Investment Analysis & Portfolio Management
Lecture 05
FUNDAMENTAL ANALYSIS
VALUATION PHILOSOPHIES:
Value comes from utility; utility comes from a variety of sources. Fundamental analysts
believe securities are priced according to fundamental economic data. Technical analysts
think supply and demand factors play the most important role.
Investors' Understanding of Risk Premiums:
Investors are almost always risk-averse. Investors often cannot explicitly define risk, but they
have an intuitive understanding of it. They do not like taking risks, but will do so in order to
increase potential investment return - Preceding chapters have discussed how investors can use
the variance of investment returns as a proxy for risk. This balance between risk and return is the
reason un-bonds have higher yields to maturity than U.S. Treasury bonds, and why some shares
of stock sell for more than others.
The Time Value of Money:
Everything else being equal, the longer someone must wait for the payoff from an
investment, the less the investment is worth today.
The Importance of Cash Flows:
Most investment research deals with predicting future corporate earnings.
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The Tax Factor:
Taxes are supposedly "one of the two certainties in life. Investors also know that, in addition to
being a certainty, the tax code is complicated and not all investments are taxed equally. For this
reason, municipal bonds (paying tax-free interest) can sell with a lower expected rate of return
than a taxable corporate bond of equal risk, and some investors will favor growth stocks (with
tax deferral of appreciation) over income stocks (with immediate taxation of dividends).
EIC Analysis:
4.
Economic Analysis
5.
Industry Analysis
6.
Company
VALUE VS GROWTH INVESTING:
The two factions within the fundamental analysts' camp are the value investors and the growth
investors. These terms became popular in the 1980s and are now a standard part of the
investment lexicon.
The Value Approach to Investing
The Growth Approach to Investing
The Information Trader:
Information traders are in a hurry; they believe information differentials in the
marketplace can be profitably exploited.
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The True Growth Investor
How Price Relates to Value:
The modern perspective: Value is inextricably intertwined with price.
The most efficient and productive company in the world is a poor investment if the stock price
is too high.
Value Stocks and Growth Stocks:
How to Tell by Looking
The Price to Book Ratio
The Price-Earnings Ratio
Differences between Industries
Neither the price-earnings ratio nor the price to book ratio is a stand-alone statistic. Important
industry differences need to be considered. A firm whose primary asset is brainpower (such as a
software company) has fewer capital assets than a smokestack company (like a steel mill). The
software industry would normally have a higher price to book ratio than the steel industry.
For this reason, relative ratios are commonly computed for both the PE and the price to book
statistics. This calculation provides the ratio of the firm's statistic to the industry average statistic.
SOME ANALYTICAL FACTORS:
Growth Rates:
Calculate dividend growth rates using the geometric mean rather than the arithmetic mean.
The Dividend Discount Model:
D
D0 (I +g)
po
=
=
k −g
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1
k −g
In this equation, Do is the current dividend; D1 is the dividend to be paid next year; g is the
expected dividend growth rate; and k is the discount factor according to the riskiness of the
stock.20 the model assumes that the dividend stream is perpetual and that the long-term growth
rate is constant.
D (I +g)
p
k= 0
+g 0
Note that the expression for k, the shareholders' required rate of return, is the sum of two
components: the expected dividend yield on the stock and the expected growth rate. If the
dividend yield is a constant, g represents the anticipated capital appreciation in the stock price.
The shareholders’ required rate of return is the sum of the expected sum of the expected
dividend yield and the expected stock price appreciation.
The Importance of Hitting the Earnings Estimate:
Corporate CFOs know the importance of hitting Wall Street's earnings estimates. Analysts are in
frequent contact with the company, know its operations well, and usually base their estimates on
sound information- The market often penalizes a company's stock substantially when the
earnings report is disappointing. This is especially true when the required rate of return and the
estimated growth rate are high.
Suppose a company has a dividend payout ratio of 50%, analysts expect earnings of $1.10 in the
coming year, the consensus median dividend growth rate is 15%, and the current stock price is
$27'/2, According to the DDM, the shareholders' required rate of return is 17%:
D1
R=
0.5($1.10)
+g =
p0 $ 27.50
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+0.15 =17%
Suppose also that the expected earnings in the upcoming quarter are $ 0.29, but the company
reports only $0.27- This is a negative surprise, meaning that actual earnings were below
expectations. This might cause the analyst to reduce the estimate of future growth and, because
of the uncertainty, to boost the discount rate. Perhaps the analyst adjusts the growth rate to 13%
and the required rate of return to 18%. If future estimates for the year remain on track, the
anticipated earnings per share will be only $1.08. How does this affect the stock price? You
might first think that being off by two cents is not a big deal, but as the following equation
shows, the stock price is hit hard by this news. It falls by nearly 61%.
