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    IAPM Unit 2 - Fundamental Analysis

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    Profitability ratios measure a company's ability to generate profit relative to its costs and other values. There are margin ratios, which compare profits to sales, and return ratios, which compare profits to assets or equity. Key return ratios include return on assets (ROA), return on equity (ROE), and return on capital employed (ROCE). Fundamental analysis evaluates a company's intrinsic value by analyzing factors that could impact its future price. Valuation methods include balance sheet, discounted cash flow, and relative valuation approaches.

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    IAPM Unit 2 - Fundamental Analysis

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    Arpita Artani
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    Profitability ratios measure a company's ability to generate profit relative to its costs and other values. There are margin ratios, which compare profits to sales, and return ratios, which compare profits to assets or equity. Key return ratios include return on assets (ROA), return on equity (ROE), and return on capital employed (ROCE). Fundamental analysis evaluates a company's intrinsic value by analyzing factors that could impact its future price. Valuation methods include balance sheet, discounted cash flow, and relative valuation approaches.

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    IAPM unit 2 - Fundamental analysis

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    Profitability ratios measure a company's ability to generate profit relative to its costs and other values. There are margin ratios, which compare profits to sales, and return ratios, which compare profits to assets or equity. Key return ratios include return on assets (ROA), return on equity (ROE), and return on capital employed (ROCE). Fundamental analysis evaluates a company's intrinsic value by analyzing factors that could impact its future price. Valuation methods include balance sheet, discounted cash flow, and relative valuation approaches.

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    © All Rights Reserved
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    266 views27 pages

    IAPM Unit 2 - Fundamental Analysis

    Uploaded by

    Arpita Artani
    Profitability ratios measure a company's ability to generate profit relative to its costs and other values. There are margin ratios, which compare profits to sales, and return ratios, which compare profits to assets or equity. Key return ratios include return on assets (ROA), return on equity (ROE), and return on capital employed (ROCE). Fundamental analysis evaluates a company's intrinsic value by analyzing factors that could impact its future price. Valuation methods include balance sheet, discounted cash flow, and relative valuation approaches.

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    of 27

    Fundamental Analysis

    Module – 2
    IAPM
    Profitability Ratios
    • Profitability ratios are financial metrics used by analysts
    and investors to measure and evaluate the ability of a
    company to generate income (profit) relative to
    revenue, balance sheet assets, operating costs,
    and shareholders’ equity during a specific period of time.
    • They show how well a company utilizes its assets to
    produce profit and value to shareholders.
    Cont.…
    • A higher ratio or value is commonly sought-after
    by most companies, as this usually means the
    business is performing well by generating
    revenues, profits, and cash flow.
    • The ratios are most useful when they are analyzed
    in comparison to similar companies or compared
    to previous periods.
    Types of profitability ratios
    • They are broadly classified into Margin Ratio and Return
    Ratio
    • Margin ratios represent the company’s ability to convert
    sales into profits at various degrees of measurement like
    gross profit margin, net profit margin, EBITDA margin, etc…
    • Return ratios are based on investments. There are mainly 3
    return ratios: return on assets, return on equity and return
    on capital employed.
    RETURN ON ASSETS (ROA)

    • It is the profitability ratio which is used to


    evaluate the company’s level of efficiency in
    employing its assets to generate profit.
    • The assets of the company if not used optimally
    will not be able to make the desired amount of
    profit and the return will also be lower. 
    Question on ROA
    • For example, Assume Shyam and Ram both start a chat
    shop. Shyam spends Rs. 1,50,000 on setting up a kiosk;
    while Ram spends Rs. 15,00,000 on setting up a theme
    based chat shop. Let's assume that those were the only
    assets each deployed. Over some given time period
    Shyam had earned Rs. 15, 000 and Ram had earned Rs. 1,
    20, 000. Use the ROA formula to identify whose business
    is efficient.
    Answer

    • Shyam = 15,000/1,50,000*100 = 10%

    • Ram = 1,20,000/15,00,000*100 = 8%

    • Shyam’s business is more efficient because he


    is able to generate more money with less
    investment.
    RETURN ON EQUITY (ROE)

    • Every equity investor looks for this ratio before investing in


    any company as it gives the insight into the company’s
    profit-generating ability to the investors.
    • The potential, as well as existing investors, keep a check on
    this ratio as it measures the return on the investment made
    in shares of the company.
    • In general, the higher the ratio, more favourable it is for the
    investors to invest in the company.
    Question on ROE

    • Company A earned net income of Rs. 17,22,000


    during the year ending march 31, 2018. The
    shareholders' equity on April 30, 2017 and
    March 31, 2018 was Rs. 1,45,87,000 and
    Rs.1,63,32,000 respectively. Calculate its return
    on equity for the year ending March 31, 2018.
    Answer

    • Average Shareholders' Equity =

    • ( Rs. 1,45,87,000 + Rs.1,63,32,000 ) / 2 =


    Rs. 1,54,59,500
    • Return on Equity = Rs. 17,22,000 / Rs.
    1,54,59,500 = 0.11 or 11%
    RETURN ON CAPITAL EMPLOYED (ROCE)

    • This is a third ratio which covers the equity as


    well as debt part too.
    • In the place of equity capital, total capital
    employed is used as the denominator to
    calculate this ratio.
    What is Fundamental Analysis
    • Fundamental analysis is a method of evaluating the intrinsic

    value of an asset and analysing the factors that could

    influence its price in the future.

    • Intrinsic value or fundamental value is the "true, inherent,

    and essential value“ of an asset independent of its market

    value.

    • Fundamental analysis is one of two major methods of

    market analysis, with the other being technical analysis. 


