Fundamental Analysis:

Company Analysis

C S Mishra
VGSOM, IIT Kharagpur
 Overview
• Importance of Company Analysis
• Company Analysis and Stock Valuation
• Broad Methodology of Company Analysis
– Strategy Analysis
• Defining Strategy
• Levels in Organization and Strategy Decisions
• Porter’s Five Forces Model Revisited
• SWOT Analysis
• PEST Analysis
• Lessons from Select Authors
– Analysis of Financial Reports
 Importance of Company Analysis
• After analyzing the economy and stock
markets for several countries, one decides
about investing some portion of one’s
portfolio in common stocks.
• After analyzing various industries, one
identifies those industries that appear to offer
above-average risk-adjusted performance over
one’s investment horizon.
• Next questions that arise:
– Which are the best companies?
– Are they overpriced or underpriced?

3
Company Analysis vs. Stock Valuation:
Points to Note
• Good companies are not necessarily good
investments.
• Compare the intrinsic value of a stock to its
market value.
• Stock of a great company may be overpriced.
• Stock of a growth company may not be a
growth stock.

4
 Growth Companies
• Growth companies have historically been
defined as companies that consistently
experience above-average increases in sales
and earnings.
• Financial theorists define a growth company
as one with management and opportunities
that yield rates of return greater than the
firm’s required rate of return.

5
 Growth Stocks
• Growth stocks are not necessarily shares in
growth companies.
• A growth stock has a higher rate of return
than other stocks with similar risk.
• Superior risk-adjusted rate of return occurs
because of market undervaluation compared
to other stocks.

6
 Defensive Companies and Stocks
• Defensive companies’ future earnings are
more likely to withstand an economic
downturn.
• Low business risk
• Not excessive financial risk
• Stocks with low or negative systematic risk (β)

7
 Cyclical Companies and Stocks
• Cyclical companies are those whose sales and
earnings will be heavily influenced by
aggregate business activity.
• Cyclical stocks are those that will experience
changes in their rates of return greater than
changes in overall market rates of return.

8
Speculative Companies and Stocks
• Speculative companies are those whose assets
involve great risk but that also have a
possibility of great gain.
• Speculative stocks possess a high probability
of low or negative rates of return and a low
probability of normal or high rates of return.

9
 Value versus Growth Investing
• Growth stocks will have positive earnings
surprises and above-average risk adjusted
rates of return because the stocks are
undervalued.
• Value stocks appear to be undervalued for
reasons besides earnings growth potential.
• Value stocks usually have low P/E ratio or low
P/B ratio.

10
Economic, Industry, and Structural Links
to Company Analysis
• Company analysis is the final step in the top-
down approach to investing.
• Macroeconomic analysis identifies industries
expected to offer attractive returns in the
expected future environment.
• Analysis of firms in selected industries
concentrates on a stock’s intrinsic value
based on growth and risk.

11
Economic and Industry Influences
• If trends are favorable for an industry, the
company analysis should focus on firms in
that industry that are positioned to benefit
from the economic trends.
• Firms with sales or earnings particularly
sensitive to macroeconomic variables
should also be considered.
• Research analysts need to be familiar with
the cash flow and risk of the firms.

12
 Structural Influences
• Social trends, technology, political, and
regulatory influences can have significant
influence on firms.
• Early stages in an industry’s life cycle see
changes in technology which followers may
imitate and benefit from.
• Politics and regulatory events can create
opportunities even when economic
influences are weak.

13
 Company Analysis:
Strategy Analysis
• Defining Strategy
• Levels in Organization and Strategy Decisions
• Porter’s Five Forces Model Revisited
• PEST Analysis
• SWOT Analysis
 Strategy Defined
• Strategy refers to a plan of action designed to
achieve a particular goal. The word is of
military origin, deriving from the Greek word
στρατηγός (stratēgos), which roughly
translates as “general”.*

*Source: http://en.wikipedia.org/wiki/Strategy, accessed on 20 June, 2010

 Importance of Strategy
• Reasons for premature death of firm
– No Strategic Intent
– Passive Management
– New opportunities not explored
– Failure to adapt to change in surroundings
Multiple Layers/ Levels of Strategy
Levels of Strategy Management Decision
Corporate Strategy Activities to enhance substantial
competitive advantage
•Selecting the Business to do?
•Entering New Market
•Exiting/ withdrawal from market
Business Strategy •Decisions to maximize competitive
position within the chosen market
Operational Strategy •Planning for execution of the goal of
the strategic business unit (SBU)

All the decisions affect the cash flows of a company, hence

important from analysis and valuation point of view.
 Firm Competitive Strategies:
Revisiting Porter’s Five Forces Model
• Current rivalry
• Threat of new entrants
• Potential substitutes
• Bargaining power of suppliers
• Bargaining power of buyers

18
The Takeaways from Porter’s Analysis
• Helps in determining potential attractiveness
of an industry- insight of margins.
• Helps decision about exit or entry.
• Allows a systematic and structured analysis of
market structure and competitive situation.
• Helps to understand strategies of the
company to reduce power of competitive
forces.
 Firm Competitive Strategies, contd..
• Defensive strategy involves positioning firm so
that it its capabilities provide the best means to
deflect the effect of competitive forces in the
industry.
• Offensive strategy involves using the
company’s strength to affect the competitive
industry forces, thus improving the firm’s
relative industry position.

