Chapter 15 COMP ANY ANAL YSIS E s ta b lishi ng the V a lue Be nchm ar k
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Chapter 15
COMPANY ANALYSIS
Establishing the Value Benchmark
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Outline
• Strategy Analysis
• Accounting Analysis
• Financial Analysis
• Estimation of Intrinsic Value
• Tools for Judging Undervaluation or Overvaluation
• Obstacles in the way of an Analyst
• Equity Research in India
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Strategy Analysis
Strategy analysis seeks to explore the economics of a firm and identify its
profit drivers so that the subsequent financial analysis reflects business
realities.
The profit potential of a firm is influenced by the industry or industries
in which it participates (industry choice), by the strategy it follows to
compete in its chosen industry or industries (competitive strategy), and by
the way in which it exploits synergies across its business portfolio
(corporate strategy).
We have considered industry analysis in the previous chapter. So, the
present discussion focuses on competitive strategy and corporate strategy
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Competitive Strategy
Among the various frameworks of strategy formulation, the one developed by
Michael E. Porter in his seminal work Competitive Strategy has been perhaps
the most influential in shaping management practice. Michael Porter argues
that the firm can explore two generic ways of gaining sustainable competitive
advantage viz., cost leadership and product differentiation.
Cost leadership can be attained by exploiting economies of scale, exercising
tight cost control, minimizing costs in area like R&D and advertising, and
deriving advantage from cumulative learning. Firms which follow this
strategy include Bajaj Auto in two wheelers, Mittal in steel, WalMart in
discount retailing, and Reliance Industries in petrochemicals.
Product differentiation involves creating a product that is perceived by
customers as distinctive or even unique so that they can be expected to pay a
higher price. Firms which have excelled in this strategy include Mercedes in
automobiles, Rolex in wristwatches, Mont Blanc in pens, and Raymond in
textiles.
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Exhibit 15.1 depicts the competitive position of the firm based on its
relative cost and differentiation positions. The most attractive
position of course is the cost-cum-differentiation advantage position.
Exhibit 15.1 Competitive Position of the Firm
Cost-cum-
differentiation
advantage
Differentiation
advantage
Low cost
advantage
Stuck-in-the
middle
Superior
Relative
Differentiation
Position
Superior
Inferior
InferiorRelative
Cost
Position
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Gaining Competitive Advantage
By choosing an appropriate strategy, a firm does not necessarily gain
competitive advantage. To do so the firm must develop the required
core competencies (the key economic assets of the firm) and
structure its value chain (the set of activities required to convert
inputs into outputs) appropriately. As Palepu et.al. say: ―The
uniqueness of a firm’s core competencies and its value chain and the
extent to which it is difficult for competitors to imitate them
determines the sustainability of a firm’s competitive advantage.‖
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Gaining Competitive Advantage
To assess whether a firm is likely to gain competitive advantage, the
analyst should examine the following:
• The key success factors and risks associated with the firm’s
chosen competitive strategy.
•The resources and capabilities, current and potential, of thefirm to deal with the key success factors and risks.
• The compatibility between the competitive strategy chosen by
the firm and the manner in which it has structured its activities
(R&D, design, manufacturing, marketing and distribution, and
support).
• The sustainability of the firm’s competitive advantage.
• The potential changes in the industry structure and the
adaptability of the firm to address these changes
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Strategy of Cost Leadership: Dell Computer
• Direct Selling
• Build-to-order manufacturing
• Low-cost service
• Negative working capital
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Corporate Strategy Analysis
When you analyse a multi-business firm, you have to evaluate not
only the profit potential of individual businesses but also the
economic implications (positive as well as negative) of managing
different businesses under one corporate canopy. For example,
General Electric has succeeded immensely in creating significant
value by managing a highly diversified set of businesses ranging
from light bulbs to aircraft engine, whereas Sears has not succeeded
in managing retailing with financial services.
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Corporate Sources of Value Creation
Thus, whether a multibusiness firm is more valuable compared to a
collection of focused firms finally depends on the context. The analyst
should examine the following factors to assess whether a firm’s corporate
strategy has the potential to create value.