    • Fundamental analysts study anything that can affect the security's
    value, from macroeconomic factors such as the state of the
    economy and industry conditions to microeconomic factors like
    the effectiveness of the company's management.

    • The end goal is to arrive at a number (intrinsic value) that an


    investor can compare with a security's current price in order to see
    whether the security is undervalued or overvalued.

    • If the intrinsic value is higher than the market price, the stock is
    deemed to be undervalued and a buy recommendation is given.
    Techniques of fundamental
    equity valuation
    • Equity valuation methods can be broadly classified into balance
    sheet methods, discounted cash flow methods, and relative valuation
    methods.

    • Balance sheet methods comprise of book value, liquidation value, and


    replacement value methods.

    • Discounted cash flow methods include dividend discount models and free


    cash flow models. 

    • Lastly, relative valuation methods are a price to earnings ratios, price to


    book value ratios, price to sales ratios etc.
    Book Value Method

    • In this method, book value as per balance sheet


    is considered the value of equity.
    • Book value means the net worth of the company
    divided by number of outstanding shares
    • Net Worth = Assets – Liabilities (or) Shareholders
    fund (capital + reserves and surplus)
    Liquidation Value
    • Value realised from liquidating all the assets of the firm
    – Amount to be paid to all the creditors and preference
    shareholders/ No. of outstanding equity shares
    • Major disadvantage of this method is that the
    liquidation value does not reflect the earnings capacity.
    Replacement Cost

    • This method takes into account ‘the amount


    required to replace the existing company’ as the
    valuation of a company. In other words, if one is to
    create a similar company in the same industry; all
    costs required to do so will form part of the value of
    the firm. This is also called as “Substantial Value”. 
    Dividend Discount Model
    • The dividend discount model (DDM) is a method of
    valuing a company's stock price based on the theory that
    its stock is worth the sum of all of its future dividend
    payments, discounted back to their present value.
    • In other words, it is used to value stocks based on the net
    present value of the future dividends.
    • https://corporatefinanceinstitute.com/resources/knowled
    ge/valuation/dividend-discount-model/
    • It attempts to calculate the fair value of a stock
    irrespective of the prevailing market conditions and
    takes into consideration the dividend pay-out factors
    and the market expected returns.
    • If the value obtained from the DDM is higher than the
    current trading price of shares, then the stock is
    undervalued and qualifies for a buy, and vice versa.
    * Refer your class notes for problems on this topic
    Relative Valuation Technique
    • Valuation ratios are usually computed as a ratio of the
    company’s share price to an aspect of its financial
    performance. Three important valuation ratios:
    • Price to Sales (P/S) Ratio
    • Price to Book Value (P/BV) Ratio and

    • Price to Earnings (P/E) Ratio


    Price/Sales Ratio

    • In many cases, investors may use sales instead of earnings to value their

    investments.

    • The earnings figure may not be true as some companies might be experiencing a

    cyclical low in their earning cycle.

    • Additionally due to some accounting rules, a profitable company may seem to

    have no earnings at all, due to the huge write offs applicable to that industry.

    • So, investors would prefer to use this ratio. This ratio compares the stock price of

    the company with the company’s sales per share.

    • The formula to calculate the P/S ratio is:

    • Price to sales ratio = Current Share Price / Sales per Share


    Price/Book Ratio
    • BV = [Share Capital + Reserves / Total Number of
    shares]
    • Price-to-book is only effective when evaluating certain
    types of businesses. Specifically, if much of a business'
    assets are intangible, as is the case with many
    technology companies, price-to-book isn't terribly
    meaningful. 
    P/E ratio or Earnings Multiplier approach

    • The earnings multiplier, also called the price-to-earnings


    ratio (P/E).

    • The price-earnings ratio (PE Ratio) is the relation between


    a company’s share price and earnings per share (EPS).

    • It denotes what the market is willing to pay for a


    company’s profits.

    • P/E ratio = Market Price per share/Earnings per share


    • Suppose the current market price of the stock of
    ABC Ltd. is Rs.90 and it’s earning per share is
    Rs.9. The Price Earning Ratio of ABC Ltd. will be
    calculated as follows:
    • P/E = 90 /9 = 10
    • Now, it can be seen that the P/E ratio of ABC Ltd.
    is ten times, which means that investors are
    willing to pay Rs.10 for every rupee of earnings.
    • The P/E ratio varies across industries and therefore,
    should either be compared with its peers having
    parallel business activity (of similar size) or with its
    historical P/E to evaluate whether a stock is
    undervalued or overvalued.
    • For instance, the IT and telecom sector companies
    have a higher P/E ratio compared to companies from
    other industries like manufacturing, textile, etc.
    High P/E
    • Companies with high price-earnings ratio are often considered to be growth

    stocks.

    • It means that investors have higher expectations for future earnings growth and

    are willing to pay more for them as it indicates a positive future performance.

    • However, the disadvantage of high P/E is that growth stocks are often

    unpredictable, and this puts a lot of pressure on companies to do more to justify

    their higher valuation.

    • Therefore, investing in growth stocks will more likely be a risky investment.

    • Also, in some cases, it can even be interpreted as an overpriced stock.


    Low P/E
    • Companies having a low price-earnings ratio are often considered to

    have undervalued stocks.

    • A low P/E may indicate a “vote of no confidence” by the market or it

    could mean that the market has just overlooked the stock.

    • Many investors made their fortunes spotting these overlooked but

    fundamentally strong stocks before the rest of the market discovered

    their true worth.

    • In conclusion, the P/E tells us what the market thinks of a stock. It

    indicates whether the market likes or dislikes the stock.

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