Fundamental Analysis 5

CONTENT AREAS

What Is Fundamental Analysis?

What Is Economic Analysis?

What Is Industry Analysis?

Difference Between IFRS and GAAP

What Is Company Analysis?

What Is Financial Statement Analysis?

How Are Resource Companies Analyzed?

LEARNING OBJECTIVES

1 | Explain how fundamental analysis aids in the security selection process.

2 | List key economic metrics and describe how the yield curve is used as an economic indicator.

3 | Explain the influence of international economic events on domestic security analysis.

4 | Explain how industry analysis is used to select stocks.

5 | Explain the difference between International Financial Reporting Standards (IFRS) and Generally
Accepted Accounting Principles (GAAP).

6 | Identify the various sources of company information.

7 | Assess the quality of a company based on its earnings.

8 | List the merits of different absolute valuation models.

9 | Assess the advantages and disadvantages of different valuation techniques.

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LEARNING OBJECTIVES

10 | Calculate a firm’s worth using any one of the valuation models.

11 | Explain the metrics used in the analysis of oil and gas companies.

12 | Calculate the metrics used in the analysis of oil and gas companies.

13 | Explain the metrics used in the analysis of mining companies.

KEY TERMS

Key terms appear in bold text in the chapter.

Absolute valuation model Econometrics Management’s Discussion &

Analysis (MD&A)
Aggregate demand curve Economic analysis
Monetary policy
Aggregate supply curve Economic forecast
Price to book (P/B)
Assets Endogenous variables
Price to earnings (P/E)
Balance of trade Equity
Price to sales (P/S)
Bank rate Exogenous variables
Relative valuation model
Barrel of oil equivalent (BOE) Finding and development
(F&D) costs Return on equity (ROE)
Barrels of oil equivalent per
day (BOE/D) Fiscal policy Sector rotation

Bottom-up analysis Fundamental analysis Statement of cash flows

Business cycle sensitivity Gross domestic product (GDP) Statement of comprehensive

income
Company analysis Industry analysis
Statement of financial
Consensus forecast Industry life cycle position

Dividend discount model Intrinsic value Top-down analysis

Earnings per share (EPS) Liabilities Whisper estimate

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INTRODUCTION
An individual can accumulate wealth over a lifetime by owning real assets, such as land, real estate properties, and
businesses. Alternatively, an individual can accumulate wealth by owning financial assets, such as equities or bonds.
Financial assets and managed products like equity and bond mutual funds are conventional means of accumulating
wealth. There are two schools of thought when analyzing securities for inclusion in a client’s portfolio: fundamental
analysis and technical analysis.

WHAT IS FUNDAMENTAL ANALYSIS?

Fundamental analysis is the study of the variables (including management, sales, regulatory environment, and
labour costs) that affect a company’s profitability, its industry, and the economy in which it operates. At the heart of
fundamental analysis is the concept of intrinsic value. The intrinsic value of a security is the estimate or opinion of
what the security’s market price should be, either currently or in the future. Every company’s stock has an intrinsic
value that is determined by those variables that affect profitability, and the current price of a stock fluctuates
toward this value. The purpose of fundamental analysis is to determine if the stock’s intrinsic value is above or
below its current market price. If the stock’s market price is below its intrinsic value, then fundamental analysis
suggests it should be purchased.
Fundamental analysis can be performed using a top-down or bottom-up approach. Proponents of top-down
analysis believe the main drivers of a company’s prospects are determined in large part by the growth of its
industry within the growth of the overall economy. While a company’s cost structure, management, and product
lines are important to profitability, its success is mainly determined by external factors, such as commodity prices,
gross domestic product (GDP) growth, interest rates, and overseas demand.
A top-down analyst initially makes an economic growth forecast by typically using econometric models. From
this forecast, the analyst extrapolates the growth rates of various industries to find the best expected performers.
Using a list of companies from these industries, the analyst conducts a financial statement analysis to discover the
companies that are expected to perform the best.
For example, a top-down analyst may forecast that the Canadian economy will fall into a recession over the next
year. Industry analysis may reveal that defensive consumer staples stocks will be the best performing industry
during this period. Within this industry, financial statement analysis may show that a major food retailer is the
company that is best positioned to operate within a recession.
Proponents of bottom-up analysis believe that a company’s individual attributes determine its profitability,
regardless of industry or macroeconomic factors. Bottom-up analysts are looking for strong companies with good
prospects. However, what constitutes a strong company is up for debate. To some analysts, it may mean a superior
rate of revenue growth compared with its industry. For others, it may mean a discount-to-book value or a high
return on equity (ROE). Or, it could be a cost or technological advantage. Whatever the focus, bottom-up analysts
are seeking companies that occupy a niche or possess a singular advantage that separates them from the rest of the
industry.

WHAT IS ECONOMIC ANALYSIS?

To carry out fundamental analysis, an advisor must understand the tenets of economic, industry, and company
analyses. Economic growth drives earnings growth, which ultimately drives growth in a company’s stock price. To
know what drives economic growth, an advisor needs to understand how the economy functions. The broadest
measure of an economy’s success is the change in its gross domestic product (GDP), which represents the value
of goods and services produced in a national economy. The level of GDP is determined by the balance between

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what output a nation will buy at a given price level (the aggregate demand curve) and what it will produce at a
given price level (the aggregate supply curve). The factors that shift these two curves ultimately determine how well
an economy performs, and what industries and companies will be profitable. The goal of economic analysis is to
understand these shifts in the aggregate demand and supply curves.

AGGREGATE DEMAND CURVE

The aggregate demand curve is the schedule of the amount of real output that consumers, firms, government,
and foreigners will buy at each price level. All things being equal, the lower the price level, the larger the real GDP.
A nation’s aggregate demand curve is derived from its total spending on goods and services at different price levels.
GDP increases as total spending increases. Total spending at a given price level is represented in the following
formula.
Total spending = C + I + G + X – M (5.1)

Where:
C = Consumption expenditures by households
I = Private investment
G = Government purchases of goods and services
X = Gross exports
M = Gross imports

Consumption (C) is the largest component of total expenditures. The general level of job creation determines
the level of household disposable income, which in turns determines the level of consumption. If households
expect their income level to increase in the long run, their consumption level also increases. Consumption is also
determined by the following factors:

Wealth The greater the amount of wealth a household accumulates, the larger the amount it
consumes and the smaller the amount it saves from any income level. For instance, the
rise in U.S. home values in the early 2000s increased people’s propensity to spend and
helped pull the country out of a recession. The term “wealth” includes real assets (such
as a home) and financial assets (cash, stocks, bonds, and pensions).

Expectations If households expect incomes, prices, and the availability of goods to rise, they will
buy now to avoid higher prices and having to do without. An income increase makes
consumers more willing to increase their current spending.

Consumer debt The greater the burden of debt on a given household, the less it is willing to spend on
current consumption so that it can reduce its indebtedness.

Taxes Taxes are paid out of current spending and savings. A tax increase reduces spending and
savings. Conversely, a tax decrease increases spending and savings.

Private investment (I) is expenditure on capital equipment in the expectation that capital goods will help return a
profit. The level of investment is established by the real interest rate (the nominal rate less the rate of inflation). The
real interest rate is the cost firms incur to borrow the money needed to buy capital goods. Investment expenditures
increase as the real interest rate drops. Investment spending is also influenced by the following factors:

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Expectations of real Improving profit expectations from investment projects increases the level of investment
net profits spending. Alternatively, if profit expectations decline because of lower consumer
incomes, deteriorating business conditions, and other factors, the level of investment
spending falls.

Taxes Firms measure the success of business projects by their after-tax return. If business taxes
increase, the profitability of future projects is reduced, which also reduces investment
spending.

Technological changes The development of new products and processes, as well as improvements to existing
machinery, spurs new investment spending. New technology may improve efficiency or
product quality, or lower costs, with a corresponding increase in expected profitability.

Government spending (G) is the amount a government spends on goods and services. Government spending is
influenced by political considerations and depends on the domestic and foreign agenda of the ruling party. When a
government spends in order to influence aggregate demand, it is known as fiscal policy and can be financed in one
of, or a combination of, three ways:

Taxation Higher levels of taxation without offsetting government spending tend to reduce overall
demand in the economy. Consequently, lower levels of taxation help the economy
expand.

Borrowing The government may enter the public capital markets to borrow money, but at the cost
of competing with private business owners. The government may “crowd out” private
investment and interest rate-sensitive consumer spending because the additional
demand for capital may drive up its cost—the interest rate.

Printing money Crowding out can be avoided by the issuance of new money in a country. The creation
of new money has a greater positive effect on aggregate demand than borrowing.
However, there is a limit to how much money can be created, because printing money
is ultimately inflationary and increases interest rates and depreciates the currency.
Excessive money creation can lower spending in the long run through higher interest
rates.

Net exports refer to the difference between a country’s gross exports and its gross imports in goods and services
trade (X – M)—also known as the balance of trade. A country’s level of net exports depends on its level of
domestic GDP.

EXAMPLE
If Canada’s GDP increases, the country’s net exports will decrease because its gross imports will increase with the
domestic economy’s level of income.

Net exports are also determined by the following factors:

Foreign incomes Increased economic activity abroad increases foreign demand for domestically produced
goods, therefore increasing net exports. Foreign citizens can afford to buy more of their
own goods and those of other nations.

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Tariffs The taxes foreign nations impose on imported goods reduce the income the exporting
nation receives from trade. The exporting nation may retaliate by imposing similar
tariffs, reducing the foreign nation’s net exports and income. Thus, higher tariffs and
other barriers to trade tend to reduce net exports.

Exchange rates The depreciation of the Canadian dollar compared with the currencies of Canada’s
trading partners reduces the foreign price of domestic goods and increases the country’s
net exports. Canadian consumers will also find that they need more money to buy
foreign goods, and must therefore reduce their overall spending on imports.

SUPPLY CURVE
The aggregate supply curve is the schedule of real domestic output that businesses would be willing to produce
at each price level. Higher price levels are an incentive for businesses to create more output. Each aggregate supply
curve assumes a given level of production inputs. If the supply of inputs increases, businesses are able to produce
more at a given price level. What follows is a list of production inputs:

Land resources As an example, intensive farming techniques or irrigation can make land more
productive. In addition, the discovery of mineral or oil deposits can increase land
resources.

Labour On average, labour accounts for 75% of all business costs. An increase in the supply
of labour, for example, through immigration, reduces the cost of labour and increases
business productivity.

Capital The level of output increases when businesses add to the quality and quantity of
productive capital. Capital includes items such as plants, equipment, and computers.

Productivity The amount of output created per unit of input is called productivity. It can be
increased by more efficient manufacturing techniques or improved technologies.

Taxes Taxes increase unit costs. Lower taxes will enable businesses to produce more at a
given price level.

Regulations It costs businesses time and money to comply with regulations. By eliminating complex
regulations and the paperwork associated with them, businesses can increase efficiency
and productivity.

OUTPUT AND PRICE LEVEL EQUILIBRIUM

With a unique set of input factors and technologies, every economy around the globe has a long-run level of
output at which there is full employment and stable prices. At any given moment, the exact output produced
by the equilibrium between aggregate demand and aggregate supply might be considerably less than (excessive
unemployment) or more than (inflationary) the long-run full employment level. Governments can try to
make adjustments to the aggregate demand and supply curves to manage output and, ultimately, prices and
employment.
For instance, if an economy is operating at less than full employment, its government can cut taxes and regulations,
or borrow money in the open market and spend it. But these policy options can only be initiated with long lag
times. It takes time to pass fiscal legislation because it needs to be debated and voted upon. Unlike fiscal policy,
monetary policy can be applied as quickly as a central bank decides to use it. As a result, monetary policy is the
instrument of choice for influencing output.

