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INVESTMENT4.pptxBAFI1042 - Investment
Topic 4: Fundamental Analysis
RMIT University
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Reference
Reilly, Frank K. , Keith C. Brown and Sanford Leeds, Investment Analysis and Portfolio Management (11th Edition), Thomson South-Western, 2019.
Chapter 8
Chapter 11 (value vs growth)
Learning Objectives
After studying this chapter you should have a better understanding of:
Top-down vs bottom-up approach
What are the major financial statements and why they are important
Why do we use financial ratios and the importance of financial ratios
What are the major categories of financial ratios
What specific ratios help determine firm’s internal liquidity, operating performance, risk and growth potential
How can DuPont analysis help evaluate past and future ROE
Value vs growth investment
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Top-Down approach versus bottom-up
Two approaches to selecting, analyzing, and valuing a stock:
Top-down, three-step approach
Bottom-up, stock valuation, stock picking approach
The difference between the two approaches is the perceived importance of economic and industry influence on individual firms and stocks
Both of these approaches can be implemented by either fundamentalists or technicians
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Top-Down approach versus bottom-up
The top-down approach does three studies in the examination of a security:
The overall market and economy
The industry https://www.abc.net.au/news/2019-05-20/share-market-surges-on-election-results-scott-morrison-win/11129440
The individual company
Exhibit 8.1
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Top-Down approach versus bottom-up
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Top-Down approach versus bottom-up
Top-down analysts:
Examine the value of an overall market and determine which markets to invest in or to overweight
Within a specific market, search for the best industries
Within the best industries, search for the best companies
May discover that the “best companies” are not the best investments because they may be overvalued
May also find that a company in a good industry offers the greatest potential for excess returns
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Major Financial Statements
Corporate shareholder annual and quarterly reports must include
Balance sheet
Income statement
Statement of cash flows
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Balance Sheet
Shows resources (Assets) of the firm and how it has financed these resources (Liabilities & Equity)
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Balance Sheet
Indicates current and fixed assets available at a point in time
Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity
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Income Statement
Contains information on the profitability of the firm during some period of time, in contrast to the balance sheet at a fixed point in time
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Income Statement
Indicates the flow of sales, expenses, and earnings during the time period
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Statement of Cash Flows
Shows the effects on the firm’s cash flow of income flows and changes in various items on the balance sheet
Cash Flow from Operating Activities: the sources and uses of cash that arise from the normal operations of a firm
Cash Flow from Investing Activities: change in gross plant and equipment plus the change in the investment account
Cash Flow from Financing Activities: financing sources minus financing uses
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Purpose of Financial Statement Analysis
It seeks to evaluate the current management performance and to provide insights that will help predict future management performance, specifically in the following three areas:
Profitability
Efficiency
Risk
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Analysis of Financial Ratios
Ratios are more informative than raw numbers
Ratios provide meaningful relationships between individual values in the financial statements
Importance of relative financial ratios: Compare a firm’s financial ratios to other entities
The aggregate economy
Its industry or industries
Its major competitors within the industry
Its past performance (time-series analysis)
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Analysis of Financial Ratios
Comparison to the Aggregate Economy
Most firms are influenced by economic expansions and contractions in the business cycle
Analysis helps you estimate the future performance of the firm during subsequent business cycles
Comparison to the Industry
Most popular comparison
Different industries affect the firms within them differently, but the relationship is always significant
The industry effect is strongest for industries with homogenous products
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Analysis of Financial Ratios
Comparison to its Major Competitors
Industry averages may not be representative
Select a subset of competitors to compare to using cross-sectional analysis, or
Construct a composite industry average from industries the firm operates in
Comparison to its Own Historical Records
Determine whether it is progressing or declining
Helpful for estimating future performance
Consider trends as well as averages over time
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Computation of Financial Ratios
The Five Categories
Common size statements
Internal liquidity (solvency)
Operating performance
Operating efficiency
Operating profitability
(4) Risk analysis
Business risk
Financial risk
External liquidity risky
(5) Growth analysis
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Common Size Statements
Normalize balance sheets and income statement items to allow easier comparison of different size firms
A common size balance sheet expresses accounts as a percentage of total assets
A common size income statement expresses all items as a percentage of sales
Common size statements also give insight into a firm’s financial condition
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Common Size Statements
A common size income statement expresses all items as a percentage of sales
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Common Size Statements
A common size balance sheet expresses accounts as a percentage of total assets
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Evaluating Internal Liquidity
Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations
They compare near-term financial obligations, such as accounts payable or notes payable, to current assets or cash flows that will be available to meet these obligations.
Does the company have enough cash coming in to cover obligations to payout cash?
Ideally, ratios would be over 1
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Evaluating Internal Liquidity
Current Ratio: Examines the relationship between current assets and current liabilities
Current Liabilities
Assets
Current
Current Ratio
=
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Evaluating Internal Liquidity
Quick Ratio: Adjusts current assets by removing less liquid assets
Cash Ratio: The most conservative liquidity ratio
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Evaluating Internal Liquidity
Receivables Turnover: Examines the quality of accounts receivable
Receivables turnover can be converted into an average collection period
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Example
Net credit sales of Company A during the year ended June 30, 2017 were $644,790. Its accounts receivable at July 1, 2016 and June 30, 2017 were $43,300 and $51,730 respectively. Calculate the receivables turnover ratio.
