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1

Equity fundamental analysts

use a variety of techniques to try to determine whether a share is over- or under-valued by the market. Most methods involve an attempt to obtain a better estimate of future earnings or dividends, either by the use of a superior model or by the use of information which hasn’t been taken into account by the market.

2

Equity fundamental analysis process:

The process can be considered as consisting of two stages.
1. The first is the construction of a model of the company which allows 
future cash flows and earnings to be estimated. 

2. The second involves the use of the output from the first stage to determine whether the company’s securities are over- or under-valued by the market. In practice, a wide range of techniques is used and the degree of sophistication employed varies greatly.

3

fundamental analysis as consisting of the following two steps:

1. Construct an appropriate financial model of the company and use it to project the future stream of earnings that it will produce. Depending upon the methodology employed, these predictions relate to the future stream of dividends that you expect to receive from owning the shares of the company. Equally they might be based on some definition of earnings, such as profit before interest and tax and/or economic value added (EVA). 

2. Use these predictions to assess the relative cheapness or dearness of the shares.

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This second step might involve:

  estimating the “true” value of the share and comparing it to the actual market price, eg using the discounted dividend model. 

  calculating an appropriate ratio, the value of which might be compared to that of other similar shares or to a “normal” value, eg the price earnings ratio (PER). 


5

key factors affecting relative demand for individual shares are investors’ expectations of

  future dividend payments 

  future capital growth 

  the risks of the business
and thus the uncertainty of estimates of the above. 



Factors that drive expectations for capital and dividend growth are estimates of profits, free cashflow, and total enterprise value. 

You may recall from Subject A301 the discounted dividend model, which is sometimes used to place a value on individual shares. As its name suggests, this model values a share as the discounted present value of the future stream of dividends that it is expected to yield. Expectations of dividend growth are therefore of the utmost importance in the valuation of shares. 
The discounted dividend model calculates a fundamental value of a share based on the predicted pattern of future dividends, which will normally be estimated following a detailed analysis of the fundamental characteristics of the company in question. As such it is an example of a numerical valuation methodology used in the second stage of fundamental share analysis. 
Changing economic factors affect different companies to different extents and possibly in different ways and so alter their relative share prices. 
For example, a company that sells luxury goods (like expensive motor cars) may be more sensitive to the state of the economy than one that sells a necessity (eg a food retailer). Risk generally refers to the statistical variability of the returns yielded by a security. In financial economic theory, it is often interpreted as the variance or standard deviation of investment returns. In this respect, cyclical companies like the car manufacturer are likely to be more risky than defensive companies such as the food retailer.

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important to note that:


  the value of any company’s shares will reflect a combination of the macroeconomic influences that affect all companies to some extent, industry- specific influences and factors specific to that particular company 

  the application of fundamental analysis is extremely subjective and requires much skill and experience. Consequently, different investors will usually produce differing estimates of the fundamental value of a share – even if they have access to identical information, which may not always be the case. 
Fundamental analysis can be applied at an industry and economy level as well at the individual company level. Indeed it is necessary to undertake a fundamental analysis of the economy as a whole and of a particular industry before assessing the prospects for an individual company. Increasingly, as enterprises and markets globalise, a global analysis will be required, at least in broad terms, in order to make a sensible assessment of the prospects for a single company. 
Issues regarding the financial management of organisations, introduced in the Core Reading for Subject A103, are of particular relevance here. 


7

One way of generating ideas in an exam about the factors that influence a particular company might therefore be to think in terms of the:

  global economy 

  domestic economy 

  industry 

  specific firm.

8

Modelling the company

The key factors driving the profits of a particular company will need to be identified and analysis focussed on them. The analyst will therefore need to have a good understanding of the company’s business. In some cases a cashflow model may be used to examine the impact of various economic scenarios on profits.

9

For which types of company will an international approach to fundamental analysis be particularly important?

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10

Estimating future cashflows and earnings

The ability of a company to generate profits is a vital factor in determining the value of its shares, so profit forecasting is often the starting point for valuing shares.

One approach involves forecasting future sales and costs for the company, building in wage and price inflation and the state of the national and international economies. Income statements (profit and loss accounts) for future years can then be drawn up.
Estimates will have to be made about rates of interest on overdrafts and any new loan stock issues. Where a company carries out separate operating divisions (eg brewing and hotel ownership) it would be normal to carry out separate projections for each operating division.
This may require a considerable amount of time and effort in order to achieve accuracy – though even then the analyst must be wary of spurious accuracy results. Even the most detailed analysis is unlikely to produce entirely accurate estimates of future cashflows, particularly beyond the next year or two.
Many of the techniques employed by fundamental analysts to predict the future performance of a company are similar to those used by the company’s own management. However, the investment analyst does not have access to the detailed information available to the company managers.
In other words, the external investment analyst does not have access to the inside information enjoyed by internal management. Consequently, the level of analysis that can be carried out is much more limited in scope.

