Process of fundamental analysis Business analysis
Understanding the Past
Acc oun tin g an alysi s
Financial analysis
Forecasting
Valuation
Trading on the valuation
1. Bu Busi sine ness ss Anal Analys ysis is · Explain the role and importance of fundamental analysis. · Describe the process of fundamental analysis. · Explain the role of macroeconomic factors in understanding the business. · Describe, explain and apply the process of industry analysis. · Describe, explain and apply the process of strategy analysis
Financial analysts are an important intermediary in the financial markets that help less sophisticated investors to make investment decisions. By doing so they contribute to more efficient allocation of resources. If they have good skills in identifying mispriced companies, they can also make money for their clients. Two approaches to analysis are common: technical and fundamental. Technical analysis seeks to predict future share prices relying on past time-series pattern of prices. Fundamental analysis looks at all the information available about the company and through process of understanding the past business of the company (business analysis, accounting analysis, financial analysis) builds expectations about the future (forecasting) that are translated into the company’s valuation and investment recommendation. An illustrative case of how a bad analysis can play a role in creating economic instability is the case of high-tech led market bubble in late 1990’s. Fundamental analysis is essentially top-bottom exercise. It is impossible to value the company without first looking at its environment. Therefore, a starting point is to look at the economy-wide factors (GDP growth, interest rates, inflation, commodity prices, exchange rates, etc.) and its impact on the industry in which company operates. This is followed by the analysis of industry structure and its growth potential (for example, by
using the tools of Porter’s 5 forces analysis) in order to assess the opportunities for value creation. Finally, the company’s own competitive positioning and corporate strategy are analysed. An additional tool to organise the available information is SWOT analysis. Through business analysis analysts should understand which the main value-drivers of the business are and how they are expected to translate into past and prospective quantitative, financial information.
2. Financial Analysis
· Perform financial analysis using trend analysis, common size analysis, financial ratios, non-financial indicators and cash flow analysis. · Evaluate usefulness of financial ratios. · Compare and evaluate differences between traditional and alternative calculations of financial ratios. Financial analysis should help in the summary assessment of the current financial position and financial performance of an entity as an input in forming expectations about the future. It involves comparing current accounting numbers and ratios with the historical trends and competitors. Non-financial indicators and cash flow analysis are the useful additional tools. The most important tool in financial analysis is financial ratios. Financial ratios are essentially financial statements summarized in a form that is useful to explain the company’s business and to compare it with the competitors in terms of profitability, leverage and activity. Financial ratios should be interpreted in the context of the business and accounting analysis. The accounting policies that directly influence the magnitude of the ratios are different across companies in a comparison group and may be different across time for a given company. Therefore, the separation of ‘true’ effect on ratios as a result of business activities from an effect of different accounting policies is not an easy task. Some other limitations in the usefulness of ratios exist as well. Ratios based on reformulated financial statements provide a clearer picture of the sources of value than the ratios computed in the traditional way due to more precise separation of operating and financing activities. 3. Forecasting · Describe and apply the process of forecasting pro-forma financial statements. · State, explain and develop most important forecasting assumptions. Summary Forecasts involve projecting future income statements and statements of financial position from which inputs to valuation can be directly calculated (earnings and cash flows). Analysis of the past (business, accounting and financial analysis) is the base on which the future is forecasted. The analyst needs to be aware of expected changes in the economy, industry and strategy on the future financial position and performance and the
effect of the accounting policies on future accounting numbers. Forecasting process starts with the sales, expenses based on the expected margins, and Income Statement. Statement of financial position is prepared on the basis of the expected activity ratios and leverage unless there is more precise and clear way to forecast them directly. Forecasting horizon needs to be as long as it is needed for company to reach steady state (constant growth and constant profitability). The terminal period assumptions about profitability and growth should be plausible and justified Forecasting details (summarised from Lundholm and Sloan, 2007, Chapter 8 Forecasting Details )
· Start from core/sustainable operating income to forecast margins by eliminating from operating income all: - Transitory, non-recurring items (e.g. loss/gain on disposals; impairment) - Non-forecasteable items (e.g. foreign exchange currency gains/losses) · Sales growth - Consider the correlation of industry sales with GDP, demographic trends and sensitivity to other macroeconomic factors - Consider the industry-specific drivers of sales (prices, capacity usage, and book of orders) for the firm - Consider the competitive position of the firm and its growth prospects relative to industry (expected to gain market share, mature, declining…) - Any future investments? (see notes to financial statements and operating and financial review section of Annual Report) - Any expected change in the usage of existing assets (change in capacity usage)? - Any expected changes in business model and strategy? · Margins - Distinguish between fixed and variable costs (economy of scale, operating leverage) - Distinguish between discretionary variable and fixed costs - Variable may vary with sales so expense margins constant, e.g. costs of material - May change as a result of successful cost management program, increase in productivity and changes in technology (e.g. lower energy consumption per unit of sale) - May change if sales growth driven by changes in prices, not volumes - Discretionary variable: behave as variable - Discretionary fixed: because they are fixed, margins are increasing with increase in sales - Discretionary fixed: RD costs highly discretionary: may vary with sales, but they are easy to cut; Advertising; Other general and selling expenses - Discretionary fixed: increase in good times following sales growth (constant margins), but not immediate decrease in bad times (falling margins); look in the past to gauge the behavior.
