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Fundamental Analysis

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All about Fundamental analysis in financial Markets

Introduction about Fundamental Analysis

What is fundamental analysis?

Fundamental analysis is a stock valuation methodology that uses financial and economic analysis to envisage the movement of stock prices. The fundamental data that is analysed could include a company’s financial reports and non-financial information such as estimates of its growth, demand for products sold by the company, industry comparisons, economy-wide changes, changes in government policies etc.

The outcome of fundamental analysis is a value (or a range of values) of the stock of the company called its ‘intrinsic value’ (often called ‘price target’ in fundamental analysts’ parlance). To a fundamental investor, the market price of a stock tends to revert towards its intrinsic value. If the intrinsic value of a stock is above the current market price, the investor would purchase the stock because he believes that the stock price would rise and move towards its intrinsic value. If the intrinsic value of a stock is below the market price, the investor would sell the stock because he believes that the stock price is going to fall and come closer to its intrinsic value.

To find the intrinsic value of a company, the fundamental analyst initially takes a top-down view of the economic environment; the current and future overall health of the economy as a whole. After the analysis of the macro-economy, the next step is to analyse the industry environment which the firm is operating in. One should analyse all the factors that give the firm a competitive advantage in its sector, such as, management experience, history of performance, growth potential, low cost of production, brand name etc. This step of the analysis entails finding out as much as possible about the industry and the inter-relationships of the companies operating in the industry as we have seen in the previous NCFM module1. The next step is to study the company and its products.

Some of the questions that should be asked while taking up fundamental analysis of a company would include:

1. What is the general economic environment in which the company is operating? Is it conducive or obstructive to the growth of the company and the industry in which the company is operating?

For companies operating in emerging markets like India, the economic environment is one of growth, growing incomes, high business confidence etc. As opposed to this a company may be operating in a developed but saturated market with stagnant incomes, high competition and lower relative expectations of incremental growth.

1 Please see NCFM’s Investment Analysis and Portfolio Management module for details.

2. How is the political environment of the countries/markets in which the company is operating or based?

A stable political environment, supported by law and order in society leads to companies being able to operate without threats such as frequent changes to laws, political disturbances, terrorism, nationalization etc. Stable political environment also means that the government can carry on with progressive policies which would make doing business in the country easy and profitable.

3. Does the company have any core competency that puts it ahead of all the other competing firms?

Some companies have patented technologies or leadership position in a particular segment of the business that puts them ahead of the industry in general. For example, Reliance Industries’ core competency is its low-cost production model whereas Apple’s competency is its design and engineering capabilities adaptable to music players, mobile phones, tablets, computers etc.

4. What advantage do they have over their competing firms?

Some companies have strong brands; some have assured raw material supplies while others get government subsidies. All of these may help firms gain a competitive advantage over others by making their businesses more attractive in comparison to competitors. For example, a steel company that has its own captive mines (of iron ore, coal) is less dependent and affected by the raw material price fluctuations in the marketplace. Similarly, a power generation company that has entered into power purchase agreements is assured of the sale of the power that it produces and has the advantage of being perceived as a less risky business.

5. Does the company have a strong market presence and market share? Or does it constantly have to employ a large part of its profits and resources in marketing and finding new customers and fighting for market share?

Competition generally makes companies spend large amounts on advertising, engage in price wars by reducing prices to increase market shares which may in turn erode margins and profitability in general. The Indian telecom industry is an example of cut throat competition eating into companies’ profitability and a vigorous fight for market share. On the other hand there are very large, established companies which have a leadership position on account of established, large market share. Some of them have near-monopoly power which lets them set prices leading to constant profitabilityType a message

Concept of “Time value of Money”

The concept of time value of money arises from the relative importance of an asset now vs. in future. Assets provide returns and ownership of assets provides access to these returns. For example, Rs. 100 of today’s money invested for one year and earning 5% interest will be worth Rs. 105 after one year. Hence, Rs. 100 now ought to be worth more than Rs. 100 a year from now. Therefore, any wise person would chose to own Rs. 100 now than Rs. 100 in future. In the first option he can earn interest on on Rs. 100 while in the second option he loses interest. This explains the ‘time value’ of money. Also, Rs. 100 paid now or Rs. 105 paid exactly one year from now both have the same value to the recipient who assumes 5% as the rate of interest. Using time value of money terminology, Rs. 100 invested for one year at 5% interest has a future value of Rs. 105. The method also allows the valuation of a likely stream of income in the future, in such a way that the annual incomes are discounted and then added together, thus providing a lump-sum “present value” of the entire income stream. For eg. If you earn Rs. 5 each for the next two years (at 5% p.a. simple interest) on Rs. 100, you would receive Rs. 110 after two years. The Rs. 110 you earn, can be discounted at 5% for two years to arrive at the present value of Rs. 110, i.e. Rs. 100.

