Smart Task 01

1. What is fundamental analysis? Why is fundamental analysis relevant for investing? How to use
PE/PB charts to identify fundamental opportunities?

Sol. 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. This form of analysis is based on external events and influences, as well
as financial statements and industry trends.

Fundamental securities analysis helps you to predict future price movement and gauge whether a stock is
undervalued or overvalued. At the same time, it helps you analyse a company’s strength and its ability to beat its
competitors.

Calculate the price to earnings (PE) ratio and the price to book (PB) ratio. The PE ratio is calculated by
dividing the stock price by the earnings per share. You can find earnings per share on the income statement
contained within the annual report. Assume earnings per share is $2. The PE ratio is 5x ($10 divided by 2).
The PB ratio is calculated by dividing share price by stockholders' equity, which can be found on the
balance sheet included in the report. It's essentially an estimate of what the company would be worth if it
were liquidated immediately. Assume stockholders' equity per share is $5. The PB is 2x ($10 divided by 5).

Find the average PE ratio of other firms in the same industry, either by computing them through the same
process or searching online for this figure. Assume the average is 5x. Multiply the company's price per
share by the industry PE ratio. The calculation is 5 multiplied by $10 or $50. This tells you that XYZ
company is undervalued and that the price should be around $50. Determine the value based on the PB ratio.
Calculate the average PB ratio for other companies in the same industry. If the average PB ratio for XYZ's
industry is six, then XYZ should be trading at a price of $12 (2 multiplied by 6). This tells you that the
company is also undervalued according to the PB multiplier.

2. How to do Financial Statement Analysis on stocks ? Elaborate key points on the following;

Annual Report key points Balance Sheet Analysis

Cash Flow Statement Analysis Profit & Loss statement Analysis

It behoves investors to take advantage of the wealth of information provided in a company's financial
statements to help them evaluate the company as a potential investment. In terms of overall profitability, the
net income is the obvious starting point when analysing a financial statement. This bottom-line dollar amount
on a company's income statement is an excellent indicator of profitability because it puts a value on the
amount a company takes in, once all costs of production, depreciation, tax, interest, and other expenses have
been deducted. However, net income shouldn’t be used exclusively when evaluating a company.

Operating Profit Margin

The operating profit margin is another important indicator of profitability and efficiency that compares the
amount a company earns before interest, and taxes on sales are calculated. The margin helps analysts and
potential investors gauge how successful company managers are at controlling expenses and generating
revenue. A high operating profit margin strongly indicates that a company is shrewdly managing costs and
generating sales.

Assessing Stock Price and Profitability for Shareholders

Financial statements can be used to assess the company's stock price and profitability for shareholders. A
variety of metrics are useful in this process. Earnings per share (EPS) is an indicator of return on investment,
showing a company's per-share profitability. The price-earnings (P/E) ratio uses a stock's EPS, compared to its
present share price, for evaluation purposes. The price to book (P/B) ratio is considered a foundational value
metric for investors, as it reveals the market's valuation of the company in relation to its intrinsic value.

Dividend Payout Ratio

The dividend payout ratio is another useful metric that measures a company's growth, financial stability, and
returns paid to stockholders. The dividend payout ratio calculates the percentage of company earnings paid out
to equity investors, in the form of dividends. The higher the ratio value, the more reliable a company’s
earnings can sustain dividend payouts, and the more stable a company is considered to be. Retained earnings,
the number of profits not paid out to shareholders as dividends, shows what portion of profits a company is
reinvesting in expanding its business.

Assets and Liabilities

The breakdown of assets and liabilities contained on a company's balance sheet provides investors with a
reliable snapshot of the company's overall financial health, as well as its debt situation. Debt ratios, such as
the current ratio, which can be calculated from the information provided in financial statements, let analysts
assess a company's ability to handle outstanding debt. Major capital expenditures can be used in evaluating a
company's current financial condition and can telegraph the potential for growth.

The annual report has many sections that contain useful information about the company. One has to be careful while
going through the annual report as there is a fragile line between the company’s facts and the marketing content that
the company wants you to read.

• Company Profile
 • The company’s vision and mission statements
• Overview of products and financial highlights over the last 5 to 10 years
• Director’s Report
• Management discussion and analysis (MDA)
• Corporate Governance Report
• Information about the company’s stock
• The auditors’ report
• Financial statements
• Notes to accounts

Balance Sheet Analysis

A balance sheet reflects the company’s position by showing what the company owes and what it owns. You can
learn this by looking at the different accounts and their values under assets and liabilities. You can also see that
the assets and liabilities are further classified into smaller categories of accounts. The value of balance sheet
accounts can be used to calculate ratios that show the liquidity, efficiency and financial structure of a business.

