bd job traning session 4

8/6/2019 BD Job Traning Session 4

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Welcome to

professional development

workshop

Fundamentals of Stock Market

Jointly organized by LankaBangla Securities Ltd (LBSL) and Bdjobs

Training


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Fundamental Analysis

Conductor: Md. Ashaduzaman Riadh


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Efficient Capital market

An efficient capital market is one in which security prices

adjust rapidly to the arrival of new information and,

therefore , the current prices of securities reflect allinformation about the security. Assumptions are:

I) A large number of profit-maximizing participants analyze

and value the securities

II) New information regarding securities comes to themarket in a random fashion and the timing of one

information is generally independent of others.


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Efficient Capital market

III) Profit maximizing investors adjust security prices

rapidly to reflect the effect of new information.

III) In an efficient market ,the expected returns implicit inthe current price of the security should reflect its risk.


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Form of hypothesis

Weak-form EMH- assumes that current stock prices fully

reflect all security market information.

Semi strong -form EMH- asserts that security pricesadjust rapidly to the release of all public information

apart from public information.

Strong-Form EMH- contends that stock prices fullyreflect all information from public and private sources.

That means that no group of investor has monopolistic

information relevant to the formation of prices.


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In what Form we belong?

studies:

I ) Stock split

II ) The size effect

III) Neglected Firm effect

IV) Book Value-Market Value Ratio

V) P/E ratio

VI) Announcement of Accounting changes


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Efficient Market and Fundamental Analysis

Fundamental analysis believe that , at any point of time ,

there is a basic intrinsic value for the individual securities

and these value depends on the underlying economic

factors. Therefore the investor should determine theintrinsic value of an investment asset at a point in time

by examining the variables that determine the value such

as :

I) Economic Factors

II) Industry Factors

III) Sales and Cost structure

IV) Current and Future earnings , Cash Flow and Risk

factors.


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Efficient Market and Fundamental Analysis

If the prevailing market price differs from the estimated intrinsic value by

enough to cover the transactions cost , you should take appropriate action:

Buy if the market price is substantially below intrinsic value

Sell or dont buy- if market price is above the intrinsic Value.

Fundamental analyst believe that, occasionally , market price and intrinsic

value differ but eventually investors recognize the discrepancy and correct

it. An investor who can do a superior job of estimating intrinsic value can

consistently make superior market timing ( asset allocation ) decisions or

acquire undervalued securities and generate above-average returns.


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Fundamental Analysis

Fundamental Analysis involves:

I) aggregate market analysis ,

II) industry analysis ,

III) company analysis ,

IV) and portfolio management.


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Intrinsic value and equity valuation

A critical assumption in equity valuation, as applied to

publicly traded securities , is that the market price of a

security can differ from its intrinsic value. The intrinsic

value of any asset is the value of the asset given its

hypothetically complete understanding of the assets

investment characteristics. If one assumed that the

market price of an equity security perfectly reflected its

intrinsic value , Valuation would simply require looking at

the market price.


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Valuation Process

1. Understanding the Business- industry and competitive

analysis, together with an analysis of financial

statements and other company disclosures, provides a

basis for forecasting company performance.

2. Forecasting company performance- forecasts of sales,

earnings, dividends , and financial position (pro forma

analysis) provide the inputs for most valuation models.

3. Selecting the appropriate valuation model: Depending

on the characteristics of the company and the context of

valuation , some valuation models will be more

appropriate than others.


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Valuation Process

4. Converting forecasts to a valuation- Beyond

mechanically obtaining the output of valuation models,

estimating value involves judgment.

5. Applying the valuation conclusion


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1) Understanding the Business:

Industry and competitive analysis, together with an analysis

of the companys financial reports, provides a basis for

forecasting performance.


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1.1 Economic Analysis

Economic Indicators

Primary economic variables that are used to determine the position on the business cycle.

Leading Indicators - may indicate where the economy will be in the next 3 to 6 months.

Money Supply

Interest Rate Spread

Lagging Indicators - Economic indicators that usually change direction after businessconditions have changed.

Average duration of unemployment (in weeks)

Change in labor cost per unit of output in manufacturing

Average Prime Rate charged by Banks

Commercial and Industrial Loans Outstanding Changes in Consumer Price Index for

services


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1.2) Industry Analysis: Business cycle

Recovery : The Economy picks up from its slowdown or

recession. Good investments to have are the countrys

cyclical stocks and commodities and riskier assets.

E

arly uprising: confidence is up. Good investments tohave are the countrys stocks and also commercial and

residential property

Late upswing: Boom mentality has taken hold . This is

not usually a good time to buy the countrys stocks. The

countrys commodity and property prices will also be

peaking . This is time to purchase the countrys bonds

and interest sensitive stocks.


