## Friday, December 24, 2010

### Fundamental Analysis - Step-by-Step Example

A method of security valuation which involves examining the company's financials and operations, especially sales, earnings, growth potential, assets, debt, management, products, and competition. Fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the market or technical analysis data.

I will focus on interpreting data rather than calculating data, which i believe is easily available in calculated form on internet.

Step1
Go to http://www.indsec.co.in/Fundamental....&MajorSector=1

I am choosing Sector: Shipping

Company1: Varun Shipping
Company2: Mercator

Step2
Varun Shipping

Price = 65
EPS = 8.46
P/E = 7.76

Forward Earnings Growth rate = {(PAT FY08- PAT FY07)/PAT FY07} *100
PAT FY08 = 207 crore
PAT FY07 = 14134 Lakh
OR
PAT FY07 =14134/100 = 141.34 Crore

Forward Earnings Growth rate= 46%

FY08 Estimate -Source ICICI & FY07 Website of varun shipping

PEG = P/E divided by "Forward Earnings Growth rate "

PEG = 7.76/46 = 0.16

Step3
MERCATOR

Price = 71
EPS = 10.88
P/E = 6.56
Forward Earnings Growth rate = {(PAT FY08- PAT FY07)/PAT FY07} *100
PAT FY08 = 238 Crore
PAT FY07 = 134 Crore

Forward Earnings Growth rate= 77.6%

FY08 estimate -Source ICICI report on Mercator

PEG = P/E divided by "Forward Earnings Growth rate "

PEG = 7.76/77.6 = 0.1

Step4
In this particular case both companies are low P/E and high growth companies.

To Summarize
Mercator scores better with Lowest PEG thus, highest growth potential..

Judgement to make w.r.t PEG within companies which can be compared with each other

- High P/E & Low PEG (below 1) - Good buy
- Low P/E & PEG below 1 - Good Buy

Step5
Debt/Equity Ratio

Debt/Equity Ratio - Analyzing how much Debt company has as compared to Equity. More the number is Big means More is Debt. Below 1 is low Debt.

Debt/Equity = Total Debt/Total Shareholder Funds

Shipping is a capital intensitive and cyclical industry. In this particluar case More Debt is expected.But still low debt company is always good.

Varun Shipping

Total Debt : 1793 Crore - FY2007
Total Debt: 1138 Crore - FY2006
Total Debt: 580 Crore - FY 2005
Total Debt : 260 Crore - FY 2004

Total Shareholder Funds: 729 - FY07
Total Shareholder Funds: 475 - FY06
Total Shareholder Funds: 342 - FY05
Total Shareholder Funds: 225 - FY04

Debt/Equity = 2.46 - FY07
Debt/Equity = 2.39 - FY06
Debt/Equity = 1.69 - FY05
Debt/Equity = 1.15 - FY04

For Varun it acquired more debt as compared to last year.
-----------------------------------------------------------------------
Mercator

Total Debt: 1337 Crore - FY 2007
Total Debt: 1310 Crore - FY2006
Total Debt: 526 Crore - FY 2005
Total Debt : 101 Crore - FY 2004

Total Shareholder Funds: 566 - FY07
Total Shareholder Funds: 521 - FY06
Total Shareholder Funds: 343 - FY05
Total Shareholder Funds: 90 - FY04

Debt/Equity = 2.36 FY 07
Debt/Equity = 2.51 FY 06
Debt/Equity = 1.53 FY 05
Debt/Equity = 1.12 FY 04

What this infer?

For Mercator, ratio improved in Last Financial year as well as it is less than Varun Shipping.
Thus, Mercator is slightly better placed in this comparison.

Step6
As of now if we look at 9 months Interest Payout in expenses towards the Debt held by each company

Varun Shipping

Interest payout = 106 Crore - FY08 (9 Months Dec 07)
Interest payout = 77 Crore - FY07 (9 Months Dec 07)

Mercator

Interest payout = 48.96 Crore - FY08 (9 Months Dec 07)
Interest payout = 48.10 Crore - FY07 (9 Months Dec 07)

This implies for Mercator we can expect year ending with marginal increase in Debt/Equity ratio while for VarunShipping there would be a further increase in Debt Equity ratio

Step7

EV - Enterprise Value

Enterprise Value (EV)

This is the minimum amount someone has to pay to buy the Company Outright, incase of Mergers or Acquisitions.

