Fundamental analysis

30th January 2020

CERN Finance Club

Joaquim CREUS PRATS

Fundamental vs Technical

Fundamental analysis

► Assumption: markets may misprice a security in the short run but the “correct” price will eventually be reached

► Determine price analyzing“fundamental” metrics

► Example measures:

► Equities: company’s financial statements

► Bonds: credit ratings

► Currencies: interest rates

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Technical analysis

► Assumption: all information is factored into the price

► Study past market data series, primarily price and volume

► Example measures:

► Trend lines

► Moving averages

► Many, many more

Strategies

► Going Long (“going long”).Hypothesis: price is expected to go up

Buying a security and selling it when the price is higher

► Going Short (“short selling”).Hypothesis: Price is expected to go down.The security is borrowed for a fee and sold in the market. Capital gain is created after security is bought at a lower price and returned to the borrower

► Dividend stocks.Businesses with strong financials distribute profits to security holders paying dividends typical return 3% of share price. Growth in revenue and share price compounds in dividends.

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What is fundamental analysis?

► Definition: Fundamental analysis is a method of evaluating a security in an attempt to measure its intrinsic value, by examining related economic, financial and other qualitative and quantitative factors.

1. Analyse the underlying factors

2. Determine the intrinsic value

3. Compare the intrinsic value to the current market price

► The various fundamental factors can be grouped into two categories:

► Qualitative factors – e.g. quality of management, brand-name

► Quantitative factors – e.g. revenues, profits

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► Market price < Intrinsic value: BUY

► Market price > Intrinsic value: SELL

Qualitative factors (1)

► Business model

► Plan on how to generate revenue, grow and make a profit

► What is the core business of the organisation?

► Market share & Competition

► What is the relative size of the business in its market?

► Does it have a competitive edge (“economic moat”)?

► Where and how is its customer base distributed?

► Business sector

► What is the status of the industry? Are transition plans in place?

mature: insurance growing: telehealth decline: coal

► Regulation

► Certain industries are heavily regulated because of the importance/severity of the product (e.g. pharma, finance)

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Qualitative factors (2)

► Board directors ( shareholders) and Management ( CEO, CFO, CTO…)

► Board appoints management, executives sets goals and compensation

► Is strategy and goals followed? How are executives compensated?

► Corporate governance

► Mechanisms, relations, and processes by which a corporation is controlled and is directed; involves balancing the many interests of the stakeholders (shareholders, executives, employees, customers, government, etc).

► Poor corporate governance:

► Company policies change constantly

► Poor board of director management leads to low performance ( incompetent politicians or family placed at the board)

► Tolerance or support of illegal activities (Volkswagen, Boeing, GE, Enron)

► Good corporate governance is where a company:

► Shareholders, executives and employees have aligned incentives

► The company is profitable but cares for corporate citizenship

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Quantitative factors

► Welcome to accounting, the three critical financial statements of a public company are:

►Balance Sheet

► Income Statement

►Cash Flow Statement

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Corporate Website: Investor Relations

Quantitative factors

► Household “equivalent” of the statements

►Balance Sheet

► Income Statement

►Cash Flow Statement

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Personal net worth

Savings of the year

Money in the bank

Balance sheet

► a.k.a. Statement of Financial Position

► Provides a snapshot of a company’s financial situation

► Assets

► Something of value to a company

► Tangible and intangible

► Current and non-current

► Liabilities

► Debt or obligations organisation is responsible for

► Current and non-current

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Equity = Assets – Liabilities

Balance sheet

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Balance Sheet

Current assetsCash, receivables, inventory, and other assets that will be liquidated within a year

Non-current assetsMachinery, buildings, and other assets that will not be liquidated within a year

Total assets

Current liabilitiesShort-term debt, payables, tax, and other liabilities that will be served within a year

Non-current liabilitiesLong-term debt and other liabilities that will be served in a year or more

Total liabilities

Share capitalCapital received from issuing shares on primary market

Retained earningsNet profit minus dividends

Total equity

$XX.XX

$XX.XX

$XX.XX

$XX.XX

$XX.XX

$XX.XX

$XX.XX

$XX.XX

$XX.XX

Income statement

a.k.a. PNL: Profit and Loss Account. Measures company’s performance over certain period

► Revenue/Sales

► Expenses

► Cost of revenue: cost to create the goods or services

► Fixed costs: marketing, salaries, utility bills

► R&D costs: programs to secure

► Interest, Tax, Depreciation and Amortization

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EBITDA= Revenue – ExpensesNet Income = EBITDA -I –T –D -A

Dividends + Equity Increase= Net Income

Income statement

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Income Statement

Revenue / Turnover / Sales– COGS= Gross Profit

– SG&A= Earnings Before Interest, Tax, Depreciation & Amortisation (EBITDA)

– Depreciation & Amortisation= Operating Profit / Earnings Before Interest & Tax (EBIT)

– Interest Payments & Tax= Net Profit

$XX.XX($XX.XX)

$XX.XX

($XX.XX)$XX.XX

($XX.XX)$XX.XX

($XX.XX)$XX.XX

Cash flow statement

Shows how much cash comes in and out of the company over a period of a year or quarter

► Information on the business liquidity to: cover operations, cover future growth, or is close to bankruptcy

► Three sections: cash flow from operations, financing and investing

► Does not follow accrual accounting recording transactions regardless of whether cash flows have been transferred. The cash flow statement records only operations that have taken place.