11

Factors affecting the relative market price of a share

Each company needs to be considered individually, but some important general factors are:
  management ability – if the company’s management is highly-regarded, investors will have more confidence in the profit prospects of the company. This is because the management typically have a key influence over the success or otherwise of a company. 

  quality of products – a company with a good range of products should be able to maintain and increase future profitability, although the current level of profits may already fully reflect the quality of products. More generally, different valuation might be placed on two otherwise similar companies, one of which has a range of successful products, whereas the other is heavily dependent on a particular product.


  prospects for market growth – these will influence the potential growth rate of the individual companies within the industry. A large company in a mature industry may have lower growth prospects than a small company in an expanding industry. 

  competition – which will determine market share and perhaps also both turnover and profit margins. For example, where the market believes that the industry in which the company operates will become more competitive, the PER for the company will be lower. 

  input costs – analysts might have a view that the cost items (rent, interest, wages) for a particular company may grow more (or less) quickly than prices, so reducing (increasing) profit margins and hence profits. 

  retained profits – a low payout ratio may mean that a company is (sensibly) retaining profits to finance future growth or alternatively that the management is less confident of future growth prospects. 

  history – the recent trend in performance will influence how the current performance is interpreted. For example, a current profit of $10m may be interpreted more favourably if last year’s profit was $6m compared to if last year’s profit was $12m.

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In order to form a view on these factors, a fundamental analyst will investigate:

  the financial accounts and accounting ratios 

  dividend and earnings cover 

  profit variability and growth (by looking at all sources of revenue and expenditure) – profit is a relatively small number calculated as the difference between two larger numbers and so can vary greatly 

  the level of borrowing 

  the level of liquidity 

  growth in asset values 

  comparative figures for other similar companies

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many other sources of information which include:

  the financial press and other commercial information providers 

  the trade press 

  public statements by the company 

  the exchange where the securities are listed 

  government sources of statutory information that a company has to provide – ie information provided to the regulator 

  visits to the company 

  discussions with company management 

  discussions with competitors 

  stockbrokers’ publications 

  credit ratings if they are available.

14

You have been asked to analyse two companies in the food retailing sector and to recommend one of them for investment. List the factors relating to the companies that you would investigate when assessing the ability of the management teams of each company.

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15

Valuation

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 the discounted dividend model or a comparison of price earnings ratios. The fundamental share value obtained can be compared with the market value and a decision made on whether the share is a candidate for buying or selling. It should be noted that a particular analyst’s fundamental value may differ from the market value even if the share is correctly priced by the market. This will occur if the analyst’s required rate of return is different from that of the market.
Recall that the price earnings ratio (PER) is defined as: ordinary share price
earnings per share



One way of using the PER to assess whether a particular share is cheap or dear is simply to compare its value to that of other similar companies. A higher/lower than industry average PER perhaps indicating that the share is over-priced or under-priced.
If, say, the share appears to be under-priced, it may be possible to make short-term profits by purchasing it ahead of the anticipated market correction that will occur once other investors realise that it is under-priced. Conversely, a fundamental value less than the market price may imply a decision either not to buy or instead to sell existing holdings.
Another approach is to avoid making a full valuation but to compare some fundamental factor (such as anticipated earnings) with the market’s consensus estimate. If the analyst’s estimate is more optimistic than the market’s then he or she might regard the share as good value.
Note that if an analyst uses this method she is explicitly accepting the market’s view of all the other factors affecting the share’s value (eg riskiness, growth prospects).

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Determination of the current market price

Fundamental analysis can therefore have an important influence upon the investment decisions of the investor as regards a particular share, though other factors – for example, technical analysis, which we discuss later in the course – may also have a bearing. It is the interaction of all of these individual decisions that produces the aggregate demand for the share in question, which in turn determines the current share price.
Consequently, the share price will reflect the estimates of fundamental value by the marginal investor – who is indifferent between buying and selling the share at its current price. For the marginal investor, the fundamental value will equal the current share price. For all other investors, the fundamental value of a share will differ from its current price. For example, to those who hold a share, its fundamental value will be at least as great as its market price (otherwise they would not hold it).

17

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

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18

Credit analysis for bond investment

Credit rating involves a thorough investigation of the financial condition of an entity in order to assess the likelihood that the entity will fail to the meet the interest payments and the repayment of principal under a financing agreement – usually the issue of debt. As discussed in Chapter 3, credit risk is a key consideration when investing in corporate bonds.

