Chapter 15

COMPANY ANALYSIS

Establishing the Value Benchmark

INTRODUCTION

Fundamental analysis of equity shares This involves two approaches: Estimating Intrinsic value Estimating expected return To find out IV analyst must forecast future performance and translate the same into the value estimate

Outline
Strategy Analysis
Accounting Analysis Financial Analysis Estimation of Intrinsic Value Tools for Judging Undervaluation or Overvaluation Obstacles in the way of an Analyst Equity Research in India

Strategy Analysis
Strategy analysis seeks to explore the economics of a firm and identify its profit drivers so that the subsequent financial

analysis reflects business realities.

The profit potential of a firm is influenced by the industry or industries in which it participates, by the strategy it follows to

compete in its chosen industry or industries (competitive

strategy), and by the way in which it exploits synergies across its business portfolio (corporate strategy).

Competitive Strategy
Michael Porter argues that the firm can explore two generic ways of gaining sustainable competitive advantage viz., cost leadership and product differentiation. Cost leadership can be attained by exploiting economies of scale, exercising tight cost control, minimizing costs in area like R&D and advertising, and deriving advantage from cumulative learning. Firms which follow this strategy include Bajaj Auto in two wheelers, Mittal in steel, WalMart in discount retailing, and Reliance Industries in petrochemicals. Product differentiation involves creating a product that is perceived by customers as distinctive or even unique so that they can be expected to pay a higher price. Firms which have excelled in this strategy include Mercedes in automobiles, Rolex in wristwatches, Mont Blanc in pens, and Raymond in textiles.

The competitive position of the firm based on its relative cost and differentiation positions. The most attractive position of course is the cost-cum-differentiation advantage position. Competitive Position of the Firm
Superior Cost-cumDifferentiation advantage

differentiation
Relative Differentiation Position advantage

Low cost
Inferior advantage Low price Relative Cost Position

Stuck-in-the middle

High price

Gaining Competitive Advantage

By choosing an appropriate strategy, a firm does not necessarily gain competitive advantage. To do so the firm must develop the

required core competencies (the key economic assets of the firm)

and structure its value chain (the set of activities required to convert inputs into outputs) appropriately. The uniqueness of a firms core competencies and its value chain and the extent to which it is difficult for competitors to

imitate them determines the sustainability of a firms

competitive advantage. Palepu et.al.

Gaining Competitive Advantage

To assess whether a firm is likely to gain competitive advantage, the analyst should examine the following: The key success factors and risks associated with the firms chosen competitive strategy. The resources and capabilities, current and potential, of the firm to deal with the key success factors and risks. The compatibility between the competitive strategy chosen by the firm and the manner in which it has structured its activities (R&D, design, manufacturing, marketing and distribution, and support). The sustainability of the firms competitive advantage. The potential changes in the industry structure and the adaptability of the firm to address these changes

Strategy of Cost Leadership: Dell Computer

Direct Selling saving the retailers margin Build-to-order manufacturing saving inventory cost Low-cost service telephone based service & third party service Negative working capital no inventory, no receivables as it is paid through credit card etc

Corporate Strategy Analysis

When you analyse a multi-business firm, you have to evaluate not only the profit potential of individual businesses but also the economic implications of managing different businesses under one corporate canopy. For example, General Electric has

succeeded immensely in creating significant value by managing a

highly diversified set of businesses ranging from light bulbs to aircraft engine, whereas Sears has not succeeded in managing retailing with financial services.

Corporate Sources of Value Creation

Thus, whether a multibusiness firm is more valuable compared to a collection of focused firms finally depends on the context. The analyst should examine the following factors to assess whether a firms corporate strategy has the potential to create value. Imperfections in the product, labour, or financial markets in the business in which the firm operates. Existence of special resources such as brand name, proprietary knowledge, scarce distribution channels, and organisational processes that potentially create economies of scope. The degree of fit between the companys specialised resources and its portfolio of businesses. The allocation of decision rights between the corporate office and business units and its effect on the potential economies of scope. The system of performance measurement and incentive compensation and its effect on agency costs.

Accounting Analysis
Accounting analysis seeks to evaluate the extent to which the firms accounting reports capture its business reality. Analyst must be familiar with: The institutional framework for financial reporting Sources of noise and bias in accounting Differences between good and bad accounting quality.