• Imperfections in the product, labour, or financial markets in the
business in which the firm operates.• Existence of special resources such as brand name, proprietary
knowledge, scarce distribution channels, and organisational processes
that potentially create economies of scope.
• The degree of fit between the company’s specialised resources and its
portfolio of businesses.• The allocation of decision rights between the corporate office and
business units and its effect on the potential economies of scope.
• The system of performance measurement and incentive compensation
and its effect on agency costs.
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Accounting Analysis
Accounting analysis seeks to evaluate the extent to which the firm’s
accounting reports capture its business reality. As an analyst youmust be familiar with.
• The institutional framework for financial reporting
• Sources of noise and bias in accounting
• Differences between good and bad accounting quality.
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The Institutional Framework for Financial
Reporting
The salient features of the institutional framework for financial
reporting are:
•
Corporate financial reports are prepared on the basis of accrualaccounting and not cash accounting.
• Preparation of financial statements involves complex judgments
by management.
• GAAP regulates managerial judgement
• External auditing is now a near universal requirement.
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Sources of Noise and Bias in Accounting
There are several sources of potential noise and bias in accounting
data.
• Accounting rules themselves introduce noise and bias as it is
often not possible to restrict managerial discretion without
diminishing the informational content of accounting reports.
• Forecasting errors are practically unavoidable.
• Managers may introduce noise and bias in accounting
reports, while making their accounting decisions.
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Good and Bad Accounting Quality
Good Accounting
Quality
Bad Accounting
Quality
The accounting data focuses
on key success factors and
risks
The accounting data fails to
highlight key success factors
and risks
Managers use their accounting
discretion to make accounting
numbers more informative
Managers use their accounting
discretion to disguise reality
The firm provides adequate
disclosures to describe itsstrategy, its current
performance, and future
prospects
The firm just fulfills the
minimal disclosurerequirements prescribed by
accounting regulations
There are no red flags There are serious red flags2
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Financials Analysis
• The key questions to be addressed in applying the earnings
multiplier approach, the most popular method in practice,
are:
• What is the expected eps for the forthcoming year?
• What is a reasonable pe ratio?
• To answer these questions, investment analysts start with a
historical analysis of earnings (and dividends), growth, risk,
and valuation and use this as a foundation for developing theforecasts required for estimating the intrinsic value.
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Earnings And Dividend Level
To assess the earnings and dividend level, investment analysts look at
metrics like the return on equity, book value per share, EPS,
dividend payout ratio, and dividend per share.
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Financials Of Horizon Ltd20X1 20X2 20X3 20X4 20X5 20X6 20X7
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
Non-operating surplus/deficit 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 (Rs. 10
par)
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
Total assets 315 366 398 412 474 520 553
Earnings per share 2.27 4.00 4.67
Market price per share
(End of the year)
21.00 26.50 29.10 31.5
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ROE : 3 Factors
PAT Sales Assets
ROE = x x
Sales Assets Equity
Net Profit Asset Leverage
Margin Turnover
THE BREAK-UP OF THE RETURN ON EQUITY IN TERMS OF ITS
DETERMINANTS FOR THE PERIOD 20X5 –
20X7 FOR HORIZON LIMITED IS
GIVEN BELOW:
Return on equity = Net profit margin x Asset turnover x Leverage multiplier
20X5 13.0 % = 4.85% x 1.48 x 1.81
20X6 20.5% = 7.78% x 1.48 x 1.78
20X7 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 :
PBIT SALES PROFIT BEFORE TAX PROFIT AFTER TAX ASSETS
ROE = X X X X
SALES ASSETS PBIT PROFIT BEFORE TAX NETWORT
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ROE : 5 Factors
PBIT Sales PBT PAT Assets
ROE = x x x x
Sales Assets PBIT PBT Net Worth
ROE = PBIT EFFICIENCY X ASSET TURNOVER X INTEREST BURDEN X
TAX BURDEN X LEVERAGETHE ROE BREAK-UP FOR OMEGA COMPANY IS GIVEN BELOW :
ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x
Leverage
20X5 13.0% = 12.70% x 1.48 x 0.764 x 0.50 x 1.81
20X6 20.5% = 16.08% x 1.48 x 0.81 x 0.60 x 1.78
20X7 21.1% = 15.48% x 1.52 x 0.81 x 0.67 x 1.67
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Book Value Per Share And Earnings Per
Share
Book Value Per Share (BVPS)
Paid-up equity capital + Reserves and surplus
Number of equity shares
20 x 5 20 x 6 20 x 7BVPS 262/15 = 17.47 292/15 = 19.47 332/15 = 22.13
Earnings Per Share (EPS)
Equity earnings
Number of equity shares
20 x 5 20 x 6 20 x 7
EPS 34/15 = 2.27 60/15 = 4.00 70/15 = 4.67
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Dividend Payout Ratio And Dividend Per
Share
Dividend Payout Ratio
Equity dividends
Equity earnings
20 x 5 20 x 6 20 x 7
DividendPayout ratio
Dividend Per Share (DPS)
20 x 5 20 x 6 20 x 7
DPS Rs 1.86 2.00 2.00
28/34 = 0.82 30/60 = 0.50 30/70 = 0.43
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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.
