Fundamental Analysis
• Introduction
• Investor’s mindset
• Annual report reading
• P&L statement
• Balance sheet
• The cash flow
• The financial ratio
• Investment due diligence
• Equity research
• DCF primer
• Notes
What to expect?
In this chapter, we will build a methodology for carrying out a “limited resource” equity research after establishing the context in the previous chapter. I use the term “limited resource” because there aren’t many resources available to you and me as retail investors to do equities research. These sources include the internet, MS Excel, and the annual report of the company. While an Institution has access to financial databases like Bloomberg, Reuters, Factset, and others, access to corporate management, human resources (analysts), industry publications, etc. So, using the limited tools at my disposal, I want to show how one might better understand a company and its business. Of course, we’ll approach this exercise with the ultimate goal in mind, which is deciding whether to buy or not to buy a stock.
As stated in the previous chapter, the method of doing equity research will be divided into three stages:
- Knowledge of the Business
- the use of the checklist
- Calculating intrinsic value (valuation) to determine the stock’s fair market value
Each of the aforementioned stages is divided into multiple steps. There is no fast way to do this, and none of these procedures should be compromised.
Stock Price vs Business Fundamentals
The first thing we do while researching a firm is to learn as much as we can about the industry. People frequently skip over this important stage and jump right into the stock price analysis. Well, if you have a short-term perspective, simply examining the stock price is fantastic. Understanding the business, though, is crucial for long-term investments.
You might be wondering why it’s significant. The answer is straightforward: the more you understand the business, the more likely you are to stick with your investment—especially in difficult times— (aka bear markets). Always keep in mind that during bad markets, prices react rather than business fundamentals. Knowing the firm and its operations inside and out provides you the conviction you need to continue holding the stock even if the market thinks otherwise. Bad markets are said to produce value, therefore if you have a strong belief in the company, you should think about investing in the stock during bear markets rather than actually selling it. This goes without saying, and it takes years of investing experience to grasp the reality that it is highly counter-intuitive.
Anyway, moving on, the company’s website and annual report are the greatest places to find information about the business. To understand how it is changing during business cycles, we need to at least review the most recent five years of annual reports.
Understanding the Business
Making a list of the questions we need to get answers to is a necessary first step in understanding the company. Please take note that you can read the company’s annual report and website to find the answers to all of these inquiries.
Here are a number of queries that, in my opinion, will aid us in our effort to comprehend the business.
These inquiries serve as discussion starters for comprehending any business. As you search for solutions, you’ll unavoidably start asking new questions that require solutions. If you use this Q&A format, it doesn’t matter which company you are considering. I have no doubt that you would significantly improve your understanding of the business. This is because participating in the Q&A process forces you to read and research the firm so extensively that you will begin to gain a deeper grasp of it.
Keep in mind that this is the first stage of the equity research procedure. Regardless of how appealing the organization appears, I would encourage you to stop further research if you notice red flags (or something amiss) while looking for the answers. Stage 2 of equity research is pointless in cases where there is a red signal.
I can tell you from experience that the first step of equity research, known as “Understanding the Company,” takes roughly 15 hours. After going through this process, I often try to write down my ideas in a way that captures all the crucial information I have learned about the organization. This fact sheet needs to be succinct and direct. If I can’t do this, it is obvious that I don’t know enough about the business. I move on to stage 2 of equity research, or “Application of Checklist,” after completing stage 1. Please keep in mind that the stages of equity research are sequential and ought to be completed in that sequence.
The second step of our equity investigation will now be conducted. Stage 2 can best be understood by putting the checklist into practice in a business.
Throughout this module, we have collaborated with Amara Raja Batteries Limited (ARBL). So I suppose it makes sense to review the checklist for the same company. Do not forget that while the firm may change, the foundation for equity research does not.
A word of warning before we continue: when we learn more about this company, the conversation will focus primarily on ARBL moving ahead. The purpose of this is not to demonstrate how effective or ineffective ARBL is, but rather to provide a framework for what I consider to be a “pretty adequate” equity research procedure.
Application of checklist
The first stage of the equity research procedure enables us to comprehend the how what, who, and why. We are better able to see the business as a whole thanks to it. No matter how appealing a business may appear to be, its financial results should also be appealing since, as they say, the proof of the pudding is in the eating.