Institutional Framework for Financial Reporting

The salient features of the institutional framework for financial reporting are: Corporate financial reports are prepared on the basis of accrual

accounting and not cash accounting.

Preparation of financial statements involves complex judgments by management.

GAAP regulates managerial judgement

External auditing is now a near universal requirement.

Sources of Noise and Bias in Accounting

There are several sources of potential noise and bias in accounting data. Accounting rules themselves introduce noise and bias as it is often not possible to restrict managerial discretion without diminishing the informational content of accounting reports. Forecasting errors are practically unavoidable. Managers may introduce noise and bias in accounting reports, while making their accounting decisions.

Good and Bad Accounting Quality

Good Accounting Quality The accounting data focuses on key success factors and Bad Accounting Quality The accounting data fails to highlight key success factors

risks
Managers use their accounting discretion to make accounting numbers more informative The firm provides adequate disclosures strategy, performance, prospects There are no red flags to its and describe its

and risks
Managers use their accounting discretion to disguise reality The firm just fulfills the minimal disclosure requirements prescribed by accounting regulations There are serious red flags2

current future

Financials Analysis
The key questions to be addressed in applying the earnings multiplier approach, the most popular method in practice, are: What is the expected EPS for the forthcoming year? What is a reasonable P/E ratio? To answer these questions, investment analysts start with a historical analysis of earnings (and dividends), growth, risk, and valuation and use this as a foundation for developing the forecasts required for estimating the intrinsic value.

Earnings And Dividend Level

To assess the earnings and dividend level, investment analysts look at

metrics like the return on equity, book value per share, EPS,
dividend payout ratio, and dividend per share. Equity earnings ROE = Equity

Financials Of Horizon Ltd

2001
Net Sales Cost of goods sold Gross profit Operating expenses Operating profit Non-operating surplus/deficit Profit before interest and tax (PBIT) Interest Profit before tax Tax Profit after tax Dividend Retained earnings Equity share capital (Rs. 10 par) Reserves and surplus Shareholders funds Loan funds Capital employed Net fixed assets Investments Net current assets Total assets Earnings per share Market price per share (End of the year) 475 352 123 35 88 4 92 20 72 30 42 20 22 100 65 165 150 315 252 18 45 315

2002
542 380 162 41 121 7 128 21 107 44 63 23 40 100 105 205 161 366 283 17 66 366

2003
605 444 161 44 117 9 126 25 101 42 59 23 36 150 91 241 157 398 304 16 78 398

2004
623 475 148 49 99 6 105 22 83 41 42 27 15 150 106 256 156 412 322 15 75 412 21.00

2005
701 552 149 60 89 89 21 68 34 34 28 6 150 112 262 212 474 330 15 129 474 2.27 26.50

2006
771 580 191 60 131 -7 124 24 100 40 60 30 30 150 142 292 228 520 390 20 110 520 4.00 29.10

2007
840 638 202 74 128 2 130 25 105 35 70 30 40 150 182 332 221 553 408 25 120 553 4.67 31.5

ROE : 3 Factors
ROE =

PAT Sales
Net Profit Margin

Sales Assets
Asset Turnover

Assets Equity
Leverage

THE BREAK-UP OF THE RETURN ON EQUITY IN TERMS OF ITS DETERMINANTS FOR THE PERIOD 20X5 20X7 FOR HORIZON LIMITED IS GIVEN BELOW:
20X5 20X6 20X7 Return on equity = Net profit margin x Asset turnover x Leverage multiplier 13.0 % = 4.85% x 1.48 x 1.81 20.5% = 7.78% x 1.48 x 1.78 21.1% = 8.33% x 1.52 x 1.67

INVESTMENT ANALYSTS USE ONE MORE FORMULATION OF THE ROE WHEREIN IT IS ANALYSED IN TERMS OF FIVE FACTORS :
ROE = PROFIT BEFORE TAX X X SALES ASSETS PBIT PBIT SALES PROFIT AFTER TAX ASSETS X X PROFIT BEFORE TAX NETWORTH

ROE : 5 Factors
PBIT ROE = Sales x Assets Sales x PBIT PBT x PBT PAT x Net Worth Assets

