Chapter 10: Fundamental analysis Flashcards
Key factors affecting relative demand for individual shares (2)
Investors expectations for:
- future capital and dividend growth - which will depend upon both the internal characteristics of the company and external economic influences
- risk
Define fundamental analysis
The study of the economic and financial factors affecting a company’s share price.
Two stages of fundamental analysis
- construct a model of the company to estimate future cashflows and earnings
- use output from the first stage to determine whether the company’s securities are over-valued of under-valued by the market.
Fundamental analysis - important general factors to consider (7)
M - Management ability
R - Retained profits
I - Input costs
C - Competition
H - History
P - Prospects for market growth
Q - Quality of products
A fundamental analyst will investigate: (7)
- the financial accounts and accounting ratios
- dividend and earnings cover
- profit variability and growth
- the level of borrowing
- the level of liquidity
- growth in asset values
- comparative figures for other similar companies
Possible sources of information: (11)
- the company’s accounts
- the financial press and other commercial information providers
- the trade press
- public statements by the company
- the exchange where the securities are listed
- government sources of statutory information that a company has to provide.
- visits to the company
- discussions with company management
- discussion with competitiors
- stockbrokers’ publications
- credit ratings
Credit rating is a four-step process involving an assessment of: (4)
- the reason for the borrowing (purpose)
- the expected source of repayment (payback)
- the risks that could jeopardise the repayment (risks)
- the structure of the borrowing (structure)
financial tests assess: (3)
- financial strength - operating leverage, financial leverage, asset leverage, capital structure, liquidity
- operating performance - profitability, revenue composition
- market profile - market risk, competitive market position, spread of risk, event risk
Credit analysis (Purpose) - Possible reasons for seeking money include: (5)
- organic growth - i.e. expanding the existing operations
- acquisition - i.e. taking over another company
- investment in an associated company - i.e. acquiring sufficient shares to obtain influence over another company, but without buying a controlling stake
- capital expenditure - e.g. investing in a new factory or office
- dividend/share buy-back - although companies don’t often borrow specifically to finance a share buy-back or a dividend payout in practice.
Credit analysis (Payback) - Issues to consider include:
- cashflow/ profit profile (over time)
- possible sale of assets and/ or businesses
- refinancing
Credit analysis (Risks) - Factors to consider (6)
Macro considerations:
- industry analysis and competitive trends
- regulatory environment
- sovereign macroeconomic analysis
Company-specific issues:
- qualitative analysis
- financial performance
- market position
The fundamentals of the rating agencies’ approach to rating companies will focus on: (8)
- fundamental risks of the company’s industry
- competitive position (relative to peers)
- 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 strength can be assessed in the form of: (5)
- Operating leverage
- Financial leverage
- Asset leverage (quality, market value and diversification of assets, exposure to investment and credit risk)
- Capital structure (including holding company capital structure, where relevant)
- Liquidity (quick and current ratios, operational and net cashflows)
A bond investor should consider the following credit aspects before investing in a bond: (3)
- the likelihood of losing some of the funding that has been provided
- the severity of any potential loss
- whether the interest rate received is adequate compensation for the risk of loss
Operating performance of a company can be assessed by considering its: (2)
- profitability (sources, trends)
2. revenue composition
