READING NOTE 2: BASICS OF EQUITY ANALYSIS AND VALUATION Arti Anand Bhargava

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1 Wealth Management Intermediate Plus On-going Training Programme for Wealth Managers READING NOTE 2: BASICS OF EQUITY ANALYSIS AND VALUATION Arti Anand Bhargava Equity investing involves choosing the stocks of companies after a careful analysis of their underlying merit and future earning potential. There are several factors that might impact the performance of a company, making equity analysis a vase and diverse area of study. In this note, we provide information on two key sets of indicators and principles: a. Financial ratios b. Valuation models PART 1: FINANCIAL RATIOS The first step in fundamental analysis of a company is a thorough examination of a company s financial statements. There are many well-tested ratios that investors may use. Financial ratio analysis helps an investor to identify and quantify a company's strengths and weaknesses, evaluate its financial position, and understand the risks involved. Liquidity Ratios Liquidity ratios are used to gauge the health of the current assets and liabilities of the business. A business would try to fund its debtors through support form the creditors. However, higher level of creditors would signal that the creation of current assets, primarily in the form of finished goods, or credit sales to be recovered, might have slowed down. a. Current Ratio = Current Assets/Current Liabilities The current ratio measures a company's ability to pay off its short-term debt obligations. In general, the higher the ratio the better as it is a clear signal that a company can pay its debts that are due in the near future and still fund its on-going operations. However too high a current ratio may suggest higher working capital needs and inability to convert assets to cash, or unwillingness of suppliers to provide adequate credit. b. Quick Ratio = Current Assets (Inventory + Receivables)/Current Liabilities The quick ratio or the acid-test ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. 2011, Centre for Investment Education and Learning Pvt Ltd 1

2 Profitability Ratios Profitability is measured by margin that compares profits to revenues. Margin is the amount of profit generated by the company as a per cent of the sales generated. The objective of margin analysis is to detect positive or negative trends in a company's earnings. Positive profit margin implies better investment quality. Consistency in margins from period to period is an indicator of stability in earnings. Better margin in a given industry is indicative of higher levels of operating efficiency or better pricing power, or both. a. Gross Profit Margin = Gross Profit/Net Revenue (Sales) The gross profit margin is used to analyse how efficiently a company is using its raw materials, labour and manufacturing-related fixed assets to generate profits. Generally, management cannot exercise complete control over such costs. However, the gross margin is an indicator of industry-level efficiencies, and any benefits the company reaps from market share, pricing advantages, or scale of operations is visible in higher or consistent gross margins. b. Operating Profit Margin = Operating Profit/Net Revenue (Sales) Operating income is obtained by subtracting selling, general and administrative expenses from a company's gross profit. Management has much more control over operating expenses as a whole. Operating margins tend to be high for new successful businesses that are able to expand quickly on a lower asset base. Established businesses tend to see a lower operating margin as competition would have brought prices down and normalised the operating costs. Operating margin varies across industry sectors, depending on the cost structure of the industry. c. Pre-tax Profit Margin = Pre-tax Profit/Net Revenue (Sales) A company may use various tax management techniques, allowing it to reduce its post tax profits. Sometimes companies may enjoy tax concessions from locations that give them a tax holiday or concessional tax treatment. Therefore, analysts prefer to use a pre-tax income number to see how profitable the business was before allowing for taxes. d. Net Profit Margin = Net Profit/Net Revenue (Sales) Often referred to as the bottom line, the net profit after tax is the most often mentioned when discussing a company's profitability. Peer company comparisons of net profit margins can be problematic as a result of the impact of the effective tax rate, depreciation, interest, other income and extraordinary items. A company's operating and pre-tax incomes are preferred over its net profit by investment analysts for making inter-company comparisons and financial projections. But equity investors care about the bottom-line, since it represents the profits available for distribution or for retention and funding of future growth. 2011, Centre for Investment Education and Learning Pvt Ltd 2

