Fundamental Analysis

Chapter 6

Fundamental Analysis

OUTLINE

• The Economy-Industry-Company (E-I-C) Framework

• The Global Economy

• Central Government Policy

• Macroeconomic Analysis

• Industry Analysis

•Company Analysis

Steps

Understanding of the macro-economic environment and developments

Analysing the prospects of the industry to which the firm belongs

Assessing the projected performance of the company and the intrinsic value of its shares

Step- 1 -- THE GLOBAL ECONOMY

IN A GLOBALISED BUSINESS ENVIRONMENT, THE TOP

DOWN ANALYSIS OF THE PROSPECTS OF A FIRM MUST

BEGIN WITH THE GLOBAL ECONOMY. THE GLOBAL

ECONOMY HAS A BEARING ON THE EXPORT PROSPECTS

OF THE FIRM, THE COMPETITION IT FACES FROM

INTERNATIONAL COMPETITORS, AND THE

PROFITABILITY OF ITS OVERSEAS INVESTORS.

THE GLOBAL ECONOMY

WHILE MONITORING THE GLOBAL ECONOMY BEAR IN MIND THE FOLLOWING:

• ALTHOUGH THE ECONOMIES OF MOST COUNTRIES

ARE LINKED, ECONOMIC PERFORMANCE VARIES WIDELY ACROSS COUNTRIES AT ANY TIME.

• FROM TIME TO TIME COUNTRIES MAY EXPERIENCE

TURMOIL DUE TO A COMPLEX INTERPLAY BETWEEN POLITICAL AND ECONOMIC FACTORS.

• THE EXCHANGE RATE IS A KEY FACTOR

AFFECTING THE INTERNATIONAL COMPETITIVENESS OF A COUNTRY’S INDUSTRIES.

CENTRAL GOVT. POLICIES

• THE GOVERNMENT EMPLOYS TWO BROAD CLASSES OF MACROECONOMIC POLICIES, VIZ. DEMAND SIDE POLICIES AND SUPPLY SIDE POLICIES.

• TRADITIONALLY, THE FOCUS WAS MOSTLY ON FISCAL AND MONETARY POLICIES, THE TWO MAJOR TOOLS OF DEMAND-SIDE ECONOMICS. FROM 1980s ONWARD, HOWEVER, SUPPLY-SIDE ECONOMICS HAS RECEIVED A LOT OF ATTENTION.

FISCAL POLICY

• FISCAL POLICY IS CONCERNED WITH THE SPENDING AND TAX INITIATIVES OF THE GOVERNMENT. IT IS THE MOST DIRECT TOOL TO STIMULATE OR DAMPEN THE ECONOMY.

• AN INCREASE IN GOVERNMENT SPENDING STIMULATES THE DEMAND FOR GOODS AND SERVICES, WHEREAS A DECREASE DEFLATES THE DEMAND FOR GOODS AND SERVICES.

• BY THE SAME TOKEN, A DECREASE IN TAX RATES INCREASES THE CONSUMPTION OF GOODS AND SERVICES AND AN INCREASE IN TAX RATES DECREASES THE CONSUMPTION OF GOODS AND SERVICES.

MONETARY POLICY

MONETARY POLICY IS CONCERNED WITH THE

MANIPULATION OF MONEY SUPPLY IN THE

ECONOMY. MONETARY POLICY AFFECTS THE

ECONOMY MAINLY THROUGH ITS IMPACT ON

INTEREST RATES.

THE MAIN TOOLS OF MONETARY POLICY ARE:

• OPEN MARKET OPERATION

• BANK RATE

• RESERVE REQUIREMENTS

• DIRECT CREDIT CONTROLS

MACRO ECONOMIC ANALYSIS

THE MACROECONOMY IS THE OVERALL ECONOMIC ENVIRONMENT IN WHICH ALL FIRMS OPERATE. THE KEY VARIABLES COMMONLY USED TO DESCRIBE THE STATE OF THE MACROECONOMY ARE :

GROWTH RATE OF GROSS DOMESTIC PRODUCT INDUSTRIAL GROWTH RATE AGRICULTURE AND MONSOONS SAVINGS AND INVESTMENTS GOVERNMENT BUDGET AND DEFICIT PRICE LEVEL AND INFLATION INTEREST RATES BALANCE OF PAYMENT, FOREX RESERVES, AND EXCHANGE

RATE INFRASTRUCTURAL FACILITIES AND ARRANGEMENTS SENTIMENTS

Step 2--INDUSTRY ANALYSIS

SENSITIVITY TO THE BUSINESS CYCLE

INDUSTRY LIFE CYCLE ANALYSIS • PIONEERING STAGE • RAPID GROWTH STAGE • MATURITY & STABILIZ’N STAGE • DECLINE STAGE

STUDY OF THE STRUCTURE AND CHARACTERISTICS OF AN INDUSTRY

* PROFIT POTENTIAL OF INDUSTRIES

Profit potential of industries – Porter Model : As per Michel Porter, the profit potential of an industry depends upon five basic competitive forces-Threat of new EntrantsRivalry among the existing firmsPressure from substitute productsBargaining power of BuyersBargaining power of Sellers