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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 20x2 – 20x7for Horizon Limited is calculated below:
Sales of 20 x 7 1/ 5 840 1/ 5 CAGR of Sales : – 1 = – 1 = 9.2%
Sales for 20 x 2 542
CAGR of earnings EPS for 20 x 7 1/ 5 7.00 1/ 5 per share (EPS) : EPS for 20 x 2 6.30
CAGR of dividend : DPS for 20 x 7 1/ 5 3.00 1/ 5 per share (DPS) DPS for 20 x 2 2.30
– 1 = – 1 = 2.1%
– 1 = – 1 = 5.5%
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Sustainable Growth Rate
The sustainable growth rate is defined as :
Sustanable 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 (20x5 – 20x7) the sustainable growthrate of Horizon Limited is:
Sustainable growth rate = 0.417 x 18.2% = 7.58%
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Risk Exposure
Beta
Beta represents volatility relative to the market
Volatility of Return on equity
Range of return on Equity over n years
Average return on equity over n years
F bl & U f bl F
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Favourable & Unfavorable Factors
Favourable UnfavorableFactors Factors
Earnings Level • High book value per share • Low book value per share
Growth Level • High return on equity • Low return on equity
• High CAGR in sales and EPS • Low CAGR in sales and EPS
• High sustainable growth Rate • Low sustainable Growth Rate
RISK EXPOSURE • Low volatility of return on • High volatility of Return on
equity equity
• Low beta • High beta
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Valuation Multiples
The most commonly used valuation multiples are :
•Price to earnings (PE) ratio
• Price to book value (PBV) ratio
PE Ratio (Prospective)
Price per share at the beginning of year nEarnings per share for year n
20 x 5 20 x 6 20 x 7
PE ratio 9.25 6.63 6.23
PBV Ratio (Retrospective)
Price per share at the end of year nBook value per share at the end of year n
20 x 5 20 x 6 20 x 7
PBV ratio 1.52 1.49 1.42
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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
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Estimation of Intrinsic Value
• Estimate the expected EPS
• Establish a p / e ratio
• Develop a value anchor and a value range
EPS F t
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EPS Forecast
20 x 7 20 x 8 Assumption
(ACTUAL) (PROJECTED)
• Net Sales 840 924 Increase by 10 Percent• Cost of Goods sold 638 708 Increase by 11 Percent
• Gross profit 202 216
• Operating Expns 74 81 Increase by 9.5 Percent
• Depreciation 30 34
• Sellin & gen.
Admn. Expns 44 47
• Operating Profit 128 135
• Non-operating
Surplus/Deficit 2 2 No Change
• Profit before
INT. & Tax (PBIT) 130 137
• Interest 25 24 Decrease by 4 Percent
• Profit before Tax 105 113• Tax 35 38 Increase by 8.57 Percent
• Profit after Tax 70 75
• Number of Equity
Shares 15 MLN 15
• Earnings per Share RS 4.67 RS 5.00
Diff t PE R ti
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Different PE Ratios
Note that different PE ratios can be calculated for the same stock at
any given point in time.