Valuing future cash flows, that may arise from an asset such as stocks, is one of the cornerstones of fundamental analysis. Cash flows from assets make them more valuable now than in the future and to understand the relative difference we use the concepts of interest and discount rates. Interest rates provide the rate of return of an asset over a period of time, i.e., in future and discount rates help us determine what a future value of asset, value that would come to us in future, is currently worth. The present value of an asset could be shown to be: Where PV = Present Value FV = Future Value r = Discount Rate t = Time

Interest Rates and Discount Factors

So, what interest rate should we use while discounting the future cash flows? Understanding what is called as Opportunity cost is very important here.

Opportunity Cost

Opportunity cost is the cost of any activity measured in terms of the value of the other alternative that is not chosen (that is foregone). Put another way, it is the benefit you could have received by taking an alternative action; the difference in return between a chosen investment and one that is not taken. Say you invest in a stock and it returns 6% over a year. In placing your money in the stock, you gave up the opportunity of another investment - say, a fixed deposit yielding 8%. In this situation, your opportunity costs are 2% (8% - 6%).

But do you expect only fixed deposit returns from stocks? Certainly not. You expect to earn more than the return from fixed deposit when you invest in stocks. Otherwise you are better off with fixed deposits. The reason you expect higher returns from stocks is because the stocks are much riskier as compared to fixed deposits. This extra risk that you assume when you invest in stocks calls for additional return that you assume over other risk-free (or near risk-free) return.

The discount rate of cost of capital to be used in case of discounting future cash flows to come up with their present value is termed as Weighted Average Cost of Capital (WACC).

Where D = Debt portion of the Total Capital Employed by the firm TC = Total Capital Employed by the frim (D+E+P) Kd = Cost of Debt of the Company. t = Effective tax rate of the firm E = Equity portion of the Total Capital employed by the firm P = Preferred Equity portion of the Total Capital employed by the firm Kp = Cost of Preferred Equity of the firm.

The Cost of equity of the firm, Ke (or any other risky asset) is given by the Capital Asset Pricing Model (CAPM)

Or Where Rf = Risk-free rate β = Beta, the factor signifying risk of the firm Rm = Implied required rate of return for the market So what discount factors do we use in order to come up with the present value of the future cash flows from a company’s stock?

Risk-free Rate

The risk-free interest rate is the theoretical rate of return of an investment with zero risk, including default risk. Default risk is the risk that an individual or company would be unable to pay its debt obligations. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a given period of time.

Though a truly risk-free asset exists only in theory, in practice most professionals and academics use short-dated government bonds of the currency in question. For US Dollar investments, US Treasury bills are used, while a common choice for EURO investments are the German government bonds or Euribor rates. The risk-free interest rate for the Indian Rupee for Indian investors would be the yield on Indian government bonds denominated in Indian Rupee of appropriate maturity. These securities are considered to be risk-free because the likelihood of governments defaulting is extremely low and because the short maturity of the bills protect investors from interest-rate risk that is present in all fixed rate bonds (if interest rates go up soon after a bond is purchased, the investor misses out on the this amount of interest, till the bond matures and the amount received on maturity can be reinvested at the new interest rate).

Though Indian government bond is a riskless security per se, a foreign investor may look at the India’s sovereign risk which would represent some risk. As India’s sovereign rating is not the highest (please search the internet for sovereign ratings of India and other countries) a foreign investor may consider investing in Indian government bonds as not a risk free investment.

For valuing Indian equities, we will take 10-Yr Government Bond as risk-free interest rate. (Roughly 7.8% - as of this writing).