POTENTIAL ENTRANTS

TREAT OF NEW ENTRANTS BARGAINING INDUSTRY BARGAINING

SUPPLIERS RIVALRY BUYERS POWER OF AMONG POWER OF SUPPLIERS FIRMS BUYERS

THREAT OF SUBSTITUTE PRODUCTS

SUBSTITUTES

Step 3 – Company Analysis

• Study of Financials

• Going Beyond the Numbers

• Estimation of Intrinsic Value

STUDY OF FINANCIALS

THIS INCLUDES A HISTORICAL ANALYSIS OF EARNINGS (AND DIVIDENDS), GROWTH, RISK, AND VALUATION AND USE THIS AS A FOUNDATION FOR DEVELOPING THE FORECASTS REQUIRED FOR FINDING OUT FUTURE OUTCOME AND THUS THE

INTRINSIC VALUE

20X3 20X4 20X5 20X6 20X7 20X8 20X9

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 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 2.8 2.27 4.00 4.67

Market price per share (End of the year) 21.00 26.50 29.10 31.5

FINANCIALS OF X-PRO INDIA LTD

ROE : 3 FACTORS

PAT SALES ASSETSROE = x x

SALES ASSETS EQUITY

NET PROFIT ASSET Equity Multiplier MARGIN TURNOVER

The break-up of the return on equity in terms of its determinants for the period 20x7 – 20x9 for X-PRO Ltd. is given below:

Return on equity = Net profit margin x Asset turnover x Eq. Multiplier20X7 13.0 % = 4.85% x 1.48 x 1.8120X8 20.5% = 7.78% x 1.48 x 1.7820X9 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 :

ROE : 5 FACTORS

PBIT SALES PBT PAT ASSETSROE = x x x x SALES ASSETS PBIT PBT EQUITY

ROE = PBIT efficiency x Asset Turnover x Interest Burden x Tax Burden x Leverage

The ROE break-up for X-PRO company is given below :

ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x Leverage 20X7 13.0% = 12.70% x 1.48 x 0.764 x 0.50 x 1.8120X8 20.5% = 16.08% x 1.48 x 0.81 x 0.60 x 1.7820X9 21.1% = 15.48% x 1.52 x 0.81 x 0.67 x 1.67

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 7 20 x 8 20 x 9 BVPS 262/15 = 17.47 292/15 = 19.47 332/15 = 22.13

Earnings Per Share (EPS)

Equity earnings

Number of equity shares

20 x 7 20 x 8 20 x 9EPS 34/15 = 2.27 60/15 = 4.00 70/15 = 4.67

DIVIDEND PAYOUT RATIO

AND DIVIDEND PER SHARE

Dividend Payout Ratio

Equity dividends

Equity earnings

20 x 7 20 x 8 20 x 9

Dividend Payout ratio

Dividend Per Share (DPS)

20 x 7 20 x 8 20 x 9DPS Rs 1.87 2.00 2.00

28/34 = 0.82 30/60 = 0.50 30/70 = 0.43

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.

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 20x4 – 20x9 for X-pro India Limited is calculated below:

Sales of 20 x 9 1/ 5 840 1/ 5 CAGR of Sales : – 1 = – 1 = 9.2%

Sales for 20 x 4 542

CAGR of earnings EPS for 20 x 9 1/ 5 4.67 1/ 5 per share (EPS) : EPS for 20 x 4 4.2

CAGR of dividend : DPS for 20 x 9 1/ 5 2.00 1/ 5 per share (DPS) DPS for 20 x 4 1.53

–1 = –1 = 2.1%

–1 = –1 = 5.5%

SUSTAINABLE GROWTH RATE

The sustainable growth rate is defined as :

Sustainable 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 (20x7 – 20x9) the

sustainable growth rate of X-pro India Ltd. is:

Sustainable growth rate = 0.417 x 18.2% = 7.58%

FAVOURABLE & UNFAVOURABLE FACTORS

FAVOURABLE UNFAVOURABLE FACTORS FACTORS

EARNINGS LEVEL • HIGH BOOK VALUE PER • LOW BOOK VALUE

SHARE PER SHARE

GROWTH LEVEL • HIGH RETURN ON • LOW RETURN ONEQUITY EQUITY

• HIGH CAGR IN SALES • LOW CAGR IN SALESAND EPS AND EPS

• HIGH SUSTAINABLE • LOW SUSTAINABLEGROWTH RATE GROWTH RATE

RISK EXPOSURE • LOW VOLATILITY OF • HIGH VOLATILITY OFRETURN ON EQUITY RETURN ON EQUITY

• LOW BETA • HIGH BETA

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

INTRINSIC VALUE

In simple words Intrinsic value is nothing but the present

value of future cash flows (say interest, dividend, redemption

value or say liquidation proceeds) of a security. The E-I-C

analysis through valuation ratios helps to determine future

outcome/earnings/ value of the company and thus instrumental to

discover the fair/intrinsic value of the stock.

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