Now, how does it gains importance while comparing companies?

In our example

Varun Shipping

EV = 2767 Crore
Total Debt = 1793 Crore
Cash = 35 Crore

Mercator

EV = 3010 Crore
Total Debt = 1337 Crore
Cash = 119 Crore

This means if somebody buys Mercator outright, he will pay EV = 3010 Crore, but will also get Cash = 119 Crore

Thus, actual Price paid would be EV- Cash = 3010 - 119 =2891 Crore.
and Less debt would be acquired as compared to varun Shipping.

Similarly, incase of varun Shipping he will pay more price and acquire more Debt.

Step 8
NPM- Net profit margin

- The net profit margin is simply the after-tax profit a company generated for a Sale or revenue generated.
- Net profit margins vary across industries, making it important to compare a potential investment against its competitors.
- Although the general rule-of-thumb is that a higher net profit margin is preferable, it is not uncommon for management to purposely lower the net profit margin in a bid to attract higher sales.
- This low-cost, high-volume approach has turned companies such as Reliance Capital and Reliance Communications into giants.

Asset turnover
- The asset turnover ratio is a measure of how effectively a company converts its assets into sales
- The asset turnover ratio tends to be inversely related to the net profit margin.
- This means if NPM is high and Asset Turnover will be low and company is following a High profit and low volume startegy and vice versa.

This implies companies might be following 2 approaches
---low-profit, high-volume(NPM is low and Asset Turnover is high)
---high-profit, low-volume(NPM is high and Asset Turnover is low)

- The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business.

Equity Multiplier
- It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity.
-The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt.

Step9

Mercator

FY07 in Crores

Assets = 1904
Sales = 718
Net profit margin(NPM) = 8%
Shareholder Equity = 566.73

Equity Multiplier = Assets/Shareholder Equity = 1904/566.73 = 3.36

Asset turnover = Sales/Assets = 718/1904 = 0.37

Return on Equity
ROE = NPM * Asset turnover * Equity Multiplier
= 8*0.37*3.36 = 9.94%

Now if we assume company is debt free, by taking the Equity multiplier out

ROE = NPM * Asset turnover = 8*0.37 = 3 %

This means 9.94% -3% = 6.94% return were because of Debt at work in business for MERCATOR.

Step 10
Varun Shipping
FY07 in Crores

Assets = 2522
Sales = 672
Net profit margin(NPM) = 20.96%
Shareholder Equity = 729

Equity Multiplier = Assets/Shareholder Equity = 2522/729 = 3.45

Asset turnover = Sales/Assets = 672/2522=0.26

Return on Equity
ROE = NPM * Asset turnover * Equity Multiplier
= 20.96*0.26*3.45 = 19.2%

Now if we assume company is debt free, by taking the Equity multiplier out

ROE = NPM * Asset turnover = 20.96*0.26 = 5.4%

This means 19.2% -5.4% = 13.8% return were because of Debt at work in business for Varun Shipping.

Thus, inspite varun Shipping having high profit margin than Mercator, sales are not concluding to ROE and high Debt is concluding more to ROE, which means for share holders, actual return on their equity is 5.4 %

This implies Mercator is still a better bet and increase in sales can result in better returns in long run. Same is reflected by Low NPM % & bigger Asset turnover ratio as compared to Varun

Step11
Mercator

FY08
Average Price in March FY06 = 34 Rs

Current Price = 75

Expected Growth = 42%

Target Price in FY08 = Average Price in March FY06 * 42% = 48 Rs

FY09

Target Price in FY08 = 48 Rs

Current Price = 75

Expected Growth = 43%

Target Price in FY09 = Target Price in FY08 * 43% = 69 Rs

Thus, the forward earnings is already being priced in Mercator. One should look for buying opportunities below this price.

Varun Shipping

FY08
Average Price in March FY06 = 54 Rs

Current Price = 70

Expected Growth = 51%

Target Price in FY08 = Average Price in March FY06 * 51% = 81 Rs

FY09

Target Price in FY08 = 81 Rs

Current Price = 70

Expected Growth = 14%

Target Price in FY09 = et Price in FY08 * 14% = 92 Rs

Thus, varun shipping is under valued as compared to current market price.

Learning: Estimated Growth in Earnings converge with Price in Long term.

#### 1 comment:

1. Amazing Research on Stock Broking company in Indiahats off to you Ashish