The goal of the second stage of equity research is to aid in our understanding of the data and enable us to assess if the nature of the company and its financial performance are complementary. It is obvious that the company will not meet the criteria for an investible grade if they do not complement one another.
Let’s assess each item on the Amara Raja Batteries checklist and see what the statistics indicate. We’ll start by looking at the P&L elements for the company: Gross Profit, Net Profit, and EPS.
Earnings & Pat Growth
The rate of a company’s growth is the first indication that it might meet the criteria for the investable grade. We must look at the sales and PAT growth to assess the company’s expansion. We shall assess growth from two angles:
Growth year over year will show us how much the business improves each year. Keep in mind that there are cyclical changes in industries. From that angle, it is acceptable if a company experiences flat growth. Simply make sure you assess the competition and confirm that industry-wide growth is stable.
Compounded Annual Growth Rate (CAGR): The CAGR reveals how the business is developing and expanding over time and throughout business cycles. A strong, investable-grade business is typically the first to weather changes in business cycles. A healthy CAGR will eventually show this.
I favor making investments in businesses with a CAGR of over 15% that are growing (revenue and PAT).
18.6 percent is the 5-year CAGR revenue growth, while 17.01 percent is the 5-year CAGR PAT growth. These data points are intriguing and fit the definition of a healthy data set. We must still assess the other figures on the checklist, though.
The income per Share (EPS)
The profitability per share is shown by the earnings per share. The fact that the company’s EPS and PAT are increasing at comparable rates suggests that it does not dilute earnings by issuing new shares, which is positive for the existing shareholders. This can be viewed as a testament to the management’s abilities at the organization.
For FY14, the five-year EPS CAGR is 1.90 percent.
The margin of gross profits
Gross profit margins are determined using the following formula:
Profits/Net Sales in Gross
Where,
Net sales less the cost of goods sold equals gross profits.
As we learned about the inventory turnover ratio, the cost of goods sold is the price associated with producing the finished product. Let’s check how the gross profit margins of ARBL have changed over time.
The Gross Profit Margins (GPM) appear to be really impressive. The checklist demands a minimum GPM of 20 percent. ARBL has a lot more GPM than is necessary. This suggests a few things:
ARBL has a privileged position within the market hierarchy. This can be due to a lack of competition in the market, which allows a select few businesses to have higher margins.
Excellent operational effectiveness, which in turn reflects the management’s ability
Debt level – examine the balance sheet
The company’s profit and loss statement was mostly addressed in the first three items on the checklist. We’ll examine a couple of balance sheet items right now. The debt is among the most crucial lines on the balance sheet that we should pay close attention to. A significant degree of financial leverage is indicated by a rising level of debt. The growth that comes at the expense of financial leverage is highly risky. Also, keep in mind that a high debt level on the balance sheet indicates a high financial expense. This reduces the company’s retained earnings.
The debt status for ARBL is as follows:
Debt(INR Crs) Assessment –
Around 85Cr, the debt appears to have reached stability. In reality, the fact that the debt has decreased from FY 09–10 is good. I like to verify the debt as a percentage of “Earnings before Interest and Taxes” in addition to the interest coverage ratio (which we have already discussed) (EBIT). This only provides a brief overview of the company’s financial management. The ratio of debt to EBIT has decreased steadily, as is evident.
In my opinion, ARBL has managed its debt level effectively, which is a good thing.
Inventory Review
It only makes sense to check the inventory data if the business under evaluation is a manufacturer. Examining the inventory data benefits us in a number of ways:
A growing corporation will have rising PAT indicators and rising inventory levels.
A consistent number of inventory days reflects management’s operational effectiveness to some extent.
The number of days for inventory is more or less constant. In actuality, there are some indications of a minor deterioration. Please take note that we covered the calculation of the inventory number of days in the chapter before. Another encouraging aspect is that both the inventory and PAT are exhibiting a similar growth trend.
Sales against Receivables
We now examine the company’s receivables along with the sales figure. A sale supported by receivables is not a promising development. Many questions stem from the fact that it denotes credit sales. For instance, do the sales representatives of the corporation sell goods on credit? Is the business attempting to boost sales by giving suppliers tempting (but unsustainable) credit?