3 Return Ratios These ratios indicate how the capital and assets of a business are performing and whether the business is generating adequate return to the providers of capital. a. Return on Assets Return on Assets = Net Income/Average Net Assets The return on assets (ROA) ratio illustrates how well the management is employing the company's total assets to make a profit. The higher the ratio, the more efficient management is in utilizing its asset base. Capital-intensive businesses have a larger investment in fixed assets than technology or service businesses. b. Return on Capital Employed RoCE = Net profit/(equity plus Debt capital) The return on capital employed (ROCE) ratio measures how well the capital deployed, both equity and debt, have performed in terms of generating adequate return. An ROCE ratio, as a very general rule of thumb, should be at or above a company's average borrowing rate. c. Earnings Per Share = Net Earnings / Average Outstanding Shares Earning per share (EPS) indicates how much post tax profit was earned per equity share. It is used in valuation measures by comparing it to the market price. The price-earing ratio, which is market price per share/earning per share, is indicative of how much an investor is willing to pay per equity share, for every rupee of earning of the company. Leverage Ratios a. The Debt Ratio The debt ratio is used to know the level of leverage being used by a company. Debt Ratio = Total Debt/Total Assets A low percentage means that the company is less dependent on borrowings. b. Debt Equity Ratio = Total Liabilities / Shareholder s Equity This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed. A high ratio here means less protection for creditors. A low ratio, on the other hand, indicates a wider safety cushion (i.e., creditors feel the owner's funds can help absorb possible losses of income and capital). c. Interest Coverage Ratio = Earnings before Interest and Taxes/Interest Expense The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The lower the ratio, the more the company is burdened by debt expense. 2011, Centre for Investment Education and Learning Pvt Ltd 3

4 Turnover Ratios These ratios look at how efficiently and effectively a company turns its assets into revenue as well as how efficiently a company converts its sales into cash. a. Fixed Asset Turnover Ratio = Revenue/ Fixed Assets (Property, Plant and Equipment) Fixed assets vary greatly among companies. For example, a technology company has less of a fixed-asset base than a heavy manufacturer. Higher the turnover, lower the investment in assets required to generate sales. b. Cash Conversion Cycle = Inventory Conversion Period + Receivables Conversion Period - Payables Conversion Period Inventory Conversion Period = (Inventory/Cost of Goods Sold)*365 Receivables Conversion Period = (Receivables/Net Sales)*365 Payables Conversion Period = (Purchases/Accounts Payable)*365 The conversion cycle indicates the working capital requirement of the company. Higher the conversion period, greater the requirement for working capital. Return on Equity One of the well-known frameworks brings ratios together to understand sustainable earnings is the ROE (Return on Equity) analysis. RoE = (PAT / sales) x (Sales / Assets) x (Assets / Net worth) PAT / Sales = profit margin Sales / Assets = asset turnover Assets / net worth = financial leverage Companies tend to target earning a margin on sales as the prime objective. A positive margin enables expansion of sales, on the existing asset base. Higher margins attract competition and over time, margins would fall from competition. Companies try and keep costs in check to counter this, as the first step. Efficient asset utilisation is thus the next objective in enhancing RoE. Companies however cannot expand sales without additional investment in capacity. The asset base has to be built and funded. Ploughing back profits to fund assets is the simplest expansion strategy. Funding visible growth with borrowings on the back of adequate profits that can afford interest payment is the third objective. RoE of a company is a combination of the three factors. The ability to leverage depends on the ability of margins to bear interest costs; the sustenance of asset expansion cannot be done without sales at a reasonable margin; growth in sales needs investment to sustain it. RoE analysis enables the understanding of the interplay of these factors on the sustainable growth for a company. 2011, Centre for Investment Education and Learning Pvt Ltd 4

5 PART 2: VALUATION MODELS Several methodologies are used to derive the fair value of an equity share, from financial data about a company. Intrinsic valuation models fit earnings and dividend data into valuation models, to arrive at fair value. Most of these are discounted cash flow (DCF) models. The present value of that future-income stream is the theoretically correct value of the stock. This method has its own difficulties and is highly technical, but it s forms part of every analyst s arsenal. It's tough to forecast how fast a company's free cash flows will grow, how long they'll grow, and at what rate they should be discounted back to the present. Discounted cash flow, sum of the parts and enterprise value are approaches used to determine the intrinsic value of a stock. Relative valuation models use earnings and such numbers from financial data of the company, and relate them to market prices. Numbers like the dividend yield, price to sales, price to order book, price to cash flow, book value to price and price-earnings ratio are simple valuation parameters. The problem with relative valuations is that not all companies are made alike--not even those in the same industry. Therefore, the key is to research factors that might justifiably make them cheaper or more expensive than similar stocks. Discounted Cash Flow - DCF Model The discounted cash flow model of valuation computes the value of a company today, based on projections of how much money it's going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as "discounted" cash flow because cash in the future is worth less in cash terms today. DCF uses the concept of the time value of money. It projects a series of future cash flows and then discounts for the time value of money, typically using the company's own weighted average cost of capital (WACC) over a period of five to 10 years. The sum of all future discounted cash flows is the company s net present value (NPV). Calculated as: Using the DCF model Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output the share price. The typical steps involved in using the DCF model to value a company are as follows: 1. Determining the forecast period 2011, Centre for Investment Education and Learning Pvt Ltd 5

