Unit 4
COMPANY ANALYSIS
Establishing the Value Benchmark
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-cum-
Differentiation
differentiation
Relative
Differentiation
Position
advantage
advantage
Stuck-in-the
Low cost
middle
advantage
Inferior
Superior
Relative
Cost
Position
Inferior
Gaining Competitive Advantage
By choosing an appropriate strategy, a firm does not necessarily gain
competitive advantage. To do so the firm must develop the required
core competencies (the key economic assets of the firm) and
structure its value chain (the set of activities required to convert
inputs into outputs) appropriately. As Palepu et.al. say: The
uniqueness of a firms core competencies and its value chain and the
extent to which it is difficult for competitors to imitate them
determines the sustainability of a firms competitive advantage.
Gaining Competitive Advantage
To assess whether a firm is likely to gain competitive advantage, the
analyst should examine the following:
The key success factors and risks associated with the firms chosen
competitive strategy.
The resources and capabilities, current and potential, of the firm
to deal with the key success factors and risks.
The compatibility between the competitive strategy chosen by the
firm and the manner in which it has structured its activities (R&D,
design, manufacturing, marketing and distribution, and support).
The sustainability of the firms competitive advantage.
The potential changes in the industry structure and the adaptability
of the firm to address these changes
Strategy of Cost Leadership: Dell Computer
Direct Selling
Build-to-order manufacturing
Low-cost service
Negative working capital
Corporate Strategy Analysis
When you analyse a multi-business firm, you have to evaluate not
only the profit potential of individual businesses but also the
economic implications (positive as well as negative) of managing
different businesses under one corporate canopy.
For example,
General Electric has succeeded immensely in creating significant
value by managing a highly diversified set of businesses ranging
from light bulbs to aircraft engine, whereas Sears has not succeeded
in managing retailing with financial services.
Corporate Sources of Value Creation
Thus, whether a multibusiness firm is more valuable compared to a
collection of focused firms finally depends on the context. The analyst
should examine the following factors to assess whether a firms corporate
strategy has the potential to create value.
Imperfections in the product, labour, or financial markets in the business
in which the firm operates.
Existence of special resources such as brand name, proprietary
knowledge, scarce distribution channels, and organisational processes that
potentially create economies of scope.
The degree of fit between the companys specialised resources and its
portfolio of businesses.
The allocation of decision rights between the corporate office and business
units and its effect on the potential economies of scope.
The system of performance measurement and incentive compensation and
its effect on agency costs.
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
Sources of noise and bias in accounting
Differences between good and bad accounting quality.
The Institutional Framework for Financial
Reporting
The salient features of the institutional framework for financial
reporting are:
Corporate financial reports are prepared on the basis of accrual
accounting and not cash accounting.
Preparation of financial statements involves complex judgments by
management.
GAAP regulates managerial judgement
External auditing is now a near universal requirement.
Sources of Noise and Bias in Accounting
There are several sources of potential noise and bias in accounting
data.
Accounting rules themselves introduce noise and bias as it is
often not possible to restrict managerial discretion without
diminishing the informational content of accounting reports.
Forecasting errors are practically unavoidable.
Managers may introduce noise and bias in accounting
reports, while making their accounting decisions.
Good and Bad Accounting Quality
Good Accounting
Bad Accounting
Quality
Quality
The accounting data focuses
The accounting data fails to
on key success factors and
highlight key success factors
risks
and risks
Managers use their accounting
discretion to make accounting
Managers use their accounting
discretion to disguise reality
numbers more informative
The firm provides adequate
disclosures
to
strategy,
performance,
describe
its
its
current
and
future
The firm just fulfills the
minimal disclosure
requirements prescribed by
accounting regulations
prospects
There are no red flags
There are serious red flags2
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.
Earnings And Dividend Level
To assess the earnings and dividend level, investment analysts look
at metrics like the return on equity, book value per share, EPS,
dividend payout ratio, and dividend per share.