Here, the business has demonstrated steadiness. We might infer from the table above that a significant portion of their sales is not actually supported by receivables, which is very good. In fact, the receivables as a percentage of net sales have also exhibited symptoms of a drop, which is rather impressive, just like the inventory number of days.
Proceeds from Operations
In truth, this is among the most significant inquiries to make before choosing to invest in a business. The business should produce cash flows from operations; here is actually where the truth is revealed. There is some kind of warning sign when a business drains its operating cash flow.
Despite being somewhat unpredictable, the cash flow from operations has been positive for the past five years. This only indicates that ARBL’s primary business operations are profitable and can be deemed successful.
Income from Equity
In chapter 9 of this lesson, we spoke at length about return on equity. If you want to review it, I’ll encourage you to do so. Return on Equity (ROE) evaluates the return produced by the business in percentage while keeping the equity of the shareholders in mind. In a way, ROE gauges how profitable the company’s promoters are after investing their own money in it.
These figures are astounding. Personally, I prefer to invest in businesses with ROEs of over 20%. Keep in mind that the debt for ARBL is rather minimal. Since there is no undue financial leverage backing the good set of return on equity metrics, this is again very desired.
Conclusion
Remember that the equity research is still at stage 2. I believe ARBL will qualify for stage 2 on practically all of the necessary criteria. As an equities research analyst, you must consider stage 2’s output in light of your stage 1 findings (which deal with understanding the business). After going through these two steps, if you can form a comfortable judgment (based on facts), the company looks to have qualities that make it an attractive investment.
However, you must make sure the pricing is reasonable before purchasing the stock. We conduct exactly this in step 3 of the equity research process.
Getting started with the DCF Analysis
The preceding chapter covered “The Net Present Value (NPV)”. The DCF valuation model heavily relies on NPV. After grasping this idea, we must now comprehend a couple of additional subjects connected to the DCF valuation model. In fact, by using the DCF model for Amara Raja Batteries Limited, we shall learn more about these ideas (ARBL). This brings the third stage of equity research—the valuation—to a close.
Then looked at the future cash flows from the pizza machine in the previous chapter to determine the price, and we discounted those future cash flows back to determine the present value. To calculate the NPV, we totaled together all of the future cash flows’ current values. We also considered the possibility of the pizza machine being replaced by the company’s shares toward the end of the previous chapter. In that instance, all we’ll need to price the company’s shares with is an estimate of its expected future cash flows.
But what kind of financial flow are we referring to? And how do we predict a company’s future cash flow?
The Free Cash Flow (FCF)
The “Free Cash flow (FCF)” of the organization is the cash flow that we must take into account for the DCF Analysis. Free cash flow is essentially the surplus operational cash that the business earns after deducting capital expenses like the cost of land, buildings, and equipment purchases. After capital expenditures are taken into account, this is the money that shareholders receive. How much free cash a corporation can produce ultimately determines how healthy it is.
Free cash is the sum of money that remains after all expenses, including investments, have been met by the company.
The presence of free cash flows is a sign of a healthy business. As a result, investors frequently search for companies with discounted stock prices but strong or rising free cash flow because they assume that over time, the discrepancy will vanish and the share price will soon rise.
Therefore, free cash flow is useful in determining whether or not a company has made profits over a given year. In order to determine the company’s true financial health as an investor, consider the free cash flow in addition to the earnings.
Any company’s FCF can be easily computed by consulting the cash flow statement. The equation is –
FCF is the sum of cash from operating activities and capital outlays.
Please take note that after accounting for income tax, net cash from operating operations is calculated. The capital expenditure is shown in red, whereas the net cash from operating activities is highlighted in green.
You may now be asking yourself a reasonable question: Why calculate historical free cash flow when the goal is to determine future free cash flow? The simple explanation is that, as we work on the DCF model, we must project future free cash flow. The best method for predicting future free cash flow is to estimate historical average free cash flow and then increase free cash flow at regular intervals by a specific rate. The industry employs this routinely.
