Chapter 15 Company Analysis

7/27/2019 Chapter 15 Company Analysis

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Chapter 15

COMPANY ANALYSIS

Establishing the Value Benchmark


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Fundamental analysis of equity shares This involves two approaches:

Estimating Intrinsic value

Estimating expected return

To find out IV analyst must forecast futureperformance and translate the same into

the value estimate

INTRODUCTION


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Outline

Strategy Analysis

Accounting Analysis

Financial Analysis

Estimation of Intrinsic Value

Tools for Judging Undervaluation or Overvaluation

Obstacles in the way of an Analyst

Equity Research in India


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Strategy Analysis

Strategy analysis seeks to explore the economics of a firm and

identify its profit drivers so that the subsequent financial

analysis reflects business realities.

The profit potential of a firm is influenced by the industry or

industriesin which it participates, by the strategy it follows to

compete in its chosen industry or industries (competitive

strategy), and by the way in which it exploits synergies across itsbusiness portfolio (corporate strategy).


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Competitive Strategy

Michael Porter argues that the firm can explore two generic ways of

gaining sustainable competitive advantage viz., cost leadership and

product differentiation.

Cost leadershipcan be attained by exploiting economies of scale,

exercising tight cost control, minimizing costs in area like R&D and

advertising, and deriving advantage from cumulative learning. Firms

which follow this strategy include Bajaj Auto in two wheelers, Mittal in

steel, WalMart in discount retailing, and Reliance Industries in

petrochemicals.

Product differentiationinvolves creating a product that is perceived

by customers as distinctive or even unique so that they can be expected

to pay a higher price. Firms which have excelled in this strategy

include Mercedes in automobiles, Rolex in wristwatches, Mont Blanc in

pens, and Raymond in textiles.


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The competitive position of the firm based on its relative cost and

differentiation positions. The most attractive position of course is

the cost-cum-differentiation advantage position.

Competi tive Position of the F irm

Cost-cum-

differentiation

advantage

Differentiation

advantage

Low cost

advantage

Stuck-in-the

middle

Superior

Relative

Differentiation

Position

Low price

Inferior

High priceRelative

Cost

Position


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Gaining Competitive Advantage

By choosing an appropriate strategy, a firm does not necessarily

gain competitive advantage. To do so the firm must develop the

required core competencies (the key economic assets of the firm)

and structure its value chain (the set of activities required to

convert inputs into outputs) appropriately.

The uniqueness of a firms core competencies and its value

chain and the extent to which it is difficult for competitors to

imitate them determines the sustainability of a firms

competitive advantage.Palepu et.al.


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Gaining Competitive Advantage

To assess whether a firm is likely to gain competitive advantage, the

analyst should examine the following:

The key success factors and risks associated with the firms

chosen competitive strategy.

The resources and capabilities, current and potential, of thefirm to deal with the key success factors and risks.

The compatibility between the competitive strategy chosen by

the firm and the manner in which it has structured its activities

(R&D, design, manufacturing, marketing and distribution, and

support).

The sustainability of the firms competitive advantage.

The potential changes in the industry structure and the

adaptability of the firm to address these changes


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Strategy of Cost Leadership: Dell Computer

Direct Sellingsaving the retailers margin

Build-to-order manufacturingsaving inventory cost

Low-cost servicetelephone based service & third party

service

Negative working capitalno inventory, no receivables as it

is paid through credit card etc


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Corporate Strategy Analysis

When you analyse a multi-business firm, you have to evaluate

not only the profit potential of individual businesses but also the

economic implications of managing different businesses under

one corporate canopy. For example, General Electric has

succeeded immensely in creating significant value by managing a

highly diversified set of businesses ranging from light bulbs to

aircraft engine, whereas Sears has not succeeded in managing

retailing with financial services.


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Corporate Sources of Value Creation

Thus, whether a multibusiness firm is more valuable compared to a

collection of focused firms finally depends on the context. The analyst

should examine the following factors to assess whether a firms corporate

strategy has the potential to create value.

Imperfections in the product, labour, or financial markets in the

business in which the firm operates. Existence of special resources such as brand name, proprietary

knowledge, scarce distribution channels, and organisational processes

that potentially create economies of scope.

The degree of fit between the companys specialised resources and its

portfolio of businesses. The allocation of decision rights between the corporate office and

business units and its effect on the potential economies of scope.

The system of performance measurement and incentive compensation

and its effect on agency costs.