Let us take a look at a few of these ratios.

▪ Current ratio: Current assets include cash, petty cash, temporary investments, and inventory, while
current liabilities include short term loans, wages payable, and trade creditors. The current ratio
is defined as current assets divided by current liabilities. The ideal value for the current ratio is between
1.5 and 2. If the current ratio is too high, then we can infer that the company is hoarding assets instead
of using them for expanding the business, which might affect long-term returns. However, businesses
must always have sufficient current assets to pay off their current liabilities. If the current ratio goes
below 1, then it is difficult for a company to meet its short-term obligations.

▪ Quick ratio: This defines a company’s ability to meet its short-term obligations while making the best
out of its liquid assets. It is also called the acid test ratio. The quick ratio is equal to the sum of cash,
cash equivalents, short term investments and current receivables divided by current liabilities. A quick
ratio equal to 1 is considered normal. This value reflects that the company is equipped with enough
assets that can be liquidated to pay off the current liabilities. When the value of the ratio is less than 1,
then the company cannot fully pay off its liabilities.

▪ Asset turnover ratio: The asset turnover ratio tells you about the efficiency with which a business
utilizes its assets. It determines if a company can generate sales from its assets by comparing net sales
with average total assets. A higher asset turnover ratio indicates that the company’s assets are being
utilized efficiently to generate sales and make profit for the business. A lower asset turnover means that
the company may not be utilizing its assets efficiently, and may experience management or production
problems.
 ▪ Inventory turnover ratio: This ratio indicates the number of times a company sells and replaces its stock
during a given period of time. High inventory turnover indicates that the company is selling its
products with ease and that those products are still in demand. A low inventory turnover value
indicates a decline in demand for the company’s products, and in turn, weaker sales.

▪ Debt-to-equity ratio: This ratio is equal to the company’s total liabilities divided by the owner’s equity.
The debt-to-equity ratio helps investors or bankers to decide if they want to lend money to the
company. They want to know if the company can generate sufficient cash flow or profit to cover all of
its expenses. The debt-to-equity ratio is a clear indicator of a company’s long-term ability to generate
sufficient income to fulfill payments and pay off debts. If the ratio is too high, then the company is
vulnerable to late interest payments or even bankruptcy.

Cash Flow Statement Analysis

▪ Cash from operating activities represents cash received from customers less the amount spent on
operating expenses. In this bucket are annual, recurring expenses such as salaries, utilities, supplies and
rent.

▪ Investing activities reflect funds spent on fixed assets and financial instruments. These are long-term,
or capital investments, and include property, assets in a plant or the purchase of stock or securities of
another company.

▪ Financing cash flow is funding that comes from a company’s owners, investors and creditors. It is
classified as debt, equity and dividend transactions on the cash flow statement.

There are a few major items to look out for trends and outliers that can tell you a lot about the health of the
business.

1. Aim for positive cash flow

When operating income exceeds net income, it’s a strong indicator of a company’s ability to remain
solvent and sustainably grow its operations.

2. Be circumspect about positive cash flow

On the other hand, positive investing cash flow and negative operating cash flow could signal
problems. For example, it could indicate a company is selling off assets to pay its operating expenses,
which is not always sustainable.

3. Analyze your negative cash flow

When it comes to investing cash flow analysis, negative cash flow isn’t necessarily a bad thing. It
could mean the business is making investments in property and equipment to make more products. A
 positive operating cash flow and a negative investing cash flow could mean the company is making
money and spending it to grow.

4. Calculate your free cash flow

What you have left after you pay for operating expenditures and capital expenditures is free cash flow.
This can be used to pay down principal, interest, buy back stock or acquire another company.

5. Operating cash flow margin builds trust

The operating cash flow margin ratio measures cash from operating activities as a percentage of sales
revenue in a given period. A positive margin demonstrates profitability, efficiency and earnings
quality.

Cash flow analysis helps your finance team better manage cash inflow and cash outflow, ensuring that there will
be enough money to run—and grow—the business.

Profit & Loss statement Analysis

The P&L statement is one of three financial statements that every public company issues on a quarterly and
annual basis, along with the balance sheet and the cash flow statement. It is often the most popular and
common financial statement in a business plan, as it shows how much profit or loss was generated by a
business.

P&L statements are also referred to as a(n):

• Statement of profit and loss

• Statement of operations
• Statement of financial results or income
• Earnings statement
• Expense statement
• Income statement

The P&L or income statement, like the cash flow statement, shows changes in accounts over a set period of
time. The balance sheet, on the other hand, is a snapshot, showing what the company owns and owes at a
single moment. It is important to compare the income statement with the cash flow statement since, under
the accrual method of accounting, a company can log revenues and expenses before cash changes hands.