6 2. Forecasting revenue growth for the period under consideration, based on assumptions of sales growth, keeping in mind the various company and industry specific factors 3. Estimating free cash flow over the forecasting period 4. Using the appropriate discount rate to calculate the net present value of the future cash flows, by considering the cost of equity and the cost of debt 5. Arriving at the fair value of the company s equity If we divide the fair value by the number of outstanding shares of the company, we get a fair value for the company's shares. If the shares are trading at a lower value than this, they could represent a buying opportunity for investors. If they are trading higher than the per share fair value, shareholders may want to consider selling the company s stock. Benefits and Limitations of DCF Developing a DCF model can prove complex and time-consuming. But in return for the effort, investors get a good picture of the key drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet capital structure, cost of equity and debt, and expected duration of growth. It also makes an investor think about the company's costs of capital and the risk factors. DCF is also less likely to be manipulated by aggressive accounting practices. DCF analysis shows that changes in growth rates and interest rates have a big impact on share valuation. Investors can also use the DCF model as a reality check. One can plug in the current share price and, working backwards, calculate how fast the company would need to grow to justify the valuation. The lower the implied growth rate, the better - less growth has therefore already been "priced into" the stock. Best of all, unlike comparison metrics like P/Es, DCF produces a believable stock value. In case of valuation ratios, stocks are compared to each other rather than judged on intrinsic value. If the companies used as comparisons are all over-priced, the investor can end up holding an expensive stock. A well-designed DCF model should prevent investors from buying into a market bubble. DCF models are powerful, but they do have shortcomings. DCF is only as good as its assumptions and inputs. Investors must constantly second-guess valuations; the inputs that produce these valuations are always changing and susceptible to error. A single, unexpected event can immediately make a DCF model obsolete. Due to the nature of DCF calculation, the method is extremely sensitive to small changes in the discount rate and the growth rate assumption. DCF analysis demands constant vigilance and modification. With its focus on long-range investing, the DCF model is not suited for short-term investments. A model that shows that ABC Technologies is worth Rs.550 does not mean that it will trade for that in the short run. 2011, Centre for Investment Education and Learning Pvt Ltd 6

7 In many small companies, it is difficult to project cash flow or earnings years into the future, and this is especially true of companies with fluctuating earnings or exposure to economic cycles. Enterprise Value Enterprise value (EV), Total enterprise value (TEV), or Firm value (FV) is an economic measure reflecting the market value of the whole business rather than its current market capitalization. Many consider it to be a more accurate representation of a firm's value because it includes debt in its calculation. It measures the theoretical takeover price that an investor would have to pay to buy a company. Long-term debt, therefore, increases the value of a company while cash equivalents decrease the effective price an acquirer has to pay. Enterprise value is calculated as follows: Market Capitalization + Total Debt - Cash Equivalents= Enterprise Value Let's assume Company XYZ has the following characteristics: Shares Outstanding: 10,00,000, with the current share price: Rs.50 Total Debt: Rs.10,00,000 Total Cash: Rs.5,00,000 Based on the formula above, we can calculate Company XYZ's enterprise value as follows: (Rs.10,00,000 x Rs.50) + Rs.10,00,000 Rs.5,00,000 = Rs.5,05,00,000 Some analysts adjust the debt portion of this formula to include preferred stock and minority interest; they may also adjust the value of associate companies. Enterprise value = Common equity at market value + Debt at market value + Minority interest at market value, if any - Associate company at market value, if any + Preferred equity at market value - Cash and cash-equivalents. Pros and Cons of EV EV is used to find attractive takeover candidates. Enterprise value is a better metric than market cap for takeovers. It takes into account the debt, which the acquirer will have to assume. Therefore, a company with a low enterprise multiple can be viewed as a good takeover candidate. The value of EV lies in its ability to compare companies with different capital structures. EV is an appropriate way to measure the value of the entire company rather than just the stock price, which looks only at the equity market capitalization of the stock, ignoring the company's cash, minority interests and debt. 2011, Centre for Investment Education and Learning Pvt Ltd 7