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Accounting Analysis

Accounting analysis seeks to evaluate the extent to which the firms

accounting reports capture its business reality.

Analyst must be familiar with:

The institutional framework for financial reporting

Sources of noise and bias in accounting

Differences between good and bad accounting quality.


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Institutional Framework for Financial

Reporting

The salient features of the institutional framework for financial

reporting are:

Corporate financial reports are prepared on the basis of accrualaccounting and not cash accounting.

Preparation of financial statements involves complex judgments

by management.

GAAP regulates managerial judgement

External auditing is now a near universal requirement.


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Sources of Noise and Bias in Accounting

There are several sources of potential noise and bias in accounting

data.

Accounting rules themselves introduce noise and bias as it is

often not possible to restrict managerial discretion without

diminishing the informational content of accounting reports.

Forecasting errors are practically unavoidable.

Managers may introduce noise and bias in accounting

reports, while making their accounting decisions.


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Good and Bad Accounting Quality

Good Accounting

Quality

Bad Accounti ng

Quality

The accounting data focuses

on key success factors and

risks

The accounting data fails to

highlight key success factors

and risks

Managers use their accounting

discretion to make accounting

numbers more informative

Managers use their accounting

discretion to disguise reality

The firm provides adequate

disclosures to describe itsstrategy, its current

performance, and future

prospects

The firm just fulfills the

minimal disclosurerequirements prescribed by

accounting regulations

There are no red flags There are serious red flags2


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Financials Analysis

The key questions to be addressed in applying the earnings

multiplier approach, the most popular method in practice,

are:

What is the expected EPS for the forthcoming year?

What is a reasonable P/E ratio?

To answer these questions, investment analysts start with a

historical analysis of earnings (and dividends), growth, risk,

and valuation and use this as a foundation for developing theforecasts required for estimating the intrinsic value.


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Earnings And Dividend Level

To assess the earnings and dividend level, investment analysts look at

metrics like the return on equity, book value per share, EPS,

dividend payout ratio, and dividend per share.

Equity earnings

EquityROE =


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Financials Of Horizon Ltd2001 2002 2003 2004 2005 2006 2007

Net Sales 475 542 605 623 701 771 840 Cost of goods sold 352 380 444 475 552 580 638 Gross profit 123 162 161 148 149 191 202 Operating expenses 35 41 44 49 60 60 74 Operating profit 88 121 117 99 89 131 128 Non-operating surplus/deficit 4 7 9 6 - -7 2 Profit before interest and tax

(PBIT)

92 128 126 105 89 124 130

Interest 20 21 25 22 21 24 25 Profit before tax 72 107 101 83 68 100 105 Tax 30 44 42 41 34 40 35 Profit after tax 42 63 59 42 34 60 70 Dividend 20 23 23 27 28 30 30 Retained earnings 22 40 36 15 6 30 40 Equity share capital (Rs. 10 par) 100 100 150 150 150 150 150 Reserves and surplus 65 105 91 106 112 142 182 Shareholders funds 165 205 241 256 262 292 332 Loan funds 150 161 157 156 212 228 221 Capital employed 315 366 398 412 474 520 553 Net fixed assets 252 283 304 322 330 390 408 Investments 18 17 16 15 15 20 25 Net current assets 45 66 78 75 129 110 120 Total assets 315 366 398 412 474 520 553 Earnings per share 2.27 4.00 4.67 Market price per share

(End of the year)

21.00 26.50 29.10 31.5


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ROE : 3 Factors

PAT Sales Assets

ROE = Sales Assets Equity

Net Profit Asset Leverage

Margin Turnover

THE BREAK-UP OF THE RETURN ON EQUITY IN TERMS OF ITS

DETERMINANTS FOR THE PERIOD 20X5

20X7 FOR HORIZON LIMITED IS

GIVEN BELOW:

Return on equity = Net profit margin x Asset turnover x Leverage multiplier

20X5 13.0 % = 4.85% x 1.48 x 1.81

20X6 20.5% = 7.78% x 1.48 x 1.78

20X7 21.1% = 8.33% x 1.52 x 1.67

INVESTMENT ANALYSTS USE ONE MORE FORMULATION OF THE ROE

WHEREIN IT IS ANALYSED IN TERMS OF FIVE FACTORS :