Financials Of Horizon Ltd
ROE : 3 Factors
PAT
ROE
Sales
x
Sales
Net Profit
Margin
Assets
x
Assets
Asset
Turnover
Equity
Leverage
ROE : 5 Factors
PBIT
ROE
Sales
x
Sales
PBT
x
Assets
PAT
x
PBIT
Assets
x
PBT
Net Worth
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
Book Value Per Share And Earnings Per
Share
Book Value Per Share (BVPS)
Paid-up equity capital + Reserves and surplus
Number of equity shares
BVPS
20 x 5
262/15 = 17.47
20 x 6
292/15 = 19.47
20 x 7
332/15 = 22.13
Earnings Per Share (EPS)
Equity earnings
Number of equity shares
EPS
20 x 5
34/15 = 2.27
20 x 6
60/15 = 4.00
20 x 7
70/15 = 4.67
Dividend Payout Ratio And Dividend Per
Share
Dividend Payout Ratio
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
Dividend Per Share (DPS)
DPS
20 x 5
Rs 1.86
20 x 6
2.00
20 x 7
2.00
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.
Compound Annual Growth Rate (CAGR)
The compound annual growth rate (CAGR) of sales, earnings per
share, and dividend per share for a period of five years 20x2 20x7
for Horizon Limited is calculated below:
CAGR of Sales :
Sales of 20 x 7
1/ 5
Sales for 20 x 2
CAGR of earnings
per share (EPS) :
EPS for 20 x 7
EPS for 20 x 2
CAGR of dividend : DPS for 20 x 7
per share (DPS)
DPS for 20 x 2
1=
840
1/ 5
542
1/ 5
1 =
1/ 5
1 =
7.00
6.30
3.00
2.30
1 = 9.2%
1/ 5
1 = 2.1%
1/ 5
1 = 5.5%
Sustainable Growth Rate
The sustainable growth rate is defined as :
Sustanable growth rate = Retention ratio x Return on equity
Based on the average retention ratio and the average return on
equity of the three year period (20x5 20x7) the sustainable growth
rate of Horizon Limited is:
Sustainable growth rate = 0.417 x 18.2% = 7.58%
Risk Exposure
Beta
Beta represents volatility relative to the market
Volatility of Return on equity
Range of return on Equity over n years
Average return on equity over n years
Favourable & Unfavorable Factors
Favourable
Factors
Unfavorable
Factors
Earnings Level
High book value per share
Low book value per share
Growth Level
High return on equity
Low return on equity
High CAGR in sales and EPS
Low CAGR in sales and EPS
High sustainable growth Rate
Low sustainable Growth Rate
Low volatility of return on
equity
Low beta
High volatility of Return on
equity
High beta
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
Going Beyond the Numbers
Sizing up the present situation and prospects
Availability and Cost of Inputs
Order Position
Regulatory Framework
Technological and Production Capabilities
Marketing and Distribution
Finance and Accounting
Human Resources and Personnel
Evaluation of management
Strategy
Calibre, Integrity, Dynamism
Organisational Structure
Execution Capability
Investor - friendliness
Estimation of Intrinsic Value
Estimate the expected EPS
Establish a p / e ratio
Develop a value anchor and a value range
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
924
638
202
74
30
20 x 8
(PROJECTED)
Increase by 10 Percent
708
Increase by 11 Percent
216
81
Increase by 9.5 Percent
34
44
128
47
135
130
25
105
35
70
137
24
113
38
75
15 MLN
RS 4.67
Assumption
15
RS 5.00
No Change
Decrease by 4 Percent
Increase by 8.57 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
PE ratio based on trailing 12 months earnings
PE ratio based on current years expected earnings
PE ratio based on the following years expected earnings
P / E Ratio
Constant Growth Dividend Model
Dividend payout ratio
P / E RATIO
=
Required
return on
equity
P/E
Expected
growth rate
in dividends
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
PE ratio
20 x 5
9.25
The average PE ratio is :
9.25 + 6.63 + 6.23
3
20 x 6
6.63
20 x 7
6.23
= 7.37
Weighted PE Ratio
PE ratio based on the constant
growth dividend discount model
: 6.36
PE ratio based on historical analysis : 7.37
6.36 + 7.37 = 6.87
2
Value Anchor and Value Range
Value Anchor
Projected EPS x Appropriate PE ratio
5.00 x 6.87 = Rs. 34.35
Value Range
Rs.30
Market Price
Rs.38
Decision
< Rs.30
Rs.30 Rs.38
> Rs.38
Buy
Hold
Sell
Tools for Judging Undervaluation or
Overvaluation
PBV-ROE Matrix
Growth-Duration Matrix
Expectations Risk Index
Quality at a Reasonable Price (VRE)
PEG: Growth at a Reasonable Price
PBV-ROE Matrix
HIGH
PBV Ratio
LOW
Overvalued
Low ROE
High PBV
High ROE
High PBV
Low ROE
Low PBV
Undervalued
High ROE
Low PBV
LOW
HIGH
ROE
Growth-Duration Matrix
High
Undervalued
Promises of
growth
Dividend
cows
Overvalued
