Ch 10 - Fundamental Analysis

Question 1

Fundamental Analysis

Answer 1

Assess the “true” or “fundamental” value of an asset by analysing all of the factors that influence the future returns

Analysis of a company’s share value and potential for future profits and dividends, based on accounting and economic information

The study of the economic and financial factors affecting a company’s share price

Question 2

The use of fundamental analysis to identify price inefficiencies relies on the existence of an…

Answer 2

Inefficient market

Question 3

FA consists of two stages:

Answer 3

Modelling
-Construct a model of the company to estimate future cashflows and earnings

Valuation
-Use the output from the 1st stage to determine whether the company’s securities are over-valued or under-valued by the market

Question 4

The key factors affecting the relative demand for individual shares are investors’ expectations for:

Answer 4

Future dividend payments and capital growth

Risks of the business

Question 5

Factors affecting the relative market price of a share

Answer 5

MR CHIMPS

Management ability
-often key influence over success

Retained profits
-low payout ratio = finance future growth or management less confident over future

Competition
-determines market share

History
-compare to last years results for example

Input costs
-growth of these and how it affects profitability

Market growth prospects
-is it in a developing sector or is it a small company

Product quality
-and range

Sustainability and environmental impact of business

Question 6

In order to form a view on these factors (affecting relative market price of a share), a fundamental analyst will investigate

Answer 6

BAD CLAP

Borrowing level
Accounting ratios and financial accounts
Dividend and earnings cover

Comparative figures for other similar companies
Liquidity level
Asset value growth
Profit variability and growth

Question 7

Possible sources of information include

Answer 7

TV FAPS SECs and DD

Trade press
Visits to the company

Financial press and other commercial information prov
Accounts of company’s
Public statements by the company
Stockbrokers’ publications

Statutory information (from gov sources)
Exchange where the securities are listed 
Credit ratings 

Discussions with company management
Discussion with competitors

Question 8

Interest cover

Answer 8

PBIT / Annual interest on debt

Question 9

Capital cover

Answer 9

(Total assets – total liabilities - intangibles) / Balance sheet value of debt

• Measures amount of company equity financed by debt

Question 10

Net asset value per share

Answer 10

(Total assets – total liabilities – intangibles) / number of issued ordinary shares

• can compare to market value per share to determine if share is traded at premium or discount

Question 11

Dividend yield

Answer 11

annual dividend per share/ share price

Question 12

Dividend cover

Answer 12

Earnings per share / dividends per share

• Ability of company to pay its dividends from earnings

Question 13

Return on capital employed

Answer 13

PBIT / Share capital & reserves + long term debt

• shows the profitability and efficiency of company generating returns from its capital employed

Question 14

Return on equity

Answer 14

net profit / net assets

Question 15

Current ratio

Answer 15

Current assets / current liabilities

Question 16

Quick ratio

Answer 16

current assets – inventories / current liabilities

Question 17

Price Earnings

Answer 17

Share price / earnings per share

Question 18

Operating leverage

Answer 18

(sales – variable costs) / PBIT

• gives indication of fixed operating costs level

Question 19

Financial leverage

Answer 19

interest payments / PBIT

• indication of level of fixed financing costs

Question 20

Capital leverage

Answer 20

debt/equity

Question 21

The estimates of future earnings or other relevant factors obtained from a fundamental analysis of a company can be used to calculate a value for the shares using methods such as:

Answer 21

Discounted dividend model

Comparison of PE ratios

Compare some fundamental factor (such as anticipated earnings)

Question 22

Why might the PER of a share be higher than that of another apparently similar share for a company in the same industry?

Answer 22

Shares are thought to be low risk– thus commands a higher share price

Dividends of the company are believed to have a higher growth rate – thus commands a higher price

Recent earnings have been depressed or exceptionally low for a particular one-off reason

Shares are over-priced

Question 23

Credit rating is a four-step process involving an assessment of:

Answer 23

Purpose
- organic growth
- acquisition
- associated company investment
- capital expenditure
- dividend share buy back

Payback (source of repayment/ability to repay)
- cashflow and profit profile over time
- sale of assets and business
- ability to refinance

Risks that could jeopardize repayment
- character and ability to repay
- macro and company-specific issue need to be considered
Macro:
- industry analysis and competitive trends
- regulatory environment
- sovereign macroeconomic analysis
Company specific:
- qualitative analysis
- financial performance
- market position

Structure
-terms and conditions of bond issue

Question 24

The fundamentals of the rating agencies’ approach to rating companies will focus on:

Answer 24

Fundamental risks of the company’s industry

Competitive position

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

Question 25

Financial tests assess:

Answer 25

Financial strength
- Operating leverage
- Financial leverage
- Asset leverage
- Liquidity
- Capital structure

Operating performance
- Profitability (sources and trends)
- revenue composition

Market profile
- Market risk
- Competitive market position
- Spread of risk
- Event risk

Qualitative factors
- Manager experience and objectives

Question 26

4 stages of the Trade Cycle

Answer 26

Economy relatively buoyant
Start of a recession
Bottom of recession
Recovery