Po =
D1
(1 +k)
+ D2
(1 +k)2
D2 (1.g) /(k −g)
(1 +k )2
These results indicate why the whisper number is important and why CFOs do not like to feed
incomplete information to the analysts who follow their companies.
The Multistage DDM:
Small firms often show initially high levels of growth that cannot reasonably be expected to
persist. In such a case, it is appropriate to use two (or more) growth rates. Suppose a firm
currently pays a $1 dividend that is expected to grow by 20 percent for the net two years, and
then grow by 5 percent annually thereafter. A growth rate that can reasonably be expected to
persist is called a customable growth rate. What is the most an investor can pay for this stock if
the required rate of return is 17%? To find out, solve for equation in the following equation.
The term for the dividend in year three is discounted only twice because the formula for tile
growing perpetuity is based on next year's dividend. Therefore, the numerator is discounted only
twice, not three times.
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Caveats about the DDM:
The dividend discount model is a useful tool in security analysis. It is not, however, a method to
predict the future. As with most analytical techniques, the DDM helps an analyst make a better
decision, but it does not make the decision. Users should understand the shortcomings of the
DDM.
First, the DDM requires that g. If the dividend growth rate is greater than or equal to the
shareholders' required rate of return, the equation cannot be used. Dividing by zero or by a
negative number obviously gives an absurd result. Also, the results are sensitive to the estimate
of g. Minor differences in the growth rate selected can materially affect the results. As shown,
there are numerous ways of estimating g.
Another consideration is the assumption that the dividend yield remains constant. A change in
dividend policy can affect the apparent growth rate. A change in the growth rate will produce
different values from the model. Finally, the model implicitly assumes the long-term ROE is
constant. The DDM does not require that every year's growth be identical. Rather, it requires that
the long-term growth rate be constant in other words, a long-term trend about which the annual
values fluctuate.
Small-Cap, Mid-Cap, and Large-Cap Stocks:
Another consideration in fundamental stock analysis relates to the size of the firm. Currently,
firms are categorized as small-cap, mid-cap, or large-cap, cap being short for capitalization.
Although no precise definition has been stated for these terms most analysts consider a firm with
capitalization less than $500 million to be a small cap stock' Lipper Analytical Services defines a
mid-cap •firm as one with capitalization between $800 million and $2 billion. Others extend the
mid-cap range up to $6 billion.
Substantial financial research finds unusually good performance from small-cap stocks; this
phenomenon is sometimes called the small firm effect. Because of this effect, some analysts
devote particular attention to small-cap firms.
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Mid-cap firms showed average earnings growth of 15 percent during 1993, compared with 12
percent for large-cap firms. Some analysts believe the mid-caps offer particularly fertile hunting
ground for the stock picker. Small-cap stocks tend to be more volatile, scaring away the more
risk-averse investors. Index funds and large institutional portfolios own large-cap stocks. The
likelihood of "striking oil" from superior analysis of these large-cap stocks is remote, because
too many other people are -trying to do the same thing.
A study by Prudential Securities found that since 1926 mid-cap stocks returned 0-4% less than
small-cap stocks but were much less volatile. Many investors find that the risk-return package
historically offered by the mid-caps is superior to that offered by either the small-caps or the
large-caps.
Future study on relative performance by market capitalization is going to be complicated by the
definitional problem. We have traditionally defined market capitalization as the current share
price multiplied by the number of outstanding shares. This definition, however, can pose a
dilemma for the thoughtful security analyst. Y Suppose you are hired as a large-capitalization
common stock manager. Your job is to build and manage a portfolio of large-cap stocks.
Cooking the Books:
Ail publicly traded firms in the United States must have their financial statements audited to
ensure they fairly present the company's financial position. Still, every year there is at least one
story of accounting fraud at a major firm. In 1992, for instance, the women's clothing firm Leslie
Fay admitted it had manipulated inventory numbers to produce earnings of $23.9 million when,
in fact, it lost $13.7 million. The news cut the stock price in half and led to bankruptcy two
months later. In recent years there have been accounting bombshells at other firms including
Cascade International, Maxwell Communication Corp., Chambers Development, MiniScribe,
Cendant, and numerous others. Unfortunately, there is not much the analyst can do about fraud.
As Patricia McConnell, a respected analyst at Bear Steams says, "A well-perpetrated fraud is
impossible to detect." The important thing to remember is that the marketplace is full of many
types of risk, and fraud is one of them.