The next crucial question is how much our free cash flow will increase. So, you should anticipate a growth rate that is as conservative as feasible. Personally, I prefer to project the FCF out for at least ten years. To achieve this, I factor in a higher rate of growth for the first five years and a lower rate for the following five years. If you’re having trouble following along with this, I’ll advise you to do the following step-by-step computation.
Determine the typical free cash flow in step 1.
I start by estimating ARBL’s average cash flow for the last three years.
= 209.7 + 262.99 + (51.6) / 3
=Rs.140.36
To guarantee that we are averaging out excessive cash flows and taking into account the cyclical nature of the business, we took the average cash flow for the previous three years. For instance, ARBL’s most recent year’s cash flow was negative by Rs. 51.6 Cr. It is obvious that this does not accurately reflect ARBL’s cash flow, hence it is usually recommended to use average free cash flow estimates.
Determine the growth rate in step two.
Choose a price that seems affordable to you. The average cash flow will increase at this rate moving ahead. Typically, I develop the FCF in two stages. The first stage addresses the first five years, and the second stage addresses the subsequent last 5 years.
With regard to ARBL specifically, I like using 18 percent for the first five years and somewhere around 10 percent for the next five. I would prefer to utilize growth rates of 15% and 10%, respectively if the company under consideration is an established business that has reached a specific size (such as a large-cap corporation). Being as conservative as you can is the goal here.
Step 3: Calculate projected cash flows.
As of 2013, there was an average cash flow of Rs. 140.26 crores. The cash flow for the years 2014 and 2015 is anticipated to be – at an 18 percent growth rate.
= 140.36 * (1 + 18 %)
= Rs. 165.62 Crs.
According to estimates, the free cash flow for the years 2015 to 2016 will be.
165.62 * (1 plus 18%)
= Rs. 195.43 Crs.
Now that we know this, we can fairly forecast the free cash flow in the future. You might be wondering how trustworthy these numbers are. Since forecasting free cash flow entails forecasting revenues, expenses, business cycles, and almost every other facet of the company. The estimated future cash flow is, after all, just that—an estimate. The key here is to assume the free cash flow growth rate while remaining as conservative as you can. For the future, we have anticipated growth rates of 18 and 10 percent, which are moderate growth rates for a successfully run business.
The Terminal Value
We have made an effort to forecast free cash flow for the next 10 years. However, what would happen to the business after ten years? Would it eventually vanish? Actually, it wouldn’t. It is believed that a business would always be a “going concern.” This implies that some free cash is produced for as long as the business is in business. The rate at which free cash is generated, however, starts to slow down as businesses get older.
The “Terminal Growth Rate” is the rate of free cash flow growth after 10 years (2024 onward). The terminal growth rate is typically thought to be less than 5%. Personally, I prefer to keep this rate between 3 and 4 percent, never going above that.
The “Terminal Value” is the total of all free cash flow that will be generated after the 10th year, also known as the terminal year. We only need to multiply the cash flow from the 10th year by the terminal growth rate to determine the terminal value. However, since we are physically calculating the value to infinity, the formula to achieve this is different.
FCF * (1 + Terminal Growth Rate) / Terminal Value (Discount Rate – Terminal growth rate)
Please take note that the FCF utilized to determine the terminal value is the one from the 10th year. Let’s determine the ARBL’s terminal value using a 9 percent discount rate and a 3.5 percent terminal growth rate.
= 517.12 * (1 + 3.5%) / (9 percent – 3.5 percent )
= Rs.9731.25 Crs
The Net Present Value (NPV)
The terminal value and anticipated free cash flow for the following ten years are both known (which is the future free cash flow of ARBL beyond the 10th year and up to infinity). The worth of these cash flows in today’s dollars must now be determined. This is the current value calculation, as you may remember. We will add these present values once we have determined their present values in order to calculate the ARBL’s net present value (NPV).
The discount rate will be set at 9 percent.
For instance, ARBL is anticipated to collect Rs. 195.29 Cr. in 2015–16, which is two years from now. The present value would be – at a 9 percent discount rate.
is 195.29 / (1+9%)2.
= Rs.164.37 Crs
Additionally, we must figure out the terminal value’s net present value. We just multiply the terminal value by the discount rate to arrive at this calculation.