ROE = PBIT EFFICIENCY X ASSET TURNOVER X INTEREST BURDEN X TAX BURDEN X LEVERAGE THE ROE BREAK-UP FOR OMEGA COMPANY IS GIVEN BELOW :
ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x Leverage 13.0% = 12.70% x 1.48 x 0.764 x 0.50 x 1.81 20.5% = 16.08% x 1.48 x 0.81 x 0.60 x 1.78 21.1% = 15.48% x 1.52 x 0.81 x 0.67 x 1.67

20X5 20X6 20X7

Book Value Per Share And Earnings Per Share

Book Value Per Share (BVPS)
Paid-up equity capital + Reserves and surplus Number of equity shares BVPS 2005 262/15 = 17.47 2006 292/15 = 19.47 2007 332/15 = 22.13

Earnings Per Share (EPS)

Equity earnings Number of equity shares EPS 2005 34/15 = 2.27 2006 60/15 = 4.00 2007 70/15 = 4.67

Dividend Payout Ratio And Dividend Per Share

Dividend Payout Ratio
Equity dividends Equity earnings 2005 Dividend Payout ratio 28/34 = 0.82 Dividend Per Share (DPS) 2005 Rs 1.86 2006 2.00 2007 2.00 30/60 = 0.50 30/70 = 0.43 2006 2007

DPS

DPS = EPS X DP Ratio

Growth Performance
To measure the historical growth, the compound annual
growth rate (CAGR) in variables like sales, net profit,
earnings per share and dividend per share is calculated. To get a handle over the kind of growth that can be maintained, the sustainable growth rate is calculated.

Compound Annual Growth Rate (CAGR)

The compound annual growth rate (CAGR) of sales, earnings per share, and dividend per share for a period of five years 2002 2007 for Horizon Limited is calculated below:

Sales of 2007
CAGR of Sales : Sales for 2002

1/ 5

1 =

840
542

1/ 5

1 = 9.2%

CAGR of earnings per share (EPS) :

EPS for 2007 EPS for 2002

1/ 5

7.00 1 = 6.30

1/ 5

1 = 2.1%

CAGR of dividend: DPS for 2007 per share (DPS) DPS for 2002

1/ 5

= 3.00 2.30

1/ 5

1 = 5.5%

Sustainable Growth Rate

The sustainable growth rate is defined as : Sustainable growth rate = Retention ratio X Return on equity Based on the average retention ratio and the average return on equity of the three year period (2005 2007) the sustainable growth rate of Horizon Limited is:

Sustainable growth rate = 0.417 x 18.2% = 7.58%

Risk Exposure
Beta represents volatility relative to the market, the risk of the stock is denoted by its beta which measures how sensitive is the return on the stock to variations in the market return.
Required return of stock = Risk-free return + Beta(Market risk Premium) E(R)i = Rf + Bi(ErM Rf)

Volatility of Return on equity =

Range of return on Equity over n years Average return on equity over n years

If n = 5 (2003 to 2007)Volatility of ROE of Horizon Limited as follows = 11.5%/19.2% = 0.60

Favourable & Unfavorable Factors

Favourable Factors Unfavorable Factors

Earnings Level
Growth Level

High book value per share

High return on equity High CAGR in sales and EPS High sustainable growth Rate

Low book value per share

Low return on equity Low CAGR in sales and EPS Low sustainable Growth Rate High volatility of Return on equity High beta

RISK EXPOSURE

Low volatility of return on equity Low beta

Valuation Multiples
The most commonly used valuation multiples are : Price to earnings (PE) ratio Price to book value (PBV) ratio Price per share at the beginning of year n Earnings per share for year n

PE Ratio (Prospective) =

PE ratio

2005 9.25

2006 6.63

2007 6.23

PBV ratio =

PBV Ratio (Retrospective) Price per share at the end of year n Book value per share at the end of year n 2005 1.52 2006 1.49 2007 1.42

Going Beyond the Numbers

Sizing up the present situation and prospects Availability and Cost of Inputs Order Position Regulatory Framework Technological and Production Capabilities Marketing and Distribution Finance and Accounting Human Resources and Personnel Evaluation of management Strategy Calibre, Integrity, Dynamism Organisational Structure Execution Capability Investor - friendliness