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Fundamental analysts believe securities are priced according to economic data; technical analysts
believe supply and demand factors are most important. Most investment research deals with
predicting future earnings. A value investor believes a security should only be purchased when
the underlying fundamentals justify the purchase. They believe in a regression to the mean of
security returns.
A growth investor seeks rapidly growing companies. Value investors place a great deal of
importance on a stock’s price to book ratio and its price-earnings ratio. A future earnings growth
rate is unobservable. Most analysts use several methods to estimate this statistic to determine a
likely range for the value rather than a single number.
The dividend discount model (also called Gordon’s growth model) can be used to value stock as
a growing perpetuity. The shareholders’ required rate of return is an input to the model. False
growth in earnings occurs any time a firm acquires another firm with a lower price-earnings
ratio. Cash flow from operations is a firm’s lifeblood. This value is often used as a check on the
quality of a firm’s earnings.
The evidence shows that small-cap stocks outperform mid- or large-cap stocks. Some analysts
believe that mid-cap stocks are particularly fertile hunting ground for the security analyst
because they receive less attention from the marketplace. Spectacular gains are occasionally
associated with initial public offerings (IPO).these gains usually disappear within the first year or
two of the new stock’s life.
Intrinsic Value and Market Price:
After making careful estimates of the expected stream of dividends and the required rate of
return for a common stock, the value of the stock today is estimated using the DDM. The value is
often called intrinsic value of the stock, which we denote as Vo. Note that intrinsic value simply
means an estimated value or a formula value. This is the end objective of a discounted cash flow
technique such as the DDM.
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If Vo > Po, the asset is undervalued and should be purchased or held if already owned.
If Vo < Po, the asset is overvalued and should be avoided, sold if held, or possibly sold short.
If Vo = Po, this implies an equilibrium in that the asset is correctly valued.
Security analysis has traditionally been thought of as the search for undervalued or overvalued
stocks. To do this, one can calculate the estimated or intrinsic value of the stock or compare this
value to the current market price if the stock. Most investors believe that stocks are not always
priced at their intrinsic values, thereby leading to buy and sell opportunities.
The P/E Ratio or Earnings Multiplier Approach:
The P/E ratio or earnings multiplier approach is the best-known and most widely used valuation
technique. Analyst are more comfortable talking about earnings per share (EPS) and P/E ratios,
and this is how their reports are often worded. Talk about EPS and P/Es ratios is the typical
language of Wall Street. Without question, the P/E ratio is one of the most widely mentioned and
discussed variables pertaining to a common stock, and will almost always appear in any report
from an analyst or an investment advisory service. For this reason, we develop the P/E ratio in
detail.
What is the P/E Ratio?
As a definition, the P/E ratio is simply the number of times investors value earnings as expressed
in the stock price. For example, a stock priced at $100, With most recent 12-month earnings of
$5, is said to selling for a multiple of 20, In contrast, if another stock had earnings of $2.50 and
was selling for $100, investors would be valuing the stock at 40 times earnings, thus, the P/E
ratio as reported daily in such sources as The Wall Street Journal is simply an identity calculated
by-dividing the current market price of the stock by the latest 12-month earnings. As such, it tells
investors the price being paid for each $1 of-most recent 12-month earnings.
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Determinants of P/E Ratio:
What variables affect the P/E ratio? To shed some light on this question, the P/E ratio can be
derived from the dividend discount model, which, as we have seen, is-the foundation of
valuation for common stocks. Note, however; that this process directly applies only for the case
of constant growth. If a multiple period growth model is applicable to the' stock being
considered, a different formulation from the one presented here will be needed. In fact, using the
P/E ratio for multiple growth rate companies can be misleading and should be done with care.
Understanding the P/E Ratio:
Most investors intuitively realize that the P/E ratio should be higher for companies whose
earnings are expected to grow rapidly. However, how much higher is not an easy question to
answer? The market will assess the degree of risk involved in -the expected future growth of
earnings, if the higher growth rate carries a high level of risk, the P/E ratio will be affected
accordingly. Furthermore, the high- growth rate may be attributable to several different factors,
some of which are more desirable than others. For example, rapid growth in unit sales owing to
strong demands for a firm's products is preferable to favorable tax situations, which may change,
or liberal accounting procedures, which one day may cause reversal in the firm's situation.
