Ch 10 - Fundamental Analysis Flashcards
Fundamental Analysis
Assess the “true” or “fundamental” value of an asset by analysing all of the factors that influence the future returns
Analysis of a company’s share value and potential for future profits and dividends, based on accounting and economic information
The study of the economic and financial factors affecting a company’s share price
The use of fundamental analysis to identify price inefficiencies relies on the existence of an…
Inefficient market
FA consists of two stages:
Modelling
-Construct a model of the company to estimate future cashflows and earnings
Valuation
-Use the output from the 1st stage to determine whether the company’s securities are over-valued or under-valued by the market
The key factors affecting the relative demand for individual shares are investors’ expectations for:
Future dividend payments and capital growth
Risks of the business
Factors affecting the relative market price of a share
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Quality of products
-and range
History
-compare to last years results for example
Competition
-determines market share
Management ability
-often key influence over success
Retained profits
-low payout ratio = finance future growth or management less confident over future
Input costs
-growth of these and how it affects profitability
Prospects for market growth
-is it in a developing sector or is it a small company
In order to form a view on these factors (affecting relative market price of a share), a fundamental analyst will investigate
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Borrowing level
Accounting ratios and financial accounts
Dividend and earnings cover
Comparative figures for other similar companies
Liquidity level
Asset value growth
Profit variability and growth
Possible sources of information include
TV FAPS SECs and DD
Trade press
Visits to the company
Financial press and other commercial information prov
Accounts of company’s
Public statements by the company
Stockbrokers’ publications
Statutory information (from gov sources) Exchange where the securities are listed Credit ratings
Discussions with company management
Discussion with competitors
Interest cover
PBIT / Annual interest on debt
Capital cover
(Total assets – total liabilities - intangibles) / Balance sheet value of debt
Net asset value per share
(Total assets – total liabilities – intangibles) / number of issued ordinary shares
Dividend yield
annual dividend per share/ share price
Dividend cover
Earnings per share / dividends per share
Return on capital employed
PBIT / Share capital & reserves + long term debt
Return on equity
net profit / net assets
Current ratio
Current assets / current liabilities
Quick ratio
current assets – inventories / current liabilities
Price Earnings
Share price / earnings per share
Operating leverage
(sales – variable costs) / PBIT
Financial leverage
interest payments / PBIT
Capital leverage
debt/equity
The estimates of future earnings or other relevant factors obtained from a fundamental analysis of a company can be used to calculate a value for the shares using methods such as:
Discounted dividend model
Comparison of PE ratios
Compare some fundamental factor (such as anticipated earnings)
Why might the PER of a share be higher than that of another apparently similar share for a company in the same industry?
Shares are thought to be low risk– thus commands a higher share price
Dividends of the company are believed to have a higher growth rate – thus commands a higher price
Recent earnings have been depressed or exceptionally low for a particular one-off reason
Shares are over-priced
Credit rating is a four-step process involving an assessment of:
Purpose
Payback (source of repayment/ability to repay)
- cashflow
- sale of assets
- ability to refinance
Risks that could jeopardize repayment
- character and ability to repay
- macro and company-specific issue need to be considered
Structure
-terms and conditions of bond issue
The fundamentals of the rating agencies’ approach to rating companies will focus on:
Fundamental risks of the company’s industry
Competitive position
Downside risk vs upside potential
Quality of profitability vs EPS growth
Cashflow generation vs book profitability
Forward looking analysis
Strategy, management track record and risk appetite
Capital structure and financial flexibility
Financial tests assess:
Financial strength
Operating performance
Market profile
Qualitative factors
4 stages of the Trade Cycle
Economy relatively buoyant
Start of a recession
Bottom of recession
Recovery
