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
Quick ratio
(current assets - inventory) / current liabilities
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 without doing a full valuation
Why may the PE ratio of a share be higher than that of another apparently similar share for a company in the same industry?
PE ratio may be higher because the:
- shares are thought to be low risk
- dividends of the company are believed to have a high growth rate
- recent earnings have been depressed or particular one-off reason
- shares are over-priced
What credit aspects should a bond investor consider before investing in a bond?
- likelihood of losing some of the funding that’s been provided
- severity of any potential losses
- whether interest rate received is adequate compansation for the risk of loss
What aspects do crediting rating agents assess when determining the credit rating for a bond?
- Purpose of funding
- Repayment of funding
- Risks
- Structure
Reasons a company may seek financing via a bond
- organic growth
- acquisition
- investment in an associated company
- capital expenditure
- dividend / share buy-back
Issues to consider when looking at the repayment of funding by an issuer
What is the expected source of repayment? Issues to consider include:
- cashflow/profit profile over time
- possible sale of assets and/or business
- refinancing
Factors to consider when assessing what risks (quantitative and qualitative) could jeopardise debt servicing in future
Macro considerations:
- industry analysis and competitive trends
- regulatory environment
- sovereign macro-economic analysis
Company-specific issues:
- quantitaive analysis
- financial performance
- market position
Particular terms and conditions might wish to consider when assessing a bond issue
- term of bond and level and frequency of coupons (structure)
- ranking relative to other bonds issued by company (status)
- provision of further bond issues (safeguards)
- limits on income and asset cover (safeguards)
- quality and value of assets (if any) on which it’s secured (safeguards)
- borrower’s ability to vary the assets on which it’s secured (safeguards)
- price and yield at which it is to be issued, and in particular the yield margin over similar risk-free government bonds (price)
Fundamentals of the rating agencies’ approach to rating companies focusses on:
- 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
What are rating opinions based on?
Evaluation of a company’s:
- financial strength
- operating performance
- market profile
Qualitative factors
How can financial strength of a company be assessed?
- 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)
How can operational performance of a company be assessed?
- profitability (sources, trends)
- revenue composition
How is the market profile of the company assessed?
Assessed in terms of:
- market risk (systematic and specific)
- competitive market position
- spread of risk
- event risk
What do qualitatve factors include?
Assessment of management experience and objectives especially with regard to achievement of future business plans.
Operating leverage
(sales – variable costs) / PBIT
- gives indicator of company’s level of fixed operating costs
Financial leverage
interest payments / PBIT
- gives indication of level of fixed financing costs
Asset or capital leverage
debt/equity
OR
debt/(debt+equity)
Advantages of having a credit rating
- More successful when raising funds if maintain good credit rating with recognised credit rating agency
- Rating agencies provide significant amount of detail on their methodologies but not detailed supporting information relating to their specific assessment
Disadvantages of credit ratings
- Bond investors place significant reliance on issuer and bond credit ratings, rather than carry out their own independent credit analysis
- Smaller investors appropriate - lower costs relative to buying independent research or building internal team of credit experts
- Larger investors - desirable to obtain or carry out independent research in addition to monitoring ratings
Major global credit rating agencies
- Fitch Ratings
- Moody’s Investor Services
- Standard and Poor’s
Cyclical companies
Fortunes of the company are closely linked to the state of the economy
Defensive companies
Fortune of company is relatively immune to the state of the economy
Standing of cyclical companies relative to defensive companies during the economic cycle
Economy moderately buoyant, no real prospects of rapid growth or recession
- Profits stable: defensive & cyclical companies similarly rated
Economy starts to move into recession
- PE ratios for cyclical companies likely to fall & those of defensive companies remain stable or rise slightly
Economy recession: ‘bumping along at the bottom’
- PE ratios of cyclical companies probably have risen from lowest point as earnings have fallen but defensive stocks will still be more highly rated
Green shoots of recovery
- PE ratio of cyclical companies will rise as prices increase in anticipation of future earnings growth. PE ratios of defensive companies may be below cyclical companies. As growth continues, cyclical companies will catch up with share price and PE ratios will fall back
Gearing
debt / shareholders’ funds
OR
debt / (debt + shareholders’ funds)
