Introduction to fundamental Analysis
There are two types of people that enter the financial markets – Traders and Investors.
Traders tend to use technical analysis, i.e., instead of researching about the company in detail, they depend on the historical prices and volume of the asset to take a decision.
In contrast to this, Investors want to value a company before they invest in it to decide whether it is overvalued or undervalued. Fundamental Analysis is basically the process of measuring an asset’s intrinsic value by various steps. It includes the study of anything that can change the value of the assets including the asset’s financial as well as other macro-economic factors such as the industry and the economy of the country in correspondence to that industry. The basic techniques of fundamental analysis are -
Analysing the Economy, Industry and the Firm
Firstly, the economy of the sector in which the company resides is analysed. The well-being of the economy of the sector in correspondence to the economy as a whole is much needed for future growth prospects. For the Industry analysis, various steps such as analysing the competition and understanding the market dynamics is absolutely necessary. This can be done by various techniques such as Porter’s Five Forces Analysis and VRIO Analysis. Porter’s five forces analysis basically includes analysing the competition among existing competitors, bargaining power of customers, bargaining power of suppliers, threat of substitute products and threat of new entrants. VRIO Analysis is an analytical technique brilliant for the evaluation of company's resources and thus the competitive advantage. VRIO is an acronym from the initials of the names of the evaluation dimensions: Value, Rareness, Imitability, Organization.
To understand the firm more deeply, cost structure analysis and Revenue analysis are performed. Many types of costs exist in a company. Cost structure analysis typically starts with a review of each type. Common types of costs include sunk, marginal, and fixed costs, which can be the most expensive in production and manufacturing. It is helpful since evaluating the expenses that make up the cost structure can often help identify points along the process that can be refined for greater efficiency or at least a more responsible use of the resources on hand. A revenue analysis is a detailed report of the total revenue generated by all company activities. They are utilized by companies to indicate areas in which they can increase revenue with the least effort. A revenue analysis can reveal which products or services sell better or which areas need improvement. Also, the future prospects of the company and their vision needs to be clearly understood. Lastly, the regulatory environment is also studied, which basically understands how smooth is it to run business in the current circumstances in the environment
Analysing the Financial statements
Financial statements are analysed using ratios to know more about the company’s liquidity, leverage, profitability, efficiency, market value etc. Some important ratios are
Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and long term obligations.
Current Ratio = Current Assets/ Current liabilities
Quick Ratio = (Current Assets – Inventories)/ Current Liabilities
Operating cash flow ratio = Operating cash flow / Current liabilities
Leverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels.
Debt service coverage ratio = Operating income / Total debt service
Interest coverage ratio = Operating income / Interest expenses
Debt to equity ratio = Total liabilities / Shareholder’s equity
Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources.
Asset turnover ratio = Net sales / Average total assets
Inventory turnover ratio = Cost of goods sold / Average inventory
Receivables turnover ratio = Net credit sales / Average accounts receivable
Days sales in inventory ratio = 365 days / Inventory turnover ratio
Profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity.
Gross margin ratio = Gross profit / Net sales
Operating margin ratio = Operating income / Net sales
Return on assets ratio = Net income / Total assets
Return on equity ratio = Net income / Shareholder’s equity
Market Value Ratios
Market value ratios are used to evaluate the share price of a company’s stock.
Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding
Dividend yield ratio = Dividend per share / Share price
Earnings per share ratio = Net earnings / Total shares outstanding
Price-earnings ratio = Share price / Earnings per share
Further Components of Fundamental analysis will be discussed in the next article
Components of Fundamental Analysis (Continued)
Forecasting Relevant Payoffs
Firstly, the value drivers of the company are identified. Value drivers are factors that increase the worth of a product, service, asset or business. In the case of a product, it could be a differentiating capability that makes the product a must-have for customers. For a business, it could be economies of scale, skilled staff or a loyal customer base that increases the value of the business for shareholders and potential buyers. Identifying and managing value drivers helps management focus their attention on activities that will have the greatest impact on value. This focus enables management to translate the broad goal of value creation into the specific actions most likely to deliver that value. There are three steps to identifying value drivers. Step 1 – Developing a value driver “map” of the business, i.e., breaking down the broad operating parameters of the business into progressively smaller components until we reach the level where daily operating management decisions reside. We then document which specific factors influence broad measures such as sales growth, operating profit, etc. Step 2 - Testing for value driver sensitivities. After assembling base levels for each operating factor, we must examine how changes in each factor impact the overall value of the business. This helps in deciding the specific importance of each value driver. Step 3 - Testing for controllability - Each variable must then be examined to discover those that management can control. After identifying the key value drivers, their best guess forecast is predicted and used to make a financial model which can help in the valuation of the business.
Formulating a Security Value
Finally, the security is valued so that an investment decision can be made. For valuation, The data collected in the previous steps is used. To formulate a security value, different valuation techniques can be used. The first step is to specify the approach to valuation. The three main valuation techniques are -
1. DCF (Discounted Cash Flow) Analysis – Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the business’ unlevered free cash flow into the future and discounts it back to today at the firm’s Weighted Average Cost of Capital (WACC). DCF is the most detailed of the three approaches and requires the most estimates and assumptions but it is also provides the most accurate valuation in comparison to the other two. A DCF model allows the analyst to forecast value based on different scenarios and even perform a sensitivity analysis. For larger businesses, the DCF value is commonly a sum-of-the-parts analysis, where different business units are modelled individually and added together.
2. Comparable Analysis (Comps) - A comparable company analysis (Comps) is a process used to evaluate the value of a company using the metrics of other businesses of similar size in the same industry. Comparable company analysis operates under the assumption that similar companies will have similar valuation multiples, such as EV/EBITDA. It is a relative valuation method in which you compare the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most common valuation method. The “comps” valuation method provides an observable value for the business, based on what other comparable companies are currently worth. Comps are the most widely used approach, as they are easy to calculate and always current.
3. Precedent Transactions Analysis - Precedent transactions analysis is based on the premise that the value of a company can be estimated by analysing the prices paid by purchasers of similar companies under similar circumstances. Precedent transactions analysis is another form of relative valuation where you compare the company in question to other businesses that have recently been sold or acquired in the same industry. These transaction values include the take-over premium included in the price for which they were acquired. The values represent the value of a business at the same time. They are useful for M&A transactions but can easily become stale-dated and no longer reflective of the current market as time passes. They are less commonly used than Comps or market trading multiples.