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MONETARY POLICY
Monetary policy is the management of a nation’s money supply to stabilize output, employment, and the general
price level. In Canada, monetary policy is the responsibility of the Bank of Canada (BoC), a non-partisan government
agency. The BoC alters money supply by manipulating the excess reserves (the lending power) of chartered banks.
By controlling the level of excess reserves, the BoC can indirectly control the amount and price of credit available for
business and consumption. The BoC exerts control over the level of excess reserves by three methods:

The bank rate The bank rate is the interest rate that the BoC charges to chartered banks for the use of
short-term money.

Open market operations The BoC buys and sells Government of Canada securities.
Example: When buying government securities, the BoC pays cash to chartered banks to
settle purchases, thereby increasing excess reserves.

Switching Government The BoC has control over a considerable amount of deposits that belong to the
of Canada deposits Government of Canada. Switching these deposits from chartered banks to the BoC can
reduce the level of excess reserves.

Part of the BoC’s mandate is to sustain and maintain economic performance that contributes to rising living
standards while keeping inflation low, stable, and predictable. Monetary policy is used to decrease the rate of
inflation during boom times or increase employment during recessionary times.
Loose monetary policy increases aggregate demand, while tight monetary policy decreases it. This effect is
transmitted through investment spending, current consumption, and expectations. Investment spending is very
sensitive to interest rate levels and trends because of its long-term nature and large cost. Land, capital equipment,
and buildings are very expensive. If monetary policy is tight, high interest costs can severely reduce the profitability
of business projects, reducing investment spending.
Current consumption is affected because it is financed to some degree by borrowing, especially for durable goods.

EXAMPLE
The monthly payment on an automobile represents a household expenditure. In good times or bad, the payment
would be made. With tight monetary policy, those who are financing automobile purchases would have to pay
more in carrying costs—money they would acquire by reducing current consumption.

The expectations of investors and consumers are shaped in large part by their confidence in the future profitability
of business and income levels. When there is an expectation of higher interest rates, future levels of both expected
corporate profitability and personal incomes are reduced and current spending is curbed.

ECONOMIC INDICATORS TO WATCH

An advisor needs to keep abreast of the latest economic data to get a sense of what factors other investors consider
important and where the economy in general is headed, and to understand the issues that economists debate.
Monitoring economic developments arises as much from an advisor’s need to explain these developments to clients
as it does from the fundamental analysis required to construct and pick equity investments on their behalf.
It is even more critical for an advisor to follow the factors that a central bank has identified as leading indicators
of inflation, since monetary policy is usually devised to anticipate changes in the inflation rate, not just react to
changes in current inflation. Table 5.1 lists the Canadian indicators, which are compiled and released by Statistics
Canada, except for housing starts, which are compiled and released by the Canada Mortgage and Housing
Corporation. Table 5.2 lists the U.S. indicators. Note that some of the data are seasonally adjusted to remove or
minimize the effect of seasonality and get a better comparison of year-to-year trends.

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Table 5.1 | Canadian Indicators

Indicator Description Frequency

National Income and Expenditure Details income and expenditures in the economy Quarterly
Accounts (GDP)

Real GDP by industry Measures value added by labour and capital on an Monthly
industry-by-industry basis

Labour Force Survey Survey of working age population Monthly

Canadian International Merchandise Details total merchandise exports and imports Monthly
Trade Balance

Industrial Capacity Utilization Rates Measures the extent of productive capacity usage Quarterly

Monthly Survey of Manufacturing Estimates of manufacturers’ shipments, Monthly

inventories, and orders

Retail Trade Survey Survey of retail sales by region Monthly

Housing starts Measures number of new self-contained housing Monthly

units started

Consumer Price Index Indicator of rate of price changes for goods and Monthly
services at the consumer level

Industrial Product Price Index Measures prices that producers earn as goods Monthly
leave their plants

Table 5.2 | U.S. Indicators

Indicator Description Frequency

Gross domestic product (GDP) Output of goods and services produced by labour and Estimated Quarterly,
property Revised Monthly

Unemployment Report Household survey on labour conditions Monthly

ISM Manufacturing Index Measures activity of manufacturing sector Monthly

Philadelphia Fed Survey Survey of activity of manufacturing firms in the Monthly

Philadelphia Federal Reserve District

Retail sales Estimate of sales and inventories at retail and food stores Monthly

Housing starts The number of new privately owned housing units started Monthly

Consumer Price Index Change in prices paid by urban consumers for a market Monthly
basket of goods and services

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Table 5.2 | U.S. Indicators

Indicator Description Frequency

Producer Price Index Changes in selling prices received by domestic producers Monthly
of goods and services

Federal Reserve Beige Book Summary of economic conditions in Federal Reserve Eight times a year
Districts

Conference Board Consumer A survey of nationwide consumer confidence Monthly

Confidence Index

INTERNATIONAL ECONOMIC DEVELOPMENT AND EVENTS

Elements of risk from outside the scope of the domestic economy affect forecasts based on economic indicators,
and often make them less relevant. A terrorist attack is an extreme example of an uncertain and unpredictable
event, with implications for most sectors of the economy and financial markets, not just in the country where it
occurred, but around the world as well.
Some would argue that a discussion of event risk does not belong in a chapter on economic analysis. Nothing
could be further from the truth. We have seen how reports of actual economic data interrelate with forecasts of
such variables to determine market direction, and how the observation of these events defines cyclical and secular
trends. What we have not discussed is how structural shifts in the economy can affect the direction of indicators.
The emergence of global terrorism has had a structural impact on economic sectors, governments, and central bank
policy formation. In some cases, it has led to a breakdown in the traditional correlations between economic factors
and security prices. The best economic models in the world will still fail to predict terrorist acts, but economic
analysis can reveal how terrorism affects the behaviour of businesses and households.
Similarly, an examination of the global economy’s changing patterns can also help investment professionals
determine the direction of the domestic economy. In the 1970s, economists did not forecast the Organization of the
Petroleum Exporting Countries (OPEC) oil crisis. But the impact on crude oil and gasoline prices created a massive
shift in the consumption profile for automobiles (from larger vehicles to smaller fuel-efficient ones), an increase
in energy conservation measures (including expanded nuclear generation), and a reduced dependence on OPEC
supply.
Country risk is slightly more predictable, as in the case of the Asian financial crisis of 1997 and the Russian debt
default of 1998. However, as the collapse of Long-Term Capital Management (LTCM) shows, models can still fail.
Russia’s default led to a flight to relatively riskless quality assets, such as U.S. government bonds, which caused U.S.
bond yields to fall precipitously; yet, LTCM had built a bond portfolio that was long on Russian bonds and short on
U.S. government bonds, which resulted in the firm losing billions of dollars.
Finally, global economic developments affect the North American economy and therefore market direction.
Economists, advisors, and investors need to stay abreast of these developments, since even though they usually
take place over a very long term, domestic economic effects can still catch the market by surprise. One case in point
is China’s growing dominance on the world economic stage. After more than 30 years of strong GDP growth, China
is now one of the three global economic superpowers. Over time, its demand for raw materials sent commodity
prices and Baltic freight shipping costs soaring. Companies without any business interactions with China had an
increased cost base because of higher input costs, which directly affected their profitability, capital expenditures,
and hiring decisions. Therefore, we saw an overall impact on the macro economy.
China’s ascension as a global economic power has created large trade imbalances with the U.S. These imbalances
are affecting the movement of global exchange rates, even in countries that have minimal economic relations with
China.

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So profound has been China’s effect on the major industrialized countries of the world that economists are already
starting to look at the next potential candidates for economic supergrowth, including India.

ECONOMIC FORECASTING
One of the key products of an economics department is a set of economic forecasts. An economic forecast is
simply an economist’s or economics department’s prediction for the outcome of a particular economic indicator or
event, including the release of economic data, the contents of an important policy-maker’s speech, or the results of
a planned central bank decision on interest rates.
Economic forecasts are used both inside and outside of the investment industry. Investment advisors need to
understand the rationale behind a forecast, how it is put together, and how it compares to other estimates.
Forecasts for many variables are created using a bottom-up or add-up model. This means that underlying economic
components are estimated or projected based on the available information and the expected relationship between
this information and the variable being estimated. Then the components are aggregated (or added up) to produce a
sector or macro forecast.
The simplest illustration of a bottom-up model is the one used to forecast expenditure-based GDP, which is a
measure of an economy’s total output based on spending. GDP is simply the sum of four variables, as shown in
Figure 5.1.
An easy way to build a bottom-up model of expenditure-based GDP is to use a spreadsheet program. The model
contains the variables for a given time period. These variables are used to forecast future values of GDP by using
projections for each of the components and then adding these projections up.
Figure 5.1 | The Components of GDP Calculation

GDP = C + I + G + X − M

Consumption Private Government Exports minus

(C) Investment (I) Spending (G) Imports (X-M)

GDP is calculated by adding up consumption, private investment, government spending, and exports minus
imports.

Economic theory usually forms the basis for the relationships between variables in a particular model, such as the
effect of higher interest rates on a forecast of automobile purchases. Since such purchases are normally financed
through a personal loan or a lease, the level of interest rates determines the cost of financing and therefore the
effective cost of the vehicle. Higher financing charges—without a commensurate increase in household income or a
decrease in the prices of other items in the consumption basket—result in either a drop in demand for vehicles or a
move away from other purchases to maintain the same level of spending on vehicles.

ECONOMETRIC ANALYSIS
Since an underlying theory may not apply to all situations or countries, economists test it mathematically using
econometric analysis, which is also known as econometrics. In the simplest terms, econometrics is the bridge
between economic theory and applied economics. Real-world observations, mathematics, and statistical analysis
are combined to test a theory and then mathematically represent that theory so that it can be used to predict the
future value of an economic variable.

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EXAMPLE
If the theory states that “automobile sales decline when interest rates rise”, econometric analysis could examine
a historical set of sales data against a time series of interest rates to determine whether a relationship indeed
existed and quantify that relationship. An economist could then use this equation in an overall forecast for
consumption in the GDP model.

One advantage of these models is that economists can incorporate new information into an overall forecast fairly
quickly. For example, the GDP forecast for a particular quarter is largely driven by estimates for consumption, since
it typically represents 50 to 60% of GDP. The consumption estimate is in turn driven by weekly and monthly retail
sales reports. As consumption reports are released, economists can adjust their quarterly consumption forecasts and
hence their GDP forecasts.
Not all economic forecasts are generated solely by mathematically deduced results for the underlying components.
Some components are themselves forecasts based on available data. These are known as endogenous variables,
meaning they depend on variables that are also generated from a forecast.
Assume that a quantifiable relationship between auto sales and interest rates was found and factored into an overall
forecast for consumption in a GDP model. It is known, however, that interest rates move up and down according to
the strength or weakness of the overall economy (as measured by GDP, which is what is being modelled), so interest
rates will influence auto sales. It is also known that over time the strength in auto sales will in turn affect interest
rates.
In this case, auto sales are considered the endogenous variable within the GDP model. Models that have this
iterative quality—meaning that one variable affects another variable that itself affects the original variable—are
rare among financial sector economics departments, mainly because of the resources that must be spent just
to maintain these models. When building a GDP model, economists tend to make qualitative assessments of
components like auto sales based on qualitative forecasts for interest rates.
Variables that are not determined from within the model are called exogenous variables; for example, the
government spending component in a GDP model. Although a government bases its spending decisions on the state
of the economy, this is only part of the process. Policies are often implemented deliberately to affect the economy
or address a policy objective that is unrelated to it. The chosen level of spending is unknown to economists until
it is published in the budget, so they must predict what the level of spending will be and include their prediction
in the model. The difference in assumptions about exogenous variables explain much of the variation between the
forecasts of different economists.