Equity Risk Premium

The notion that risk matters and that riskier investments should have higher expected returns than safer investments, to be considered good investments, is both central to modern finance. Thus, the expected return on any investment can be written as the sum of the risk-free rate and a risk premium to compensate for the risk. The equity risk premium reflects fundamental judgments we make about how much risk we see in an economy/market and what price we attach to that risk. In effect, the equity risk premium is the premium that investors demand for the average risk investment and by extension, the discount that they apply to expected cash flows with average risk. When equity risk premia rises, investors are charging a higher price for risk and will therefore pay lower prices for the same set of risky expected cash flows.

Equity risk premia are a central component of every risk and return model in finance and is a key input into estimating costs of equity and capital in both corporate finance and valuation.

The Beta

The Beta is a measure of the systematic risk of a security that cannot be avoided through diversification. Therefore, Beta measures non-diversifiable risk. It is a relative measure of risk: the risk of an individual stock relative to the market portfolio of all stocks. Beta is a statistical measurement indicating the volatility of a stock’s price relative to the price movement of the overall market. Higher-beta stocks mean greater volatility and are therefore considered to be riskier but are in turn supposed to provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.

The market itself has a beta value of 1; in other words, its movement is exactly equal to itself (a 1:1 ratio). Stocks may have a beta value of less than, equal to, or greater than one. An asset with a beta of 0 means that its price is not at all correlated with the market; that asset is independent. A positive beta means that the asset generally tracks the market. A negative beta shows that the asset inversely follows the market; the asset generally decreases in value if the market goes up. where = Beta of security with market = Covariance between security and market = Variance of market returns OR Where = Coefficient of Correlation between security and market returns Consider the stock of ABC Technologies Ltd. which has a beta of 0.8. This essentially points to the fact that based on past trading data, ABC Technologies Ltd. as a whole has been relatively less volatile as compared to the market as a whole. Its price moves less than the market movement. Suppose Nifty index moves by 1% (up or down), ABC Technologies Ltd.’s price would move 0.80% (up or down). If ABC Technologies Ltd. has a Beta of 1.2, it is theoretically 20% more volatile than the market.

Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for higher returns. Lower-beta stocks pose less risk but generally offer lower returns. This idea has been challenged by some, claiming that data shows little relation between beta and potential returns, or even that lower-beta stocks are both less risky and more profitable.

Beta is an extremely useful tool to consider when building a portfolio. For example, if you are concerned about the markets and want a more conservative portfolio of stocks to ride out the expected market decline, you’ll want to focus on stocks with low betas. On the other hand, if you are extremely bullish on the overall market, you’ll want to focus on high beta stocks in order to leverage the expected strong market conditions. Beta can also considered to be an indicator of expected return on investment. Given a risk-free rate of 2%, for example, if the market (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 should return 11% (= 2% + 1.5(8% - 2%)).

Problems with Beta

The Beta is just a tool and as is the case with any tool, is not infallible. While it may seem to be a good measure of risk, there are some problems with relying on beta scores alone for determining the risk of an investment.

• Beta is not a sure thing. For example, the view that a stock with a beta of less than 1 will do better than the market during down periods may not always be true in reality. Beta scores merely suggest how a stock, based on its historical price movements will behave relative to the market. Beta looks backward and history is not always an accurate predictor of the future.

• Beta also doesn’t account for changes that are in the works, such as new lines of business or industry shifts. Indeed, a stock’s beta may change over time though usually this happens gradually.

As a fundamental analyst, you should never rely exclusively on beta when picking stocks. Rather, beta is best used in conjunction with other stock-picking tools.

Risk Adjusted Return (Sharpe Ratio)

The Sharpe ratio / Sharpe index / Sharpe measure / reward-to-variability ratio, is a measure of the excess return (or risk premium) per unit of risk in an investment asset or a trading strategy. It is defined as:

Where, R is the asset return, Rf is the return on a benchmark asset such as the risk free rate of return, [R − Rf] is the expected value of the excess of the asset return over the benchmark return and σ is the standard deviation of the asset.