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Industry Analysis- Life cycle

When an industry is young, it is in the Introduction or Development Stage, sales or

profits are not strong but developing.

We all want investment that are in the Growth & Expansion phase the steep portion

of the graph.

Introduction

GrowthMaturity

Decline

Industry Life Cycle


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Industry Analysis- Life cycle

As an industry matures, it's profits (sales) level off. At this point, the mature firm is

making money and not expanding like the growth phase. Investors (owners) expectthe firm to begin paying dividends.

The act of a firm paying dividends is a signal to investors that they are (1) not able to

reinvest the money into the firm profitably; (2) they are beyond growth phase

Introduction

GrowthMaturity

Decline

Industry Life Cycle


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Industry Analysis: External Factors Affecting

Sales and Profitability

Technology

Government

Social Changes

Demographics

Foreign influence


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1.3) Competitive forces that shape the

industry profitability

Threat of Entry: depends on

I) Barrier to entry which again depends on:

Supply side economies of scale

Demand side economies of scale Customer switching cost

Capital requirements

Incumbency advantages independent of size

Unequal access to distribution channels

Restrictive government policy


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Threat of Entry: depends on

II) Expected retaliation: which again depends on

How incumbents have previously responded vigorously

to new entrants Incumbents possess substantial resources to fight back

Excess capacity

Industry growth is slow so newcomers can gain volume

only by taking it from incumbents.


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The Power of Supplier: the company depend on a wide

range of different supplier groups for inputs .a supplier

group is powerful if:

It is more concentrated than the industry it sells to

The supplier group does not depend heavily on the

industry for its revenue.

Industry participants face switching costs in changing

suppliers.

Suppliers offer products that are differentiated.

There is no substitute for what the supplier group

provides.

The supplier group can credibly threaten to integrate

forward into the industry.


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The power of Buyers-As with the suppliers, there may be

distinct groups of customers who differ in bargaining

power. Customer is powerful if-

There are few buyer or purchases in large volume

The industry products are standardized or

undifferentiated

Buyers face few switching costs in changing vendors

Buyer can credibly threaten to integrate backward andproduce the industrys product themselves if vendors are

too profitable.


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A Buyer group is price sensitive if:

The product it purchases from the industry represents a

significant fraction of its cost structure or procurementbudget

Buyer under pressure to trim its purchase cost

The quality of buyers products or services is little

affected by the industrys product. The industry product has little effect on the buyers other

cost.


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The threat of a substitute is high if

If offers an attractive price-performance trade-off to the

industrys product

The buyers cost of switching to the substitute is low


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Rivalry among Existing Competitors:

The intensity of rivalry is greatest if:

Competitors are numerous or are roughly equal in size

and power . Industry growth is slow

Exit barriers are high

Rivals are highly committed to the business and have

aspirations for leadership Products and services of rivals are nearly identical and

there are few switching costs for buyers.

Overcapacity

Products are perishable


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It is especially important to avoid the common mistake :

1. Industry Growth Rate(fast growing industry is not

always attractive)2. Technology and innovation

3. Government

4. Complementary products and services


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1.4) Financial Statement Analysis

Understanding the Income StatementXYZ

companyIncome Statement

For the year ended ..monthyear

Year 1 Year 2

Revenue

Cost of Goods Sold

Gross Profit

Selling& Admin Exp.

Income from Operation

Interest Expense

Income before taxes

Tax Expense

Income after taxes

Earning Per Share


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Understanding the Balance Sheet

XYZ company

Balance Sheet

For the year ended ..monthyear

Year 1 Year 2

Non Current Assets

Current Asset

Total Asset

Non Current Liabilities

Current Liabilities

Total Liabilities

Equity

Total Liability and

shareholders equity


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Understanding Cash FlowXYZ company

Statement of Cash Flow (Indirect Method)For the year ended ..monthyear

Year 1 Year 2

Cash flow from operatingactivities

Net Income

Dep.E

xp

Gain on sale of equipment

Net Cash provided by operatingactivities

Cash flow from investingactivities

Cash received from sale of

equipmentCash paid for purchase ofequipment

Net Cash used for investingactivities

Cash Flow from financing

activities

Net Cash Increase / decrase


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Common ratios used in financial analysis

Activity Ratio: Measures how efficiently company

performs day to day task.

Inventory turnover ratio.

Days on sales outstanding Number of days of payable

Total Asset turnover.

Liquidity ratio: Measures company's ability to meet

its short term obligation

Current Ratio.

Quick Ratio.

Cash Ratio.


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Du Pont Analysis decomposition of ROE

ROE= Net profit Margin* Asset turnover * leverage.