20
 Firm Competitive Strategies, contd..
• Porter suggests two major strategies:
– Low-Cost Strategy
• The firm seeks to be the low-cost producer, and hence
the cost leader in its industry.
– Differentiation Strategy
• Firm positions itself as unique in the industry.
• However, companies may opt for different
strategies depending upon the products.

21
 SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
– Threats

22
 SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses INTERNAL ANALYSIS
– Opportunities
– Threats

23
 SWOT Analysis
• Examination of a firm’s:
– Strengths
– Weaknesses
– Opportunities
EXTERNAL ANALYSIS
– Threats

24
 Strategy Analysis- External:
PEST
• P: Political & A Change in Government,
Policy or Law
Legal Changes
• E: Economic Rising level of living standards
or interest rate change
Changes
• S: Social More Working Women
going out to work
Changes
• T: Technological New Inventions and
Ideas
Changes
 Strategy Analysis – Internal Environment

• Review of Resources
– Tangible
– Intangible
• Review of Capabilities
– Knowledge based capabilities
– R&D
– Customer Service/ Support
– Global Operations
– Core Competencies- The areas where firm functions
well.
Lessons from Select Authors
 Some Lessons from Peter Lynch
Favorable Attributes of Firms:
1. Firm’s product should not be faddish.
2. Firm should have some long-run comparative
advantage over its rivals.
3. Firm’s industry or product has market stability.
4. Firm can benefit from cost reductions.
5. Firms that buy back shares show there are putting
money into the firm.

28
 Tenets of Warren Buffet*
• Business Tenets
• Management Tenets
• Financial Tenets
• Market Tenets

* Source: Hagstorm, Robert G: The Essential Buffet, Wiley, 2001, as presented in Reilly and Brown, 2007.

29
 Tenets of Warren Buffet, contd..
• Business Tenets:
– Is the business simple and understandable?
– Does the business have a consistent operating
history?
– Does the business have favorable long-term
prospects?
• Management Tenets:
– Is management rational?
– Is management candid with its shareholders?

30
 Tenets of Warren Buffet, contd..
• Financial Tenets:
– Focus on return on equity, not earnings per share
– Calculate “owner earnings”
– Look for companies with high profit margins
– For every dollar retained, make sure the company
has created at least one dollar of market value
• Market Tenets:
– What is the intrinsic value of the business?
– Can the business be purchased at a significant
discount to its fundamental intrinsic value?

31
 Financial Analysis of Companies
• Estimating Intrinsic Value
• Analyzing financial statements
• Red flags in financial reporting
• Measures of Value Addition
– Economic Value Added (EVA)*
– Market Value Added (MVA)*

*Stern and Stewart, New York

 Estimating Intrinsic Value
A. Present value of cash flows (PVCF)
– 1. Present value of dividends (DDM)
– 2. Present value of free cash flow to equity (FCFE)
– 3. Present value of free cash flow to firm (FCFF)
B. Relative valuation techniques
– 1. Price earnings ratio (P/E)
– 2. Price cash flow ratios (P/CF)
– 3. Price book value ratios (P/BV)
– 4. Price sales ratio (P/S)

33
 P/E and P/B Ratios
Price-Earning and Price-Book Value Ratio Sensex Companies as on 21 June 2010
# Company Name P/E P/B # Company Name P/E P/B
1A C C Ltd. 10.31 2.58 17Mahindra & Mahindra Ltd. 18.45 4.54
2Bharat Heavy Electricals Ltd. 28.18 7.47 18Maruti Suzuki India Ltd. 15.91 3.41
3Bharti Airtel Ltd. 10.66 2.74 19N T P C Ltd. 18.99 2.26
4Cipla Ltd. 27.66 4.47 20Oil & Natural Gas Corpn. Ltd. 15.38 2.91
5D L F Ltd. 63.82 3.75 21Reliance Communications Ltd. 77.47 0.74
6H D F C Bank Ltd. 31.17 4.27 22Reliance Industries Ltd. 21.46 2.71
7Hero Honda Motors Ltd. 18.11 10.53 23Reliance Infrastructure Ltd. 25.25 2.19
8Hindalco Industries Ltd. 16.29 1.03 24State Bank Of India 16.53 2.3
9Hindustan Unilever Ltd. 27.02 15.65 25Sterlite Industries (India) Ltd. 55.88 2.78
10HDFC Limited 30.68 5.6 26Tata Consultancy Services Ltd. 28.78 10.26
11I C I C I Bank Ltd. 24.97 1.95 27Tata Motors Ltd. 13.24 2.44
12I T C Ltd. 28.1 8.19 28Tata Power Co. Ltd. 45.46 2.76
13Infosys Technologies Ltd. 27.75 7.3 29Tata Steel Ltd. 8.87 1.19
14Jaiprakash Associates Ltd. 14.77 3.65 30Wipro Ltd. 20.73 6.37
15Jindal Steel & Power Ltd. 43.19 9.43  Average 27.34 4.72
16Larsen & Toubro Ltd. 35 6.18  Median 25.11 3.53
 Analysis of Growth Companies
• Generating rates of return greater than the
firm’s cost of capital is considered to be
temporary.
• Earnings higher the required rate of return are
pure profits.
• How long can they earn these excess profits?
• Is the stock properly valued?