CONSENSUS FORECAST
Investors sometimes base trading decisions on their own economic views and projections, and sometimes on a
single external forecast (or on the forecast of their investment dealer’s economics department, if available). Often,
however, they arrive at a decision by considering a wide range of forecasts, or what is called a consensus forecast,
which is simply the average forecast of several economists. The term consensus (which implies agreement) may
seem like an odd way to label the average projection from a group of economists that may have widely different
opinions on the outlook for the economy. However, just as consensus estimates for corporate profits determine the
movement in share prices when actual results are released, consensus economic forecasts provide a reference to
which the reported performance of the economy and its sectors are compared. There are two situations in which a
consensus forecast comes into play:
• Providing an average view of the major economic variables used in making investment and business decisions.
• Positioning markets ahead of key economic releases.

Nearly every day of the month, official statistical agencies report on some measure of economic activity. For the
major releases, several economists are polled about their expectations, often by an electronic wire service (e.g.,

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Bloomberg or Reuters). From this survey, the service will calculate a consensus forecast. Sometimes it will also
report the high and low estimates for the survey. The consensus forecast is then disseminated to the investment
community through the wire services or in the print media. Most economics departments offer investment
advisors and their clients a weekly calendar of releases that shows the date and time for the release of a report, the
consensus forecast, and sometimes the department’s estimate.

DEVIATION FROM CONSENSUS FORECAST

When an economics report is released, market participants compare the outcome to the published consensus and
react. Each market—equities, bonds, money market, commodities, or foreign exchange—may react differently to a
particular report. Some markets will ignore a release, even when it causes another market to move in a significant
manner.
Probably the most closely watched economic indicator is the monthly U.S. payrolls report. If the actual increase in
payrolls in a given month is larger than the consensus forecast, equity prices tend to rally; bond markets tend to sell
off; the U.S. dollar tends to strengthen; and in some situations, commodity prices will increase on the perception
that stronger employment growth suggests stronger overall demand for commodities.
If the difference between the outcome and consensus forecast is large, the movements of the various markets
tend to be more significant. Some indicators, because of the economic weight they carry, have a greater impact on
market direction for a given deviation from consensus than others. Depending on the current stage of the economic
cycle, markets tend to gravitate away from reliance on one set of indicators to another. If the economy’s growth has
been evident for several months, markets tend to place less emphasis on indicators of real growth (as opposed to
growth from price increases)—such as GDP, spending, and employment—and more emphasis on inflation indicators.
The emphasis is on inflation because as growth continues, a central bank would be expected to tighten monetary
policy to dampen inflation, and thus would be monitoring inflation variables.
If an investment advisor has access to consensus forecasts, it might seem that figuring out the market reaction to
a set of possible outcomes would be fairly simple. Unfortunately, it is not. Since there are often situations in which
interim information arrives after the consensus is calculated (usually several days before the actual event), but
before the actual data is released, the market often formulates what is called a whisper estimate. People on the
trading and sales desks will discuss this estimate in the lead-up to the report. Rather than comparing the outcome
to the printed consensus, they react to deviations from the whisper estimate instead.
Over the years, those who conduct economic surveys have tried to improve the accuracy and relevance of their
consensus forecasts by surveying economists about interim information. Typically, there is not enough time to get
a representative sample size before the data release, so the revised consensus forecasts may be no more relevant
than the original ones. This does not mean that the whisper estimate is a superior forecast of the release; it may turn
out that the published consensus forecast is more accurate. It is important to understand, however, that investment
success ultimately comes down to how the market actually perceives reality and not how it should perceive reality.
For long-term investors, the market’s day-to-day deviations and gyrations are inconsequential. For short-term
portfolio decisions, however, advisors need to know the complete market intelligence picture behind each release,
from published consensus forecasts to whisper estimates. Advisors may learn about the whisper estimates from the
morning meeting and economist briefing notes, but more typically, they get this information in direct discussion
with trading and sales professionals.
Some economic events are not the subject of published consensus forecasts at all. Most weekly reports, for
example, do not have consensus forecasts associated with them (except for the Thursday report on U.S. jobless
claims). These include the U.S. reports on mortgage applications and weekly retail sales (the two main reports
come from Instinet Research Redbook and the International Council of Shopping Centers), as well as the Bloomberg
Consumer Comfort Index. These reports attract attention among investors, however, by providing leading indications
for some important monthly economic reports (employment, retail sales, and consumer confidence).

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In addition to the weekly reports, investors also have to account for infrequent release of government non-
data reports, such as the U.S. Federal Reserve’s Beige Book, the BoC’s Monetary Policy Report, and speeches by
government and central bank officials. None of these reports carry numerical estimates, but nonetheless the market
has expectations about their potential impact on security prices.

YIELD CURVE AS AN ECONOMIC INDICATOR

The yield curve has a very good record of predicting recessions in the U.S. For analytical purposes, the slope of the
yield curve is defined as the difference between a long- and short-term rate of U.S. Treasury issues. The securities
used in this case were the 10-year Treasury bond and the federal funds rate.
Tightening shows up the most in short-term rates and to a lesser degree in long-term rates. The higher short-term
rates slow down the economy. If pushed high enough, short-term rates could invert the yield curve and tip the
economy into recession. Historically, there is strong relationship between the inversion of the yield curve and its
correct prediction of a recession.
While a yield curve inversion generally occurs before a recession, it can also occur for reasons other than declining
economic growth, as follows:
1. Low inflation expectations, which flatten the yields of longer-dated securities.
2. Large purchases of U.S. Treasuries, notably in the longer maturities, by foreign central banks.
3. Pension and hedge fund purchases, as pension funds buy longer-dated bonds to match long-dated liabilities,
and hedge funds use long treasuries to execute trading strategies.

WHAT IS INDUSTRY ANALYSIS?

Whatever outlook an advisor takes on the economy, it is necessary to translate the implication of this outlook into a
forecast for certain industries, because different industries exhibit different sensitivities to the business cycle.

EXAMPLE
During the recession in 2001, technology companies fared worse than financial ones.

Understanding the impact of the business cycle on different industries and the factors that determine industry
responsiveness to changes in the business cycle is a goal of industry analysis. Industry analysis helps the advisor
target the right industry to invest in. Frequently, the returns on industries vary over a wide range. They are also
inconsistent over time. Therefore, past performance is not necessarily a good indicator of future performance. Also,
stock selection is easier within an industry that is expected to perform well, as opposed to one that is expected to
perform poorly.

CLASSIFICATION BY INDUSTRY LIFE CYCLE

The first step of industry analysis is to grasp the different industry classifications and how responsive they are to
the business cycle. The classification by industry life cycle reflects the fact that, to a great extent, the life cycle
of an individual firm depends on the life cycle of its industry. In general, an industry follows four life cycle phases:
pioneering, expansion, mature, and declining.

PIONEERING PHASE
The pioneering phase is the most profitable and riskiest of the four life cycle phases. Early in the life cycle, the
novelty of an industry’s new products leads to very strong sales and earnings growth. The demand for products
is high, and companies are expanding and producing outstanding rates of return. These returns may lead more

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competitors to enter the field. Weaker firms are forced out of business by the weight of start-up costs, failure to
comply with emerging industry standards, or simply by price and market share competition.
The Internet bubble of the late 1990s serves as an illustration of the pioneering stage. Many Internet companies had
great ideas, yet no earnings. High stock prices discounted fantastic earnings growth years into the future. Failure
to meet earnings expectations collapsed stock valuations, cutting off any chance of additional financing, and drove
many companies into bankruptcy.

EXPANSION PHASE
During the expansion phase, an industry’s leading firms move to the forefront as its weaker firms are acquired or
forced out. Overall, there are fewer surviving firms than in the pioneering phase and, on average, they tend to be
in better financial health. Bankruptcy rates drop. Growth rates are still attractive, but not nearly as strong as in the
pioneering phase. Earnings expectations are more realistic.
Investment opportunities become more attractive as the industry attains more stable growth. Firms gain
experience, tune their products, and use economies of scale to lower prices. At this point, some companies may
choose to float an initial public offering.

MATURE PHASE
Through the mature phase, leading firms will produce stable cash flows. Earnings forecasts will generally be reliable.
However, at some point during this phase, an industry’s profitability will begin to level off or decline. The market
might be saturated or consumer demand may fall off. The value of the industry’s stocks might decline.
The mature phase may be a good time to divest from the industry. However, some companies find innovative ways
to survive by accommodating to shifts in demand. This may result in a company repositioning itself at an earlier
phase of the life cycle.

DECLINING PHASE
For an industry’s remaining firms, competition from newer products or low-cost suppliers makes it difficult to
generate profits. The industry’s growth rates are no better or weaker than the economy at large.

CLASSIFICATION BY SENSITIVITY TO THE BUSINESS CYCLE

No two industries have the exact same response to the business cycle. In an economic upturn, steel-producing firms
will have higher rates of return than the retail industry. Therefore, it is useful to classify industries by their business
cycle sensitivity. There are four groups: growth, cyclical, defensive and cyclical growth.

GROWTH INDUSTRY
Growth industries can sustain a successful growth rate regardless of the economy’s performance. What comprises
a growth industry changes over time. Home electronics and computers, once considered luxuries, have become
staples and their businesses are considered growth industries today. To comprehend these industries, an advisor
needs to understand societal trends and ascertain how consumers spend their money in all types of economic
conditions.

CYCLICAL INDUSTRY
Cyclical industries have a growth pattern that follows the business cycle. They prosper in upturns, but suffer more
than the average in downturns.

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EXAMPLE
When the economy is expanding, people feel more secure about their income and purchase housing. When the
economy is stagnant, few people can afford to purchase housing.

To be successful in selecting cyclical industries, you need to depend on the accuracy of economic forecasts.

DEFENSIVE INDUSTRY
Defensive industries display less sensitivity than growth or cyclical industries to the phases of the economy, because
they are usually involved in the production of necessities. Investments in defensive industry stocks are more secure
than those in growth or cyclical industries.

EXAMPLE
The utilities industry is an example of a defensive industry. The earnings of utilities companies are very
predictable because their pricing is regulated by government boards.

CYCLICAL GROWTH INDUSTRY

Cyclical growth industries share the attributes of both the cyclical and growth industries because they change
and update their products, which boosts profits and increases efficiencies. This industry’s growth pattern is more
complex. Determining the cycle highs and lows for cyclical growth businesses is more difficult than for cyclical
businesses.

SOURCES OF BUSINESS CYCLE SENSITIVITY

Innumerable factors influence business cycle sensitivity, including the types of products and services industries
offer, the types of income and costs, the amount of competition and ease of entry, demographic and
technological factors, and government and labour relations. Some examples follow.
Sales sensitivity to income – Necessities such as food and medical services are less sensitive business conditions,
because people spend the money when needed, regardless of the economy. In contrast, businesses such as steel,
autos and transportation are highly sensitive to economic conditions.
Operating leverage – Companies with a larger proportion of variable costs over fixed costs, or low operating
leverage, are less sensitive to business cycle changes. As the economy takes a downturn, these companies can
reduce their costs and still maintain their profit margins. Companies with high fixed costs are more sensitive to
business cycle changes.
Financial leverage – Companies must pay interest on loans, regardless of business conditions, and those that
carry debt have financial leverage. In an economic upturn, a leveraged company is more profitable than a non-
leveraged one.
Competition – The more firms there are in an industry, the lower the overall expected rates of return will be. The
ability of new firms to enter an industry will depend on the barriers to entry that they face. The following are
examples of barriers to entry:
• Economies of scale – A new entrant into an industry will be at a relative disadvantage because it lacks market
share and will not be able to produce as many goods as established competitors to spread out costs. An
industry with large economies of scale is the auto industry.
• Patents – Contracts give a company exclusive rights, preventing competitors from using, making, or selling a
new or innovative product or process. Licensing fees can also act as a barrier. An example of an industry that
restricts entry through patents is the pharmaceutical industry.

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SOURCES OF BUSINESS CYCLE SENSITIVITY

• Research and development – Some products, such as specialized drugs or microprocessors, require a huge
upfront investment in time and money. Few potential competitors can afford this level of investment, which
thus serves as a deterrent.
• Customer loyalty – Established firms may have existing customers who are faithful to recognized products or
services. New firms will find it difficult to take customers away from established ones.
• Distributor or supplier agreements – Exclusive arrangements with key suppliers or distributors in the product
chain entrench established firms in their industry, making it difficult for new businesses to enter. For
example, supermarket shelves are already filled with the products of major food manufacturers.

