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# Fundamental analysis

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### Fundamental analysis

1. 1. Inter Connected Stock Exchange of India Khalsa College 18 th April 2007 By Anil Harolikar anilharolikar@rediffmail.com
2. 2. Structure  Interpretation of Financial Statements  Ratio Analysis  Fundamental Analysis  Valuation Ratios  Price Target and Projections  Summary
3. 3. Balance sheet Structure of Balance Sheet Financial Statements Ratio Analysis
4. 4. Structure of a Balance Sheet  Balance Sheet as at 31 st March 2006  Profit and Loss Account for the Year / Period ended 31 st March 2006  Schedules  Cash Flow  Ratios  Notice of AGM  Chairman’s Statement  Directors Report  Management Discussion and Analysis  Corporate Governance  Auditor’s Report  Notes on Accounts
5. 5. Definition   Ratio is relationship between two amounts Proportion that one amount bears to another
6. 6. Different forms    Pure Ratio – DER    Related to Time period- Working capital turnover    Percentage – NP / Sales
7. 7. IMPORTANCE  Helps analyse relationships  Helps prepare budgets and formulate policy  Trend analysis  Inter company comparison  Liquidity position
8. 8. For whom    Analysts  Portfolio Managers  Creditors / Lenders  Suppliers  Government  Management  Investors / Shareholders  Public at large
9. 9. Different classes of Ratios  Based on Balance Sheet ( or Financial)  Based on Revenue Statement ( or Operational)  Based on Combination of both statements
10. 10. Working capital cycle  Current Assets =  Cash / Bank >  Raw materials >  Work in process >  Finished Goods stock >  Receivables (if sold on credit) >  Cash / Bank.
11. 11. Current Liabilities  Unpaid Expenses like salaries / wages, power bills, telephone bills,  Materials purchased on credit,  Interest due on Working Capital and Term loans.
12. 12. Financial Ratios I. Liquidity / Solvency ratios II. Gear ratio III. Asset cover ratios a. Current a.Debentures b. Liquid b.Creditors c. Absolute liquidity c. Pref. shareholders d. Proprietary d.Equity e. Fixed asset e. Security cover f. Debt Equity
13. 13. Financial Ratios  LIQUIDITY Ratios  Current Ratio = Current Assets / Current Liabilities  Acid Test or Quick Ratio = CA minus Inventories / short term Liabilities
14. 14. LEVERAGE RATIOS  Total DER = Total Debt / NW  LT DER = LT Loans / NW
15. 15. COVERAGE Ratios  Security Cover = Assets to TL
16. 16. Operational Ratios REVENUE STATEMENT RATIOS
17. 17. Operational Ratios I. Expense ratios II. Earnings ratios III. Profit cover ratios a. Fixed cost / Total cost a.GP ratio or Turnover ratio a. Dividend cover b. RM / sales b. NP ratio b. Interest cover c. Wages / sales c. Operating profit ratio c. Total coverage ratio d. Office & admin.exp /sales e. Selling &
18. 18. REVENUE STATEMENT RATIOS  EXPENSE RATIOS  EARNINGS RATIOS  PROFIT COVER
19. 19. EXPENSE RATIOS FC to Total Cost = Power + Employee + Others + Depreciation + Interest charges / Total Cost Wages / Sales
20. 20. Concept of Breakeven  Contribution = Sale consideration − Variable cost.  The higher the contribution, better.  Breakeven point = the level of activity at which revenues and costs are equal.  The lower the fixed cost, the earlier will the company reach breakeven.
21. 21. EARNINGS RATIOS GP Margin = Gross Profit / Sales OP Margin = Operating Profit / Sales NP Margin = Net Profit / Sales
22. 22. Gross Profit  Gross profit = Net Sales minus cost of Goods sold  Cost of goods sold = costs incurred for manufacturing the goods sold.  Includes Direct material cost, Direct labour cost and factory overheads.
23. 23. Operating profit  Operating profit = Gross profit minus Operating Expenses.  Operating Expenses = General Administrative expenses + Selling and Distribution expenses + Depreciation.
24. 24. EBITA margin  Profit before Interest and taxes = EBITA = Operating profit + Non – operating surplus / deficit.  Measure of profit not influenced by Financial leverage and Tax factor.  Considered More Suitable for inter- company comparison.
