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Knowledge Corner

Fundamental Analysis in Capital Markets -II

Valuation methodologies:
In the top-down approach, an analyst investigates both international and domestic economic indicators, such as GDP growth rates, energy prices, inflation, interest rates etc. The search for the best security then trickles down to the analysis of total sales, price levels and foreign competition etc. in a sector in order to identify the best business in the sector. In the bottom-up approach, the analyst starts the search with specific businesses, irrespective of their industry/region.
Top-Down Valuation (E-I-C Analysis):
The stock market does not operate in a vacuum. It is an integral part of the whole economy of a country. To gain an insight into the complexities of the stock market one needs to develop a sound economic understanding and be able to interpret the impact of important economic indicators, which may be studied to assess the national economy as a whole. The leading indicators predict what is likely to happen to an economy. Perfect examples of leading indicators are the unemployment position, rainfall and agricultural production, fixed capital investment, corporate profits, money supply, credit position and the index of equity share prices. An overall growing or a contracting economy affects every industry in the country positively or negatively. One can seldom find flourishing industries in an otherwise stagnant economy. Thus, understanding economy and capital flows, interest rate cycles and currency fluctuations, etc. is very important as it impacts the stock prices.
Economic Indicators
An economic indicator (or business indicator) is a statistic about the economy. Economic indicators allow analysis of economic performance and predictions of future performance. Economic indicators include various indices, earnings reports and economic summaries, such as unemployment, housing starts, consumer price index (a measure for inflation), industrial production, bankruptcies, Gross Domestic Product, broadband internet penetration, retail sales, stock market prices, money supply changes etc. Economic indicators are primarily studied in a branch of macroeconomics called “business cycles”.
Economic indicators fall into three categories: leading, lagging and coincident.
Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines and they improve before the economy begins to pull out of a recession.
Baltic Dry Index, an index that tracks bulk dry freight rates across the world is another leading indicator and indicates a slowdown in the bookings for bulk dry carriers with its fall and thus indicating a subsequent slowdown in the international trade. Leading economic indicators are the most important type for investors as they help predict what the economy will be like in the future.
A lagging economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a lagged economic indicator as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.
Coincident indicators are those which change at approximately the same time and in the same direction as the whole economy, thereby providing information about the current state of the economy. Personal income, GDP, industrial production and retail sales are coincident indicators. A coincident index may be used to identify, after the fact, the dates of peaks and troughs in the business cycle.
Many different groups collect and publish economic indicators in different countries. In the U.S. the collection of economic indicators is published by the United States Congress. Their Economic Indicators are published monthly and are available for download in PDF and text formats. The indicators fall into seven broad categories. Each of the statistics in these categories helps create a picture of the performance of the economy and how the economy is likely to do in the future.
Total Output, Income, and Spending
These tend to be the broadest measures of economic performance and include such statistics as the Gross Domestic Product which is used to measure economic activity and thus is both pro-cyclical and a coincident economic indicator. The Implicit Price Deflator is a measure of inflation. Inflation is procyclical as it tends to rise during booms and falls during periods of economic weakness. Measures of inflation are also coincident indicators. Consumption and consumer spending are also pro-cyclical and coincident.
Employment, Unemployment, and Wages
The unemployment rate is a lagged, countercyclical statistic. The level of civilian employment measures how many people are working so it is pro-cyclic. Unlike the unemployment rate it is a coincident economic indicator.
Production and Business Activity
These statistics cover how much businesses are producing and the level of new construction in the economy. Changes in business inventories are an important leading economic indicator as they indicate changes in consumer demand. New construction including new home construction is another pro-cyclical leading indicator which is watched closely by investors. A slowdown in the housing market during a boom often indicates that a recession is coming, whereas a rise in the new housing market during a recession usually means that there are better times ahead.
  • Prices - This category includes both the prices consumers pay as well as the prices businesses pay for raw materials and include:
  • Producer Prices [monthly]
  • Consumer Prices [monthly]
  • Prices Received and Paid by Farmers [monthly]
These measures are all measures of changes in the price level and thus measure inflation.
Money, Credit, and Security Markets
These statistics measure the amount of money in the economy as well as interest rates and include:
  • Money stock (M1, M2, and M3) [monthly]
  • Bank Credit at all commercial banks [monthly]
  • Consumer credit [monthly]
  • Interest rates and bond yields [weekly and monthly]
  • Stock prices and yields [weekly and monthly]
Nominal interest rates are influenced by inflation, so like inflation they tend to be pro-cyclical and a coincident economic indicator. Stock market returns are also pro-cyclical but they are a leading indicator of economic performance.
Government Finance
These are measures of government spending and government deficits and debts:
  • Budget Receipts (Revenue)[yearly]
  • Budget Outlays (Expenses) [yearly]
  • Union Government Debt [yearly]
Governments generally try to stimulate the economy during recessions and to do so they increase spending without raising taxes. This causes both government spending and government debt to rise during a recession, so they are countercyclical economic indicators. They tend to be coincident to the business cycle.
International Trade
These are measure of how much the country is exporting and how much they are importing:
  • Industrial Production and Consumer Prices of Major Industrial Countries
  • International Trade In Goods and Services
  • International Transactions
When times are good people tend to spend more money on both domestic and imported goods. The level of exports tends not to change much during the business cycle. So the balance of trade (or net exports) is countercyclical as imports outweigh exports during boom periods. Measures of international trade tend to be coincident economic indicators. While we cannot predict the future perfectly, economic indicators help us understand where we are and where we are going which is of great help when assessing the overall health of the economy.
Fundamental analysis consists of a detailed analysis of a specific industry; its characteristics, past record, present state and future prospects. The purpose of industry analysis is to identify those industries with a potential for future growth and to invest in equity shares of companies selected from such industries. We look at the product lifecycle phase and competitive outlook in a particular industry to gauge the overall growth and competitive rivalry amongst the players in the industry.