8 To get a better sense for a company's true valuation, many analysts and investors prefer to compare earnings, sales, and other measures to enterprise value. Valuation multiples such as EV/EBITDA, EV/FCF or EV/SALES are much more stable and have a greater predictable value. These multiples allow for easier comparisons between companies in the same sector, or even between companies from different sectors, as they eliminate distortions coming from different debt levels, minorities or non-operational assets. However, enterprise value by itself is worthless, because a company can have a much greater enterprise value because it has a much greater debt, which would actually lessen the value of the enterprise with all other things being equal. Sum of Parts Valuation Sum of The Parts (SoTP) valuation approach involves valuing a company by determining what its divisions would be worth if it was broken up and spun off or acquired by another company. SoTP values the different parts of the business separately using a range of appropriate valuation metrics and adds the values of the different parts of the business together to arrive at the enterprise value. For example, a company may have a growth business that deserves a high PE and a mature business that deserves a low PE. A cyclical business may require a higher discount rate when doing a DCF. Consider a company that has three businesses: - a subsidiary in which it owns a 50% stake and which is separately listed, - a new business in which it has heavy capital investment but which is not expected to become profitable for several years, - a mature, stable business that produces predictable cash flows. Applying a single PE, DCF or EV/EBITDA to this business would be difficult. A possible approach using a sum of parts would be: - Value the separately listed subsidiary using the market value of its shares. - Use a DCF for the new start-up. - Use an EV/EBITDA for the stable business Adding all the three together will provide the EV of the company. Pros and Cons of SoTP SoTP is regarded as the best tool to value companies with diversified business interests. It evaluates each business or division of the company separately and assigns a value to its contribution. This valuation also captures future potential of the new ventures, which are not generating revenues right now. SoTP valuation indicates if the company s value would be increased if it was split into separate business units. Having said that, SoTP valuations are dependent on stage of value unlocking in many cases these may be understated given limited visibility of movement to higher stages. Given 2011, Centre for Investment Education and Learning Pvt Ltd 8

9 heightened awareness of the SoTP approach, it is possible that individual parts may be valued ahead of what the value unlocking stage dictates, leading to over-valuation. Relative Valuation Models Price/Earnings Ratio The most common valuation technique used by analysts is the price to earnings ratio, or P/E. To compute this figure, take the stock price and divide it by the annual EPS figure. For example, if the stock is trading at Rs.100 and the EPS is Rs.5, the P/E is 20 times. Historical or trailing P/Es are computed by taking the current price divided by the sum of the EPS for the last four quarters. Forward or leading P/Es are computed by taking the current stock price divided by the sum of the EPS estimates for the next four quarters. For example, consider a company whose fiscal year ends in March In order to compute the forward P/E for financial year ending 2011 (technically called FY11), we would add together the quarterly EPS estimates for its quarters ended June 2010, September 2010, December 2010 and March We could use the current price divided by this number to arrive at the FY11 P/E. Theoretically, a stock's P/E tells us how much investors are willing to pay per rupee of earnings. In other words, a P/E ratio of 10 suggests that investors in the stock are willing to pay Rs.10 for every Re.1 of earnings that the company generates. Interpretation of P/E Ratio Although a simple indicator to calculate, the P/E is actually quite difficult to interpret. Future growth is already accounted for in the stock price. As a result, the P/E ratio is as a reflection of the market's optimism concerning a company's growth prospects. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop. A good example is Microsoft. During the late 1990s, when it was growing by leaps and bounds, its P/E ratio was over 100. Today, Microsoft is one of the largest companies in the world, so its revenues and earnings can't maintain the same growth as before. As a result, its P/E has dropped to a more realistic level. It's important to compare the P/E of their prospective stock purchase to the P/E ratio for the overall market (S&P Nifty), the company's industry segment, and two or three peer companies. Pros and Cons of using the P/E Ratio The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, all things being equal, a Rs.10 stock with a P/E of 75 is much more "expensive" than a Rs.100 stock with a P/E of 20. It is difficult to determine whether a particular P/E is high or low without taking into account two main factors: 2011, Centre for Investment Education and Learning Pvt Ltd 9