Year ROE Net profit

Margin

Asset

turnover

leverage.

2005 5.92 3.33 1.11 1.602004 1.66 1.11 0.95 1.58

2003 1.62 1.13 0.93 1.54

2002 -0.62 -0.47 0.84 1.60


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Selected Quality ofEarnings Indicators

Category Observation Potential Interpretation

Revenues and gain Recognizing revenue

early, for example bill

and hold sales

Classification ofnonoperating income or

gains as part of

operations.

Acceleration in the

recognition of revenue

boosts reported income

masking a decline inoperating performance

Expense and losses Recognizing too much

or too little reserve in the

current year. Exp:restructuring reserve

Deferral of expenses

by capitalizing

expenditures as an

assets. For example:

long depreciable lives

May boost or decrease

current income at the

expense of futureincome


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Selected Quality ofEarnings Indicators

Category observation Potential interpretation

Balance Sheet Issues

Use of off-balance sheet

financing such leasing

asset or securitizing

receivables.

Asset or liability may not

be properly reflected on

the balance sheet.

Operating cash flow Characterization of an

increase in a bank

overdraft as OCF

Operating cash flow may

be artificially inflated.


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2) Forecasting Company

Performance

top-down forecasting approach

Bottom-up forecasting approach


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3) Selecting the appropriate Valuation model

3.1) Absolute valuation model: is a model that specifies an

assets intrinsic value . Such models are used to

produce an estimate of value that can be compared with

the assets market price. Different types of absolute

valuation model are Dividend Discount Model (DDM),

Free Cash Flow to Firm Model , Free Cash Flow to

Equity Model, Residual income models

3.2) Relative Valuation Models : estimate an assets value

relative to that of another asset. Relative valuation istypically implemented by using Price multiples ( P/E,

P/BV , P/cash flow) or enterprise multiple (EV/EBITDA)


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Absolute valuation model (DDM)

Dividend Discount Model

DDM is the simplest and oldest present value approach to valuing

stock. The dividend discount model defines cash flows as dividends.

Generally , the definition of returns as dividends , and the DDM , is

most suitable when:

When company is dividend paying

The board of directors has established a dividend policy that bears

an understandable and consistent relationship to the companys

profitability , and

The investor takes a non control perspective


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Dividend Discount Model

DDM can be one of the following kinds

The Gordon Growth model

Multistage DDM

The H-Model


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The Gordon Growth model

The Gordon Growth Model assumes that dividends grow

indefinitely at a constant rate. This model is most

appropriate for companies with earnings expected to

grow at a rate comparable to or lower than the

economys nominal growth rate (GDP).

g= sustainable growth rate ( ROE b)

b= retention ratio ( 1- dividend payout ratio)

dividend payout ratio= (dividend/ net profit)

r= required rate of return


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How to find required rate of return (r)

r can be calculated by using

CAPM

multifactor model (FFM)

r= risk free rate + Beta * equity risk premium

Equity Risk Premium requires

The equity index to represent equity market return The time period for computing the estimate

The type of mean calculated

The proxy for risk free rate


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Multifactor model

r= risk free rate+ beta*market risk premium + beta * SMB +

Beta * HML


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Multi stage DDM models

Growth phase typically enjoy rapidly expanding

market , abnormally high growth rate in EPS

Transition phase- transition to maturity , earning growth

gets slow and about to converge economic growth rate.

Mature phase- ROE approaches to Cost of Capital andsales and earning growth stabilizes.


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Free Cash Flow Valuation

Free cash flow is used under following conditions-

The company does not pay dividends

The company pays dividends but the dividends paid differ

significantly from the companys capacity to pay dividends. Free cash flows align with profitability within a reasonable forecast

period with which the analyst is comfortable.

The investor takes a control perspective. With control comes

discretion over the uses of free cash flow.


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Defining the Free Cash Flow

Free cash Flow to Firm- is the cash flow available to the

companys suppliers of capital ( both equity and debt

holders) after all operating expenses has been paid and

necessary investment in working capital and fixed capital

have been made.

Free cash flow to equity is the cash flow available to the

companys holders of common equity after all operating

expenses , interest , and principal payments have been

paid and necessary investments in working capital andfixed capital have been made . FCFE is the cash flow

from operations minus capital expenditures minus

payments to debt holders.


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Free Cash Flow

Free cash flow indicates cash available to the capital providersafter proper allocation to the investment for growth.

FCFF = EBIT (1- Tax rate) + Depreciation FCInv WCInv.

FCFE = FCFF Int (1- tax rate) + Net Borrowing.