Lifestyle and demographic changes – The age and income distribution may determine a particular industry’s
growth prospects. Sustainability of growth prospects may be difficult to predict depending on whether the
change is permanent or a passing fancy.
Technological changes – An industry’s profits are vulnerable if technological changes allow for the creation of
inexpensive substitutes or more efficient operations. Profitability will be determined by continued maintenance
of market share in the face of the substitutes or the speed of adaptability to new technology.
Relationship with government – An industry’s relationship with the government may determine its growth. If
the government considers the business important to accomplishing its agenda, it will support the industry
legislatively and financially. For example, as security concerns have increased in the U.S., manufacturers of
military equipment have gained more contracts. If the government does not approve of the industry, especially
if it causes environmental or health problems, there will be more regulation and legislation that may negatively
affect revenue.
Labour conditions – Labour is a fixed cost and in many industries the largest component of total costs. Many
labour-related situations can affect business cycle sensitivity:
• Strikes – If the industry is labour-intensive, a strike will disrupt business and reduce revenues.
• Unions – If the workforce is unionized, higher wage and benefit settlements can weigh heavily on
profitability for many years.
• Collective bargaining – Poor management and workforce relations damage the industry every time collective
bargaining agreements are negotiated. Production declines and industry reputations are damaged. Profits
may fall as customers refuse to buy their products.
• Pension obligations – Companies may declare bankruptcy as a result of pension obligations.
• Automation – Generally, the more an industry can automate, the more it can be insulated from wage
increases.
• Worker compensation – Labour peace is more likely if members of the workforce share ownership in
companies or are compensated with bonuses related to profitability and productivity.
• Worker productivity – If workers are more productive, this higher productivity may offset increased wages.

APPLYING INDUSTRY ANALYSIS

An advisor can use industry analysis to underweight, marketweight, or overweight each industry in a portfolio. If
the advisor’s anticipated return for an industry is higher than the consensus return expectation, they can overweight
the industry. However, the level of portfolio risk may increase in lockstep with diversification decreases, and returns
may decrease as a result of trade and management costs.

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Sector rotation involves adjusting the portfolio weights of different economic sectors or industry categories in
anticipation of trends. It can also mean adjusting portfolio weights in stocks according to attributes such as size,
dividend policy, or value measures.

EXAMPLE
If a long growth period is expected, an overweight allocation to companies that produce capital goods may be
appropriate.

Although most industries are positively correlated to each other to some degree (meaning when the market starts
to fall, most industries also fall), the amount of movement is often different (meaning some industries will fall
more than others). The success of industry timing depends on selecting the leading industries at each stage of the
economic cycle and picking the stocks within these industries that are most likely to outperform. Although the
benefits of sector rotation can be significant, it is difficult to predict which sectors will excel at various times.
Many advisors who use sector rotation pay attention to industry momentum, trying to spot changes in leadership
among the various industries. Momentum rankings list industries according to their performance over the past
several periods. These rankings indicate the consistency of an industry’s performance relative to other industries and
the broad market, and can provide insight into future relative performance.
When considering sector rotation strategies, an advisor needs to remember that stock prices for companies in two
industries with similar economic sensitivity display positive return correlations as all companies experience an
increase or a decrease in product demand. An investor needs exposure to only one of these industries to benefit
from an upswing in the economy. This reduces the potential diversification benefits of sector rotation gains. Holding
securities in both industries could leave the portfolio overexposed.

DIFFERENCE BETWEEN IFRS AND GAAP

Generally Accepted Accounting Principles (GAAP) had been the standard for over 75 years in the U.S. and Canada,
guiding the preparation and presentation of financial information for a publicly traded company.
Canadian publicly accountable enterprises (PAEs) gave up using GAAP and switched to International Financial
Reporting Standards (IFRS) for annual reporting periods starting on or after January 1, 2011.
The major philosophical difference between the two accounting methodologies is that IFRS is almost entirely
principles-based, whereas U.S. GAAP is primarily rules-based. Rules-based accounting is more rigid, meaning
specific procedures are observed when preparing financial statements. This makes for less ambiguity, but also
increases the complexity of the process. It is also more difficult to make rules that fit every situation.
In principle-based accounting, guidelines are more general because the goal is to have the completed financial
statements achieve a set of good reporting objectives.

EXAMPLE
An example of a good reporting objective is sufficient disclosure of data so that an investor can make an objective
analysis.

EXAMPLE
A principles-based process can be adapted to many more situations than a rules-based one. Also, by having a
wide adoption of principle-based standards, comparing financial statements among firms across industries or
countries is easier to do.

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Under IFRS, both accounting professionals and company management are required to use the accounting policy
that best reflects the economic aspect of a company’s transactions. Accordingly, there is a greater likelihood that
similar companies might account for the same transaction in a (somewhat) different manner. But IFRS does require,
as an offset, the company to provide more extensive and detailed disclosure to explain why particular accounting
treatments are utilized.

WHAT IS COMPANY ANALYSIS?

Company analysis is both a quantitative and qualitative evaluation of a company’s business. An advisor requires
a comprehensive understanding of the company’s business, management and personnel, suppliers and customers,
and fiscal health, as reflected in its financial statements. The information can be gathered from regulatory filings,
conference calls, investor tradeshows, financial records, and other sources of information. There are four major parts
of a company’s financial statements: the statement of financial position, the statement of comprehensive income,
the statement of changes in equity (which provides a link between the statement of comprehensive income and the
statement of financial position), and the statement of cash flows.

STATEMENT OF FINANCIAL POSITION

The statement of financial position lists a company’s assets, equity, and liabilities at a specified point in time.
Assets are owned by the company (e.g., cash) or owed to the company (e.g., accounts receivable). Equity is the
total capital invested in the company’s shares plus its accumulated profit and loss over time. Liabilities are owed by
the company (e.g., long-term debt).
Assets, liabilities, and equity are related by the following equation:
Assets = Equity + Liabilities (5.2)

STATEMENT OF COMPREHENSIVE INCOME

The statement of comprehensive income lists all revenue and expenses for a specified time period. Revenue is
funds that have been or will be received for the delivery of goods or services to customers. Expenses are amounts
that have been paid or assets that have been used up during the time period in which the delivery of the goods and/
or services took place. Profit is the difference between revenue and expenses.

STATEMENT OF CASH FLOWS

The statement of comprehensive income matches expenses with revenue to determine a company’s profit.
Although profit is an important indicator of a company’s performance and sustainability, its survival over the long
term ultimately depends on its ability to generate cash. Since a statement of comprehensive income does not
include a breakdown of cash inflows and outflows, and includes some non-cash accounting items, companies are
required to prepare a statement of cash flows. The statement of cash flows breaks down a company’s sources and
uses of cash in a particular period according to its operating activities, investing activities, and financing activities, as
follows:
• Cash flow from operating activities equals cash received from the sale of goods or services minus cash used to
generate revenue.

• Cash flow from investing activities equals cash received from the sale of long-term assets minus cash used to
buy long-term assets plus any dividends received from associates.

• Cash flow from financing activities equals cash received from the sale of new shares or the issuance of new debt
securities minus cash paid to buy back shares, repay debt securities, or pay dividends.

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The sum of the cash flows from the three activities equals the change in the company’s cash (as reported on the
statement of financial position) from one period to the next.

NOTES TO THE FINANCIAL STATEMENTS

Notes to the financial statements list important information that could not be included in the company’s ledgers.
The notes explain the company’s accounting policies and provide more detailed information about individual items
in the financial statements, making them easier to follow.

MANAGEMENT’S DISCUSSION AND ANALYSIS

The Management’s Discussion & Analysis (MD&A) presents a synopsis of a company’s previous year of
operations and a review of its performance. Management will also discuss the upcoming year, outlining goals and
future projects. The MD&A section is very important in regards to studying management and its style. MD&A
provides information not found elsewhere in the financial statements, though the quality of this information is at
management’s discretion.
The following are some items to look for in the MD&A:
• Significant financial trends.
• Potential risks and uncertainties.

OTHER REGULATORY FILINGS

To maintain a listing on a Canadian stock exchange, a company must file audited annual financial statements
through the System for Electronic Document Analysis and Retrieval (SEDAR). The statements must be prepared
according to IFRS and approved by the company’s board of directors. If a company has securities listed on the
Toronto Stock Exchange (TSX), it must file these audited annual financial statements within 90 days of the end of
its financial year end. If a company has securities listed only on the TSX Venture Exchange or Canadian Securities
Exchange (CSE), it must file the statements within 120 days of the end of its fiscal year.
Listed companies must also file interim unaudited financial statements. For companies listed on the TSX,
statements must be filed through SEDAR within 45 days of the end of the interim period. If securities are listed only
on the TSX Venture Exchange or CSE, the filing period is within 60 days of the end of the interim period.
In the U.S., most companies file a Form 10-K with the Securities and Exchange Commission (SEC) within 90 days
after the end of the company’s fiscal year. This annual report provides a comprehensive overview of the company’s
business. Most reporting companies in the U.S. also file a Form 10-Q on a quarterly basis. It includes unaudited
financial statements and provides a view of the company’s financial position during the year. The report must be
filed for each of the first three fiscal quarters of the company’s fiscal year and is due within 45 days of the close of
the quarter.

THE LIMITS OF ACCOUNTING DATA

At first glance, financial records of public companies give the appearance of precision and meticulousness. After
all, the information flows nicely from the statement of comprehensive income to the statement of financial
position, and from both of these to the statement of cash flows. All accounts balance and the entire package is
normally audited by a large multinational accounting firm and reviewed by the company’s board of directors.
In reality, not every accounting entry is based on an actual transaction and involves an exchange of actual cash.
The accuracy of a fair number of accounts relies on the judgment of the corporate auditor and management.
Management itself is given a wide berth by the accounting profession to exercise this judgement. All in all,
investors cannot always take financial statements at face value.

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THE LIMITS OF ACCOUNTING DATA

Investors who perform fundamental analysis would be wise to familiarize themselves with the knowledge of
what the basic issues of accounting are, what motivates management to choose particular ways of handling
accounting rules, and how management can make financial statements show the company in the most
favourable possible light.

Accounting Issues
Mergers and acquisitions (M&A) – M&A activity has sharply increased since 1980. In most cases, companies have
been bought out at well in excess of their tangible net book value. The acquiring company records the excess as
goodwill—an intangible asset—on their statement of financial position. The complexity escalates with firms such
as Procter and Gamble or General Electric, which make multiple acquisitions each year.

Motivations for Management to Exaggerate Financial Records

Increased stock valuation – This is the most influential factor that motivates management to exaggerate
financial records. Management has two avenues to increase the company’s value. One is to improve operations
and the other is to improve the appearance of the financial statements, which for most investors are the only
information available about a company’s performance. Higher equity values manifest themselves in several
positive ways:
• Good financial performance and continued expectations of good performance secure access to equity
financing opportunities.
• The pricing of equity finance opportunities improves if the stock has a better valuation. The company would
give up less ownership based on a higher share price and might be able to complete larger financings.
• Company managers receive stock options as part of their overall compensation. A higher stock price leads to
a greater option value.

Access to debt markets – Institutional lenders rely on financial statements to ascertain a firm’s creditworthiness.
Managers may stretch results to maintain access to lenders and keep the cost of capital at a reasonable level.
For instance, a small improvement in a company’s credit rating can translate into several millions of dollars in
interest cost savings.
Job preservation – Steady growth in revenue and earnings keeps the board of directors pleased, which means
more job security for the company’s managers.

QUALITATIVE ASSESSMENTS
A qualitative study of a firm’s business considers how it generates revenue and profit. A firm’s success competing
within its industry depends on its sustained competitive advantage, the degree and duration of which depends on
three factors:
• Low costs – Among its competitors, the firm should have one of the lowest, if not the lowest, cost structure in
the industry.