PBIT SALES PROFIT BEFORE TAX PROFIT AFTER TAX ASSETS

ROE = X X X X

SALES ASSETS PBIT PROFIT BEFORE TAX NETWORT

X X


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ROE : 5 Factors

PBIT Sales PBT PAT Assets

ROE = x x x x

Sales Assets PBIT PBT Net Worth

ROE = PBIT EFFICIENCY X ASSET TURNOVER X INTEREST BURDEN X

TAX BURDEN X LEVERAGETHE ROE BREAK-UP FOR OMEGA COMPANY IS GIVEN BELOW :

ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x

Leverage

20X5 13.0% = 12.70% x 1.48 x 0.764 x 0.50 x 1.81

20X6 20.5% = 16.08% x 1.48 x 0.81 x 0.60 x 1.7820X7 21.1% = 15.48% x 1.52 x 0.81 x 0.67 x 1.67


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Book Value Per Share And Earnings Per Share

Book Value Per Share (BVPS)

Paid-up equity capital + Reserves and surplus

Number of equity shares

2005 2006 2007

BVPS 262/15 = 17.47 292/15 = 19.47 332/15 = 22.13

Earnings Per Share (EPS)

Equity earnings

Number of equity shares

2005 2006 2007

EPS 34/15 = 2.27 60/15 = 4.00 70/15 = 4.67


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Dividend Payout Ratio And Dividend Per Share

Dividend Payout Ratio

Equity dividends

Equity earnings

2005 2006 2007

DividendPayout ratio

Dividend Per Share (DPS)

2005 2006 2007

DPS Rs 1.86 2.00 2.00

DPS = EPS X DP Ratio

28/34 = 0.82 30/60 = 0.50 30/70 = 0.43


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Growth Performance

To measure the historical growth, the compound annual

growth rate (CAGR) in variables like sales, net profit,

earnings per share and dividend per share is calculated.

To get a handle over the kind of growth that can be

maintained, the sustainable growth rate is calculated.


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Compound Annual Growth Rate (CAGR)

The compound annual growth rate (CAGR) of sales, earnings per

share, and dividend per share for a period of five years 20022007for Horizon Limited is calculated below:

Sales of 2007 1/ 5 840 1/ 5CAGR of Sales : 1 = 1 = 9.2%

Sales for 2002 542

CAGR of earnings EPS for 2007 1/ 5 7.00 1/ 5per share (EPS) : EPS for 2002 6.30

CAGR of dividend: DPS for 2007 1/ 5 3.00 1/ 5per share (DPS) DPS for 2002 2.30

1 = 1 = 2.1%

1 = 1 = 5.5%


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Sustainable Growth Rate

The sustainable growth rate is defined as :

Sustainable growth rate = Retention ratio X Return on equity

Based on the average retention ratio and the average return on

equity of the three year period (2005 2007) the sustainable growthrate of Horizon Limited is:

Sustainable growth rate = 0.417 x 18.2% = 7.58%


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Risk Exposure

Beta represents volatility relative to the market, the risk of thestock is denoted by its betawhich measures how sensitive is the

return on the stock to variations in the market return.

Required return of stock = Risk-free return + Beta(Market risk Premium)

E(R)i = Rf + Bi(ErM

Rf)

Volatility of Return on equity =

Range of return on Equity over nyears

Average return on equity over nyears

If n = 5 (2003 to 2007)Volatility of ROE of Horizon Limited as

follows = 11.5%/19.2% = 0.60

F bl & U f bl F t


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Favourable & Unfavorable Factors

Favourable UnfavorableFactors Factors

Earnings Level High book value per share Low book value per share

Growth Level High return on equity Low return on equity

High CAGR in sales and EPS Low CAGR in sales and EPS

High sustainable growth Rate Low sustainable Growth Rate

RISK EXPOSURE Low volatility of return on High volatility of Return on

equity equity

Low beta High beta


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Valuation Multiples

The most commonly used valuation multiples are :

Price to earnings (PE) ratio

Price to book value (PBV) ratio

Price per share at the beginning of year n

Earnings per share for year n

2005 2006 2007

PE ratio 9.25 6.63 6.23

PBV Ratio (Retrospective)Price per share at the end of year n

Book value per share at the end of year n

2005 2006 2007

1.52 1.49 1.42

PE Ratio

Prospective) =

PBV ratio =


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Going Beyond the Numbers

Sizing up the present situation and prospects

Availability and Cost of Inputs Order Position

Regulatory Framework

Technological and Production Capabilities

Marketing and Distribution Finance and Accounting

Human Resources and Personnel

Evaluation of management

Strategy

Calibre, Integrity, Dynamism

Organisational Structure

Execution Capability

Investor - friendliness


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Estimation of Intrinsic Value

Estimate the expected EPS

Establish a p / e ratio

Develop a value anchor and a value range

EPS F t


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EPS Forecast

20 x 7 20 x 8 Assumption

(ACTUAL) (PROJECTED)

Net Sales 840 924 Increase by 10 Percent Cost of Goods sold 638 708 Increase by 11 Percent

Gross profit 202 216

Operating Expns 74 81 Increase by 9.5 Percent

Depreciation 30 34

Sellin & gen.