10 Company growth rates in the past and how they are likely to be in future. If the earnings are not set to grow, the company risks being de-rated or valued progressively at lower and lower PEs. Industry - Companies must be compared to others in the same industry, or to the industry average. For example, comparing a tech company to a utility is useless as the nature of the two industries is different. It is important to remember that P/Es change constantly and ratio needs to be recomputed every time there is a change in the price or earnings estimates. The projected P/Es are based on analyst estimates that are not always precise. Companies that are not profitable, and consequently have a negative EPS, are difficult to interpret. The average P/E ratio in the market and among industries fluctuates significantly depending on economic conditions. Price Earnings to Growth ratio (PEG Ratio) This valuation technique has really become popular over the past decade or so. It is better than just looking at a P/E because it takes three factors into account - the price, earnings, and earnings growth rates. The formula used to compute the PEG ratio is as below: This ratio may be used to express the extent to which price that an investor is willing to pay for a company, is justified by the earnings. The assumption with high P/E stocks (generally growth stocks) is that investors are willing to buy at a high price because they believe that the stock has significant growth potential. The PEG ratio helps investors determine the degree of reliability of that growth assumption. The thumb rule is that if the PEG ratio is 1, it means that the market is correctly valuing a stock in accordance with the stock's estimated EPS growth. If the PEG ratio is less than 1, it means that EPS growth is potentially able to surpass the market's current valuation and the stock's price is undervalued. On the other hand, stocks with high PEG ratios can indicate just the opposite - that the stock is currently overvalued. This is based on a belief that P/E ratios should approximate the long-term growth rate of a company's earnings. The PEG ratio may show that one company, compared to another, may not have the growth rate to justify its higher P/E, and its stock price may appear overvalued. Although the PEG ratio improves upon (i.e. provides additional valuation insight) the P/E ratio, it is still far from perfect. Misreading of a company's or analysts' predictions of future earnings are very common. Also, investor sentiment regarding a stock's pricing and earnings prospects is usually overly optimistic during bull markets and overly pessimistic in bear markets. 2011, Centre for Investment Education and Learning Pvt Ltd 10

11 Price to Book Value Ratio Price to Book Value (P/BV) is a valuation ratio used by investors, which compares a stock's per-share price (market value) to its book value (shareholders' equity). The P/BV ratio is an indication of how much shareholders are paying for the net assets of a company. The book value per share is calculated by dividing the reported shareholders' equity (balance sheet) by the number of common shares outstanding (balance sheet). If a company's stock price (market value) is lower than its book value, it can indicate one of two possibilities. The first scenario is that the stock is being incorrectly undervalued by investors and represents an attractive buying opportunity at a bargain price. On the other hand, if the company is correctly valued in the opinion of the investors, then it will be regarded as a losing proposition. Some analysts feel that the use of book value is limited because a company's assets are recorded at historical cost. Depending on the age of these assets and their physical location, the difference between current market value and book value can be substantial. Also, intellectual property is difficult to assess in terms of value. Hence, analysts fear that book value may undervalue these kinds of assets, both tangible and intangible. The P/B ratio therefore has its shortcomings but is still widely used as a valuation metric. It is probably more relevant for use by investors looking at capital-intensive or finance-related businesses, such as banks. While Price earnings ratios look at the market value of equity relative to earnings to equity investors, Value earnings ratios look at the market value of the firm relative to operating earnings. EV/EBITDA EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization) is a valuation multiple that is often used in parallel with, or as an alternative to, the P/E ratio. Typically, this ratio is applied when valuing cash-based businesses. It is also known as the Enterprise Multiple or EBITDA Multiple. An advantage of this multiple is that it is equally applicable across companies with different capital structures. Enterprise multiples can vary depending on the industry. Therefore, it is important to compare the multiple to other companies or to the industry in general. Expect higher enterprise multiples in high growth industries and lower multiples in industries with slow growth. A low ratio indicates that a company might be undervalued. It's useful for transnational comparisons because it ignores the distorting effects of individual countries' taxation policies. The EV/EBITDA is a better alternative to be used while comparing 2011, Centre for Investment Education and Learning Pvt Ltd 11

12 companies because it is purely driven by business operations of the company unlike PE multiple, as earnings get impacted by extraordinary and non-business items in the business. Two companies in a sector may have similar PE multiple but very different EV/EBITDA multiple. All the same, it is more tedious to compute than the PE multiple due to removal of nonoperating aspects of income, expenses and assets. Pitfalls in Relative Valuation Relative valuation is simple and has spawned a large number of rules of thumb. For example, investors believe that stocks with price book value less than one, stocks at low price-earning multiples or stocks with high dividend yield, should be undervalued. While using relative value variables, caution has to be exercised in questioning the apparent undervaluation of a stock and seeking additional information before acting on such overtly simplified thumb rules. High Dividend Yield Stocks with high dividend yield appeal to investors who are income seeking and somewhat averse to risky investments. Companies with good growth prospects may be wary of paying high dividends, but may instead like to use the profits for funding their growth. Therefore stocks with high dividend yield may not always turn out to be stocks that hold the potential for capital appreciation. Therefore high dividend yield stocks may have the risk of lower future earnings growth. Low Price-Earnings Multiple Many consider stocks with low PE multiples as being cheap, mispriced or undervalued. Low PEs are pre-dominantly from higher risk associated with the earnings, or lower expected growth rate in earnings, or both. Most stocks with low PE multiples may be qualitatively poor than stocks that sell at a higher PE multiple. 2011, Centre for Investment Education and Learning Pvt Ltd 12