Chapter 11: Fundamental Analysis Flashcards
d. Principles of fundamental analysis of equities and bonds.
Explain what is meant by fundamental analysis of shares and describe the two stages in the process.
Fundamental Analysis:
- Study of economic, environmental and financial factors affecting a company’s share price.
- it can be applied at an industry and economic level and as well as the level of the individual company.
Two stages of fundamental analysis:
- Construction of model of a company which allows future cashflows and earnings to be estimated.
- Calculate the true value of the share (from stage 1) and compare this value against the share’s market price or calculate an appropriate ratio and compare with similar shares or “normal value” do determine whether company’s securities are over-valued or under-valued by the market.
d. Principles of fundamental analysis of equities.
List factors that affect equity prices
- Level of supply and demand (and company specific factors in card 3 and 4)
Key factors affecting demand are expectations of:
- future dividends (and expectations of dividend growth)
- future capital growth
- risk of the business and thus the uncertainty of the estimates of the above
Key factors affecting the first two:
- estimates of profits
- free cashflow
- enterprise value
- Industry and sector factors
- Trends in the industry
- Competition in the industry
- Regulation
- Economic factors
- Interest rates
- inflation
- currency exchange movements
- environmental factors such as climate change (and potential regulation to these)
- Market sentiment and Psychology
- Investor confidence
- Market trends and momentum
- News and events
- Geopolitical events
- Wars and conflict
- Increased uncertainty
- Economic disruptions
- Sector specific impacts
- Political unrest
- Policy uncertainty/political unrest
- Government policy
- Fiscal policy
- Stimulus
- Austerity
- Monetary Policy
- Interest rates
- Quantitative easing
- Trade policies
- Regulation
- Industry specific regulations, e.g., environmental
- labour laws
d. Principles of fundamental analysis of equities.
List eight general factors that should be considered when analyzing a particular company and its share.
MRCHIMPS
1. Management ability
2. Retained profits
3. Competition
4. (recent) History
5. Input costs
6. prospects for Market growth
7. quality of Products
8. Sustainability and environmental impact of the business
d. Principles of fundamental analysis of equities.
For exam purposes, how can you generate ideas for factors affecting a particular company:
generating ideas in a exam of factors affecting a particular company useful to think in terms of:
- global economy
- domestic economy
- industry
- specific firm
eg., types of companies where international approach to FA is important
- multinational
-exporters
- those selling imported goods domestically, or output heavily relies on factor inputs imported
d. Principles of fundamental analysis of equities.
List eight quantitative factors that should be considered when analysing a company and its share.
- Financial accounts and accounting ratios (revenue, expenses, debt, equity, ROE and debt to equity ratio)
- current and future environmental changes and regulatory responses to these (costs, operations and future prospects)
- dividends and earnings cover
- profit variability and growth
- level of borrowing
- level of liquidity
- growth of asset values.
- comparative figures from other similar companies
d. Principles of fundamental analysis of equities.
Outline how to model a company and its share in the FA process.
Identify Profit Drivers:
- Understand what factors most influence the company’s profits. This requires good company knowledge.
- Cash Flow Model:
- Build a model (often a spreadsheet) to estimate how different economic situations might impact profits. This model focuses on future cash flow.
- Profit Forecasting:
This is the heart of the model. Here’s how you do it:
- Sales & Costs: Forecast future sales and the company’s costs associated with producing those sales.
- Economic Factors: Consider how factors like inflation (wage and price increases) and the state of the overall economy might affect sales and costs.
- Income Statement: Based on these forecasts, project an income statement for future years.
- Financing Costs: Estimate future interest rates on debt and any new borrowing needs.
- Divisional Breakdown: Consider making separate projections for different company divisions if applicable.
Important Reminders:
- Time & Effort: Building an accurate model takes time and effort. Don’t get hung up on unrealistic levels of precision.
- Information Limits: Investors may not have access to the same level of detail as company management. This limits the depth of analysis.
d. Principles of fundamental analysis of equities.
List six external and six internal sources of information about a companyand list two considerations.
Internal sources:
1. Company reports and accounts
2. Press releases
3. Company visits
4. discussions with management
5. information provided to exchange where listed
6. statutory information provided to regulator
External sources
1. Financial press and other commercial information providers
2. relevant government industry forums, websites or reports
3. trade press
4. discussions with competitors
5. credit ratings
6. stock broker’s or investment banker’s publications
Important to consider:
- potential contravention of insider trading regulations
- objectivity of provider
d. Principles of fundamental analysis of equities.
List the five main sources of information within report and accounts.
- Balance sheet
- statement of profits or loss
- cashflow statement
- notes to accounts
- Chairman’s reports
d. Principles of fundamental analysis of equities.
List three ways of determining whether a share appears to be cheap or dear.
- Comparing the value of share obtained using discounted dividend model with actual share price
- Comparing value for share obtained using price earnings ratio with actual share price
- compare some fundamental factor (such as anticipated earnings) with market’s consensus estimate. If analyst’s estimate better/worse than market’s then share might be cheap/dear.
d. Principles of fundamental analysis of equities.
List factors affecting different PER of similar companies.
higher because:
- shares thought to be low risk
- dividends believed to have higher growth rate
- recent earnings depressed or exceptionally low for particular one-off reason
- shares over-priced
d. Principles of fundamental analysis of bonds.
List six ‘canons of lending’.
- Character and ability of the borrower (risks)
- Purpose of the loan
- amount that is being borrowed
- borrower’s ability to repay
- security offered to the lender
- trade between risk and reward
Core reading uses related headings: purpose, repayment, risk and structure.
d. Principles of fundamental analysis of bonds.
What are the credit aspects to consider before investing in a bond:
And outline the main focus of credit analysts.
- Likelihood of losing some of the funding
- severity of any potential loss
- whether interest received is adequate to compensate for the risk of loss
(side note: A key reason for the fundamental analysis of a bond is to make an assessment of all factors that might influence the ability of issuer to repay the coupons and principal in future i.e. assessing the credit risk and determining whether level of risk is in line with the investor’s risk appetite)
Credit analysis covers all three above aspects.
Credit analysts will primarily focus on:
- the balance sheet cover for funding provided cashflow is sufficient to cover interest costs
- carry out analysis within issuer’s sector and across sectors and countries…
- …this is to establish whether the interest rate received is consistent with those observed for other bonds.
d. Principles of fundamental analysis of bonds.
Give six possible reasons for seeking finance.
- Organic growth - i.e., expanding existing growth (hire additional staff or purchase additional materials)
- acquisition
- investment in associated company
- Capital expenditure - e.g., investing in a new factory or office
- financing dividend
- financing share buy-back
When rating credit, it is important to consider how the raising and subsequent spending of the monies raised may affect the financial strength of the company.
d. Principles of fundamental analysis of bonds.
List three credit rating issues to consider in relation to the repayment of a loan.
Expected sources of repayment? Any secondary sources?
- future (internal) cashflows and profit profile ( sufficient to repay loan?)
- possible sale of assets and/or businesses
- refinancing - i.e., by raising further funds in future.
The above relate to the ability to repay the loan.
d. Principles of fundamental analysis of bonds (credit analysis of bonds)
List six credit ratings factors to consider under the heading ‘risks’.
What risks could jeopardise debt servicing in future?
Macro considerations:
- Industry analysis and competitive trends
- regulatory environment
- sovereign macroeconomic analysis
Company-specific issues:
- qualitative analysis, e.g., of management, goods and services.
- company’s financial performance - both recent past and projected future
- company’s market position - relative to its competitors
