Unit 4 Company Analysis: Establishing The Value Benchmark
Unit 4 Company Analysis: Establishing The Value Benchmark
Unit 4 Company Analysis: Establishing The Value Benchmark
COMPANY ANALYSIS
Establishing the Value Benchmark
Outline
Strategy Analysis
Accounting Analysis
Financial Analysis
Estimation of Intrinsic Value
Tools for Judging Undervaluation or Overvaluation
Obstacles in the way of an Analyst
Equity Research in India
Strategy Analysis
Strategy analysis seeks to explore the economics of a firm and identify its
profit drivers so that the subsequent financial analysis reflects business
realities.
The profit potential of a firm is influenced by the industry or industries
in which it participates (industry choice), by the strategy it follows to
compete in its chosen industry or industries (competitive strategy), and by
the way in which it exploits synergies across its business portfolio
(corporate strategy).
We have considered industry analysis in the previous chapter. So, the
present discussion focuses on competitive strategy and corporate strategy
Competitive Strategy
Among the various frameworks of strategy formulation, the one developed by
Michael E. Porter in his seminal work Competitive Strategy has been perhaps
the most influential in shaping management practice. Michael Porter argues
that the firm can explore two generic ways of gaining sustainable competitive
advantage viz., cost leadership and product differentiation.
Cost leadership can be attained by exploiting economies of scale, exercising
tight cost control, minimizing costs in area like R&D and advertising, and
deriving advantage from cumulative learning. Firms which follow this
strategy include Bajaj Auto in two wheelers, Mittal in steel, WalMart in
discount retailing, and Reliance Industries in petrochemicals.
Product differentiation involves creating a product that is perceived by
customers as distinctive or even unique so that they can be expected to pay a
higher price. Firms which have excelled in this strategy include Mercedes in
automobiles, Rolex in wristwatches, Mont Blanc in pens, and Raymond in
textiles.
Exhibit 15.1 depicts the competitive position of the firm based on its
relative cost and differentiation positions. The most attractive
position of course is the cost-cum-differentiation advantage position.
Exhibit 15.1 Competitive Position of the Firm
Superior
Cost-cum-
Differentiation
differentiation
Relative
Differentiation
Position
advantage
advantage
Stuck-in-the
Low cost
middle
advantage
Inferior
Superior
Relative
Cost
Position
Inferior
Direct Selling
Build-to-order manufacturing
Low-cost service
For example,
Accounting Analysis
Accounting analysis seeks to evaluate the extent to which the firms
accounting reports capture its business reality. As an analyst you
must be familiar with.
Bad Accounting
Quality
Quality
risks
and risks
to
strategy,
performance,
describe
its
its
current
and
future
prospects
There are no red flags
Financials Analysis
ROE : 3 Factors
PAT
ROE
Sales
x
Sales
Net Profit
Margin
Assets
x
Assets
Asset
Turnover
Equity
Leverage
ROE : 5 Factors
PBIT
ROE
Sales
x
Sales
PBT
x
Assets
PAT
x
PBIT
Assets
x
PBT
Net Worth
20 x 5
262/15 = 17.47
20 x 6
292/15 = 19.47
20 x 7
332/15 = 22.13
20 x 5
34/15 = 2.27
20 x 6
60/15 = 4.00
20 x 7
70/15 = 4.67
20 x 5
28/34 = 0.82
20 x 6
30/60 = 0.50
20 x 7
30/70 = 0.43
20 x 5
Rs 1.86
20 x 6
2.00
20 x 7
2.00
Growth Performance
Sales of 20 x 7
1/ 5
Sales for 20 x 2
CAGR of earnings
per share (EPS) :
EPS for 20 x 7
EPS for 20 x 2
1=
840
1/ 5
542
1/ 5
1 =
1/ 5
1 =
7.00
6.30
3.00
2.30
1 = 9.2%
1/ 5
1 = 2.1%
1/ 5
1 = 5.5%
Risk Exposure
Beta
Beta represents volatility relative to the market
Volatility of Return on equity
Range of return on Equity over n years
Average return on equity over n years
Favourable
Factors
Unfavorable
Factors
Earnings Level
Growth Level
RISK EXPOSURE
Valuation Multiples
The most commonly used valuation multiples are :
Price to earnings (PE) ratio
Price to book value (PBV) ratio
PE Ratio (Prospective)
Price per share at the beginning of year n
Earnings per share for year n
PE ratio
20 x 5
9.25
20 x 6
6.63
20 x 7
6.23
20 x 5
1.52
20 x 6
1.49
20 x 7
1.42
EPS Forecast
20 x 7
(ACTUAL)
Net Sales
Cost of Goods sold
Gross profit
Operating Expns
Depreciation
Sellin & gen.
Admn. Expns
Operating Profit
Non-operating
Surplus/Deficit
Profit before
INT. & Tax (PBIT)
Interest
Profit before Tax
Tax
Profit after Tax
Number of Equity
Shares
Earnings per Share
840
924
638
202
74
30
20 x 8
(PROJECTED)
Increase by 10 Percent
708
Increase by 11 Percent
216
81
Increase by 9.5 Percent
34
44
128
47
135
130
25
105
35
70
137
24
113
38
75
15 MLN
RS 4.67
Assumption
15
RS 5.00
No Change
Decrease by 4 Percent
Increase by 8.57 Percent
Different PE Ratios
Note that different PE ratios can be calculated for the same stock at
any given point in time.
P / E Ratio
Constant Growth Dividend Model
Dividend payout ratio
P / E RATIO
=
Required
return on
equity
P/E
Expected
growth rate
in dividends
Weighted P /E ratio
Ratio
Historical Analysis
PE ratio
20 x 5
9.25
20 x 6
6.63
20 x 7
6.23
= 7.37
Weighted PE Ratio
PE ratio based on the constant
growth dividend discount model
: 6.36
Value Range
Rs.30
Market Price
Rs.38
Decision
< Rs.30
Rs.30 Rs.38
> Rs.38
Buy
Hold
Sell
PBV-ROE Matrix
Growth-Duration Matrix
PBV-ROE Matrix
HIGH
PBV Ratio
LOW
Overvalued
Low ROE
High PBV
High ROE
High PBV
Low ROE
Low PBV
Undervalued
High ROE
Low PBV
LOW
HIGH
ROE
Growth-Duration Matrix
High
Undervalued
Promises of
growth
Dividend
cows
Overvalued
Expected 5-Yr
EPS Growth
Low
Low
High
price depending on
expected future growth
ERI Illustration
Omegas price per share
= Rs.150
= 15 percent
= 20 percent
= 50 percent
ERI Illustration
Omegas base line value =
Rs.10
0.15
= Rs.66.7
Acceleration ratio =
150 66.7
150
= 0.56
1.50
1.20
= 1.25
Future
Equity researchers who are able to do their job well have bright
prospects. The future belongs to those who will:
Summing Up