P/E ratios reflect investors' expectations about the growth potential of a stock and the risk
involved. These two factors can offset each other. Other things being equal, the greater the risk
of a stock, the lower the P/E ratio; however, growth prospects may offset the risk and lead to a
higher P/E ratio. The Internet companies that were so popular in the late 1990s were clearly very
risky, but investors valued their potential very highly, and were willing to pay very high prices
for these companies.
The P/E ratio reflects investor optimism and pessimism. It is related to the required rate of return.
As the required rate of return increases, other things being equal, the P/E ratio decreases.
The required rate of return, in turn, is related to interest rates, which are the required returns on
bonds. As interest rates increase, required rates of return on all securities, including stocks, also
generally increase.
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As interest rates increase, bonds become more attractive compared to stocks on a current return
basis. Based on these relationships, an inverse relationship between P/E ratios and interest ratesis to be expected. As interest rates rise (decline), other things being equal, P/E ratios should
decline (rise).
Which Approach to Use?
We have described the two most often used approaches in fundamental analysis, discounted
cash-flow techniques and relative valuation techniques. Which should be used?
In theory, the discounted cash-flow approach is a correct, logical, and sound position.
Conceptually, the best estimate of the current value of a company's common stock is the present
value of the (estimated) cash flows to be generated by that company. However, some analysts
and investors feel that this model is unrealistic. After all; they argue, with regard to the DDM, no
one can forecast dividends into the distant future with very much accuracy. Technically, the
model calls for an-estimate of all dividends from now to infinity, which is an impossible task.
Finally, many investors want capital gains and not dividends, so for some investors focusing
solely on dividends is not desirable.
The previous discussion dealt with these objections that some raise about the dividend discount
model. Can you respond to these objections based on this discussion?
Possibly because of the objections to the dividend discount model cited here, or possibly because
it is easier to use, relative valuation techniques such as the earnings multiplier or P/E model
remain a popular approach to valuation. They are less sophisticated less formal and more
intuitive models. In fact, understanding the P/E model can help investors to understand the
DDM. Because dividends are paid out of earnings, investors must, estimate the growth in
earnings before they can estimate the growth in dividends or dividends themselves.
Ratio Analysis:
Financial ratio analysis is a fascinating topic to study because it can teach us so much about
accounts and businesses. When we use ratio analysis we can work out how profitable a business
is, we can tell if it has enough money to pay its bills and we can even tell whether its
shareholders should be happy.
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Ratio analysis can also help us to check whether a business is doing better this year than it was
last year; and it can tell us if our business is doing better or worse than other businesses doing
and selling the same things.
In addition to ratio analysis being part of an accounting and business studies syllabus, it is a very
useful thing to know anyway.
The overall layout of this section is as follows: We will begin by asking the question, what do we
want ratio analysis to tell us? Then, what will we try to do with it? This is the most important
question. The answer to that question then means we need to make a list of all of the ratios we
might use: we will list them and give the formula for each of them.
Once we have discovered all of the ratios that we can use we need to know how to use them,
who might use them and what for and how will it help them to answer the question we asked at
the beginning?
At this stage we will have an overall picture of what ratio analysis is, who uses it and the ratios
they need to be able to use it. All that's left to do then is to use the ratios; and we will do that
step- by-step, one by one.
By the end of this section we will have used every ratio several times and we will be experts at
using and understanding what they tell us.
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LIQUIDITY RATIOS:
1. The Current Ratio:
The current ratio is also known as the working capital ratio and is normally presented as a real
ratio. The formula to calculate the current ratio is;
Current Ratio = Current Assets / Current Liabilities
The ratio is mainly used to give an idea of the company's ability to pay back its short-term
liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher
the current ratio, the more capable the company is of paying its obligations. A ratio under 1
suggests that the company would be unable to pay off its obligations if they came due at that
point. While this shows the company is not in good financial health, it does not necessarily mean
that it will go bankrupt - as there are many ways to access financing – but it is definitely not a
good sign.
The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to
turn its product into cash. Companies that have trouble getting paid on their receivables or have
long inventory turnover can run into liquidity problems because they are unable to alleviate their
obligations. Because business operations differ in each industry, it is always more useful to
compare companies within the same industry.
This ratio is similar to the acid-test ratio except that the acid-test ratio does not include inventory
and prepaid as assets that can be liquidated. The components of current ratio (current assets and
current liabilities) can be used to derive working capital (difference between current assets and
current liabilities). Working capital is frequently used to derive the working capital ratio, which
is working capital as a ratio of sales.
The working capital means the amount that current assets exceed the current liabilities. In simple
words, it is the difference current assets and current liabilities.
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Working Capital = Current Assets – Current Liabilities
Positive working capital means that the company is able to pay off its short-term liabilities.