The Sharpe ratio is a risk-adjusted measure of return that is often used to evaluate the performance of an asset or a portfolio. The ratio helps to make the performance of one portfolio comparable to that of another portfolio by making an adjustment for risk. It is excess return generated for an asset or a portfolio for every one unit of risk. For example, if stock A generates a return of 15% while stock B generates a return of 12%, it would appear that stock A is a better performer. However, if stock A, which produced the 15% return but has much larger risks than stock B (as reflected by standard deviation of stock returns or beta), it may actually be the case that stock B has a better risk-adjusted return. To continue with the example, say that the risk free-rate is 5%, and stock A has a standard deviation (risk) of 8%, while stock B has a standard deviation of 5%. The Sharpe ratio for stock A would be 1.25 while stock B’s ratio would be 1.4, which is better than stock A. Based on these calculations, stock B was able to generate a higher return on a risk-adjusted basis. A ratio of 1 or better is considered good, 2 and better is very good, and 3 and better is considered excellent.

Combination and Analysis of the Results
Once the three components have been calculated, they can be combined to form the ROE, as follows:

While additional measures for prior years would provide the basis for a necessary trend analysis, this result is not meaningful until it is compared to an industry or best practices benchmark. The DuPont ratio/or the Indian IT Industry is: 20*1.01 * 1.1 = 22.2%

As can be seen, strengths in XYZ are immediately evident in the comparison of DuPont values for XYZ and Indian IT Industry. The company appears to be significant in profitability, while total asset turnover seems to be roughly in line with the industry. The overall industry leverage is slightly higher than XYZ’Ss zero debt balance sheet. The analyst can now focus on the company’s profitability. A quick analysis of profitability yields the following result:

Sound financial statement analysis is an integral part of the management process for any organization. The DuPont ratio, while not the end in itself, is an excellent way to get a quick snapshot view of the overall performance of a firm in three of the four critical areas of ratio analysis, profitability, operating efficiency and leverage. By identifying strengths and/or weaknesses in any of the three areas, the DuPont analysis enables the analyst to quickly focus his or her detailed study on a particular spot, making the subsequent inquiry both easier and more meaningful. Some caveats, however, are to be noted.

The DuPont ratio consists of very general measures, drawing from the broadest values on the balance sheets and income statements (e.g., total assets is the most broad of asset measures). A DuPont study is not a replacement for detailed, comprehensive analysis. Further, there may be problems that the DuPont decomposition does not readily identify. For example, an average outcome for net profitability may mask the existence of a low gross margin combined with an abnormally high operating margin. Without looking at the two detailed measures, understanding of the true performance of the firm would be lost.

The DuPont ratio can also be broken into more components called ‘The Extended DuPont’, depending upon the needs of the analyst In any case, the DuPont can add value, even “on the fly,” to understand and solving a broad variety of business problems.

Extended DuPont Formula
Cash Conversion Cycle

This liquidity metric expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable. The cash conversion cycle (CCC) measures the number of days a company’s cash is tied up in the production and sales process of its operations and the benefit it gets from payment terms from its creditors. The shorter this cycle, the more liquid the company’s working capital position is. The CCC is also known as the “cash” or “operating” cycle.

DIO is computed by

1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure; 2. Calculating the average inventory figure by adding the year’s beginning (previous yearend amount) and ending inventory figure (both are in the balance sheet) and dividing by 2 to obtain an average amount of inventory for any given year; and 3. Dividing the average inventory figure by the cost of sales per day figure. For XYZ FY 2010 (in Rs. crores), its DIO would be computed with these figures:

DIO gives a measure of the number of days it takes for the company’s inventory to turn over, i.e., to be converted to sales, either as cash or accounts receivable. Understandably, being an IT company, DIO for XYZ comes out to be zero.

DSO is computed by

1. Dividing net sales (income statement) by 365 to get a net sales per day figure; 2. Calculating the average accounts receivable figure by adding the year’s beginning (previous yearend amount) and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable for any given year; and 3. Dividing the average accounts receivable figure by the net sales per day figure. For XYZ FY 2010 (in Rs. crores), its DSO would be computed with these figures:

DSO gives a measure of the number of days it takes a company to collect on sales that go into accounts receivables (credit purchases).