Solution Average Accounts Receivable = ($43,300 + $51,730) ÷ 2 = $47,515 Receivables Turnover Ratio = $644,790 ÷ $47,515 ≈ 13.57
AvgReceivableCollectionPeriod=365/13.57=27 days
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Evaluating Internal Liquidity
Inventory Turnover: Relates inventory to sales or cost of goods sold (CGS)
Given the turnover values, you can compute the average inventory processing time
Average Inventory Processing Period
= 365/Annual Inventory Turnover
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Evaluating Internal Liquidity
Cash Conversion Cycle: Combines information from the receivables turnover, inventory turnover, and accounts payable turnover. That is
Receivable Days
+ Inventory Processing Days
- Payables Payment Period
= Cash Conversion Cycle
Where,
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Evaluating Operating Performance
Ratios that measure how well management is operating a business
Operating Efficiency Ratios: Examine how the management uses its assets and capital, measured in terms of sales dollars generated by asset or capital categories
Operating Profitability Ratios: Analyze profits as a percentage of sales and as a percentage of the assets and capital employed
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Operating Efficiency Ratios
Total Asset Turnover: The total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base (net assets equals gross assets minus depreciation on fixed assets)
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Operating Efficiency Ratios
Equity turnover: Examines turnover for capital component
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Operating Profitability Ratios
Operating profitability ratios measure
1. The rate of profit on sales (profit margin)
2. The percentage return on capital
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Operating Profitability Ratios
Gross Profit Margin: Measures the rate of profit on sales (gross profit equals net sales minus the cost of goods sold)
Net profit margin relates net income to sales
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Operating Profitability Ratios
Operating Profit Margin: Measures the rate of profit on sales after operating expenses (operating profit is gross profit minus sales, general and administrative (SG + A) expenses)
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Operating Profitability Ratios
Return on Owner’s Equity (ROE): Indicates the rate of return earned on the capital provided by the stockholders
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Operating Profitability Ratios
The DuPont Analysis: It divides the ROE ratio into several component ratios that provide insights into the causes of a firm’s ROE and any changes in it
Profit Total Asset Financial
Margin Turnover Leverage
=
x
x
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Risk Analysis
Risk analysis examines the uncertainty of income flows for the total firm and for the individual sources of capital
Debt
Preferred stock
Common stock
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Risk Analysis
Total risk of a firm has two components:
Business risk
The uncertainty of income caused by the firm’s industry
Generally measured by the variability of the firm’s operating income over time
Financial risk
Additional uncertainty of returns to equity holders due to a firm’s use of fixed obligation debt securities
The acceptable level of financial risk for a firm depends on its business risk
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Business Risk & Financial Risk
Relationship between business risk and financial risk
Acceptable level of financial risk for a firm depends on its business risk
The three sets of financial ratios to measure financial risk
Balance sheet ratios
Earnings and Cash Flow Coverage Ratios
Cash Flow–Outstanding Debt Ratios
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Balance Sheet Ratios
Proportion of Debt (Balance Sheet) Ratios: Indicate what proportion of the firm’s capital is derived from debt compared to other sources of capital, such as preferred stock, common stock, and retained earnings
Debt-Equity Ratio=long-term debt/equity
Long-Term Debt/Total Capital Ratio
Total Debt-Total Capital Ratios
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Earnings or Cash Flow Ratios
Earnings or Cash Flow Ratios: Relate the flow of earnings or cash available to meet the required interest and lease payments
Interest Coverage Ratio=EBIT/Debt interest charges
Cash Flow Coverage Ratio=CF from operating+interest +implied lease interest/(interest+lease interest)
Cash Flow–Outstanding Debt Ratios
Cash Flow–Long-Term Debt Ratio
Cash Flow–Total Debt Ratio
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Analysis of Growth Potential
Determinants of Growth
Resources retained and reinvested in the entity
Rate of return earned on the resources retained
= RR x ROE
where:
g = potential growth rate
RR = the retention rate of earnings
ROE = the firm’s return on equity
g = RR x ROE
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Example
Company W has an ROE of 10%, and it retains 40% of its earnings.
g=40%*10%=4%
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Value versus Growth Investing
A growth investor focuses on the current and future economic “story” of a company, with less regard to share valuation
A value investor focuses on share price in anticipation of a market correction and, possibly, improving company fundamentals.
Value stocks generally have offered somewhat higher returns than growth stocks, but this does not occur with much consistency from one investment period to another
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Value versus Growth Investing
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Value versus Growth Investing
Growth-oriented investor will:
Focus on EPS and its economic determinants
Look for companies expected to have rapid EPS growth
Assumes constant P/E ratio
Value-oriented investor will:
Focus on the price component
Not care much about current earnings
Assume the P/E ratio is below its natural level
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The Value of Financial Statement Analysis
Financial statements, by their nature, are backward-looking
An efficient market will have already incorporated these past results into security prices, so why analyze the statements?
Analysis provides knowledge of a firm’s operating and financial structure, and strategy
This aids in estimating future returns and risks
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Summary
Top-down vs Bottom-up
Major Financial Statements
Balance Sheet
Income statement
DuPont Analysis
3 steps or 5 steps
Comparative Analysis of Ratios
Internal liquidity
Current ratio, quick ratio, and cash ratio
Operating performance
Efficiency ratios and profitability ratios
Risk Analysis
Growth analysis
Value vs Growth investment
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