35
 Negative Growth Model
• Firm retains earnings, but reinvestment
returns are below the firm’s cost of capital
• Since growth will be positive, but slower than
it should be, the value will decline when the
investors discount the reinvestment stream at
the cost of capital.

36
 Intra-Industry Analysis
• Directly compare two firms in the same industry
• Factors to consider
– A major difference in the risk involved
– Inaccurate growth estimates
– Stock with a low P/E relative to its growth rate
is undervalued
– Stock with high P/E and a low growth rate is
overvalued

37
 Historical Financial Analysis
• Normalization and adjustments for accounting figures
• Evaluation of accounting strategy
• Review of accounting policies and notes to accounts
• Assessing adequacy and quality of disclosures
• Financial ratio analysis for
– Profitability
– Asset utilization
– Long term solvency
– Liquidity
– Market performance
Fraud and Red Flags in Financial Reporting
• Cooking the books
• Financial Analysis is not expected to detect the frauds it
starts with the assumption that figures are not
misrepresented
• Carefully done, financial statement analysis can reveal
unusual patterns that are difficult to rationalize- questions
all ‘red flags’
• Numbers on their own may not make any sense.
Questioning the number can help.
• Some indications of red flags:
– Assets utilization ratios that provide early warning signal.
– Unexplained changes are reasons for suspicious activities
– Unreasonable growth goals that can not be financed easily
 Red flags in Financial Reporting
• Unexplained changes in policies & estimates especially in doom
days
• Unexplained transactions to boost profit
• Very consistent margin, growth rate and stable or consistent
increasing cash and bank balance
• Unusual increase in debtors and inventories in relation to sales
• Unusual increase in intangible assets
• Reduction in managed cost- like advertisement to boost cost
• One time profit from non-operating assets
• Unexplained focus or shift towards non-core business
• Significant changes in segment revenue & margin
 Red flags in Financial Reporting
• Improper method adopt in asset valuation
• Increasing gap between accounting income and
taxable income
• Increasing gap between reputed income and cash
from operation
• Unexplained write-off
• R&D partnership
• Presence of special purpose vehicles/ enterprises
(SPVs/ SPEs)
• Weak governance structure
• Complex ownership and financial structure
 Measures of Value-Added
• Economic Value-Added (EVA)
– Compare net operating profit less adjusted taxes
(NOPLAT) to the firm’s total cost of capital in
dollar terms, including the cost of equity
• EVA return on capital
EVA/Capital
• Alternative measure of EVA
– Compare return on capital to cost of capital

42
 Measures of Value-Added
• Market Value-Added (MVA)
– Measure of external performance
– How the market has evaluated the firm’s
performance in terms of market value of debt and
market value of equity compared to the capital
invested in the firm
• Relationships between EVA and MVA
– mixed results

43
 Site Visits and the
Art of the Interview
• Focus on management’s plans, strategies, and
concerns
• Restrictions on nonpublic information
• “What if” questions can help gauge sensitivity of
revenues, costs, and earnings
• Management may indicate appropriateness of
earnings estimates
• Discuss the industry’s major issues
• Review the planning process
• Talk to more than just the top managers

44
 When to Sell
• Holding a stock too long may lead to lower returns
than expected
• If stocks decline right after purchase, is that a further
buying opportunity or an indication of incorrect
analysis?
• Continuously monitor key assumptions
• Evaluate closely when market value approaches
estimated intrinsic value
• Know why you bought it and watch for that to change

45
 Efficient Markets
• Opportunities are mostly among less well-
known companies
• To outperform the market you must find
disparities between stock values and market
prices - and you must be correct
• Concentrate on identifying what is wrong
with the market consensus and what
earning surprises may exist

46
Global Company and Stock Analysis
Factors to Consider:
– Availability of Data
– Differential Accounting Conventions
– Currency Differences (Exchange Rate Risk)
– Political (Country) Risk
– Transaction Costs
– Valuation Differences

47
 References
• Bodie, Kane, Marcus and Mohanty: Investments, 8e, Tata
McGraw Hill, 2009
• Hagstorm, Robert G: The Essential Buffet, Wiley, 2001
• Lynch, Peter: One Up on Wall Street, Simon & Schuster,
1989
• Lynch, Peter: Beating the Street, Simon & Schuster, 1993
• Porter, Michael E.: Competitive Strategy: Techniques for
Analyzing Industries and Competitors, 1998
• Reilly and Brown: Investment Management and Portfolio
Management, 8e, Thomson Learning (Now, Cengage
Learning), 2007

48