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Cash flow statement

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Cash Flow Statement

Cash Flow From Operating ActivitiesRevenue from sales, payment of wages, interest payments, taxes

Cash Flow From Investing ActivitiesCapital expenditure on machinery, acquisitions, etc.

Cash Flow From Financing ActivitiesCash received for issued shares or bonds, dividend payments

Net Cash Flow

$XX.XX

($XX.XX)

$XX.XX

$XX.XX

Financial ratios

Let’s put the financial statement data to use:

► Financial ratios are a simple and consistent method of establishing metrics

► Standardised comparisons can be made between firms of the same sector and maturity

► Metrics are the starting point for analysis. Need to consider the “bigger picture” beyond ratios!

► Consider four categories: profitability, debt, liquidity, valuation

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Profitability ratios

► Profit margin

► Indicates how much every dollar of sales is kept in earnings

► e.g. 20% profit margin: company has a gross profit of $0.20 for every $1 of revenue

► Gives an indication of how well costs and operating expenses are being managed

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𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭 𝐌𝐚𝐫𝐠𝐢𝐧 =𝐑𝐞𝐯𝐞𝐧𝐮𝐞 − 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐑𝐞𝐯𝐞𝐧𝐮𝐞

𝐑𝐞𝐯𝐞𝐧𝐮𝐞

𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐏𝐫𝐨𝐟𝐢𝐭 𝐌𝐚𝐫𝐠𝐢𝐧 =𝐑𝐞𝐯𝐞𝐧𝐮𝐞 − 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐑.−𝐂𝐨𝐬𝐭 𝐨𝐟 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧

𝐑𝐞𝐯𝐞𝐧𝐮𝐞

Profitability ratios

► Return on assets (ROA)

► Indicates how efficient management is at using its assets to generate profit

► Return on equity (ROE)

► Indicates how efficient management is at using the money invested by shareholders to generate profit

► Warning: large debt large ROE

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𝐑𝐞𝐭𝐮𝐫𝐧 𝐎𝐧 𝐀𝐬𝐬𝐞𝐭𝐬 =𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭

𝐀𝐬𝐬𝐞𝐭𝐬

𝐑𝐞𝐭𝐮𝐫𝐧 𝐎𝐧 𝐄𝐪𝐮𝐢𝐭𝐲 =𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭

𝐄𝐪𝐮𝐢𝐭𝐲

Debt ratios

► Help to quantify risk of bankruptcy of the firm and the debt load it carries

► Debt ratio

► Gives a quick evaluation of the riskiness of the firm, high ratio = highly leveraged = more risky

► Debt-to-equity ratio

► Measure of financial leverage

► Not atypical for the value to be significantly above 1 for large firms

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𝐃𝐞𝐛𝐭 𝐑𝐚𝐭𝐢𝐨 =𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

𝐀𝐬𝐬𝐞𝐭𝐬

𝐃𝐞𝐛𝐭 𝐄𝐪𝐮𝐢𝐭𝐲 𝐑𝐚𝐭𝐢𝐨 =𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

𝐄𝐪𝐮𝐢𝐭𝐲

Liquidity ratios

► Does the firm have sufficient cash and liquid assets to pay off its obligations?

► Affects its reputation, credit rating and therefore future borrowing costs

► Current ratio

► A larger value indicates that the firm is able to pay off its short term liabilities

► Low values may not be a problem if inventory turnover is high and horizon of accounts receivable is short

► Quick ratio (“acid test”)

► Adjusts current ratio by excluding assets that take longer to convert into cash (e.g. inventory), and including only the most liquid assets (e.g. cash, short-term investments)

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𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐑𝐚𝐭𝐢𝐨 =𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

𝐐𝐮𝐢𝐜𝐤 𝐑𝐚𝐭𝐢𝐨 =𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 − 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

Valuation ratios

► Price-to-Book (P/B) ratio

► Used to see if a stock is relatively cheap to buy (“value stock”)

► Compares market price to “book value” (shareholder’s equity)

► Price-Earnings (P/E) ratio

► Best known and most widely used financial ratio

► Price of stock per dollar of earnings

► High PE ratio = expectation of large earnings growth (“growth stock”)

► Useful to compare companies in the same sector

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𝐏𝐄 𝐑𝐚𝐭𝐢𝐨 =𝐒𝐭𝐨𝐜𝐤 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 (𝐄𝐏𝐒)

𝐏𝐁 𝐑𝐚𝐭𝐢𝐨 =𝐒𝐭𝐨𝐜𝐤 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

𝐄𝐪𝐮𝐢𝐭𝐲 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

Valuation ratios

► Price-Sales (P/S) ratio

► Compare market value to the revenue

► A typical acquisition should be 2-10x Revenue

► Earnings per share (EPS) ratio

► Profitability: Portion of profit per share per year

► Important when the number of shares changes one year to another

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𝐄𝐏𝐒 =𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕

𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬

𝐏

𝑺=𝐒𝐭𝐨𝐜𝐤 𝐩𝐫𝐢𝐜𝐞 ∗ 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔

𝐑𝐞𝐯𝐞𝐧𝐮𝐞

Summary

Covered the basics of fundamental analysis

► Qualitative factors

► Business model, market share, competition, industry, regulation, management, corporate governance

► Quantitative factors

► Financial statements: balance sheet, income statement, cash flow statement

► Financial ratios: profitability, debt, liquidity, valuation

► This talk was educational only, don’t use it as investment advice!

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