Admn. Expns 44 47

Operating Profit 128 135

Non-operating

Surplus/Deficit 2 2 No Change

Profit before

INT. & Tax (PBIT) 130 137

Interest 25 24 Decrease by 4 Percent

Profit before Tax 105 113 Tax 35 38 Increase by 8.57 Percent

Profit after Tax 70 75

Number of Equity

Shares 15 MLN 15

Earnings per Share RS 4.67 RS 5.00

Diff t PE R ti


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Different PE Ratios

Note that different PE ratios can be calculated for the same stock at

any given point in time.

PE ratio based on last years reported earnings

PE ratio based on trailing 12 months earnings

PE ratio based on current years expected earnings

PE ratio based on the following years expected earnings

P / E Ratio


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P / E Ratio

Constant Growth Dividend Model

Dividend payout ratioP / E RATIO =

Required Expected

return on - growth rate

equity in dividends

Cross Section Analysis

P / E = a1 + a2 Growth Rate in + a3 dividend

earnings payout ratio

+ a3 Variability in earnings

+ a4 company sizeHistorical analysis

Weighted P /E ratio

R ti


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Ratio

Historical Analysis

20 x 5 20 x 6 20 x 7PE ratio 9.25 6.63 6.23

The average PE ratio is :

9.25 + 6.63 + 6.23

3

Weighted PE Ratio

PE ratio based on the constantgrowth dividend discount model

PE ratio based on historical analysis : 7.37

6.36 + 7.37

2

= 7.37

= 6.87

: 6.36

Value Anchor and Value Range


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Value Anchor and Value Range

Value Anchor

Projected EPS x Appropriate PE ratio

5.00 x 6.87 = Rs. 34.35

Value Range

Rs.30 Rs.38

Market Price Decision

< Rs.30 Buy

Rs.30Rs.38 Hold

> Rs.38 Sell

Tools for Judging Undervaluation or


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Tools for Judging Undervaluation or

Overvaluation

PBV-ROE Matrix

Growth-Duration Matrix

Expectations Risk Index

Quality at a Reasonable Price (VRE)

PEG: Growth at a Reasonable Price


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Overvalued High ROE

HIGH Low ROE High PBV

High PBV

Low ROE Undervalued

LOW Low PBV High ROE

Low PBV

LOW HIGH

ROE

PBV Ratio

PBV-ROE Matrix


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Expectations Risk Index (ERI)

Developed by Al Rappaport, the ERI reflects the risk in

realising the expectations embedded in the current market

price

Proportion of stock Ratio of expected future

price depending on growth to recent growth

expected future growth (Acceleration ratio)

ERI = X

ERI Ill t ti


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ERI Illustration

Omegas price per share = Rs.150

Omegas operating cash flow

(before growth investment)

Omegas cost of equity = 15 percent

Growth rate in after-tax cash operating

earnings over the past three years

Market expectation of the growth in after-taxcash operating earnings over the next threeyears

= Rs.10 per shar

= 20 percent

= 50 percent

ERI Illustration


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ERI Illustration

Omegas base line value = = Rs.66.7

Proportion of the stock price coming

from investors expectations of future = = 0.56

growth opportunities

Acceleration ratio = = 1.25

ERI = 0.56 x 1.25 = 0.70

In general, the lower (higher) the ERI, the greater (smaller) the

chance of achieving expectations and the higher (lower) the expected

return for investors.

15066.7

150

Rs.10

0.15

1.50

1.20

Quality at a Reasonable Price


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Quality at a Reasonable Price

Determining whether a stock is overvalued or undervalued is often

difficult. To deal with this issue, some value investors use a metriccalled the value of ROE or VRE for short.

The VRE is defined as the return on equity (ROE) percentage

divided by the PE(price-earning) ratio. For example, if a company

has an expected ROE of 18 percent and a PE ratio of 15, its VRE is

1.2 (18/15).According to value investors who use VRE:

A stock is considered overvalued if the VRE is less than 1.