25. 25. Net Profit  Net profit = OP (+/– non-OP) - financial expenses ( interest on borrowed funds).  PBT = NP  PAT = PBT- tax  Retained earnings = PAT - dividends
26. 26. PROFIT COVER  Dividend Cover Ratio = NP / Dividend amount  Dividend pay out ratio  What is the reasonable ratio Growing company Mature company Cash strapped company Cash rich company
27. 27. PROFIT COVER  Interest Cover = NP+ Interest added back / Interest  Manufacturing company  Banking / Finance company
28. 28. Combined Ratios  I. Turnover ratios  Inventory turnover  Debtors turnover  Creditors turnover  Turnover to assets and liabilities  II. Profitability ratio  ROCE/RONW/ROE  NP to Fixed assets /NP to Total assets  EPS / PE ratio / Div Yield ratio / DPS / Div payout ratio
29. 29. Combined Ratios  TURNOVER or VELOCITY RATIOS  Inventory Turnover = Sales / Inventory  Debtors Turnover = Credit Sales / Debtors  Turnover to Assets = Sales / Total Assets
30. 30. PROFITABILITY RATIOS  ROCE = NP / Total Capital  RONW = NP / NW  EPS = NP / No. of Shares  DPS = Dividend amount / No. of shares
31. 31. OTHER RATIOS  SPS = Sales / No. of Shares  Book Value = NW (less revaluation reserves) per share
32. 32. Limitations    Basis of valuation of stock    Depreciation methods    Authenticity of data    More meaningful if trend analysis    Past results may not help predict future    Varies for Industry / Company / Season
33. 33. Fundamental Analysis What we mean by FA
34. 34. Definition  Fundamental analysis is the examination of the underlying forces that affect the well being of the Economy, Industry groups and Companies  Fundamental Analysis determines the worth of a business by its future expected earning potential which in turn depends on quality of company’s management, business outlook for the company, outlook for the industry in which the company operates and the overall economic backdrop.
35. 35. How does it differ from Technical analysis Technical    “Future price is based on past price trend and current price”     Efficient market     Price discounts every thing. Fundamental     Future price can not be determined using past / current price     Current price does not reflect fair value     It is only reflection of the past     Weak form of market efficiency
36. 36. What is the Goal or Objective  Derive a forecast for the future  Profit from future price movements
37. 37. How do we achieve this      Value      What is value The intrinsic value of a company depends on the underlying business strength of the company      Price      What is price
38. 38. General Steps  “TOP DOWN” Approach  Economy  Industry groups  Specific Company
39. 39. INDICATORS GDP growth rate Index of Industrial Production ( IIP ) Inflation indices –WPI / CPI. Growth rate of Money supply Growth rate of Population Growth rate of Agriculture
40. 40. Indicators -- contd  Growth rate of per capita income  Growth rate of Imports and Exports  Interest rates.  Stock Market Indices  Foreign Exchange Reserves
41. 41. The Political Equation  The political stability of the country is of paramount importance. No industry or company can grow and prosper in the midst of political turmoil.
42. 42. Contribution of different Sectors to Economy Last Year Expected in Future Agriculture 54 ? Industry 24 ? Services 22 ? Total 100 100
43. 43. INDUSTRY    Overall growth rate Market size Importance to economy
44. 44. Industry Analysis Industry Life Cycle Product Demand Profitability Embryonic phase Low- Educating Buyers Low-High Fixed cost, Low capacity Growth phase Approaching Saturation level Good, decreasing Shake out phase Approaching Saturation level Good, decreasing Maturity phase Stagnant, Replacement Low, steady Decline phase Declining Declining, Rivalry
45. 45. Steps 1. Demand Supply Analysis 2. Profitability Analysis 3. Level of Competition
46. 46. Michael Porter’s Analysis Threat of New Entrants Bargaining Power of Suppliers Rivalry among Existing Competitor s Bargaining Power of Buyers Threat of Substitute Products or
47. 47.   Right Industry or Right Company  Stocks move in groups  More important to be in right industry than in right stock
48. 48. Company selection    Leader    Innovator    Edge – Market / Technology / Market share / Product positioning / Innovations  Barriers to entry
49. 49. Company Analysis     Sensible business plan     Solid Management – track record, talent, team     Financial analysis
50. 50. Valuation models which one to adopt  Discounting Models  Relative Valuation Models
51. 51. “Discounted cash flow “ valuation model  Dividend discount model  Free cash flow to company model  Free cash flow to equity model
52. 52. DIVIDEND DISCOUNT MODEL •      John Burr Williams The present worth of a share is the present value of future dividends ( rather than the Earnings).
53. 53. “ Relative” Valuation Models  Assumption  Company will sell at a specific multiple of earnings, revenue or growth.