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the purpose for which the loan is required.

What does the company do and why do they need to borrow? Possible reasons
for seeking finance include:
  organic growth – ie expanding the existing operations, perhaps by recruiting additional staff and purchasing additional materials in order to expand the existing operation 

  acquisition – ie taking over another company 

  investment in an associated company – ie acquiring sufficient shares to 
obtain influence over another company, but without buying a controlling stake 

  capital expenditure – eg investing in a new factory or office 

  dividend / share buy-back – although companies don’t often borrow specifically to finance a share buy-back or a dividend payout in practice. 
When rating credit, it is important to consider how the raising and subsequent spending of the monies raised may affect the financial strength of the company

20

Payback

This relates to the ability to repay the loan.
What is the expected source of repayment? Is there a secondary source? 
Issues to consider include:
  cashflow / profit profile (over time) – ie whether future internal cashflows will 
be sufficient to repay borrowings when they fall due 

  possible sale of assets and / or businesses 

  refinancing – ie by raising further funds in the future.

21

Risks

This relates to the character and ability of the borrower and its ability to repay.
What risks (quantitative and qualitative) could jeopardise debt servicing in
future? Factors to consider include:
  macro considerations:
–  industry analysis and competitive trends – ie the growth prospects for the industry as a whole and how the total market will be split between the different companies operating within the industry. 

–  regulatory environment – which might change in a way that affects the financial position of the company 

–  sovereign macroeconomic analysis – in order to assess the state of the economy in which the company operates. This will often include an assessment of the “creditworthiness” of the particular country in order to obtain a rating for its sovereign (ie government) debt. (Problems with sovereign debt may be indicative of problems with corporate debt. ) 

  company-specific issues:
–  qualitative analysis – of factors such as the company’s management, 
technology, range of goods and services, etc 

–  financial performance – eg the trends in its financial ratios (profitability, liquidity, etc), both the historical trends over recent years and projections of future trends over the next two or three years 

–  market position – relative to its competitors, as reflected in its market share.

22

Structure

Does the bond structure reflect the risks and protect investors’ interests (Structure, Status, Safeguards, Pricing)? 
In other words, what are the terms and conditions of the particular bond issue? 


23

What particular terms and conditions might we wish to consider when assessing a bond issue?

.

24

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

  fundamental risks of the company’s industry – which will reflect the type of industry in which the company operates; for example, cyclical or defensive, global or predominantly domestic 

  competitive position (relative to peers) 

  downside risk vs. upside potential 

  quality of profitability vs. EPS growth – ie we need to consider the security/stability of profits as well as the projected growth rate 

  cashflow generation vs. book profitability – ie whether the company is actually getting the cash in 

  forward looking analysis – ie projecting the possible future experience of the company 

  strategy, management track record and risk appetite – ie business plans and the character and ability of management 

  capital structure and financial flexibility.

25

General approach to credit rating

Ratings will be formally evaluated at least once every 12 months and following any significant event. Significant events might include a merger or takeover, the launch of a new project, a rights issue or a bond issue. 
The formal review is based on comprehensive information, both public and private (background and supplemental rating questionnaires). An important component is frequent meetings and discussions between rating analysts and company management, providing crucial information and understanding of the company’s operations, financial condition, competitive market position and future business plans. 
Rating opinions are based on an evaluation of a company’s financial strength, operating performance and market profile. Quantitative evaluation will typically involve assessment of performance over at least 5 years, using a battery of financial tests. 
Examples include the following financial factors under the headings of:
  financial strength 

  operating performance 

  market profile. 


26

Financial strength

This can be assessed in terms of:
  operating leverage 

  financial leverage 

  asset leverage (quality, market value and diversification of assets, exposure to investment and credit risk) 

  capital structure (including holding company capital structure, where relevant) 

  liquidity (quick and current ratios, operational and net cashflows). Operating leverage can be measured as: 
sales - variable costs profit before interest & tax 
It gives an indicator of a company’s level of fixed operating costs.
The term financial leverage is often used to refer to income gearing, which can be 
measured as: 
interest payments profit before interest & tax 
and gives an indication of the level of fixed financing costs. Asset or capital leverage is typically measured as either: 
debt or debt debt + equity equity 
based on balance sheet values. 
Capital structure just refers to the financial structure of the company, ie the balance between debt and equity (and also anything else eg preference shares, short-term borrowings etc)

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operating performance of a company can be assessed by considering its:

  profitability (sources, trends) – ie which goods and services generate its profits 

  revenue composition – ie sales of necessity/defensive goods, sales of luxury/cyclical goods, revenue from overseas subsidiaries, income from investments, exceptional items etc. 
Market profile 
The company’s market profile in terms of:
  market risk (systematic and specific) – ie the risks relating to the market sector as a whole. These will reflect the experience of both the economy as a whole (systematic risk) and that of the particular sector (specific risk) 

  competitive market position – within the sector 

  spread of risk – across different markets 

  event risk – ie exposure to specific events, such as takeover. 
Qualitative factors will include assessment of management experience and objectives, particularly with regard to the achievement of future business plans. 
Discussions with the management will be especially important here in order to assess what their aims and objectives are.