Estimation of Intrinsic Value

Estimate the expected EPS
Establish a p / e ratio
Develop a value anchor and a value range

EPS Forecast
20 x 7 (ACTUAL)
Net Sales Cost of Goods sold Gross profit Operating Expns Depreciation Sellin & gen. Admn. Expns Operating Profit Non-operating Surplus/Deficit Profit before INT. & Tax (PBIT) Interest Profit before Tax Tax Profit after Tax Number of Equity Shares Earnings per Share 840 638 202 74 30 44 128 2 130 25 105 35 70 15 MLN RS 4.67

20 x 8 (PROJECTED)
924 708 216 81 34 47 135 2 137 24 113 38 75 15 RS 5.00

Assumption
Increase by 10 Percent Increase by 11 Percent Increase by 9.5 Percent

No Change

Decrease by 4 Percent

Increase by 8.57 Percent

Different PE Ratios
Note that different PE ratios can be calculated for the same stock at any given point in time. PE ratio based on last years reported earnings

PE ratio based on trailing 12 months earnings

PE ratio based on current years expected earnings PE ratio based on the following years expected earnings

P / E Ratio
Constant Growth Dividend Model
Dividend payout ratio P / E RATIO =

Required return on equity P/E

Expected growth rate in dividends

Cross Section Analysis = a1 + a2 Growth Rate in + a3 dividend earnings payout ratio + a3 Variability in earnings + a4 company size

Historical analysis

Weighted P /E ratio

Ratio
Historical Analysis 20 x 5 9.25 20 x 6 6.63 = 7.37 20 x 7 6.23

PE ratio

The average PE ratio is : 9.25 + 6.63 + 6.23 3

Weighted PE Ratio PE ratio based on the constant growth dividend discount model : 6.36

PE ratio based on historical analysis : 7.37 6.36 + 7.37 = 6.87 2

Value Anchor and Value Range

Value Anchor

Projected EPS x Appropriate PE ratio

5.00 x 6.87 = Rs. 34.35

Value Range Rs.30 Market Price < Rs.30 Rs.30 Rs.38 Hold Rs.38 Decision Buy

> Rs.38

Sell

Tools for Judging Undervaluation or Overvaluation

PBV-ROE Matrix
Growth-Duration Matrix

Expectations Risk Index

Quality at a Reasonable Price (VRE)

PEG: Growth at a Reasonable Price

PBV-ROE Matrix

HIGH PBV Ratio LOW

Overvalued Low ROE High PBV Low ROE Low PBV

High ROE High PBV

Undervalued High ROE Low PBV HIGH ROE

LOW

Growth-Duration Matrix

High
Expected 5-Yr EPS Growth Low

Undervalued

Promises of growth

Dividend cows

Overvalued

Low

High

Duration (1/Dividend Yield)

Expectations Risk Index (ERI)

Developed by Al Rappaport, the ERI reflects the risk in

realising the expectations embedded in the current market

price

ERI =

Proportion of stock price depending on

Ratio of expected future growth to recent growth

expected future growth

(Acceleration ratio)

ERI Illustration
Omegas price per share Omegas operating cash flow
(before growth investment)

= Rs.150

= Rs.10 per share

Omegas cost of equity Growth rate in after-tax cash operating

earnings over the past three years

= 15 percent

= 20 percent

Market expectation of the growth in after-tax

cash operating earnings over the next three years

= 50 percent

ERI Illustration
Omegas base line value =

Rs.10 0.15

= Rs.66.7
150 66.7 150

Proportion of the stock price coming

from investors expectations of future = growth opportunities

= 0.56

Acceleration ratio =
ERI = 0.56 x 1.25 = 0.70

1.50 1.20

= 1.25

In general, the lower (higher) the ERI, the greater (smaller) the chance of achieving expectations and the higher (lower) the expected return for investors.