This document follows a general form as seen in the example below. It begins with an entry for revenue,
known as the top line, and subtracts the costs of doing business, including the cost of goods sold, operating
expenses, tax expenses, and interest expenses. The difference, known as the bottom line, is net income, also
referred to as profit or earnings.
 3. Understanding following approach and suggest some stocks which follows the approach,
o Benjamin Graham and Buffett approach
o Peter Lynch Approach

Sol. Benjamin Graham’s method of value investing stresses that there are two types of investors: long-term
and short-term investors. Short term investors are speculators who bet on fluctuations in the price of an asset,
while long-term, value investors should think of themselves as the owner of a company. If you are the owner
of a company, you shouldn’t care what the market thinks about its worth, as long as you have solid evidence
that the business is or will be sufficiently profitable.

Using the Benjamin Method

The original Benjamin Method for finding the intrinsic value of a stock was:

\begin{aligned}&V \ =\ EPS \ \times\ (8.5\ +\ 2g)\\&\textbf{where:}\\& V\ =\ \ {intrinsic value}\\&EPS\ =\

\text{trailing 12-mth } EPS\text{ of the company}\\&8.5\ =\ P/E\text{ ratio of a zero-growth stock}\\&g\ =\
\text{long-term growth rate of the company}\end{aligned}
V = EPS × (8.5 + 2g)where:V = intrinsic valueEPS = trailing 12-
mth EPS of the company8.5 = P/E ratio of a zero-growth stockg = long-term growth rate of the company

In 1974, the formula was revised to include both a risk-free rate of 4.4%, which was the average yield of high-
grade corporate bonds in 1962 and the current yield on AAA corporate bonds represented by the letter Y:

V=\frac{EPS\ \times\ (8.5\ +\ 2g)\ \times\ 4.4}{Y}V=YEPS × (8.5 + 2g) × 4.4

Ex- MRF LTD.,SHREE CEMENTS LTD. BOSCH LTD

Buffett's Investing Style

Buffett’s tenets fall into the following four categories:

1. Business
2. Management & Business Tenets
3. Financial measures & value

Buffett restricts his investments to businesses he can easily analyze. After all, if a company's operational
philosophy is ambiguous, it's difficult to reliably project its performance. For this reason, Buffett did not suffer
significant losses during the dot-com bubble burst of the early 2000s due to the fact that most technology plays
were new and unproven, causing Buffett to avoid these stocks.
Management Tenets

Buffett's management tenets help him evaluate the track records of a company’s higher-ups, to determine if
they've historically reinvested profits back into the company, or if they've redistributed funds to back
shareholders in the form of dividends. Buffett favors the latter scenario, which suggests a company is eager to
maximize shareholder value, as opposed to greedily pocketing all profits.

Buffett also places high importance on transparency. After all, every company makes mistakes, but only those
that disclose their errors are worthy of a shareholder’s trust.Lastly, Buffett seeks out companies who make
innovative strategic decisions, rather than copycatting another company’s tactics.

Tenets in Financial Measures

In the financial measures silo, Buffett focuses on low-levered companies with high profit margins. But above
all, he prizes the importance of the economic value added (EVA) calculation, which estimates a company’s
profits, after the shareholders’ stake is removed from the equation. In other words, EVA is the net profit,
minus the expenditures involved with raising the initial capital.

On first glance, calculating the EVA metric is complex, because it potentially factors in more than 160
adjustments. But in practice, only a few adjustments are typically made, depending on the individual company
and the sector in which it operates.

\begin{aligned} &\text{Economic Value Added}= NOPAT-(CI \times WACC)\\ &\textbf{where:}\\

&NOPAT = \text{net operating profit after taxes} \\ &CI = \text{capital invested} \\ &WACC=\text{weighted
average cost of capital}\\ \end{aligned}Economic Value Added=NOPAT−(CI×WACC)

where:NOPAT=net operating profit after taxesCI=capital investedWACC=weighted average cost of capital

Buffett's final two financial tenets are theoretically similar to the EVA. First, he studies what he refers to as
"owner's earnings." This is essentially the cash flow available to shareholders, technically known as free cash
flow-to-equity (FCFE). Buffett defines this metric as net income plus depreciation, minus any capital
expenditures (CAPX) and working capital (W/C) costs. The owners' earnings help Buffett evaluate a
company’s ability to generate cash for shareholders.

