry

than in right stock

Company selection

  Leader   Innovator   Edge – Market / Technology /

Market share / Product positioning / Innovations

Barriers to entry

Company Analysis

    Sensible business plan

    Solid Management – track record, talent, team

    Financial analysis

Valuation modelswhich one to adopt

Discounting Models Relative Valuation Models

“Discounted cash flow “ valuation model

Dividend discount model Free cash flow to company model Free cash flow to equity model

DIVIDEND DISCOUNT MODEL

•      John Burr Williams

The present worth of a share is the present value of future

dividends ( rather than the Earnings).

“ Relative” Valuation Models

Assumption Company will sell at a specific multiple of

earnings, revenue or growth.

PRICE EARNING RATIO

     P/ E = MP * EPS   What is the right PE ? – Industry -       Expectations       -- Future earning potential Commodity stock EPS rises faster

when market is recovering and drops faster during decline

PE ratio-continued

TISCO-1994 to 2004 CAGR 17% 2001 to 2004 CAGR 193% FY 2002 EPS P / E = 20.5 FY 2005 EPS P / E = 5

PE ratio-continued Siemens India – FY 06Net profit (consolidated) – Rs.39169 Lacs.No. of equity shares - 1685.8 LacsCurrent market price – Rs.1150EPS = 39169/1685.8 = 23.23PE Multiple = 1150/23.23 = 49.5Earnings yield = 1*100/49.5 = 2.02%

Relatively simple to calculate and use

Industry composite P/E=8.5

Name EPS Price P/E ratio

Essar 4.7 38.5 8.3

JSW 55.1 338 6.1

SAIL 9.7 87.4 9.0

Tata steel 60.4 506 8.4

PRICE EARNINGS GROWTH RATIO   P / E = G   The P/E ratio of any Company that is

fairly priced will equal the Growth rate. P/E is past and does not include effect

of Brand, Human capital, Expectations,

Barriers to entry- factors which affect growth rate

PEG RatioName Price EPS P/E Growth

%YoY %

Blue star info

107 5.5 19.7 11.81

Geometric 118 2.9 40.8 107.82

HCL 19.7 611 31.0 101.65

Iflex 1576 29.7 53.0 109.76

Infosys 43.5 2071 47.6 52.44

Mastek 338 17.5 19.4 42.16

Satyam 422 18.9 22.3 49.40

TCS 1059 27.8 38.2 44.10

WIPRO 532 14.1 37.7 49.70

PRICE TO SALES per SHARE RATIO Earnings-complicated, some times

reflect non-recurring amounts PSR = Share Price / Annual sale per

share Simple But carries no information about

Debt or Profitability

PRICE / BOOK VALUE Book value = Net worth / Number of

shares Sectoral view-Old Economy- Good

Indicator Services sector-Low tangible assets Services, Software, FMCG-High Auto, Engineering, Steel-Low

P / BV Ratio

Bank Price BV P/BV

Allahabad 89 54 1.65

Andhra 95 54 1.76

Canara 290 171 1.70

SBI 1109 525 2.11

Syndicate 79 39 2.03

Centurion 26 2 13.0

Federal 219 86 2.55

ICICI 998 149 6.70

HDFC 768 142 5.41

IDBI 80 88 0.91

Market capitalisation

 Market cap = MP * Number of shares Capacity Commodity companies Barrier to entry

Price Target and Projection  The value of a share ( Say

Allahabad Bank) by looking at the pricing of a comparable company ( say Andhra Bank)

Relative to a common variable Earnings, Book value, Sales (say

BV) Two stage process

Components of forecasting

1. Determine the length of the extraordinary growth period,

2. Select appropriate variable,3. Estimate earnings ( or whatever

variable) during this high growth period,4. Stable growth period5. Estimate earnings (variable) during this

period

Components of forecasting

1. Projected value of variable after desired period say 3 years

2. Select an appropriate company for comparison

3. BV of Allahabad Bank as on 31-03-20104. Projected target price of Allahabad

bank=BV* Multiple5. Say 1.65 to 1.76----

WARREN BUFFET VALUE FORMULA Intrinsic value = Estimated future

earnings * Confidence Margin Confidence margin –Zero to 100 % 100 = risk free return – Yield on

Government securities

Summary Strengths Weaknesses

STRENGTHS    Good for understanding long

term trends    Value spotting – Warren Buffet Thorough understanding of the

business

Weaknesses      Time constraint      Industry and Company specific     Subscription based - ISP     Refining margin – Oil Company      Subjective      Bias Definition of Fair value

Winston Churchill

No two on earth in all things can agree.

All things have some darling singularity.

Behavioral Finance Overconfidence Overreaction Loss aversion Risk tolerance Attachment

George Bernard Shaw

The Reasonable Man adapts himself to the world.

The Unreasonable One persists in trying to adapt the World to himself.

Therefore all progress depends on the unreasonable man.

Any Questions??

THANK YOU

anilharolikar@rediffmail.com