Quality at a Reasonable Price

Determining whether a stock is overvalued or undervalued is often difficult. To deal with this issue, some value investors use a metric called the value of ROE or VRE for short. The VRE is defined as the return on equity (ROE) percentage divided by the PE(price-earning) ratio. For example, if a company has an expected ROE of 18 percent and a PE ratio of 15, its VRE is 1.2 (18/15). According to value investors who use VRE: A stock is considered overvalued if the VRE is less than 1. A stock is worthy of being considered for investment, if the VRE is greater than 1. A stock represents a very attractive investment proposition if the VRE > 2 A stock represents an extremely attractive investment proposition if the VRE > 3

PEG: Growth at a Reasonable Price

What price should one pay for growth? To answer this difficult

question, Peter Lynch, the legendary mutual fund manager,

developed the so-called PE-to-growth ratio, or PEG ratio. The PEG ratio is simply the PE ratio divided by the expected EPS growth rate (in percent). For example, if a company has a PE ratio of 20 and its EPS is expected to grow at 25 percent, its PEG ratio is 0.8 (20/25).

PEG: Growth at a Reasonable Price

Proponents of PEG ratio believe that: A PEG of 1 or more suggests that the stock is fully valued.

A PEG of less than 1 implies that the stock is worthy of being

considered for investment. A PEG of less than 0.5 means that the stock possibly is a very attractive

investment proposition.
A PEG of less than 0.33 suggests that the stock is an unusually attractive investment proposition.

Thus, the lower the PEG ratio, the greater the investment
attractiveness of the stock. Growth-at-a-reasonable price (GARP) investors generally shun stocks with PEG ratios significantly greater than 1.

Obstacles in the Way of an Analyst

Inadequacies or incorrectness of data
Future uncertainties
Irrational market behaviour

Excellent Versus Unexcellent Companies

In general, it appears that financial performance of excellent companies deteriorates whereas financial performance of non-excellent companies improves. Empirical evidence of this kind reflects the phenomenon of reversion to the mean which says that, over time, financial performance of companies tends to converge to the average value of the group as a whole. Thanks to this tendency, good past performers are likely to produce inferior investment results and poor past performers are likely to produce superior investment results.

Equity Research in India

Traditionally, lip sympathy was paid to equity research. Financial institutions (mutual funds, in particular) had a research cell because

it was in good form to have one. Likewise, large brokers set up

equity research cells to satisfy their institutional clients. In the mid1980s more progressive firms like Enam Financial, DSP Financial Consultants, and Motilal Oswal Securities Limited set up research divisions to exploit the opportunities in the equity market. With the

entry of foreign institutional investors and the emergence of more

discerning investors, the need for equity research is felt more widely. Indeed, currently equity research is a growing area.

Future
Equity researchers who are able to do their job well have bright prospects. The future belongs to those who will: Have a clear understanding of what their research is supposed to do and how they should go about doing it.

Learn to interpret financial numbers and assess qualitative factors which may not be immediately reflected in numbers.
Develop a medium-term or long-term perspective based on an incisive understanding of the dynamics of the companies analysed.

How to Make Most of Stock Research Reports

To make the most of stock research reports, follow these guidelines: Dont trust a research report naively. Use it as a starting point and do your own due diligence before acting on it.

Check the credibility of the brokerage house by reading its reports over a period of time.
Be wary of unscrupulous brokerage houses which prepare biased research reports with ulterior motives. Often a buy recommendation is given, when promoters or some other investors want to exit a stock.

Summing Up

In practice, the earnings multiplier method is the most popular method. The key questions to be addressed in this method are: what is the expected EPS for the forthcoming year? What is a reasonable PE ratio given the growth prospects, risk exposure, and other characteristics? Historical financial analysis serves as a foundation for answering these questions.

The ROE, perhaps the most important metric of financial performance, is decomposed in two ways for analytical purposes. ROE = Net profit margin x Asset turnover x Leverage ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x Leverage

To measure the historical growth, the CAGR in variables like sales, net profit, EPS and DPS is calculated.

To get a handle over the kind of growth that can be maintained, the sustainable growth rate is calculated. Beta and volatility of ROE may be used as risk measures.

An estimate of EPS is an educated guess about the future profitability of the company.
The PE ratio may be derived from the constant growth dividend model, or cross-section analysis, or historical analysis.

 The value anchor is : Projected EPS x Appropriate PE ratio PBV-ROE matrix, growth-duration matrix, and expectation risk index are some of the tools to judge undervaluation or overvaluation.