• PE ratio based on last year’s reported earnings
• PE ratio based on trailing 12 months earnings
• PE ratio based on current year’s expected earnings
•
PE ratio based on the following year’s expected earnings
P / E Ratio
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P / E Ratio
Constant Growth Dividend Model
Dividend payout ratioP / E RATIO =
Required Expected
return on - growth rate
equity in dividends
Cross Section Analysis
P / E = a1 + a2 Growth Rate in + a3 dividend
earnings payout ratio
+ a3 Variability in earnings
+ a4 company sizeHistorical analysis
Weighted P /E ratio
R ti
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Ratio
Historical Analysis
20 x 5 20 x 6 20 x 7PE ratio 9.25 6.63 6.23
The average PE ratio is :
9.25 + 6.63 + 6.23
3
Weighted PE Ratio
PE ratio based on the constantgrowth dividend discount model
PE ratio based on historical analysis : 7.37
6.36 + 7.37
2
= 7.37
= 6.87
: 6.36
V l A h d V l R
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Value Anchor and Value Range
Value Anchor
Projected EPS x Appropriate PE ratio
5.00 x 6.87 = Rs. 34.35
Value Range
Rs.30 — Rs.38
Market Price Decision
< Rs.30 Buy
Rs.30 – Rs.38 Hold
> Rs.38 Sell
Tools for Judging Undervaluation or
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Tools for Judging Undervaluation or
Overvaluation
• PBV-ROE Matrix
• Growth-Duration Matrix
• Expectations Risk Index
• Quality at a Reasonable Price (VRE)
• PEG: Growth at a Reasonable Price
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Overvalued High ROE
HIGH Low ROE High PBV
High PBV
Low ROE Undervalued
LOW Low PBV High ROE
Low PBV
LOW HIGH
ROE
PBV Ratio
PBV-ROE Matrix
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Growth-Duration Matrix
UndervaluedPromises of
growth
Dividend
cows Overvalued
High
Low
High Low
Expected 5-Yr
EPS Growth
Duration (1/Dividend Yield)
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Expectations Risk Index (ERI)
Developed by Al Rappaport, the ERI reflects the risk in
realising the expectations embedded in the current market
price
Proportion of stock Ratio of expected future
price depending on growth to recent growth
expected future growth (Acceleration ratio)
ERI = X
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ERI Illustration
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ERI Illustration
• Omega’s base line value = = Rs.66.7
• Proportion of the stock price coming
from investors’ expectations of future = = 0.56
growth opportunities
• Acceleration ratio = = 1.25
ERI = 0.56 x 1.25 = 0.70
In general, the lower (higher) the ERI, the greater (smaller) the
chance of achieving expectations and the higher (lower) the expected
return for investors.
150 – 66.7
150
Rs.10
0.15
1.50
1.20
Quality at a Reasonable Price
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Quality at a Reasonable Price
Determining whether a stock is overvalued or undervalued is often
difficult. To deal with this issue, some value investors use a metriccalled the value of ROE or VRE for short.
The VRE is defined as the return on equity (ROE) percentage
divided by the PE(price-earning) ratio. For example, if a company
has an expected ROE of 18 percent and a PE ratio of 15, its VRE is
1.2 (18/15).According to value investors who use VRE:
• A stock is considered overvalued if the VRE is less than 1.
• A stock is worthy of being considered for investment, if the VRE
is greater than 1.• A stock represents a very attractive investment proposition if the
VRE > 2
• A stock represents an extremely attractive investment
proposition if the VRE > 3
PEG: Growth at a Reasonable Price
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PEG: Growth at a Reasonable Price
What price should one pay for growth? To answer this difficult
question, Peter Lynch, the legendary mutual fund manager,
developed the so-called PE-to-growth ratio, or PEG ratio. The PEG
ratio is simply the PE ratio divided by the expected EPS growth rate
(in percent). For example, if a company has a PE ratio of 20 and its
EPS is expected to grow at 25 percent, its PEG ratio is 0.8 (20/25).