54. 54. PRICE EARNING RATIO       P/ E = MP * EPS    What is the right PE ? – Industry -        Expectations        -- Future earning potential  Commodity stock EPS rises faster when market is recovering and drops faster during decline
55. 55. PE ratio-continued  TISCO-1994 to 2004 CAGR 17% 2001 to 2004 CAGR 193%  FY 2002 EPS P / E = 20.5  FY 2005 EPS P / E = 5
56. 56. PE ratio-continued  Siemens India – FY 06 Net profit (consolidated) – Rs.39169 Lacs. No. of equity shares - 1685.8 Lacs Current market price – Rs.1150 EPS = 39169/1685.8 = 23.23 PE Multiple = 1150/23.23 = 49.5 Earnings yield = 1*100/49.5 = 2.02%  Relatively simple to calculate and use
57. 57. Industry composite P/E=8.5 Name EPS Price P/E ratio Essar 4.7 38.5 8.3 JSW 55.1 338 6.1 SAIL 9.7 87.4 9.0 Tata steel 60.4 506 8.4
58. 58. PRICE EARNINGS GROWTH RATIO    P / E = G  The P/E ratio of any Company that is fairly priced will equal the Growth rate.  P/E is past and does not include effect of Brand, Human capital, Expectations, Barriers to entry- factors which affect growth rate
59. 59. PEG Ratio Name Price EPS P/E Growth% YoY % Blue star info 107 5.5 19.7 11.81 Geometric 118 2.9 40.8 107.82 HCL 19.7 611 31.0 101.65 Iflex 1576 29.7 53.0 109.76 Infosys 43.5 2071 47.6 52.44 Mastek 338 17.5 19.4 42.16 Satyam 422 18.9 22.3 49.40 TCS 1059 27.8 38.2 44.10
60. 60. PRICE TO SALES per SHARE RATIO  Earnings-complicated, some times reflect non-recurring amounts  PSR = Share Price / Annual sale per share  Simple  But carries no information about Debt or Profitability
61. 61. PRICE / BOOK VALUE  Book value = Net worth / Number of shares  Sectoral view-Old Economy- Good Indicator  Services sector-Low tangible assets  Services, Software, FMCG-High  Auto, Engineering, Steel-Low
62. 62. P / BV Ratio Bank Price BV P/BV Allahabad 89 54 1.65 Andhra 95 54 1.76 Canara 290 171 1.70 SBI 1109 525 2.11 Syndicate 79 39 2.03 Centurion 26 2 13.0 Federal 219 86 2.55 ICICI 998 149 6.70 HDFC 768 142 5.41
63. 63. Market capitalisation   Market cap = MP * Number of shares  Capacity  Commodity companies  Barrier to entry
64. 64. Price Target and Projection   The value of a share ( Say Allahabad Bank) by looking at the pricing of a comparable company ( say Andhra Bank)  Relative to a common variable  Earnings, Book value, Sales (say BV)  Two stage process
65. 65. Components of forecasting 1. Determine the length of the extraordinary growth period, 2. Select appropriate variable, 3. Estimate earnings ( or whatever variable) during this high growth period, 4. Stable growth period 5. Estimate earnings (variable) during this period
66. 66. Components of forecasting 1. Projected value of variable after desired period say 3 years 2. Select an appropriate company for comparison 3. BV of Allahabad Bank as on 31-03-2010 4. Projected target price of Allahabad bank=BV* Multiple 5. Say 1.65 to 1.76----
67. 67. WARREN BUFFET VALUE FORMULA  Intrinsic value = Estimated future earnings * Confidence Margin  Confidence margin –Zero to 100 %  100 = risk free return – Yield on Government securities
68. 68. Summary  Strengths  Weaknesses
69. 69. STRENGTHS     Good for understanding long term trends     Value spotting – Warren Buffet  Thorough understanding of the business
70. 70. Weaknesses       Time constraint       Industry and Company specific      Subscription based - ISP      Refining margin – Oil Company       Subjective       Bias  Definition of Fair value
71. 71. Winston Churchill No two on earth in all things can agree. All things have some darling singularity.
72. 72. Behavioral Finance  Overconfidence  Overreaction  Loss aversion  Risk tolerance  Attachment
73. 73. George Bernard Shaw The Reasonable Man adapts himself to the world. The Unreasonable One persists in trying to adapt the World to himself. Therefore all progress depends on the unreasonable man.
74. 74. Any Questions?? THANK YOU anilharolikar@rediffmail.com