Chapter 11: Fundamental Analysis Flashcards

1
Q

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.

A

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:

  1. Construction of model of a company which allows future cashflows and earnings to be estimated.
  2. 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.
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2
Q

d. Principles of fundamental analysis of equities.

List factors that affect equity prices

A
  1. Level of supply and demand
    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
  2. changing economic factors
    - Interest rates
    - inflation
    - government policy (fiscal and monetary policy)
    - geopolitical events
  3. environmental factors such as climate change (and potential regulation to these)
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3
Q

d. Principles of fundamental analysis of equities.

List eight general factors that should be considered when analyzing a particular company and its share.

A

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

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4
Q

d. Principles of fundamental analysis of equities.

List eight quantitative factors that should be considered when analysing a company and its share.

A
  1. Financial accounts and accounting ratios (revenue, expenses, debt, equity, ROE and debt to equity ratio)
  2. current and future environmental changes and regulatory responses to these (costs, operations and future prospects)
  3. dividends and earnings cover
  4. profit variability and growth
  5. level of borrowing
  6. level of liquidity
  7. growth of asset values.
  8. comparative figures from other similar companies
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5
Q

d. Principles of fundamental analysis of equities.

Outline how to model a company and its share in the FA process.

A

Identify Profit Drivers:

  1. Understand what factors most influence the company’s profits. This requires good company knowledge.
  2. 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.
  1. 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.

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6
Q

d. Principles of fundamental analysis of equities.

List six external and six internal sources of information about a companyand list two considerations.

A

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

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7
Q

d. Principles of fundamental analysis of equities.

List the five main sources of information within report and accounts.

A
  1. Balance sheet
  2. statement of profits or loss
  3. cashflow statement
  4. notes to accounts
  5. Chairman’s reports
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8
Q

d. Principles of fundamental analysis of equities.

List three ways of determining whether a share appears to be cheap or dear.

A
  1. Comparing the value of share obtained using discounted dividend model with actual share price
  2. Comparing value for share obtained using price earnings ratio with actual share price
  3. 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.
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9
Q

d. Principles of fundamental analysis of equities.

List factors affecting different PER of similar companies.

A

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

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10
Q

d. Principles of fundamental analysis of bonds.

List six ‘canons of lending’.

A
  1. Character and ability of the borrower (repayment)
  2. Purpose of the loan
  3. amount that is being borrowed
  4. borrower’s ability to repay
  5. security offered to the lender
  6. trade between risk and reward

Core reading uses related headings: purpose, repayment, risk and structure.

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11
Q

d. Principles of fundamental analysis of bonds.

What are the credit aspects to consider before investing in a bond:

A
  1. Likelihood of losing some of the funding
  2. severity of any potential loss
  3. whether interest received is adequate to compensate for the risk of loss

Credit analysis covers all three above aspects.

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12
Q

d. Principles of fundamental analysis of bonds.

Give six possible reasons for seeking finance.

A
  1. Organic growth - i.e., expanding existing growth (hire additional staff or purchase additional materials)
  2. acquisition
  3. investment in associated company
  4. Capital expenditure - e.g., investing in a new factory or office
  5. financing dividend
  6. financing share buy-back
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13
Q

d. Principles of fundamental analysis of bonds.

List three credit rating issues to consider in relation to the repayment of a loan.

A
  1. future cashflow and profit profile
  2. possible sale of assets and/or businesses
  3. refinancing - i.e., by raising further funds in future.
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14
Q

d. Principles of fundamental analysis of bonds (credit analysis of bonds)

List six credit ratings factors to consider under the heading ‘risks’.

A
  1. Industry analysis and competitive trends
  2. regulatory environment
  3. sovereign macroeconomic analysis
  4. qualitative analysis, e.g., of management, goods and services.
  5. company’s financial performance - both recent past and projected future
  6. company’s market position - relative to its competitors
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15
Q

d. Principles of fundamental analysis of bonds (role of credit rating agencies)

List four credit rating factors to consider relating to the structure of the bond.

A
  1. structure of bond, i.e., term, coupon rate, fixed or variable
  2. status in ranking
  3. safeguards, such as security, guarantees and covenants
  4. price and yield

More:
5. provisions for further bond issues (safeguards)
6. any limits on income and asset cover
7. the quality and value of assets (if any) on which it is secured
8. borrower’s ability to vary assets on which it is secured

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16
Q

d. Principles of fundamental analysis of bonds (role of credit rating agencies)

List five factors that can be used to assess the company’ financial strength.

A
  1. operating leverage:

sales - variable costs divided by profit before tax and interest

  1. financial leverage:

interest payment/profit before interest and tax

  1. asset leverage:

debt/ debt + equity or debt/equity

  1. Capital structure
  2. liquidity
17
Q

d. Principles of fundamental analysis bonds of (role of credit rating agencies)

List:
1. Two factors that must be considered when assessing the operating performance of a company

  1. four factors that must be assessed in relation to company’s market profit
A

Operating performance:
1. Sources and trends in profitability
2. revenue composition

market profile:

  1. market risk - risk relating to market sector as a whole
  2. competitive market position within sector
  3. spread risk across different markets
  4. event risk, exposure to specific events, e.g., hurricane for insurance company.
18
Q

Principles of fundamental analysis bonds of (role of credit rating agencies)

Outline the role of credit rating agencies.

A
  • allows bond issuers to successfully raise funds
  • form a view and provide an issuer rating and bond rating
  • reduces costs of carrying out own credit analysis independently for smaller investors (less compelling for larger investors)
19
Q

Principles of fundamental analysis of equities and bonds

Outline important account ratios to consider:

A

Accounting Ratios Can PIN Down Dangerous, Complicated Questions

𝑅𝑂𝐶𝐸=𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥 divided by 𝑆ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 & 𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠+𝑑𝑒𝑏𝑡

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑐𝑜𝑣𝑒𝑟=𝑇𝑜𝑡𝑎𝑙 𝐴−𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿−𝐼𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒𝑠/𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝑠ℎ𝑒𝑒𝑡 𝐷𝑒𝑏𝑡 𝑣𝑎𝑙𝑢𝑒

𝑃𝐸𝑅=𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒/𝐸𝑃𝑆

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟=𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥/𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑑𝑒𝑏𝑡

𝑁𝐴𝑉 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒=𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑓𝑢𝑛𝑑𝑠−𝑖𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒𝑠/# 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖e𝑙𝑑=𝐷𝑃𝑆/𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐶𝑜𝑣𝑒𝑟=𝐸𝑃𝑆/𝐷𝑃𝑆

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜=𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴/𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿

𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜=𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴−𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦/𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿

20
Q

Describe how the price earnings ratios (PERs) typically vary over the course of the economic cycle for defensive and cyclical companies.

A
  • if economy moderately buoyant and profits are fairly stable, defensive and cyclical companies similarly rated
  • As economy moves into recession, PERs of cyclical companies fall, while those of defensive companies remain stable or rise slightly.
  • At bottom of cycle, PERs of cyclical companies will probably have risen from low point as earnings have fallen, but defensive stocks will still be more highly rated (ie.g., higher PERs)
  • As economy starts to recover, PERs of cyclical companies will rise as price increases in anticipation of future earnings growth. PERs of defensive companies will below those of cyclicals (may even fall)
  • As growth continues, earnings of cyclical companies catch up with share price and PERs fall back

(attempt question on page 21)

21
Q

d. Principles of fundamental analysis of equities.

For exam purposes, how can you generate ideas for factors affecting a particular company:

A

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