• Differentiation – The firm’s products and services should stand out and be unique in the minds of its customers.

• Focus – The firm serves a narrow customer base that is underserved or overlooked by the industry.

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To determine a firm’s sustained competitive advantage, qualitative analysis considers four areas of its operations:
1. Corporate issues
2. Products and markets
3. Production and distribution
4. Competition

Corporate issues include matters of company strategy, management, personnel, properties, and the government
laws that regulate company performance. A company should have a credible business plan to drive long-term
revenue. Management must be able to match corporate resources with competitors. Growth, either internally
generated or obtained through acquisitions, should be manageable. Corporate culture should be conducive to
productivity and retention of good employees. Management should have a depth of experience and operate as
a team.
Products and markets refers to the sale and development, both current and new, of a firm’s goods and services,
and the markets it operates in. The firm should have a variety of products that are well differentiated from its
competitors. Corporate growth depends on a steady stream of product extensions and innovations. The research
and development budget should be well-funded. The company should have a diverse customer base to lessen
dependency on a single purchaser. The marketing strategy should be sufficient to sustain and grow revenue. Also,
customer service must meet clients’ needs in a timely fashion.
Production and distribution is the manufacturing and delivery of the firm’s end products. The company should
understand and be able to avoid the bottlenecks in the production process. There should be sufficient production
facilities. Production should depend on a number of suppliers to lessen delivery risk. Inputs could be a business issue
if their value is volatile and they are a large component of manufacturing. The firm should have access to a secure
distribution channel or acquire one once revenue reaches a threshold level.
Competition determines the degree of profitability. The higher the barriers to entry, the fewer competitors there will
be. Competing firms may be domestically or foreign based, and they may or may not be well-capitalized or affected
by currency fluctuations.

WHAT IS FINANCIAL STATEMENT ANALYSIS?

Financial statement analysis is the quantitative portion of company analysis. It is useful in identifying the key drivers
of a company’s performance. Factors such as cost of sales, depreciation, revenue, and capital expenditures are
components of the ratios used in financial statement analysis. At a minimum, advisors should be familiar with the
terms and properties of the following four categories of financial ratios (summarized in Table 5.3):
1. Liquidity ratios – Measure a company’s ability to meet its short-term obligations.
2. Risk analysis ratios – Indicate how well a firm services its debt obligations and its capacity to assume more debt.
3. Operating performance ratios – Help determine a firm’s long-run growth prospects. They also measure how
well the company has made use of its resources.
4. Value ratios – Assess the market’s opinion on the worth of the company’s share price relative to its dividends,
earnings, or book value.

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Table 5.3 | Summary of Financial Ratios

Type Measures
Liquidity ratios
Working capital (current) ratio Ability to meet short-term debt.
Quick (acid test) ratio Similar to current ratio but more stringent; excludes inventory.
Risk analysis ratios
Asset coverage Measures the protection provided by the tangible assets after all liabilities
are met; tangible assets are what remain after goodwill and other intangible
assets are subtracted from total assets.
Debt to equity Amount of debt incurred relative to the equity.
Cash flow to total debt Firm’s ability to repay borrowed funds.
Interest coverage Firm’s ability to pay interest charges on debt.
Operating performance ratios
Gross profit margin Rate of profit allowing for cost of sales.
Net profit margin Rate of profit allowing for all expenses and taxes.
Net return on common equity Return generated for common shareholders.
Inventory turnover Number of times per period inventory is theoretically
bought and sold.
Value ratios
Earnings per common share Earnings available to each common share.
Dividend Yield Annual dividend as a percentage of the current market price of the
company’s shares.
Price-to-earnings ratio or multiple Number of times earnings that investors are currently paying for common
stock.
Equity per common share Value of the equity theoretically available for each common share.

EARNINGS ANALYSIS
Since earnings ultimately drive a company’s stock price, investors should pay special attention to the earnings or
profitability ratios. Earnings per share (EPS) is the amount of profit attributable to each outstanding common
share. The formula to calculate basic EPS is:
Profit (5.3)
Earnings per share (EPS) =
Weighted-average of number of outstanding common shares
EPS can also be calculated on a fully diluted basis, in which case the number of outstanding common shares includes
all unexpired warrants and granted stock options, shares issued from convertible debentures, and convertible
preferred shares.

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EXAMPLE
If a company has only unexpired stock options, the fully diluted EPS will be lower than basic EPS.

If a company does not have any of these potentially “extra” common shares, then the basic and fully diluted EPS will
be the same.
The denominator—the number of outstanding shares—is a time-weighted average number. It is calculated by
multiplying the number of issued and outstanding shares at a given point in the fiscal period by the proportion of
the fiscal period when these shares were outstanding. The process is repeated until a full fiscal period is covered.
Then all the weighted periods are added up to arrive at the denominator.

EXAMPLE
If Company ABC had 100 million outstanding shares January 1, issued another 10 million shares on April 1, and
issued a further 10 million shares on October 1, the number of issued and outstanding shares over the 12 months
ending December 31 is:
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çç 3 ´ 100÷÷ + çç 6 ´ 110÷÷ + çç 3 ´ 120÷÷ = 110 million
èç 12 ÷
ø èç 12 ÷
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Return on equity (ROE) displays the rate of return on an investment for common shareholders. It is the residual
income after other securities holders (such as debt securities) have been paid. ROE has three components: net profit
margin, total asset turnover, and financial leverage.
DuPont Return on Equity (ROE) Model:
(5.4)
Profit Revenue Total Assets
ROE = ´ ´
Revenue Total Assets Common Equity
= Net Profit Margin ´ Total Asset Turnover ´ Financial Leverage

Net profit margin is the company’s rate of profit after paying out all of the costs, such as interest and taxes, of
running the business. Total asset turnover is the revenue generated for each dollar of assets. Financial leverage is a
measure of the company’s total assets as a proportion of its common equity.
For common equity, the average common equity from the beginning and ending of the year is used in the
calculation.
Earnings analysis also includes an examination of a company’s sustainable growth rate. A company’s estimated
sustainable growth rate is an important component in the calculation of its intrinsic value.
Sustainable Growth Rate
g = b × ROE
= (1 – dividend payout ratio) × ROE (5.5)

Where:
g = Growth
b = Retention ratio

The retention ratio is the amount not paid out by the firm from total earnings in the form of dividends.

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CALCULATING INTRINSIC VALUE

If a company looks attractive as an investment after completing an economic and industry analysis, making a
qualitative assessment of its merits, and calculating its financial ratios, the next step in the fundamental analysis
process is to calculate an intrinsic value to compare to current price. Intrinsic value can be estimated by one of two
methods:
1. Absolute valuation models make a point-in-time estimate of intrinsic value based on a set of forecast
company fundamentals. The most widely used absolute valuation model is the dividend discount model.

2. Relative valuation models find intrinsic value by comparing a stock’s value ratios or price multiples to a
benchmark value for the price multiple. If a stock’s current price multiple is less than the benchmark value, the
stock is undervalued; if it is greater than the benchmark, the stock is overvalued. Three of the more commonly
used price multiples are price to earnings (P/E), price to book (P/B), and price to sales (P/S).

Dividend discount models assume a stock’s intrinsic value is equal to the present value of its stream of future
dividends. The accuracy of the value computed by the model depends on the accuracy of the dividend forecast, as
well as on the estimate of the dividend growth rate and discount rate.
The dividend forecast and dividend growth rate are based on the earnings forecast and, in turn, are driven by the
projected financial statements. The discount rate is the stock’s expected return, which is usually the sum of a risk-
free rate plus a risk premium.
The dividend discount model is suitable for valuing mature firms that pay dividends and have a dividend payout
consistent to its profitability. The model is generally not used to value non-dividend-paying firms. The following
outlines the dividend discount model, known as the constant (or Gordon) growth model.
Constant (or Gordon) Growth Model
V0 = D0 (1+g) / (r – g) = D1 / (r – g) (5.6)
Where:
V0 = Intrinsic value
D1 = Dividend in period 1
r = Discount rate
g = Growth rate

EXAMPLE
If Medium Bank has a current share price of $50 and has a current dividend of $1, a discount rate of 6%, and a
growth rate of 4%, the Gordon growth model calculates the stock’s intrinsic value as follows:
V0 = 1 (1.04) / (0.06 – 0.04) = $52

According to the model, Medium Bank’s stock is undervalued by $2.

Note that the Gordon growth model can only be used if the required return on the company’s stock exceeds the
growth rate on its dividends. The Gordon model also assumes that the company’s growth rate is constant. If the
company has a high growth rate early in its existence that later tails off, the intrinsic value can be estimated using
a multi-stage dividend discount model. Dividends in the high-growth period are forecast and their present value is
calculated. Once the company settles to a steady growth phase, the Gordon growth model values the remaining
stream of dividends into a terminal value. Then the present value of the terminal amount is found and added to the
present value of the high-growth period.

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SPECIFIC DIVIDEND FORECASTS

Rather than assume any growth rate stages, analysts sometimes use dividend forecasts based on their financial
statement projections. Since these projections do not extend into the future forever, analysts must also come up
with an estimate for the stock’s intrinsic value on the last forecast dividend date. This estimate, which is often called
the stock’s terminal value, can be based on the Gordon growth model or on some other valuation model. Equation
5.7 shows the formula.
D1 D2 D + VT (5.7)
V0 = + 2
+¼ + T
(1 + r ) (1 + r ) (1 + r )T

Where:
VT = Terminal Value

T = End Of the holding period

EXAMPLE
An analyst has forecast that ABC will pay dividends of $1.50 next year, $2.50 the following year, $3 the year after
that, and $3.50 the year after that. From there on, the analyst expects the company’s dividend to increase 4% a
year indefinitely. The analyst estimates the stock’s required return is 8%.
The first thing the analyst must do is calculate the stock’s terminal value of the stock using the Gordon growth
model. Based on a constant growth rate of 4% and a required return of 8%, the stock’s terminal value is $91, as
follows:
$3.50 ´ (1.04)
V4 =
0.08 - 0.04
$3.64
=
0.04
= $91

The analyst plugs this value along with his dividend forecasts into Equation 5.7 to arrive at an intrinsic value of
$75.37:

$1.50 $2.50 $3 $3.50 + $91

V0 = + 2
+ 3
+
1.08 (1.08) (1.08) (1.08)4
= $1.39 + $2.14 + $2.38 + $69.46
= $75.37

DISCOUNTED CASH FLOW MODELS

Discounted cash flow models assume that a stock’s intrinsic value is equal to the present value of a stream of future
cash flow. Similar to dividend discount models, inputs to discounted cash flow models include cash flow forecasts
and/or cash flow growth rates, and discount rates.
The term cash flow has many applications in the securities industry. Discounted cash flow models use one of two
particular applications: free cash flow to equity (FCFE) and free cash flow to the firm (FCFF). This course talks briefly
about discounted cash flow models based on FCFE.
FCFE is cash flow available to the company’s common shareholders after paying all operating expenses and interest
and principal on its debt after investing in working capital and fixed assets. When we say free cash flow is available
to the company’s common shareholders, we mean that this is the amount it could potentially use to pay dividends.

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FCFE is not the same as the cash flow from operations item on the company’s cash flow statement, although
sometimes it is mistaken as such. One big difference between the two is that free cash flow recognizes that the
company must invest in working capital and fixed assets to at least maintain the business.
FCFF is cash flow available to the company’s common shareholders and debt holders. FCFF includes FCFE plus the
after-tax interest expense minus net new borrowing.
This course does not present any discounted cash flow models, because they use almost identical formulas to the
ones provided in the section on dividend discount models. However, there are some differences, particularly in the
use of FCFF models:
• The discount rate is the weighted average cost of capital, which is a weighted average of the required return on
the company’s debt and equity securities.

• They provide an intrinsic value for the entire company, not just its equity. To determine the intrinsic value of the
company’s equity, analysts subtract the market value of its debt securities.

