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COMPANY ANALYSIS
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 (industry choice), 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). We have considered industry analysis in the previous chapter. So, the present discussion focuses on competitive strategy and corporate strategy
Competitive Strategy
Among the various frameworks of strategy formulation, the one developed by Michael E. Porter in his seminal work Competitive Strategy has been perhaps the most influential in shaping management practice. 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.
Exhibit 15.1 depicts 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. Exhibit 15.1 Competitive Position of the Firm
Superior Cost-cumdifferentiation Relative Differentiation Position advantage Differentiation advantage
Stuck-in-the middle
advantage
Relative Cost Position
Inferior
Accounting Analysis
Accounting analysis seeks to evaluate the extent to which the firms accounting reports capture its business reality. As an analyst you must be familiar with. The institutional framework for financial reporting
disclosures
strategy,
to
its
describe
its
minimal disclosure
requirements prescribed by accounting regulations There are serious red flags2
performance, prospects
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 pe 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.
metrics like the return on equity, book value per share, EPS,
dividend payout ratio, and dividend per share.
ROE : 3 Factors
PAT
ROE = Sales Net Profit Margin x Assets Asset Turnover
Sales
x
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 20X5 13.0% = 12.70% x 1.48 x 0.764 x 0.50 x 1.81 20X6 20.5% = 16.08% x 1.48 x 0.81 x 0.60 x 1.78 20X7 21.1% = 15.48% x 1.52 x 0.81 x 0.67 x 1.67
BVPS
20 x 5 262/15 = 17.47
20 x 6 292/15 = 19.47
20 x 7 332/15 = 22.13
EPS
20 x 5 34/15 = 2.27
20 x 6 60/15 = 4.00
20 x 7 70/15 = 4.67
Equity dividends
Equity earnings Dividend Payout ratio 20 x 5 28/34 = 0.82 20 x 6 30/60 = 0.50 20 x 7 30/70 = 0.43
DPS
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.
Sales of 20 x 7
CAGR of Sales : Sales for 20 x 2
1/ 5
1=
840
542
1/ 5
1 = 9.2%
1/ 5
1 =
7.00 6.30
1/ 5
1 = 2.1%
1/ 5
1 =
3.00 2.30
1/ 5
1 = 5.5%
Risk Exposure
Beta Beta represents volatility relative to the market Volatility of Return on equity Range of return on Equity over n years
Earnings Level
Growth Level
RISK EXPOSURE
Valuation Multiples
The most commonly used valuation multiples are : Price to earnings (PE) ratio Price to book value (PBV) ratio PE Ratio (Prospective) Price per share at the beginning of year n Earnings per share for year n PE ratio
20 x 5 9.25
20 x 6 6.63
20 x 7 6.23
PBV Ratio (Retrospective) Price per share at the end of year n Book value per share at the end of year n
PBV ratio
20 x 5 1.52
20 x 6 1.49
20 x 7 1.42
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
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
P / E Ratio
Constant Growth Dividend Model
Dividend payout ratio P / E RATIO =
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
Weighted PE Ratio PE ratio based on the constant growth dividend discount model : 6.36
Value Range Rs.30 Market Price < Rs.30 Rs.30 Rs.38 Hold Rs.38 Decision Buy
> Rs.38
Sell
PBV-ROE Matrix
Growth-Duration Matrix
PBV-ROE Matrix
LOW
Growth-Duration Matrix
High
Expected 5-Yr EPS Growth Low
Undervalued
Promises of growth
Dividend cows
Overvalued
Low
High
ERI =
(Acceleration ratio)
ERI Illustration
Omegas price per share Omegas operating cash flow
(before growth investment)
= Rs.150
= 15 percent
= 20 percent
= 50 percent
ERI Illustration
Omegas base line value =
Rs.10 0.15
= Rs.66.7
150 66.7 150
= 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.
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.
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.
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.