Chapter 11: Fundamental analysis Flashcards
Fundamental share analysis
The study of economic, financial and environmental factors affecting a company’s share price is known as fundamental share 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.
Factors affecting equity prices
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 and capital growth - depend on internal characteristics of the company and external economic influences
- risks
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
General 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
profit 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
What aspects do crediting rating agents assess when determining the credit rating for a bond?
- Purpose of funding
- Repayment of funding (expected source of repayment)
- Risks (risks that coud jeopardise the repayment)
- Structure
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
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 leverage, financial leverage, asset leverage, capital structure, liquidity
- operating performance - profitability, revenue composition
- market profile - market risks, competitive market position, spread of risk, event risk
Qualitative factors - 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
Gearing
debt / shareholders’ funds
OR
debt / (debt + shareholders’ funds)