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Example

A company reported the following results in its fiscal year,

EBIT = 500 mil

Tax rate = 40%

Depreciation = 300 mil

Net Investment in Fixed Capital = 400 mil

Net increase in working capital = 45 mil

Net Borrowing = 75 mil

Interest = 100 mil


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Solution

FCFF = 500 ( 1- .40) + 300 400 45

= 155 mil.

FCFE = 155 100 ( 1 - .40) + 75

= 170 mil.

Investment Decision:

A company with positive free cash flow has cash available for its investorsafter meeting all of its expenses including capital expenditure for growth

opportunities. Hence, can be recommended as a sound company to investin.


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Relative Valuation

What is it?: The value of any asset can be estimated by looking at how themarket prices similar or comparable assets.

Philosophical Basis: The intrinsic value of an asset is impossible (or closeto impossible) to estimate. The value of an asset is whatever the market is

willing to pay for it (based upon its characteristics) Information Needed: To do a relative valuation, you need an identical

asset, or a group of comparable or similar assets a standardized measure ofvalue (in equity, this is obtained by dividing the price by a commonvariable, such as earnings or book value) and if the assets are not perfectlycomparable, variables to control for the differences

Market Inefficiency: Pricing errors made across similar or comparableassets are easier to spot, easier to exploit and are much more quickly corrected


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Relative Approach

Provide information abouthow the market is currently

valuing stock at several levels-

Aggregate market

Alternative industries

Individual stocks withinthe industry

Aggregate

Market

Alternati

industrie

Individual

stock


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Price to Earnings Ratio P/E

A valuation ratio of a company's current share price compared to its per-share earnings. Alsosometimes known as "price multiple" or "earnings multiple".

The P/E is sometimes referred to as the "multiple", because it shows how much investors arewilling to pay per dollar of earnings. If a company were currently trading at a multiple (P/E)of 20, the interpretation is that an investor is willing to pay Tk. 20 for Tk.1 of currentearnings

For example, if a company is currently trading at Tk.43 a share and earnings over the last 12months were Tk. 1.95 per share, the P/E ratio for the stock would be 22.05 (Tk.43/Tk.1.95).

Based on EPS from the last four quarters is called trailing P/E. Based on EPS taken from theestimates of earnings expected in the next four quarters is called forward P/E.

Price of StockEarning Per share

Price / Earnings Ratio =


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Trailing P/E and Forward P/E

"Trailing P/E" calculates stocks P/E ratio based on Companys most recent twelvemonths earnings. This is used to get the Companys P/E based on its historicalearning performance.

Forward P/E" calculates stocks P/E ratio based on Companys Expected Earningper Share. This is used to get the Companys P/E based on its Future Earning prospects.

Market Price of the Stock

EPS based on most recent 12 month periodTrailing P/E =

Market Price of the Stock

Expected Earning per Share

Forward P/E =


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Price to Earnings Ratio P/E

In general, a high P/E suggests that investors are expecting higher earnings growth inthe future compared to companies with a lower P/E.

However, the P/E ratio doesn't tell us the whole story by itself. It's usually more usefulto compare the P/E ratios of one company to other companies in the same industry, to

the market in general or against the company's own historical P/E.

It would not be useful for investors using the P/E ratio as a basis for their investmentto compare the P/E of a Banks to a Manufacturing company as each industry has muchdifferent growth prospects.


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Book Value or Net Asset Value

(NAV) A company's common stock equity as it appears on a balance sheet, equal to total

assets minus liabilities, preferred stock, and intangible assets such as goodwill.

This is how much the company would have left over in assets if it went out of

business immediately.

Since companies are usually expected to grow and generate more profits in the

future, market capitalization is higher than book value for most companies. Since book value is a more accurate measure of valuation for companies which

aren't growing quickly, book value is of more interest to value investors thangrowth investors.

NAV per share =Total Shareholders Equity

Number of share outstanding


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When relative valuation works

best..

This approach is easiest to use when there are a large number of assetscomparable to the one being valued these assets are priced in a marketthere exists some common variable that can be used to standardize the

priceThis approach tends to work best for investors who have relatively short

time horizons are judged based upon a relative benchmark (the market,other portfolio managers following the same investment style etc.)

can take actions that can take advantage of the relative mispricing; for

instance, a hedge fund can buy the under valued and sell the over valuedassets


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4. Converting forecasts to a valuation

Two important aspects of converting forecasts to

valuation are:

Sensitivity Analysis

Scenario analysis


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What approach would work for you?

As an investor, given your investment philosophy, time horizon andbeliefs about markets (that you will be investing in), which of theapproaches to valuation would you choose?

Discounted Cash Flow Valuation

Relative Valuation

Neither. I believe that markets are efficient.


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Thank you

bd job traning session 4

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