· Depreciation (fixed cost) - Depreciation rates and useful lives given in accounting policies section of financial statements - Forecast depreciation in relation to the PPE in BS, not sales - Have in mind composition of future assets (e.g. is company investing in plants or building a new premises?) · Interest rate (Borrowing costs) - Past interest rate a good indicator of future rates - Forecast in relation to financial obligations in BS, not in relation to sales - Note that investment and cash balances are more variable than long-term debt, as components of net financial obligations · Unusual items - Zero - However, if impairment and asset-write downs show continually in the past, think if they are worth forecasting · Other operating income - Usually income from associates and joint ventures. This income needs to be forecasted separately · Tax rate - Use notes to financial statements where differences between effective tax rate (tax expense/profit before tax) and statutory tax rate are reconciled - Gauge the effective tax rate by forecasting these differences - Deferred tax issue For Statement of Financial position items, ratios are usually defined in terms of ending (or beginning) assets and liabilities (not average!) for the purpose of easier calculation. · Working capital (inventories, receivables, prepayments, operating cash, payables, accruals) - Driven by operating cycle - Cash: usually treated as financial assets, but if operating than usually around 3% of sales - Receivables: depend on the collection period and credit risk; bargaining power important (e.g. small suppliers of large retailers) - Inventories: usually stable, decrease as a result of slow sales (recession?) or fast growth; increase as a result of changes in logistics (just-in-time inventory system) - Trade payables: mirror image of receivables - Other: small or stable
· Property, plant and equipment - Future investment plans – look at the notes to financial statements - Investment is lumpy, so capacity usage is increasing, effects of economy of scale, and consequently Sales/PPE ratio decreases - However, the capacity usage of PPE (and economy of scale) depends on the nature of industry; in services PPE tend to grow with sales (e.g. restaurants) - Technology changes: increase in turnover - Note: unlike for other items PPE is first forecasted (since we usually know investment plans in a near-term), and then turnover Sales/PPE ratio calculated · Intangibles - One-off event, usually as a result of acquisition (purchased brand, goodwill); - Keep the amount fixed or write it off if you think that the benefits do not exist · Equity holdings classified as operating assets - Measured at cost or fair value, or cost+share of profits - If fair value, then keep constant; same for cost - Associates (cost+share of profits), should be looked in more details at the level of that company · Provisions - Deferred taxes: if firms are rapidly growing, liabilities will grow as a % of assets; if shrinking, it will go down as a % of assets; in steady-state constant % of assets - Other (warranty, pensions, restoration liability) depend on the nature of provision Sales/Ending Net operating assets should be relatively stable over time since it is a function of technology; big changes are extremely rare. Consequently, sales growth and margin forecasting are more important for the accuracy of valuation. · Net financial obligations - Consider target long-term capital structure - Stable over time - Investments in debt (financial assets), treat as a part of overall capital structure policy - If leverage is increasing, it is likely that borrowing costs will increase as well. Changes in equity are residual when all other balance sheet items are forecasted Dividend payout needs to be balanced against potential equity issuance (given that net change in equity is already defined as a residual) Check if your DuPont decomposition for forecasted ratios makes sense. (Note that DuPont analysis is based on the beginning of the year assets, to be consistent with valuation models) 4. Valuation Models · Explain main principles behind the forecasting-based valuation. · State simplified forms of forecasting-based valuation models and explain under what assumptions simple models can be used.