A stock is worthy of being considered for investment, if the VRE

is greater than 1. A stock represents a very attractive investment proposition if the

VRE > 2

A stock represents an extremely attractive investment

proposition if the VRE > 3



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What price should one pay for growth? To answer this difficult

question, Peter Lynch, the legendary mutual fund manager,

developed the so-called PE-to-growth ratio, or PEG ratio. The PEG

ratio is simply the PE ratio divided by the expected EPS growth rate

(in percent). For example, if a company has a PE ratio of 20 and its

EPS is expected to grow at 25 percent, its PEG ratio is 0.8 (20/25).



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Proponents of PEG ratio believe that:

A PEG of 1 or more suggests that the stock is fully valued.

A PEG of less than 1 implies that the stock is worthy of being

considered for investment.

A PEG of less than 0.5 means that the stock possibly is a very attractiveinvestment proposition.

A PEG of less than 0.33 suggests that the stock is an unusually

attractive investment proposition.

Thus, the lower the PEG ratio, the greater the investment

attractiveness of the stock. Growth-at-a-reasonable price (GARP) investors

generally shun stocks with PEG ratios significantly greater than 1.

Obstacles in the Wa of an Anal st


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Obstacles in the Way of an Analyst

Inadequacies or incorrectness of data

Future uncertainties

Irrational market behaviour

Excellent Versus Unexcellent Companies


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Excellent Versus Unexcellent Companies

In general, it appears that financial performance of

excellent companies deteriorates whereas financial

performance ofnon-excellent companies improves.

Empirical evidence of this kind reflects the phenomenon of

reversion to the mean which says that, over time, financial

performance of companies tends to converge to the averagevalue of the group as a whole. Thanks to this tendency,

good past performers are likely to produce inferior

investment results and poor past performers are likely to

produce superior investment results.



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Traditionally, lip sympathy was paid to equity research. Financial

institutions (mutual funds, in particular) had a research cell because

it was in good form to have one. Likewise, large brokers set up

equity research cells to satisfy their institutional clients. In the mid-

1980s more progressive firms like Enam Financial, DSP Financial

Consultants, and Motilal Oswal Securities Limited set up research

divisions to exploit the opportunities in the equity market. With the

entry of foreign institutional investors and the emergence of more

discerning investors, the need for equity research is felt more widely.

Indeed, currently equity research is a growing area.

Future


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Future

Equity researchers who are able to do their job well have bright

prospects. The future belongs to those who will:

Have a clear understanding of what their research is

supposed to do and how they should go about doing it.

Learn to interpret financial numbers and assess qualitative

factors which may not be immediately reflected in numbers.

Develop a medium-term or long-term perspective based on an

incisive understanding of the dynamics of the companies

analysed.

How to Make Most of Stock Research


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How to Make Most of Stock Research

Reports

To make the most of stock research reports, follow these guidelines:

Dont trust a research report naively. Use it as a starting point

and do your own due diligence before acting on it.

Check the credibility of the brokerage house by reading its

reports over a period of time.

Be wary of unscrupulous brokerage houses which prepare biased

research reports with ulterior motives.

Often a buy recommendation is given, when promoters or some

other investors want to exit a stock.

Summing Up


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Summing Up

In practice, the earnings multiplier method is the most

popular method. The key questions to be addressed in this

method are: what is the expected EPS for the forthcoming

year? What is a reasonable PE ratio given the growth

prospects, risk exposure, and other characteristics? Historical

financial analysis serves as a foundation for answering these

questions.

The ROE, perhaps the most important metric of financial

performance, is decomposed in two ways for analytical

purposes.

ROE = Net profit margin x Asset turnover x Leverage

ROE = PBIT efficiency x Asset turnover x Interest burden

x Tax burden x Leverage

T th hi t i l th th CAGR i i bl lik


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To measure the historical growth, the CAGR in variables like

sales, net profit, EPS and DPS is calculated.

To get a handle over the kind of growth that can bemaintained, the sustainable growth rate is calculated.

Beta and volatility of ROE may be used as risk measures.

An estimate of EPS is an educated guess about the future

profitability of the company.

The PE ratio may be derived from the constant growth

dividend model, or cross-section analysis, or historical

analysis.


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The value anchor is :

Projected EPS x Appropriate PE ratio

PBV-ROE matrix, growth-duration matrix, and expectation

risk index are some of the tools to judge undervaluation or

overvaluation.

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Chapter 15 Company Analysis