= 9731.25 / (1 + 9%) 10
= Rs.4110.69 Crores
As a result, the sum of the cash flow present values is equal to the net present value of future free cash flows plus the terminal value.
= 1968.14 + 4110.69
= Rs.6078.83 Crores
In other words, from where I am now and going ahead, I anticipate ARBL to generate a totally free cash flow of Rs. 6078.83 Cr., all of which would belong to the company’s stockholders.
The Share Price
The DCF analysis has reached its conclusion. On the basis of the company’s projected free cash flow, we will now determine ARBL’s share price.
We now know the estimated total free cash flow that ARBL will produce. We are also aware of the number of outstanding shares on the market. We might calculate the price per share of ARBL by dividing the total free cash flow by the entire number of shares.
But first, we have to figure out how much “Net Debt” the company has based on its balance sheet. Current year total debt less current year cash and cash balance equal current year net debt.
‘
Net Debt = Total Debt for the Current Year – Cash and Cash Balance.
This would be (according to the FY14 Balance sheet) for ARBL:
Net Debt = 75.94 – 294.5
= (Rs.218.6 Crs)
A bad omen means that the business has more cash than debt. The entire present value of free cash flows must, of course, include this.
= Rs.6078.83 Crs – (Rs. 218.6 Crs)
= Rs.6297.43 Crores
The share price of the company, also known as the company’s intrinsic value, can be calculated by dividing the aforementioned figure by the total number of shares.
Share Price is calculated as Shares Outstanding / Total Present Value of Free Cash Flow.
According to ARBL’s annual report, there are currently 17.081 billion shares outstanding. Consequently, the intrinsic value or the value per share is –
= Rs.6297.43 Crs / 17.081 Crores
~ Rs.368 per share!
This, in fact, is the final output of the DCF model.
Modeling Error & the intrinsic value band
The DCF model is predicated on a number of assumptions, despite being quite scientific. Especially in finance, assuming becomes an art form. As you continue and get more experience, you get better at it. Therefore, for all practical purposes, we should assume (yet another assumption) that we made a few mistakes when performing the intrinsic value computation. We should therefore make room for modeling inaccuracies.
Simply said, a margin for modeling error enables us to be adaptable when determining the per-share value. For what I believe to be the stock’s fundamental worth, I personally like to add a +10% upper band and a -10% lower band.
Using that to inform our calculation:
The lower intrinsic value is equal to 368 * (1- 10%), which is Rs.
additional intrinsic value=Rs.405
As a result, I would now think that the stock is fairly valued between Rs. 331 and 405, as opposed to Rs. 368 as the previous assumption. The intrinsic value band would be this.
We now check the stock’s market value while maintaining this value in context. On the basis of its current market price, we draw the following conclusions:
We deem a stock to be undervalued if its price is below the lower bound of its intrinsic value band. Therefore, one should consider purchasing the stock.
The stock is deemed to be reasonably priced if its price falls within the range of its intrinsic value. While it is not advisable to make a new purchase, it is still possible to hold onto the stock without adding to current positions.
The stock is regarded as overvalued if its price is higher than the higher intrinsic value band. At these prices, the investor has the option of taking a profit or staying put. But you should not buy at these prices.
A share of the stock is currently trading for Rs. 726.70! Much greater than the intrinsic value band’s highest limit. Buying the stock at these prices means that one is purchasing at extraordinarily high valuations, which is obvious.
Spotting buying opportunities
Long-term investments and the activities that surround them go slowly, like a locomotive train. Contrarily, active trading is comparable to a swift bullet train. When a long-term value opportunity arises, it remains in the market for some time. It doesn’t actually vanish quickly. For instance, we now understand that the current market price of Amara Raja Batteries Limited is excessive. Trading is much above the intrinsic value band’s upper bound. But a year ago, the situation was entirely different. Remember that ARBL’s intrinsic value ranges from Rs. 331 to Rs. 405 depending on the FY 2013–2014.
The stock traded comfortably within the band for almost five months, as evidenced by the blue accent. The stock was available for purchase for the entire year. All you had to do after purchasing was wait for the returns to arrive!
Actually, it is for this very reason that it is said that bear markets produce value. The markets remained gloomy during the entire year 2013 and provided excellent purchasing opportunities in high-quality equities.