· State general forms of discounted cash flow models, residual income model · Calculate cost of capital using CAPM. · Adjust valuation for the period from the financial year-end to the time of the valuation. · Describe and evaluate asset-based valuation. · Describe and explain determinants of price-to-book and price-to-earnings ratios. · Understand how price-to-book and price-to-earnings ratio articulate. · Use price-to-book and price-to-earnings ratio for a quick analysis of the company’s performance and expected prospects. Forecasting-based valuation models are more complex, but also more accurate as they take into account the information analysed and forecasted in previous steps of fundamental analysis. The underlying principle behind this type of models is that the entity is a going-concern. In this course, we also assume that Miller-Modigliani proposition on value-irrelevance of capital structure and dividend payout holds. Forecasting-based models are essentially present-value exercise where future payoffs (dividends, free cash flows, residual earnings) are discounted using cost of capital. Value of equity can be also indirectly estimated by firstly estimating value of operations and then deducting value of debt (which is assumed to be equal to its book value). Simplified versions of forecasting-based valuation models assume that the company is already in steady state. These versions are useful in ‘reverse engineering’ exercise to challenge the market assumptions about growth and expected return embedded in the observed market share price. There are three important caveats to remember about the determinants of value: · Increase in financial leverage creates growth in earnings per share, but does not add value because increase in earnings is offset by higher financial risk (and cost of equity capital). · Smaller (higher) dividend payout creates (more) less growth, but it adds value only in investment is a positive NPV project (rate of return is higher than WACC). · Accounting choice and accounting policy may result in earnings growth, but accounting itself does not create or destroys value. Formula Basic EPS = (Net income – Preferred dividends)/Weighted average number of shares outstanding Inventory Turnover = Cost of goods sold/Average inventory Days of Inventory on Hand = 365/Inventory turnover Receivables Turnover = Revenue/Average receivables Days of Sales Outstanding = 365/Receivables turnover Payables Turnover = Purchases/Average trade payables Number of days of payables = 365/Payables turnover Working capital turnover = Revenue/Average working capital Fixed asset turnover = Revenue/Average fixed assets
Total Asset Turnover = Revenue/Average total assets Current ratio = Current assets/Current liabilities Quick ratio = (Cash + Short-term marketable investments + Receivables)/Current liabilities Cash ratio = (Cash + Short-term marketable investments)/Current liabilities Debt-to-assets ratio = Total debt/Total assets Debt-to-capital ratio = Total debt/(Total debt + Shareholders’ equity) Debt-to-equity ratio = Total debt/Shareholders’ equity Financial leverage ratio = Average total assets/Average total equity Financial leverage=Average total assets/Average shareholders funds Financial leverage ratio=Net financing obligations/Shareholders funds Interest coverage ratio = EBIT/Interest payments Gross profit margin = Gross profit/Revenue Operating profit margin = Operating profit/Revenue Net profit margin = Net profit/Revenue ROA = Net income/Average total assets Return on total capital = EBIT/ (Short-term debt + Long-term debt + Equity) Return on equity = Net income/Average total equity Return on common equity = (Net income – Preferred dividends)/Average common equity ROE = ROA x Leverage ROE = Net profit margin x Asset turnover x Leverage P/E = Price per share/Earnings per share P/S = Price per share/Sales per share P/BV = Price per share/Book value per share Dividends per share = Common dividends declared/Weighted average number of ordinary shares Dividend payout ratio = Common share dividends/Net income attributable to common shares Sustainable growth rate = Retention rate x ROE
Cash Flow Classification under U.S. GAAP CFO Inflows Cash collected from customers. Interest and dividends received. Proceeds from sale of securities held for trading.
CFI Inflows
Outflows Cash paid to employees. Cash paid to suppliers. Cash paid for other expenses. Cash used to purchase trading securities. Interest paid. Taxes paid. Outflows
Sale proceeds from fixed assets. Sale proceeds from long-term investments CFF Inflows Proceeds from debt issuance. Proceeds from issuance of equity instruments
Purchase of fixed assets. Cash used to acquire LT investment securities. Outflows Repayment of LT debt. Payments made to repurchase stock. Dividends payments.