COMPARING DISCOUNTED CASH FLOW MODELS TO DIVIDEND DISCOUNT MODELS

It is common for the FCFE model to value equity higher than the dividend discount model. This premium reflects the
value of controlling the firm’s dividend policy. In the infrequent event that the dividend discount model values the
equity higher than the FCFE, dividend payouts exceed free cash flow. This is unsustainable and a negative for equity
values, because the firm probably has to borrow funds for the payout. FCFE is more appropriate in valuing a firm
that is likely to be taken over or have its management changed. The dividend discount model is appropriate when
changes in corporate control are more difficult to effect because of size or legal restrictions on takeovers.
Using FCFF in the cash flow model provides a value for the entire firm as opposed to FCFE, which values only the
equity; however, the value of the equity can be extracted from the firm’s value by subtracting the market value
of the outstanding debt. The advantage of the FCFF approach is that it includes after-tax interest cost. Therefore,
FCFF is the appropriate version to use when valuing firms with high leverage or that are in the process of changing
leverage. FCFF is also more appropriate when FCFE is negative, since FCFF considers cash flow before debt payments
and is thus much less likely to be negative.

RELATIVE VALUATION
Price to earnings (P/E) is the most widely used multiple in the relative valuation method. By multiplying a firm’s
estimated EPS by the P/E multiple, an investor can arrive at an estimated share price. P/E multiples can also be an
indicator of other company characteristics, such as growth and risk. The trailing or historical P/E ratio is calculated
as follows:
Market price per common share (P0 ) (5.8)
P/E =
EPS of the last four quarters (EPS0 )

P/E ratios are uninformative when earnings are negative or very small. The volatility of earnings can lead to volatility
in P/E ratios. At cyclical firms, for example, stock prices reflect future expectations, while earnings follow the
economy. P/E ratios at cyclical firms may peak at the bottom of a recession and trough at the peak of a boom,
rendering them useless for comparison purposes.
Finally, finding comparable companies as far as risk and potential for growth are concerned can be a very subjective
and difficult exercise. If the companies are not comparable, neither will the multiples.

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Price-to-book (P/B) ratio provides a method for finding undervalued companies. P/B is calculated as follows:
P/B = P0 / BV0 (5.9)

Where:
P0 = Market price per common share

BV0 = Book value per common share

The book value per common share can be derived as the company’s net book value divided by the number of
outstanding shares.
The P/B ratio has characteristics that make it inherently more useful than other multiples. First, an investor seeking
to buy growth companies at a reasonable price can compare the P/B ratio to the firm’s ROE as a check. Large
discrepancies may be a warning sign.

EXAMPLE
An overvalued stock would have a low ROE and a high P/B ratio.

Next, the book value itself is a relatively stable measure of value compared to cash flow estimates. Lastly, the ratio
can be used to value firms with negative earnings.
The P/B ratio still has limitations that investors should be aware of. It is only useful when examining capital
intensive firms or those with plenty of tangible assets. Book value neglects to include intangible assets like goodwill
and is therefore a relatively insignificant number for service firms.
Book value is not relevant for firms with a high debt load or sustained losses. Debt can increase liabilities to the
point where they wipe out the value of a company’s tangible assets, creating a high P/B value that may hide the
value of productive assets.
Price-to-sales (P/S) ratio places a monetary value on each dollar of company sales. There are reasons to use the
P/S ratio over other types of multiples. Revenue is relatively more stable than earnings, as unlike earnings or even
book value, it is available even for the most troubled or cyclical of firms. Finally, revenue provides an indication of
corporate decisions, such as the impact of pricing.
The P/S ratio can still produce a misleading valuation if a firm has trouble controlling costs. Revenues may not
decline even though earnings and book value drop rapidly.

EXAMPLE
A highly leveraged company on the brink of bankruptcy can have a low P/S ratio.

HOW ARE RESOURCE COMPANIES ANALYZED?

In this section, we will look at the common methods used to value resource companies. First, we will examine the
methods used for companies in the oil and gas industry, then examine those used for companies in the mining
industry.

OIL AND GAS INDUSTRY

RESERVES
Petroleum reserves are an important equity valuation parameter for oil and gas exploration and production
companies. Reserves are an estimate of the amount of hydrocarbon owned by an exploration and production

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company that is still in the ground. Since reserves are the source of the company’s future revenues and cash flows,
and thus represent the majority of the company’s value, they are important.
Petroleum reserves are divided into three major classifications, as follows:
1. Proved: Claim of a reasonable certainty of recovery (> 90% confidence interval) under existing technology.
Also known as “P90” or “1P” reserves.
2. Probable: Claim of a 50% recovery confidence interval. Also known as “P50”, “2P”, or “proved + probable”.
3. Possible: Claim of a 10% recovery confidence interval. Also known as “P10”, “3P”, or “proved + probable +
possible”.

The proved category, which is the highest quality due to its very high statistical threshold, forms the basis for a
number of valuation methods. Accordingly, it is divided into three sub-classifications:
1. Proved developed reserves (or PDP): Can be recovered through existing wells and facilities, and by existing
methods. PDP assets are generally not risked (or discounted by an engineering factor) since they are currently
generating cash flow.
2. Proved developed not producing reserves (or PDNP): Same as PDP, but not currently producing. PDNP assets are
discounted, or risked by about 25%.
3. Proved undeveloped reserves (or PUD): Potentially recoverable with existing technology, but not considered
commercially recoverable due to more than one of the following contingencies: economic, legal,
environmental, political, or regulatory risks. PUD assets are risked by about 35%.

RESERVE UNITS
The global unit measure of oil and gas industry reserves is barrel of oil equivalent (BOE), which is defined as
follows:
• The amount of barrels (bbls) of oil used when measuring liquid reserves, such as oil and natural gas liquids
(NGLs), plus

• The amount of natural gas reserves at a conversion ratio of 6,000 standard cubic feet (scf) of natural gas per
BOE. This second factor reflects the fact that 6,000 scf of natural gas contains the same amount of heat as one
barrel of oil. It is also often referred to as heat or British thermal unit (BTU) equivalency. Specifically, one scf of
natural gas contains one BTU, and one barrel of oil contains 6,000 BTUs of heat.

The BOE measure is necessary since almost all oil and gas companies have reserves of and produce oil, NGLs, and
natural gas, and it is necessary to bring these three types of hydrocarbon assets to one common unit for analysis.

EXAMPLE
BOE Conversion
Spitfire Oil and Gas Limited is a seven-year old oil and natural gas exploration company headquartered in
Calgary, Alberta. It has been very successful in its exploration and development efforts and had the following 2P
reserves at its prior fiscal year end: 35 million bbls of oil and NGLs, and 120 billion scf of natural gas.
(Q) What is the BOE of Spitfire’s entire reserves?
(A) Total BOE = 35 million bbls + (120 billion scf / 6,000 scf per BOE) = 55 million BOE

PRODUCTION RATE
Similar to reserve units, the daily production rate of liquid hydrocarbons and natural gas is combined and expressed
as barrels of oil equivalent per day (BOE/D), which brings all forms of hydrocarbon production to one common
unit for analysis.

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ECONOMIC VALUE
Economic value (EV) is a standard measure of a resource-based company’s economic value and is calculated as
follows:
EV = Market value of the company’s equity
+ Book value of the outstanding debt
– Amount invested in cash and short-term securities (5.10)

EV is a more complete measure of the combined value of all sources of capital and financing for a company. This
measure incorporates net debt and is more appropriate, especially for resource-based companies that can include a
significant amount of debt in their capital structure. EV is used in numerous valuation metrics.

EXAMPLE
Economic Value
Bearcat Petroleum Limited has 45 million outstanding common shares and is currently trading at $5.50/share.
It has a $200 million line of credit with a major Canadian bank and has currently used $100 million of this credit
facility. The company also has $45 million of cash and short-term investments currently on its statement of
financial position.
(Q) What is Bearcat’s current EV?
(A) EV = (45 million X $5.50/share) + $100 million – $45 million = $302.5 million

PRODUCTION VALUATION METRIC

The most common production valuation metric for an oil and gas exploration and production company is the
economic value per barrels of oil equivalent per day (EV/BOE/D). It represents the combined debt and equity market
value currently paid per flowing barrel of production (per BOE/D). It relates the company’s economic value per unit
of production. Analysts can then compare this metric for similar firms to evaluate the company’s relative value.
It is important that this metric is considered in the context of the composition of the BOE/D production figure that is
used for the company. Since the economics and margins associated with natural gas production can be significantly
different from those associated with liquid-based production, it is necessary to calculate what portion of the
company’s BOE/D production figure is liquid-based versus natural gas-based. Equity markets are aware of this and
will therefore assign a different market value to the natural gas-based portion of the company’s daily production as
compared to the liquid-based portion.

EXAMPLE
Production Valuation Metric
Canada Oil and Gas Corp has 45 million outstanding common shares and a current market value of $4.25/share.
It has $12.5 million in bank loans outstanding, and cash and equivalents of $11.5 million. The company’s current
average daily production is 4,500 BOE/D.
(Q) What is Canada Oil and Gas Corp’s EV/(BOE/D)?
(A) EV / (BOE/D) = [(45 million X $4.25) + $ 12.5 million – $11.5 million] / 4,500 BOE/D = $42,722 / BOE/D

RESERVE VALUATION METRIC

In a similar manner as the production valuation metric, markets assign a value to an oil and gas exploration and
development company’s hydrocarbon reserves. EV can be calculated on the basis of various reserve valuation
metrics, with the most common metric being the EV per 1P or 2P reserves. It measures the amount the equity
market is paying per BOE of reserves.

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EXAMPLE
Reserve Valuation Metric
Oaktree Energy Limited has 45 million outstanding shares and is currently trading at $6.50/share. It has $10
million in bank debt and $2.5 million in cash and short-term securities on its statement of financial position. The
company has 35 million BOE of 1P reserves and 55 million BOE of 2P reserves.
(Q) What is the market valuing Oaktree’s reserves at?
(A1) EV/1P reserves = [(45 million X $6.50/share) + $10 million – $2.5 million]/35 million BOE
= $8.57/BOE (1P)
(A2) EV/2P reserves = [(45 million X $6.50/share) + $10 million – $2.5 million]/55 million BOE
= $5.45/BOE (2P)

RESERVE LIFE INDEX

The reserve life index (RLI) represents the number of years it would take to deplete the company’s existing reserves
at its current daily production rate. It is calculated by dividing the company’s current reserves by its current annual
production rate, or as follows:
Current reserves (BOE) (5.11)
RLI =
Current daily production rate (BOE/D) × 365

The RLI does not incorporate any potential future reserve growth or changes in production level; as such, it
represents the company’s remaining “life”, assuming there is no further investment in exploration and development.
The RLI is used in two particular valuation applications. First, it provides a relative valuation metric between
similarly sized competitors. Since oil and gas resources are depleting assets, companies with larger RLIs offer the
investor a longer-life investment and, all things being equal, should represent better value. Second, an increasing
RLI over time indicates that a company is adding resources at a faster rate than it is increasing production. This
generally indicates a successful exploration effort, since development activities are considered low risk, as compared
to exploration, and lead to higher production volumes, albeit with a lag due to the time required to complete wells
and tie them into a pipeline for product sale.
RLIs are typically in the range of six to 11 years, with top-decile exploration companies having RLIs as long as 20
years in some instances.

EXAMPLE
RLI
Quasar Oil and Gas Limited has 2P reserves of 75 million BOE and a current production rate of 15,000 BOE/D.
(Q1) What is Quasar’s RLI?
(A1) RLI = 75,000,000 / (15,000 × 365 days) = 13.7 years
(Q2) How is this number interpreted?
(A2) It means that Quasar could continue to produce at its current daily rate for another 13.7 years, even if no
further reserves are discovered.

