IntroductionWhat is fundamental analysis?• Equity valuationmethodology utilizingfinancial and economicanalysis.• Used to determine intrinsicvalue of a stock.• Intrinsic value determineswhether investor shouldbuy, sell or hold the stock.• Enables informedinvestment decisions.DEMOCurrentMarket PriceIntrinsicValueDecision100 120 Buy100 90 Sell100 100 Hold
Fundamental analysis approach• Macro economic analysis• Industry analysis• Company analysis• Company ValuationDEMO
Understanding the BasicsTime Value of MoneyPresent Value of moneyAn amount available today is worthmore than the same amount in futuredue to its potential earning capacity.For e.g. If you receive Rs 117 after 3years, then the present value of thisamount today would be Rs 100.This is because if today you investedRs 100 for a period of 3 years and youearn a simple interest of 8% perannum then the maturity amountwould be Rs117.DEMOExamplePV = FV 100(1+r)tFV = PV * (1+r)tWherePV = Present ValueFV = Future Value 117r = Discount Rate 0.08t = Time 2
Understanding the BasicsFuture Value of MoneyThe value of an amount at aspecified date in the futurethat is equivalent in value to aspecified sum today.The future value of Rs 100invested at 8% per annumearning simple interest is Rs117DEMOExampleFV = PV * (1+r)t 100WherePV = Present Value 100FV = Future Value 117r = Discount Rate 0.08t = Time 2
Understanding the BasicsInterest rates and discount rates• Interest rates provide the rate of return of an asset whilediscount rates help us determine the present value of thefuture earnings of an asset.• To determine the appropriate interest rates to be used fordiscounting future cash flows, understanding the followingconcepts is important.• Weighted Average Cost of Capital (WACC)• Risk-free Rate• Equity Risk Premium• The BetaDEMO
Understanding the BasicsWeighted Average Costof Capital (WACC)WACC is the discountrate of the cost ofcapital required fordiscounting futurecash flows todetermine presentvalue of the said cashflowsDEMOWACC = D * (1-t) + E * Ke + P * KpTC TC TCWhereD = Debt portion of firms total employed capitalTC = Firms total capital employed (D+E+P)Kd =Firms cost ofdebtt =Firms effective taxrateE = Equity portion of firms total employed capitalP = Preferred equity portion of firms total employed capitalKp = Cost of firms preferred equity capitalKe = Cost of firms equity
Understanding the BasicsRisk-Free Rate (RFR)• The theoretical rate of return ofan investment with zero risk,including default risk. The defaultrisk is the risk of an individual orcompany or even a country wouldbe unable to pay its obligations toits debt holders.• The risk-free rate represents theinterest an investor would expectfrom an absolutely risk-freeinvestment over a specified periodof time.DEMOIn practice the RFR doesnot exist, as even thesafest investments carrya very small amount ofrisk. Hence, often theinterest rate of a 3-month U.S treasury billis used as the RFR.
Understanding the BasicsEquity Risk Premium• The excess return provided bya stock or the overall equitymarket over the risk-free rate(RFR). This is required tocompensate investors for therelatively higher risk of thestock.• High risk equity investmentshave higher risk premiums andthe premiums also changeconstantly, thus reflecting thechanging market conditions.DEMOIf the return ona stock is 17% and therisk-free rate over thesame period is 8% ( e.g.GOI 10 year bond), theequity-risk premiumwould be 9% for this stockover that period of time.
Understanding the BasicsThe Beta• Statistical measure indicatingthe volatility of a stock’s pricerelative to the price movementof the entire market.• Higher beta stocks have greaterprice volatility with greaterriskiness however such stockshave potential of providinghigher returns. Lower betastocks have lower risks and alsohave lower returns.DEMOBetaMarket Stock Explanation1 0 No correlation between stockprice and market1 1 Perfect correlation betweenstock price and market1 < 1 Stock price less volatile thanthe market1 >1 Stock price more volatile thanthe market
Understanding the BasicsRisk Adjusted Return (Sharpe Ratio)• Calculated by subtracting the risk-free rate - such as that of the 10-year GOI bond - from the rate ofreturn for a portfolio and dividingthe result by the standarddeviation of the portfolio returns.• Enables comparable portfolioanalysis by adjusting for risk.• Helps to determine whetherportfolio returns are due to skilfulstock picking or due to excessiverisk taking.DEMOS = R - RfσS = Sharpe RatioR = Stock returnRf = Risk free returnσ =Standarddeviation ofthe stockSharpe Ratio Remark1 - 2 Good2 - 3 Very Good> 3 Excellent
Financial Statement AnalysisManagement Discussion &AnalysisThe MDA includes an analysisof the results of operations anddiscusses management’sopinion about current andfuture performance. Itcompares the prior year’soperations with the currentyear’s and their impact on thecompany’s financials. It alsocontains an analysis of thefirm’s financial condition.DEMO
Financial Statement AnalysisThe Auditor’s ReportBefore issuing annualstatements, allpublicly heldcorporations arerequired to have anindependent audit oftheir financialstatements. TheCPAs who conductthe audit render anopinion as to thefairness of thestatements.DEMO