Negative working capital means that a company currently is unable to meet its short-term
liabilities with its current assets (cash, accounts receivable and inventory).
2. The Acid Test Ratio:
The acid test ratio is also known as the liquid or the quick ratio. The idea behind this ratio is that
stocks are sometimes a problem because they can be difficult to sell or use. That is, even though
a supermarket has thousands of people walking through its doors every day, there are still items
on its shelves that don't sell as quickly as the supermarket would like. Similarly, there are some
items that will sell very well.
Nevertheless, there are some businesses whose stocks will sell or be used slowly and if those
businesses needed to sell some of their stocks to try to cover an emergency, they would be
disappointed. Engineering companies can have their materials in stock for as much as 9 months
to a year; a greengrocer should have his stocks for no longer than 4 or 5 days - a good
greengrocer anyway.
We'll look at the acid test ratio;
Acid Test Ratio = (Current Assets - Inventory) / Current Liabilities
PROFITABILITY RATIOS:
1. Gross Profit Margin:
Gross Profit Margin = Gross Profit / Net Sales * 100
Remember;
Gross Profit = Sales – Cost of Goods Sold
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The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost of
goods sold. It is a very simple idea and it tells us how much gross profit per Rs. 1 of turnover our
business is earning.
Gross profit is the profit we earn before we take off any administration costs, selling costs and so
on. So we should have a much higher gross profit margin than net profit margin.
2. Operating Margin:
A ratio used to measure a company's pricing strategy and operating efficiency. Calculated as:
Operating Margin = Operating Income / Net Sales
Operating margin is a measurement of what proportion of a company's revenue is left over after
paying for variable costs of production such as wages, raw materials, etc. A healthy operating
margin is required for a company to be able to pay for its fixed costs, such as interest on debt.
Operating margin gives analysts an idea of how much a company makes (before interest and
taxes) on each dollar of sales. When looking at operating margin to determine the quality of a
company, it is best to look at the change in operating margin over time and to compare the
company's yearly or quarterly figures to those of its competitors. If a company's margin is
increasing, it is earning more per rupee of sales. The higher the margin, the better it is.
3. Net Profit Margin:
Net Profit Margin = Net Profit / Net Sales *100
Remember;
Net Profit = Gross Profit - Expenses
Why do we have two versions of this ratio - one for net profit and the other for profit before
interest and taxation? Well, in some cases, you will find they use the term net profit and in other
cases, especially published accounts, they use profit before interest and taxation.
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They both mean the same. The net profit margin ratio tells us the amount of net profit per Rs. 1
of turnover a business has earned. That is, after taking account of the cost of sales, the
administration costs, the selling and distributions costs and all other costs, the net profit is the
profit that is left, out of which they will pay interest, tax, dividends and so on.
4. Earnings per share (EPS):
The portion of a company's profit allocated to each outstanding share of common stock. EPS
serves as an indicator of a company's profitability. Calculated as:
Earnings per Share = Profit Available to Shareholders / Average common shares
outstanding
Earnings per share (EPS) is the profit attributable to shareholders (after interest, tax, and
everything else) divided by the number of shares in issue. It is the amount of a company's profits
that belong to a single ordinary share.
LEVERAGE RATIO:
Any ratio used to calculate the financial leverage of a company to get an idea of the company's
methods of financing or to measure its ability to meet financial obligations.
A general term describing a financial ratio that compares some form of owner's equity (or
capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the degree
to which a firm's activities are funded by owner's funds versus creditor's funds.
Leverage = Long term debt / total equity
The higher a company's degree of leverage, the more the company is considered risky. As for
most ratios, an acceptable level is determined by its comparison to ratios of companies in the
same industry. The best known examples of gearing ratios include the debt-to-equity ratio (total
debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and
debt ratio (total debt / total assets).
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A company with high gearing (high leverage) is more inerrable to downturns in the business
cycle because the company must continue to service its debt regardless of how bad sales are. A
greater proportion of equity provides a cushion and is seen as a measure of financial strength.
1. Interest Coverage Ratio:
A ratio used to determine how easily a company can pay interest on outstanding debt. The ratio
is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by
the company's interest expenses of the same period:
The interest cover ratio tells us the safety margin that the business has in terms of being able to
meet its interest obligations. That is, a high interest cover ratio means that the business is easily
able to meet its interest obligations from profits. Similarly, a low value for the interest cover ratio
means that the business is potentially in danger of not being able to meet its interest obligations.
Here's a reminder of the formula:
Interest Coverage Ratio = Earnings before interest and tax / interest expense
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