Chapter 11: Fundamental analysis Flashcards
Fundamental analysis
Assess the ‘true’ or ‘fundamental’ value of an asset, which can then be compared to the price at which it can be bought or sold, so as to determine whether the asset is cheap or dear.
The study of economic, financial and environmental factors affecting a company’s share price is known as fundamental analysis.
The use of fundamental analysis to determine price inefficiencies relies on the existence of an inefficient market.
Equity funadamental analysis stages
- The first is the construction of the model of the company which allows future cashflows and earnings to be estimated.
- The second involves the use of the ouput from the first stage to determine whether the company’s securities are over- or under-valued by the market.
What affects the price of an individual company’s shares and what are the key factors affecting this?
The price is affected by the level of supply and demand for those shares. Key factors affecting relative demand for individual shares are investors’ expectations of:
- future dividend payments
- future capital growth
- the risks of the business and thus the uncertainty of the estimates above.
What are the factors that drive expectations for capital and dividend growth?
- estimates of profits
- free cashflow
- total enterprise value
Broad factors that influence a particular company
- global economy
- domestic economy
- industry
- specific firm
PE ratio
PE ratio = share price / earnings per share
- Typically calculated on historical, net earnings basis, allowing for the most recent profit figures
- Shows what a market is willing to pay for a stock based on its past or future earnings
- A measure of expected earnings
- Higher PE ratio means the stock is more expensive compared to the same stock with a lower PE ratio
Factors affecting the relative market price of a share
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Products quality (Quality of products)
Environmental impact and sustainability of the business
Retained profits
Competition
History
Input costs
Managment ability
Prospects for market growth
To form a view on the factors affecting the 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
Current and future environmental changes and potential regulatory responses to these
Liquidity level
Asset value growth
Profit variability and growth (by looking at sources of revenue and expenditure)
Possible sources of information
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- Company’s published accounts
- Financial press and other commercial information providers
- Trade press
- Exchange where the securities are listed
- Statutory information that company must provide
- Company visits
- Managment discussions (management of the company)
- Discussions with competitiors
- Government and industry forumns, websites or reports
- Public statements by the company
- Stock brokers’ or investment bankers’ publications
Take care that the use of info obtained from private discussions or company vistis doesn’t contravene insider trading regulations
Interest cover
protfit before interest and tax / annual interest on debt
Capital cover
(total assets - current liabilities - intangibles) / balance sheet value of debts
NAV per share
(ordinary shareholders’ funds - intangibles) / number of issued ordinary shares
Dividend yield
dividend per share / price of ordinary share
Dividend cover
earnings per share / dividends per share
Return on capital employed
proft before interest and tax / (share capital & reserves + long-term debt)
OR
profit before tax / share capital & reserves
Current ratio
current assets / current liabilities