28

The role of credit rating agencies

Bond issuers have found that they are more successfully able to raise funds if they maintain credit ratings with a recognised ratings agency. Currently there are three major global ratings agencies: Fitch Ratings, Moody’s Investor Services and Standard & Poor’s. The cost of obtaining a rating is met by the issuer.

29

Explain briefly what are meant by operating leverage and financial leverage.

Ratings agencies apply a mix of qualitative and quantitative analysis in carrying out their assessments, and also have direct access to senior officers of the issuer. Having carried out their analysis, they form a view and provide an issuer rating and a bond rating (which can be higher or lower than the issuer rating, and differ from other bonds from the same issuer). Ratings agencies provide significant amounts of detail on their methodologies, however they do not provide detailed supporting information relating to their specific assessments.
Historically, many bond investors have tended to place significant reliance on issuer and bond credit ratings, rather than carry out their own credit analysis independently. For smaller investors, this may be appropriate on the grounds of lower costs relative to buying independent research or building an internal team of credit experts. However, for larger investors these factors are less compelling and it is generally considered desirable to obtain or carry out independent research in addition to monitoring ratings.
During the Financial Crisis of 2008-–2009, ratings agencies came under criticism for the fact that they had underappreciated the extent of systemic risks across the fixed income universe, primarily within the financial sector and particularly for structured credit issues. Whilst this was arguably rectified as the crisis unfolded as evidence accumulated about the deteriorating creditworthiness of individual bonds or loans, a number of bonds were subject to multiple downgrades within very short periods. In most cases, bond prices had fallen significantly before downgrades were announced, implying that ratings were lagging indicators of weakening creditworthiness compared to observable bond prices.

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Economy moderately buoyant, no real prospects of rapid growth or recession

If the economy is moderately buoyant and profits are fairly stable, both defensive and cyclical companies might be similarly rated, ie have similar PERs. The range of PERs might be quite narrow.

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Changes in the economic environment affect companies in different ways.

For example, using historic price/earnings ratios (PERs), the valuation of some companies varies relative to others over the course of the trade cycle.
The fortunes of some companies are very closely linked to the state of the economy. When the economy is booming, their profits are high. When the economy is flat, their profits are low. These are known as “cyclical” companies (eg construction companies). The share price of cyclical companies relative to the rest of the market will therefore depend on the current state of the economy and the extent to which the stock market has discounted expected future changes in the economy.
The standing of cyclical companies relative to defensive companies such as food retailers (ie ones that are relatively immune to the state of the economy) is usually as follows.

32

Economy starts to move into recession

As the economy starts to move into recession, PERs for cyclical companies are likely to fall as the market starts to anticipate a drop in profits, while those of defensive companies will remain stable or may even rise slightly.

33

Economic recession: “bumping along at the bottom”

At the bottom of the cycle PERs of cyclical companies will probably have risen from their low point as earnings have fallen, but defensive stocks will still be more highly rated (ie higher PERs). A company that has made exceptionally low profits might have a very high PER. No PER is given for companies that make losses.

34

Green shoots of recovery


As the economy starts to recover, the PER of cyclical companies will rise as the price increases in anticipation of future earnings growth. PERs of defensive companies may be below those of cyclical companies.

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ratios

1. interest cover = profit before interest & tax annual interest on debt 

2. capital cover = total assets - current liabilities - intangibles balance sheet value of debt 

3. net asset value per share = ordinary shareholders' funds - intangibles number of issued ordinary shares 

4. dividend yield = dividend per share price of ordinary share 

5. dividend cover = earnings per share dividends per share 

6. return on capital employed = profit before interest & tax
share capital & reserves + long - term debt 

or return on capital employed = profit before tax share capital & reserves
7. current ratio = current assets current liabilities

36

Operating leverage refers to

the level of a company’s fixed operating costs. Thus, a company with high fixed operating costs and low marginal costs is said to have high “operational” leverage, so that a small change in sales gives a big change in profits. 
Financial leverage refers to the level of company’s fixed financing, ie interest costs. A company with lots of fixed interest borrowing is “highly-leveraged”, so that a small change in the profits before interest and tax can have a very large proportionate impact on the profits for shareholders.