RECYCLE RATIO
The recycle ratio is a very popular measure of operational profitability and exploration cost efficiency combined.
It relates the current gross profit per barrel of production to the cost of finding and developing an additional barrel
of reserves. In order to calculate the recycle ratio, two separate standard metrics must be calculated: one for the
numerator and one for the denominator.

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The term gross profit per barrel of production is not normally used in the oil and gas industry, but its equivalent
is referred to as a “field netback” and is always calculated and expressed on a per BOE basis. The field netback is
defined and calculated as follows:
Field netback per BOE = Revenue per BOE – direct operating costs per BOE –
provincial royalties per BOE (5.12)

Note that the field netback does not include any administration costs, exploration and development-related
costs, financing costs, or income taxes. It is the standard measure of financial efficiency as it relates to production
activities alone. And the larger the field netback, the more efficient production activities are considered to be. Of
course, larger production wells generally lead to more favourable field netbacks.
Meanwhile, the denominator of the recycle ratio calculation represents the costs of adding an additional BOE to
the company’s reserves. It is normally referred to as finding and development (F&D) costs, and represents all of
the expenditures directly related to exploration activities and bringing production on-line. Of course, lower F&D
costs indicate more efficient exploration activities. F&D costs are affected by the type and size of well drilled. The
now more popular horizontally drilled wells with 20-plus fractures can range in cost from $5 to $15 million per well
drilled. This compares to exploration costs of approximately $750,000 to $1 million for conventional vertical wells.
However, the higher exploration costs may be worth it given the potential for more prolific discoveries with new
drilling technology. Successful horizontal wells can have initial production (IP) rates typically in the range of 4 to
7 million standard cubic feet per day (scf/d), compared to 1 million scf/d or less for conventional vertically drilled
natural gas wells.
The recycle ratio can now be calculated as follows:
Field netback per BOE (5.13)
Recycle Ratio =
F&D costs per BOE
Note that valuable information is contained in both terms in the recycle ratio calculation and they represent very
useful metrics when analyzing an oil and gas company, especially relative to its peers.

EXAMPLE
Recycle Ratio
For the first quarter of this fiscal year, Spruce Energy Ltd. had the following production and exploration financial
and operational results:
– Average well-head revenue per BOE produced: $87.50 per BOE
– Direct oil field operating costs: $18.25 per BOE
– Alberta royalty rate: 18% of well-head revenue
– F&D costs: $25 million
– New reserves discovered: 1.25 million BOE
(Q1) What is Spruce’s field netback?
(A1) Field netback = $87.50 per BOE – $18.25 per BOE – ($87.50 X 0.18) = $53.50 per BOE
(Q2) What are Spruce’s F&D costs per BOE of new reserves?
(A2) F&D = $25 million / 1.25 million BOE = $20.00 per BOE
(Q3) What is Spruce’s recycle ratio and explain what it means?
(A3) Recycle ratio = $53.50 / $20.00 = 2.68
This recycle ratio means that Spruce’s field netback per barrel produced during the quarter was sufficient enough
to fund the exploration costs required to add 2.68 BOE of new reserves.

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CASH FLOW MULTIPLES

Oil and gas companies are not generally valued on an earnings basis due to the large non-cash components in their
expense structure. However, cash flow multiples are key in the evaluation of these types of companies. The metric
referred to as debt-adjusted cash flow (DACF) is used for this industry.
DACF is calculated as follows:
DACF = Cash flow from operations + Financing costs (after tax)
+ Exploration costs (before tax) +/- Changes in working capital (5.14)

DACF is preferred for analyzing oil and gas companies since:

• It is an after-tax calculation, which is good for the oil and gas industry since it often pays high resource and
income taxes.
• It is independent of a company’s financing decisions.

DACF is used in two main valuation metrics for the oil and gas industry: DACF/share and EV/DACF.

EXAMPLE
DACF
Big Sun Oil and Gas Limited has 30 million outstanding common shares with a market value of $16.50/share. It
has $15 million in bank debt outstanding and $10 million in cash and short-term investments. The company had
the following results for the most recent fiscal reporting year:
– Cash flow from operations: $35 million
– Financing costs (after tax): $12 million
– Exploration costs: $40 million
– Changes in working capital: $5 million (increase)
(Q1) What is Big Sun’s DACF/share?
(A1) First, calculate Big Sun’s DACF, as follows:
DACF = $35 million + $12 million + $40 million – $5 million = $82 million
Second, divide the DACF amount by the number of outstanding common shares:
DACF / Number of outstanding common shares = $82 million / 30 million shares = $2.73/share
(Q2) What is Big Sun’s EV/DACF?
(A2) First, calculate Big Sun’s EV as follows:
EV = (30 million shares X $16.50/share) + $15 million – $10 million = $500 million
Second, divide this amount by the firm’s DACF, as follows:
EV/DACF = $500 million / $82 million = 6.1 [This means that the market is willing to pay 6.1 times the DACF
value. This metric is compared to other similar oil and gas companies in order to assess the relative valuation of
Big Sun on a “cash flow-type” basis.]

MINING INDUSTRY
It is not surprising that as a resource-based industry, the mining industry shares many of the same valuation
measure concepts as the oil and gas industry, albeit with appropriate adjustments where required. EV, EV/DACF,
DACF/share, and EV/reserves for mining companies are calculated in a similar manner to oil and gas exploration and
development companies. One area of difference is in the definition and calculation of reserves.

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RESERVES
Mining industry reserve standards are defined under National Instrument 43-101 (NI 43‑101). The regulations only
permit mineral resources to be reported under the following specific resource categories:
Table 5.4 | National Instrument 43-101 Resource Categories and Definitions

NI 43-101 Resource Category Brief Definition

Inferred mineral resource Insufficient data to confirm continuity of resource.

Indicated mineral resource Similar to inferred mineral resource, except there is sufficient data to give
a reasonable expectation of the mineralization’s continuity.

Measured mineral resource Sufficient data are available to confirm the mineralization’s continuity.

Probable mineral resource The economically mineable portion of an indicated resource.

Proven mineral resource The economically mineable portion of a measured resource.

The mining company must strictly adhere to the methods prescribed and the statistical tests and thresholds set out
in the regulation when they communicate their reserves to regulators, stock exchanges, and the public. As a normal
course, reserves are upgraded to higher-confidence resources with additional exploration activity and investment.
Understandably, equity markets, as well as lenders, assign progressively higher values to the higher-confidence
reserves. Mineral exploration companies design their exploration activities with this in mind, especially as they
approach the time to decide whether a property should be developed into an operating mine.

MAIN EQUITY VALUATION METRICS: PRE-PRODUCTION COMPANIES VERSUS

CURRENTLY PRODUCING ONES
The main equity valuation metrics used for mining companies vary somewhat based primarily on whether the
company is in a pre-production state or currently producing.

PRE-PRODUCTION COMPANIES
Mining companies that are solely focused on the discovery of mineral resources and/or the development of a
discovered resource, and are not capable of any metals production in the short‑to intermediate-time period, are
generally referred to as being in their exploration and development phase.
Cash flow- or earnings-based equity valuation measures are not applicable to these companies, as their current
focus on exploration and development activities, as well as their lack of product sales, invariably renders them cash
flow negative and certainly without any anticipated sales or earnings in the short to medium term.
The primary equity valuation metric applied to early-stage mining companies is market value per ounce of resource
or reserve (MV/ounce). Due to their different inherent levels of risk, different market values per ounce are applied
to the amount of resources and reserves the company reports in each respective securities commission-defined
resource or reserve categories. The ounces included in the proven and probable reserve categories have the highest
equity market value per ounce, followed by measured and indicated resources, which have a lower per-ounce
market value. Inferred resources have the lowest market value assigned per ounce. This resource-based valuation
metric is heavily relied on, particularly for mining companies that are in the exploration stage and/or have become a
takeover target.
For early-stage mining companies that are well into their development phase and have published an independent,
expertly prepared project feasibility analysis for their potential mine, the company’s valuation will shift to a focus on
an estimate of the company’s market price to net asset value per share (P/NAVPS). The net asset value calculation
for the potential mine is facilitated by the mine’s feasibility study, as it incorporates operating and financial

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information, such as estimates for the mine’s capital costs, operating costs, start-up timing, annual production
volumes, life of the mine, and overall project profitability at various future metal prices.

CURRENTLY PRODUCING COMPANIES

Understandably, currently producing mines inherently have significantly less operational and financial risk compared
to companies in the pre-production stage, and therefore the method of valuation differs to reflect this.
Mining companies that are currently in production have two primary operational and financial goals:
1. Maximize immediate cash flow: Realized through the combination of higher revenue as a result of maximizing
current metal production volumes and the accompanying reduction in marginal operating costs due to
improved economies of scale.
2. Increase their mineral resource and reserves base, and life of mine estimate: Realized through continued
successful targeted exploration activities.
In accordance with these two main goals, equity valuation for currently producing companies focuses on:
a. A cash flow-based valuation metric, with economic value per earnings before interest, taxes, depreciation,
and amortization (EV/EBITDA) being the most frequently used cash flow-based metric.
b. A present value-type metric, with P/NAVPS being the most popular.

Many mining industry analysts use a uniquely weighted combination of these two metrics in order to develop a
target market price for a particular company’s stock. This valuation methodology implies that equity market prices
for currently producing mining companies are driven by the company’s ability to produce its product profitably and
grow its value by increasing its resource base successfully and economically.
The cash flow metric (EV/EBITDA) indicates the degree of the mining company’s operational efficiency. This
efficiency measure is important since strong cash flow generation capability is critical to the company’s ability
to finance the potential growth of its operations in the future and return capital to shareholders through future
dividend payments and/or share repurchase programs. Strong cash flow generation also reduces the company’s
potential need to access the capital markets, perhaps at an inopportune time, in the future.
The present value metric (P/NAVPS) reflects the degree to which the company can grow its resource size
economically. This is important since mines are depleting assets and it is critical that the company be able to extend
its operational life (commonly referred to as “life of mine”) as much as possible, thus increasing its value in present
value terms.

NET ASSET VALUE

Investors in resource-based companies value reserve growth over time, provided that this growth is done in an
economic manner that will benefit shareholders. Accordingly, investors want to ensure that the price paid for new
or additional reserves is reasonable, whether done through organic growth (i.e., exploration activities) or through
corporate or asset acquisitions. Reserves normally play the most important role in the calculation of the company’s
net asset value (NAV) and net asset value per share (NAVPS).
In a similar manner to book value, NAV considers the present value of all after-tax cash flows from the reserves over
time. It is critical that the analyst discern whether the NAV calculation is based on existing resources or whether it
includes the present value of cash flows from future expected exploration activity. These cash flows are normally
discounted at a rate of 10%, but analysts often also run sensitivities at discount rates above and below 10% as they
deem necessary.
NAVPS is frequently used to value resource-based companies in the same way that analysts generally use a
discounted cash flow valuation for an industrial or consumer products company.

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There are eight basic steps to create a NAV model:

1. Make assumptions for reserves, production volumes, commodity prices, future operating costs, and discount
rates (with a discount rate of 10% per annum used in the base case).
2. Project production volumes and realized prices for commodities over time horizon.
3. Make operating expense and tax assumptions.
4. Calculate annual after-tax cash flows.
5. Calculate the net present value (NPV) of the annual after-tax cash flows.
6. Value other assets (note that only producing assets have been included in the calculations so far. At this point,
the value of such assets as undeveloped land must be estimated and added to the NPV.)
7. As the NPV is essentially the EV at this point in the calculation, it is necessary to make the appropriate
statement of financial position adjustments, such as adding cash and subtracting debt. It is then possible to
calculate the equity value and the implied NAVPS.
8. A table of sensitivities to the NAVPS can now be created based on different commodity price scenarios or
other model input assumptions (the calculations in the table are beyond the scope of this course).

