Fundamental Analysis

 The process of gathering information, organising it into a logical framework and then using it to determine the underlying value of a share.

Intrinsic Value  The underlying or inherent value of a stock as determined through fundamental analysis.  The entire concept of stock valuation is based on the belief that all securities possess an intrinsic value that their current market or trading value must approach over time.

Intrinsic Value Depends On:  Estimates of the share’s future cash- flows  The discount rate used to translate these future cash flows into a present value  The amount of risk embedded in achieving the forecasted level of performance

Fundamental Analysis  Intended to help investors formulate expectations about the future performance of the company and its shares  By analysing its past performance and current situation to determine how well it is situated to meet future challenges

Fundamental Data Defined  We will define ‘fundamental’ data to include ;  company financial reports (and their analysis),  earnings forecasts,  directors dealings,  announcements,  broker’s research / tips,  and attempt to answer the following questions.

Fundamental Questions 1 of 3  Is the firm financially sound  This will involve checking the company’s accounts, to establish  profitability  liquidity  gearing  fixed asset values  sufficient resources to sustain profitability and cope with setbacks

Fundamental Questions 2 of 3  Does the firm have anything going for it ?  A really impressive product  superior marketing  skilled management  built -in growth  Based on all of the above - what profits will the firm make this year ?

Fundamental Questions 3 of 3  Do I have enough information to estimate the picture into the future too ?  Based on my profits forecast, what will earnings per share (EPS) be ?  Based on EPS, what is the price/earnings ratio (P/E) ?  Also referred to as ‘PER’, ‘PE’, ‘p/e’ or ‘rating’.  Beware of comparing historic to forecast PE.  Can I work out PE ratios for future years ?

Significance of P/E (1 of 2)  Example  Present share price750p (2003) actual (2004) forecast (2005) forecast  eps50p75p (a rise of 50%) 90p  P/E 1510  If the earnings grow by 50% ! The P/E falls by 33% (if the price stays the same).  This would further imply a forecast P/E of 8.3 for nearly half of its 2003 figure.

Significance of P/E (2 of 2)  Given we have a growing earnings stream the market may be willing to pay 15 or more years earnings to buy this share.  This would produce two ‘target prices’  75p x 151,125p  90p x 151,350  Representing a gain of 600p per share or 80% over two years

Estimating EPS  Can be derived from the normal formula EPS (yr.t) = Earnings (yr.t) No. of Shares (yr.t)  Or an alternative approach would be EPS=ROEx Book Value per Share  Thus focussing on the key aspects the firms success – particularly when the ROE is broken down

ROE broken down Dupont Ratios

Profitability can go further! Dupont Ratios

Factors affecting P/E  The future P/E tends to be the most difficult to estimate, being a function of ;  State of the market  Current and projected inflation  Growth rate in earnings  Amount of debt  Level of dividends

General Rules Regarding P/E  Higher P/E ratios can be expected with higher  An optimistic market outlook  Rising inflation translates into falling P/E’s  Growth rates in earnings  Lower debt levels  Lower levels of dividend payout  A good starting point can be the average market multiple and establish a  Relative P/E Multiple.

Valuation - Definitions  The process by which an investor uses risk and return concepts to determine the worth of a security  Or  The process by which the underlying value of a stock is established on the basis of its forecasted risk and return performance

Forecasts - based on Fundamentals  Fundamental analysis is intended to help investors formulate expectations about the future performance of the company and its shares  By analysing its past performance and current situation to determine how well it is situated to meet future challenges

Valuation Bases  Generally based on the required rate of return (CAPM)  Starting point in establishing value –  forecast - sales and profit margins  Which would be used to establish  Forecast – earnings and P/E ratios

Valuation Models (common) DCF  PV of Dividend (DDM)  Zero, Constant,  Variable  PV of Free Cash Flow  PV of Dividends and Earnings (D&E) RELATIVE  Price Earnings Approach (P/E)  Price to Cash Flow  Price to Book Value  Price to Sales

Summary of Data Required  Required rate of return (associated discount factors)  Risk free rate  Market return  Beta value  Current share price and number of issued shares  P/E and P/E projections  EPS and EPS projections  DPS and DPS projections  Either historic DPS figures or  ROE and dividend payout ratio

Levels of provision In considering how this information can be obtained, it may be useful to categorise it into the following types:  Basic historic Basic historic  Analysed historic Analysed historic  Current Current  Combined Combined

Basic - Fundamental Data  Consists of Annual Corporate Reports for analysis  which can be obtained from:  icibinc (by ordering for postage)  CAROL UK, (online - and as well as UK, companies, European & Asian are now included) CAROL UK,  EDGAR,(US ‘standard’. Equivalent to an electronic Companies House) EDGAR,

Analysed - Fundamental Data  The ‘Bible’ for fundamentalists has traditionally been :  Hemmington Scott - ‘REFS’ Hemmington Scott  Really Essential Financial Statistics Access to parts of REFS is increasingly appearing online but the searchable CD Rom version is a must for those attempting to carry out frequent search and analysis.

Current - Fundamental Data  Consider the links (in red) and articles suggested on the database for this session.  ACTIVITY:  Go to at least 3 of the sites listed and extract and compare fundamental information relating to one or more of your investment decisions. IC Database

Combined - Fundamental Data  Many software providers are now attempting to include fundamental data downloads with their price updates.  Indications of the ‘fundamental’ events can then be viewed on the price charts.  Synergy’s - Portfolio Advantage Synergy’s  Ionic’s - Sharescope Ionic’s

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