DPO is computed by

1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure; 2. Calculating the average accounts payable figure by adding the year’s beginning (previous yearend amount) and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an average accounts payable amount for any given year; and 3. Dividing the average accounts payable figure by the cost of sales per day figure. For XYZ FY 2010 (in Rs. crores), its DPO would be computed with these figures: DPO gives a measure of how long it takes the company to pay its obligations to suppliers. CCC computed: XYZ’S cash conversion cycle for FY 2005 would be computed with these numbers (rounded):

Often the components of the cash conversion cycle - DIO, DSO and DPO – are expressed in terms of turnover as a times (x) factor. For example, in the case of XYZ, its days debtors outstanding of 57 days would be expressed as turning over 6.4x annually (365 days ÷ 57 days = 6.4 times). However, actually counting days is more literal and easier to understand when considering how fast assets turn into cash. An often-overlooked metric, the cash conversion cycle is vital for two reasons. First, it’s an indicator of the company’s efficiency in managing its important working capital assets; second, it provides a clear view of a company’s ability to pay off its current liabilities. It does this by looking at how quickly the company turns its inventory into sales, and its sales into cash, which is then used to pay its suppliers for goods and services. Again, while the quick and current ratios are more often mentioned in financial reporting, investors would be well advised to measure true liquidity by paying attention to a company’s cash conversion cycle. The longer the duration of inventory on hand and of the collection of receivables, coupled with a shorter duration for payments to a company’s suppliers, means that cash is being tied up in inventory and receivables and used more quickly in paying off trade payables. If this circumstance becomes a trend, it will reduce, or squeeze, a company’s cash availabilities. Conversely, a positive trend in the cash conversion cycle will add to a company’s liquidity. By tracking the individual components of the CCC (as well as the CCC as a whole), an investor is able to discern positive and negative trends in a company’s all-important working capital assets and liabilities. For example, an increasing trend in DIO could mean decreasing demand for a company’s products. Decreasing DSO could indicate an increasingly competitive product, which allows a company to tighten its buyers’ payment terms. As a whole, a shorter CCC means greater liquidity, which translates into less of a need to borrow, more opportunity to realize price discounts with cash purchases for raw materials, and an increased capacity to fund the expansion of the business into new product lines and markets. Conversely, a longer CCC increases a company’s cash needs and negates all the positive liquidity qualities just mentioned.

Current Ratio Vs. The CCC

The obvious limitations of the current ratio as an indicator of true liquidity clearly establish a strong case for greater recognition, and use, of the cash conversion cycle in any analysis of a company’s working capital position.

Cash Conversion cycle for XYZ over five years :
The Satyam Case and Need for Forensic Accounting

In what became India’s biggest corporate scandal till date, Mr. Ramalinga Raju, founder and chairman of Satyam Computers Ltd., one of India’s four premier IT companies, admitted of a fraud through a letter addressed to the board of the company in January 2009.

The Fraud

• There was Rs. 5040 crores worth inflated cash and bank balance • Non-existent accrued interest of Rs. 376 crores • Understated liability of Rs. 1230 crores • Overstated debtor position of Rs. 490 crores • Overstated Revenues & operating profit by Rs. 588 crores Added together, it was a discrepancy of Rs. 7724 crores in the accounts for a company having annual revenues of Rs. 10,000 odd crores.

Satyam’s share price crashed 77% to Rs. 40.25 on the news and the great story for a seemingly successful Indian IT company ended. Fingers were pointed, concerns were raised, complaints were filed and dreams were shattered.

The government was quick to act, appointing a new board for Satyam which helped carry out bidding process for the IT giant and saved the company from extinction. The Satyam fracas is one more fraud in the long history of misappropriation of resources given in trust to individuals and institutions. What this entire episode brings to the fore, is the following: • Any control system is only as good as the people administering it • Audits are not a replacement for responsible management • Laws and regulations cannot deter persons who wish to defeat them – at least temporarily.

In this context, the relevance of forensic accounting and forensic accounts has grown enormously in recent years. In the interest of organizations and numerous investors who have direct stake in the financial well-being of the organizations, more and more forensic accountants should be involved to ward off financial disasters.

The integration of accounting, auditing and investigative skills yields the speciality known as Forensic Accounting. There is a growing need among analysts, law enforcement professionals, small business owners, and department managers to better understand basic forensic accounting principles, how different types of frauds occur and how to investigate a fraud that is detected in a way that maximizes the chances of successful prosecution of the perpetrator

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