PEG: Growth at a Reasonable Price
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PEG: Growth at a Reasonable Price
Proponents of PEG ratio believe that:
A PEG of 1 or more suggests that the stock is fully valued.
• A PEG of less than 1 implies that the stock is worthy of being
considered for investment.
•
A PEG of less than 0.5 means that the stock possibly is a very attractive
investment proposition.
• A PEG of less than 0.33 suggests that the stock is an unusually
attractive investment proposition.
Thus, the lower the PEG ratio, the greater the investment
attractiveness of the stock. Growth-at-a-reasonable price (GARP) investors
generally shun stocks with PEG ratios significantly greater than 1.
Ob t l i th W f A l t
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Obstacles in the Way of an Analyst
•
Inadequacies or incorrectness of data
• Future uncertainties
• Irrational market behaviour
Excellent Versus Unexcellent Companies
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Excellent Versus Unexcellent Companies
• In general, it appears that financial performance of
―excellent‖ companies deteriorates whereas financial
performance of ―non-excellent‖ companies improves.
• Empirical evidence of this kind reflects the phenomenon of
reversion to the mean which says that, over time, financial
performance of companies tends to converge to the averagevalue of the group as a whole. Thanks to this tendency,
―good‖ past performers are likely to produce inferior
investment results and ―poor‖ past performers are likely to
produce superior investment results.
Equity Research in India
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Equity Research in India
Traditionally, lip sympathy was paid to equity research. Financial
institutions (mutual funds, in particular) had a research cell because
it was in good form to have one. Likewise, large brokers set up
equity research cells to satisfy their institutional clients. In the mid-
1980s more progressive firms like Enam Financial, DSP Financial
Consultants, and Motilal Oswal Securities Limited set up research
divisions to exploit the opportunities in the equity market. With the
entry of foreign institutional investors and the emergence of more
discerning investors, the need for equity research is felt more widely.
Indeed, currently equity research is a growing area.
Future
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Future
Equity researchers who are able to do their job well have bright
prospects. The future belongs to those who will:
• Have a clear understanding of what their research is
supposed to do and how they should go about doing it.
• Learn to interpret financial numbers and assess qualitative
factors which may not be immediately reflected in numbers.
• Develop a medium-term or long-term perspective based on an
incisive understanding of the dynamics of the companies
analysed.
How to Make Most of Stock Research
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How to Make Most of Stock Research
Reports
To make the most of stock research reports, follow these guidelines:
• Don’t trust a research report naively. Use it as a starting point
and do your own due diligence before acting on it.
• Check the credibility of the brokerage house by reading its
reports over a period of time.
• Be wary of unscrupulous brokerage houses which prepare biased
research reports with ulterior motives.
• Often a buy recommendation is given, when promoters or some
other investors want to exit a stock.
Summing Up
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Summing Up
• In practice, the earnings multiplier method is the most
popular method. The key questions to be addressed in this
method are: what is the expected EPS for the forthcoming
year? What is a reasonable PE ratio given the growth
prospects, risk exposure, and other characteristics? Historical
financial analysis serves as a foundation for answering these
questions.
• The ROE, perhaps the most important metric of financial
performance, is decomposed in two ways for analytical
purposes.
ROE = Net profit margin x Asset turnover x Leverage
ROE = PBIT efficiency x Asset turnover x Interest burden
x Tax burden x Leverage
T th hi t i l th th CAGR i i bl lik
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• To measure the historical growth, the CAGR in variables like
sales, net profit, EPS and DPS is calculated.
• To get a handle over the kind of growth that can bemaintained, the sustainable growth rate is calculated.
• Beta and volatility of ROE may be used as risk measures.
• An estimate of EPS is an educated guess about the future
profitability of the company.
• The PE ratio may be derived from the constant growth
dividend model, or cross-section analysis, or historical
analysis.
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http://slidepdf.com/reader/full/chapter-15-company-analysisppt 51/51
• The value anchor is :
Projected EPS x Appropriate PE ratio
• PBV-ROE matrix, growth-duration matrix, and expectation
risk index are some of the tools to judge undervaluation or
overvaluation.