EXAMPLE
NAVPS Sensitivity Table
An example of a typical NAVPS sensitivity table for a hypothetical Canadian gold mining company is as follows:
NAVPS (C$/share)
Long-Term Gold Price Assumption (US$/oz.)
1050 1200 1350 1500 1650
0% Discount 5.94 6.92 7.90 8.88 9.86
5% Discount 4.31 4.92 5.53 6.14 6.75
10% Discount 3.36 3.76 4.16 4.56 4.96
15% Discount 2.77 3.04 3.32 3.59 3.86

In this sensitivity table, the NAVPS is provided for various gold bullion prices ranging from US$1,050/oz. to
US$1,650/0z., and for various discount rates ranging from 0% to 15%. For example, the $4.56/share number
represents the stock’s NAVPS at an US$1,500/oz. gold bullion price and a discount rate of 10% per annum. The
table is intended to show how sensitive the NAVPS is to changes in these two variables.

EQUITY VALUATION LESSONS FROM THE NEW MILLENNIUM PRECIOUS METALS

BULL MARKET
Over the last 20 years, the underperformance of precious metals common stocks, as compared to precious metals
commodity price movements, is primarily attributable to three main factors that were essentially underappreciated
or ignored by most common stock investors:
1. Rapidly escalating capital and operating costs.
2. A decline in mine head grade.
3. An incorrect (or too narrow) measurement of cost of production.

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RAPIDLY ESCALATING CAPITAL AND OPERATING COSTS

Commodity-related industries are generally understood to be cyclical in nature with the timing of capital
investment attempting to capture the often powerful upward swings in commodity prices brought on by periods
of economic revival and associated price inflation. Unfortunately, this is often followed by an equally abrupt fall in
both commodity prices and the financial fortunes of commodity producers and their investors.
The end of the last century was characterized as a period of low inflation and stagnant-to-declining commodity
prices. This resulted in a period of negligible capital investment in the mining industry in general, and the precious
metals industry in particular. The pro-forma economics of capital investment in new precious metals mines was
not supportable with US$250/ounce gold bullion prices. In turn, this also translated into declining investment in
productive capacity in related industries that supported mine maintenance and new mine construction, such as ore
drilling and ore transportation equipment. Furthermore, the metals bear market was so severe that many qualified
tradespersons and skilled miners left the mining industry for other industries that offered potentially better
employment opportunities. This environment also discouraged many younger individuals from entering mining and
related industries as a career due to perceived poor future employment prospects.
However, the commodities price boom that began 20 years ago led to very rapid capital expansion plans in the
mining industry on a global basis and over all types of mining-related commodities ranging from precious metals
and base metals, right through to potash and uranium. This demand quickly led to rapid cost increases for all types
of materials and services that are required to both build and maintain mines. This cost escalation was exacerbated
by the underinvestment that had occurred at the end of the last century, as noted above.
Capital cost estimates on multibillion-dollar mining projects were revised upward almost on an annual basis as
project planners tried to reflect the increasing cost of inputs.
Operating costs were also impacted, as many of the products and services required to operate a mine are the same
or very similar to the ones needed to construct a new mine. Some mining analysts have estimated that the total
global gold mine and mill operating costs have increased (on an annual compound percentage basis) at an amount
just slightly below the average annual compound percentage price change in the price of gold bullion over the last
20 years.
However, these rising costs were for the most part neglected, or downplayed, as rapidly rising precious metals
prices were assumed to outstrip the negative impact of rising capital and operating costs. These cost increases
were material over time and were seen retrospectively as limiting the gross margin increase for the precious metals
mining industry overall.

DECLINE IN HEAD GRADE

Head grade is the average grade of the ore at the face (or “head”) of the mine. In the precious metals mining
industry, head grade represents the concentration of gold or silver in the mine’s ore that will be sent to the mill
for processing and precious metals recovery. It is generally measured and expressed in the following units: grams/
tonne, ounces/tonne, or parts per million (ppm).
The primary economic benefit of higher-grade ore is that less ore must be mined and milled in order to recover an
ounce of gold or silver. This is critical to mining economics, since the cost to mine and mill a tonne of ore is the same
regardless of the amount of precious metals contained in the tonne of ore.
Furthermore, head grade has an inverse relationship with the cost to mine and, accordingly, the gross margin. The
relationship between average mine head grade, total mine and mill operating costs, and gross margin per ounce of
gold produced is shown in the table below.

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Table 5.5 | Gold Mining Head Grade, Operating Cost, and Pre-tax Profit

Average Gold Total Operating Cost to Recover One Pre-tax Profit2

Head Grade Ounce of Gold1 (US$/Ounce) (US$/Ounce)
Grams/Tonne Ounces/Tonne
4.0 0.13 310 990
3.0 0.10 415 885
2.0 0.06 620 680
1.0 0.03 1,240 60
Notes 1 Assumes a total operating cost to both mine and mill one tonne of ore is US$40/tonne.
2 Assumes US$1,300/ounce gold bullion market price.

Three important points must be considered when examining the table above:
1. Operating costs per tonne mined and milled more than doubled over the last 20 years, thus magnifying the
inverse relationship head grade and pre-tax profit relationship.
2. Pre-tax profits per ounce of gold produced are extremely sensitive to head grade, especially at very low mine
head grades.
3. The average mine head grade for the global gold mining industry has dramatically declined over the last
20 years. This mine head grade factor alone caused pre-tax profits per ounce of gold produced to decline.

The decline in mine head grade is primarily attributable to the gold mining industry’s inability to replace its reserves
with high-grade ore. This decline in gross margin per ounce of gold produced has dramatically impacted the precious
metals mining industry’s profitability and break-even gold price economics. Clearly, investors in mining companies
must consider the size of a mining company’s reserves and resources, but also the quality (head grade) in order to
value it properly.

DEFINITION OF OPERATING COSTS

An accurate and clear definition of operating costs is crucial to the correct valuation of any company.
First, there is some ambiguity as to whether reported operating costs comprise only all marginal cash costs
associated with operating a mine and mill (such as direct field and plant labour, fuel, maintenance and repairs,
royalty payments to governments, and others), or whether they also include additional cash and non-cash operating
costs, such as general and overhead costs, gold/silver bullion hedging costs, and depreciation and amortization
costs.
Including all three types of costs results in an increasingly used operating cost measure commonly referred to as
all-in costs that provides a better measure of the company’s gross margin and the overall efficiency of its current
operations.
Second, and perhaps more material, is the decision to include two specific types of costs in the reported operating
costs:
1. Exploration and development costs
2. Continuing capital costs

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Precious metals mining companies often decide to capitalize portions of their exploration and development costs,
and thus potentially underestimate their total operating costs. This despite the fact that some of these activities
are more closely related to supporting the company’s current/near-term precious metals production volume, rather
than increasing its resources and reserves (which could be argued more successfully as additions to the firm’s
assets).
In addition, some operating costs are capitalized despite the fact that they often occur year after year, which raises
the question of whether they are more representative of ongoing annual operating costs than statement of financial
position items. These particular costs are referred to as continuing capital costs and represent one of the main
reasons why free cash flow to equity calculations are playing an ever-increasing role in fundamental analysis and
equity valuation of all capital intensive companies, including commodity producing companies.
These two particular cost items can be material, even when compared to the all-in cost figure. For example, if
analysts reported all-in operating costs for gold mining companies on a global basis at about US$1,200/ounce of
gold produced, this cost figure might increase to almost US$1,600/ounce of gold produced when continuing capital
costs and all exploration and development costs are included.

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SUMMARY
In this chapter, we discussed the following aspects of fundamental analysis:
1. Explain how fundamental analysis aids in the security selection process.
It is the study of the variables that affect a company’s profitability, its industry, and the economy in which it
operates.
It determines if the intrinsic value is above or below a stock’s current price.

2. List key economic metrics and how the yield curve is used as an economic indicator.
The broadest measure of an economy’s success is the change in its gross domestic product (GDP).
Other economic metrics include housing starts, retail sales, employment, and consumer prices.
The slope of the yield curve, especially an inversion, can be used to predict a recession.

3. Explain the influence of international economic events on domestic security analysis.

The examination of the global economy’s changing patterns can help investment professionals determine
the direction of the domestic economy.
Global economic developments affect the North American economy and therefore market direction.

4. Explain how industry analysis is used to select stocks.

An advisor can use industry analysis to underweight, marketweight, or overweight each industry in a
portfolio.
Sector rotation involves adjusting the portfolio weights of different economic sectors or industry categories
in anticipation of trends.

5. Explain the difference between International Financial Reporting Standards (IFRS) and Generally Accepted
Accounting Principles (GAAP).
The major philosophical difference between the two accounting methodologies is that IFRS is almost
entirely principle-based whereas U.S. GAAP is primarily rules-based. Rules-based accounting is more rigid.
In principle-based accounting, guidelines are more general.

6. Identify the various sources of company information.

Company information can be gathered from regulatory filings, conference calls, investor tradeshows,
financial records, and other sources of information.
There are four major parts of a company’s financial statements:
1. Statement of financial position
2. Statement of comprehensive income
3. Statement of changes in equity (which provides a link between the statement of comprehensive income
and the statement of financial position)
4. Statement of cash flows

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7. Assess the quality of a company based on its earnings.

A qualitative study of a firm’s business considers how it generates revenue and profit. A firm’s success
competing within its industry depends on its sustained competitive advantage.

8. List the merits of different absolute valuation models.

Absolute valuation models make a point-in-time estimate of intrinsic value based on a set of forecast
company fundamentals.
Dividend discount model: Assumes a stock’s intrinsic value is equal to the present value of its stream of
future dividends. This model is suitable for valuing mature companies that pay dividends and have a dividend
payout consistent to its profitability.
Discounted cash flow model: Assumes a stock’s intrinsic value is equal to the present value of a stream of
future cash flow.

9. Assess the advantages and disadvantages of different valuation techniques.

Price to earnings (P/E) is the most widely used multiple in the relative valuation method. The P/E ratio is
uninformative when earnings are negative or very small.
The price-to-book (P/B) ratio provides a method for finding undervalued companies. The P/B multiple is only
useful when examining capital-intensive firms or those with plenty of tangible assets.
The price-to-sales (P/S) ratio places a monetary value on each dollar of company sales. Revenue, unlike
earnings or even book value, is available even for the most troubled or cyclical of firms.

10. Calculate a firm’s worth using any one of the valuation models.
Dividend discount model:
V0 = D0 (1+g) / (r – g) = D1 / (r – g)

Price-to-earnings ratio:
Market price per common share (P0 )
P/E =
EPS of the last four quarters (EPS0 )

Price-to-book ratio:
P/B = P0 / BV0

11. Explain the metrics used in the analysis of oil and gas companies.
Petroleum reserves are an important equity valuation parameter for oil and gas exploration and production
companies.
The global unit measure of reserves for the oil and gas industry is the barrel of oil equivalent (BOE).
The most common production valuation metric for an oil and gas exploration and production company is
the economic value (EV)/barrels of oil equivalent per day (BOE/D).
The most common reserve valuation metric is the economic value (EV) per 1P or 2P reserves.
The reserve life index (RLI) represents the number of years it would take to deplete existing reserves at the
current daily production rate.
The recycle ratio measures operational profitability and exploration cost efficiency combined.
The debt-adjusted cash flow is used in the evaluation of oil and gas companies.

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12. Calculate the metrics used in the analysis of oil and gas companies.
Calculations used in the analysis of oil and gas companies include: economic value (EV), reserve life index
(RLI), field netback, recycle ratio, and debt adjusted cash flow (DACF). DACF is used in the calculation of
DACF/share and EV/DACF.

13. Explain the metrics used in the analysis of mining companies.

The primary equity valuation metric applied to early-stage mining companies is market value per ounce of
resource or reserve.
For early-stage mining companies that are well into their development phase, a market price to net asset
value per share (NAVPS) can be used for equity valuation.
For currently producing mining companies, equity valuation focuses on a cash flow‑based metric (economic
value per earnings before interest, taxes, depreciation, and amortization) and a present value-type metric
(market price to NAVPS).

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