Value Tenets

In this category, Buffett seeks to establish a company's intrinsic value. He accomplishes this by projecting the
future owner's earnings, then discounting them back to present-day levels. Furthermore, Buffett generally
ignores short-term market moves, focusing instead on long-term returns. But on rare occasions, Buffett will act
on short-term fluctuations, if a tantalizing deal presents itself. For example, if a company with strong
fundamentals suddenly drops in price from $50 per share to $40 per share, Buffett might acquire a few extra
shares at a discount. Finally, Buffett famously coined the term "moat," which he describes as "something that
gives a company a clear advantage over others and protects it against incursions from the competition”.

Ex- Fineotex Chemical, Gujarat Ambuja Exports, Schaeffler India

Peter Lynch Approach

Peter Lynch Fair Value is calculated based on Lynch's famous rule of thumb: He is willing to buy a growth
company at a P/E multiple that is equal to its growth rate. Therefore, to Peter Lynch, at fair value, the PEG ratio
of a growth company should be Because of this, the calculation of Peter Lynch Fair Value is very
straightforward. It simply equals to the growth rate multiplied by its earnings. That is:

Peter Lynch Fair Value = Earnings Growth Rate * Earnings.

Therefore, if a company grows its earnings 20% a year, to Peter Lynch, its fair valuation is 20 times its earnings.

Peter Lynch Fair Value = PEG * Earnings Growth Rate * Earnings.

In this formula, PEG =1, as we should note even more.

Ex. Mindtree Ltd, Deepak Nitrite Ltd., Info Edge (India) Ltd.

4. Understand following types of stocks and suggest some stocks of each type;

Multibagger Stocks Magic Formula Stocks

Wide Moat Stocks Defensive Stocks

Value Stocks Momentum Stocks

Low PE and High EPS stocks Bear Cartel Stocks

Bull Cartel Stocks

• Stocks that give returns that are several times their costs are called multibaggers. These are essentially
stocks that are undervalued and have strong fundamentals, thus presenting themselves as great
investment options. Multibagger stock companies are strong on corporate governance and have
businesses that are scalable within a short span of time. Ex- Hemang Resources

• Magic formula investing refers to a rules-based, disciplined investing strategy that teaches people a
relatively simple and easy-to-understand method for value investing. Ex- TCS, ITC
• A wide-moat company can withstand tough times without a huge effect on its success. Amazon, Apple,
and Walmart are all examples of wide-moat stocks that have stood the test of time.

• Defensive stocks are those that tend to provide stable earnings and consistent returns, even during an
economic downturn. Shares of well-established companies in the consumer staples, utilities, and
healthcare sectors are common examples of defensive stocks Ex- HUL, DABUR

• Value stocks are generally considered low-risk, dependable investments with limited near-term upside
potential. Growth stocks are usually considered more volatile, higher-risk stocks that have potential for
significant near-term upside. Ex- Coal India, L&T Infotech

• Stocks that tend to move with the strength of momentum are called momentum stocks. Momentum is
used by investors to trade stocks in an uptrend by going long (or buying shares) and going short (or
selling shares) in a downtrend.

• Stocks that tend to move with the strength of momentum are called momentum stocks. Ex- Chennai
Ferrous

• Low PE and High EPS stocks Ex- AGI Greenpac

• Short selling means that traders sell the shares of a particular company without owning them. They can do
this by borrowing shares from other shareholders or by going short in the futures market. To create
maximum impact on the share prices, the traders create a group termed as a bear cartel. Ex - Hinduja
Global, Dish TV

• A bull market is typified by a sustained increase in prices. In the case of equity markets, a bull market
denotes a rise in the prices of companies' shares. In such times, investors often have faith that the uptrend
will continue over the long term. Ex- Adani Power

5. Understand and Explain following discounting methodology

a. CAGR
b. CAPM
c. CRP
d. WACC
e. Buffett & Munger Approach for Discounting
a. CAGR is the rate of return required for the value of an investment or financial metric to grow
from its beginning value to its ending value between two dates.

CAGR provides the growth rate as if the changes occurred evenly at the same rate over each
individual period, so the CAGR effectively “smoothens” the growth rate.

b. The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
the expected return and risk of investing in a security. It shows that the expected return on a
security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security

c. Country Risk Premium (CRP) is the additional return or premium demanded by investors to
compensate them for the higher risk associated with investing in a foreign country, compared
with investing in the domestic market.

d. The WACC is used as a discount rate when the organization wants to generate as much cash
flows as it is paying to the investors for their capital.

e. In order to calculate intrinsic value, you take those cash flows that you expect to be generated
and you discount them back to their present value