Expected 5-Yr
EPS Growth
Low
Low
High
Duration (1/Dividend Yield)
Expectations Risk Index (ERI)
Developed by Al Rappaport, the ERI reflects the risk in
realising the expectations embedded in the current market
price
Proportion of stock
ERI =
price depending on
expected future growth
Ratio of expected future
X
growth to recent growth
(Acceleration ratio)
ERI Illustration
Omegas price per share
= Rs.150
Omegas operating cash flow
= Rs.10 per share
(before growth investment)
Omegas cost of equity
Growth rate in after-tax cash operating
earnings over the past three years
= 15 percent
= 20 percent
Market expectation of the growth in after-tax
cash operating earnings over the next three
years
= 50 percent
ERI Illustration
Omegas base line value =
Rs.10
0.15
= Rs.66.7
Proportion of the stock price coming
from investors expectations of future =
growth opportunities
Acceleration ratio =
150 66.7
150
= 0.56
1.50
1.20
= 1.25
ERI = 0.56 x 1.25 = 0.70
In general, the lower (higher) the ERI, the greater (smaller) the
chance of achieving expectations and the higher (lower) the expected
return for investors.
Quality at a Reasonable Price
Determining whether a stock is overvalued or undervalued is often
difficult. To deal with this issue, some value investors use a metric
called the value of ROE or VRE for short.
The VRE is defined as the return on equity (ROE) percentage
divided by the PE(price-earning) ratio. For example, if a company
has an expected ROE of 18 percent and a PE ratio of 15, its VRE is
1.2 (18/15).
According to value investors who use VRE:
A stock is considered overvalued if the VRE is less than 1.
A stock is worthy of being considered for investment, if the VRE is
greater than 1.
A stock represents a very attractive investment proposition if the
VRE > 2
A stock represents an extremely attractive investment proposition if
the VRE > 3
PEG: Growth at a Reasonable Price
What price should one pay for growth? To answer this difficult
question, Peter Lynch, the legendary mutual fund manager,
developed the so-called PE-to-growth ratio, or PEG ratio. The PEG
ratio is simply the PE ratio divided by the expected EPS growth rate
(in percent). For example, if a company has a PE ratio of 20 and its
EPS is expected to grow at 25 percent, its PEG ratio is 0.8 (20/25).
PEG: Growth at a Reasonable Price
Proponents of PEG ratio believe that:
A PEG of 1 or more suggests that the stock is fully valued.
A PEG of less than 1 implies that the stock is worthy of being considered
for investment.
A PEG of less than 0.5 means that the stock possibly is a very attractive
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.
Obstacles in the Way of an Analyst
Inadequacies or incorrectness of data
Future uncertainties
Irrational market behaviour
Excellent Versus Unexcellent Companies
In general, it appears that financial performance of
excellent companies deteriorates whereas financial
performance of non-excellent companies improves.
Empirical evidence of this kind reflects the phenomenon of
reversion to the mean which says that, over time, financial
performance of companies tends to converge to the average
value of the group as a whole. Thanks to this tendency,
good past performers are likely to produce inferior
investment results and poor past performers are likely to
produce superior investment results.
Equity Research in India
Traditionally, lip sympathy was paid to equity research. Financial
institutions (mutual funds, in particular) had a research cell because
it was in good form to have one. Likewise, large brokers set up
equity research cells to satisfy their institutional clients. In the mid1980s more progressive firms like Enam Financial, DSP Financial
Consultants, and Motilal Oswal Securities Limited set up research
divisions to exploit the opportunities in the equity market. With the
entry of foreign institutional investors and the emergence of more
discerning investors, the need for equity research is felt more widely.
Indeed, currently equity research is a growing area.
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.
How to Make Most of Stock Research
Reports
To make the most of stock research reports, follow these guidelines:
Dont trust a research report naively. Use it as a starting point and
do your own due diligence before acting on it.
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.