At the final stage of fundamental analysis, the investor analyses the company. This analysis has two thrusts:
  • How has the company performed vis-à-vis other similar companies? and
  • How has the company performed in comparison to earlier years
It is imperative that one completes the economic analysis and the industry analysis before a company is analyzed because the company’s performance at a period of time is to an extent a reflection of the economy, the political situation and the industry.
What does one look at when analyzing a company?
There is no point or issue too small to be ignored. Everything matters.
The different issues regarding a company that should be examined are:
  • The Management
  • The Company
  • The Annual Report
  • Cash flow
  • Ratios
The Management
The single most important factor one should consider when investing in a company and one often overlooked, is its management. It is upon the quality, competence and vision of the management that the future of company rests. A good, competent management can make a company grow while a weak, inefficient management can destroy a thriving company. Indian corporate history has many examples where an able and visionary management has worked wonders for companies and their stock prices. Sunil Mittal of Bharti Airtel, Azim Premji of Wipro, Narayan Murthy of XYZ, Deepak Parekh of HDFC, are few such examples where the management of the companies headed by strong leadership have helped companies create significant wealth for their investors.
In India, management can be broadly divided in two types:
  • Family Management
  • Professional Management
Discounted Cash Flow (DCF) Models
In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. The cash flow could be either the dividend which is actually paid out to shareholders or free cash flow which is accrued to the firm or to the shareholders. The basic principle behind the DCF models is that every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. The information required in order to find out the intrinsic value of any asset using DCF is :
  • to estimate the life of the asset
  • to estimate the cash flows during the life of the asset
  • to estimate the discount rate to apply to these cash flows to get present value.
In case of a stock, the assumption of going concern entails that we use perpetuity as our estimated life of a company (and hence stock) unless conditions require assumptions otherwise. The estimate of cash flow could be divided as, Free Cash Flow to Firm (FCFF) or Free Cash Flow to Equity (FCFE) depending upon the exact method of DCF valuation we choose. The discount rate used to deduce the present value should reflect the uncertainty (risk) of the cash flows and opportunity cost of capital
Dividend Discount Model (DDM)
In the strictest sense, the only cash flow you receive from a firm when you buy publicly traded stock is the dividend. The simplest model for valuing equity is the dividend discount model -- the value of a stock is the present value of expected dividends on it. While many analysts have turned away from the dividend discount model and viewed it as outmoded, much of the intuition that drives discounted cash flow valuation is embedded in the model. In fact, there are specific companies where the dividend discount model remains a useful tool for estimating value.
Relative Valuation
In relative valuation, the value of an asset is compared to the values assessed by the market for similar or comparable assets. To do relative valuation then
  • we need to identify comparable assets and obtain market values for these assets.
  • convert these market values into standardized values, since the absolute prices cannot be compared This process of standardizing creates price multiples.
  • compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the multiple, to judge whether the asset is under or overvalued.
Most valuations in the markets are relative valuations
  • Almost 85% of equity research reports are based upon a multiple and comparables.
  • More than 50% of all acquisition valuations are based upon multiples
  • Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments. While there are more discounted cash flow valuations in consulting and corporate finance, they are often relative valuations masquerading as discounted cash flow valuations.
  • The objective in many discounted cash flow valuations is to back into a number that has been obtained by using a multiple.
  • The terminal value in a significant number of discounted cash flow valuations is estimated using a multiple.
Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when, the objective is to sell a security at that price today (as in the case of an IPO) investing on “momentum” based strategies with relative valuation, there will always be a significant proportion of securities that are Undervalued and overvalued. Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs. Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens).
Even if you are a true believer in discounted cash flow valuation, presenting your findings on a relative valuation basis will make it more likely that your findings/recommendations will reach a receptive audience. In some cases, relative valuation can help find weak spots in discounted cash flow valuations and fix them. The problem with multiples is not in their use but in their abuse. If we can find ways to frame multiples right, we should be able to use them better.
Price / Earnings Ratio:
Price-to-earnings ratio is popular in the investment community. Earnings power is the primary determinant of investment value.
PE = Market Price per Share / Earnings Per Share
There are a number of variants on the basic PE ratio in use. They are based upon how the price and the earnings are defined.
Price: is usually the current price is sometimes the average price for the year
Earnings Per Share (EPS):
  • earnings per share in most recent financial year
  • earnings per share in trailing 12 months (Trailing PE)
  • forecasted earnings per share next year (Forward PE)
  • forecasted earnings per share in future year
Trailing P/E or P/E TTM
Earnings per share is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. This is the most common meaning of PE ratio if no other qualifier is specified. Monthly earning data for individual companies are not available, so the previous four quarterly earnings reports are used and EPS is updated quarterly. Note, companies individually choose their financial year so the schedule of updates will vary.
Trailing P/E from continued operations
Instead of net income, uses operating earnings which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls and write-downs), or ccounting changes.
Forward P/E or Estimated P/E:
Instead of net income, uses estimated net earnings over next 12 months. Estimates are typically derived as the mean of a select group of analysts (note, selection criteria is rarely cited). In times of rapid economic dislocation, such estimates become less relevant as “the situation changes” (e.g. new economic data is published and/or the basis of their forecasts become obsolete) more quickly than analysts adjust their forecasts. Based on XYZ’S EPS of Rs. 101 for the year FY21, the trailing 12 month PE of XYZ at a price of Rs. 2200 per share works out to be 22X. If we come up with an estimated EPS of Rs. 120 for FY22 based on our analysis and assume the same PE multiple of 22X (Forward P/E) for the next year, then the target price works out to be (22 * 120) Rs. 2640.
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