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- Top-down vs. Bottom-up
- Top-down approach: economy analysis and industry analysis
- Bottom-up approach: Technical analysis and security analysis
- Security analysis
- - Traditional fundamental analysis
- - Value based metrics analysis
- - Quantitative fundamental analysis
- Traditional fundamental analysis
- - Sources of information
- - COMPANY ANALYSIS
- Financial ratio analysis
- Fund flow statement analysis
- Cash flow statement analysis
- Break-even analysis and contribution analysis
- Financial Analysis and measures of risk
- Interviewing company representatives
- Quality of management, brand image etc.
- - Estimation of intrinsic value
- Value based metric analysis
- - EVA and selection of company

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Top-down

- Relies heavily on the analysis and forecasting of trends in the economy and industry
- Evaluates the expected impact of changes in the world economy on the macro economy of the country.
- Evaluates the expected influence of these changes on the domestic industry.
- Identifies the stocks which are expected to outperform the market.
- Thus, the expected market changes are the driving force behind this particular investment strategy.

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Bottom-up

- Places greater emphasis on individual stock selection.
- Picks up stock which are undervalued and have the potential to outperform.
- Despite its weakness, this approach is very popular primarily because of their inability
- - to forecast long-term economic and market trends or
- - to undertake low-cost stock selection, as well as
- their inherent tendency to speculate.

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Economy Analysis

- Growth Rate of National Income (GDP Growth Rate):
- Growth Rate in Industry
- Growth Rate in Service
- Growth Rate in Agriculture

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Economy Analysis

- Inflation:
- Higher rates of inflation upset business plans, lead to cost escalation and reduce profit margin.
- It leads to erosion of purchasing power.

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Economy Analysis

- Interest Rates:
- High Interest Payment Lower Profitability
- Lower Interest rate stimulates Investment Activity

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Economy Analysis

- Government Revenue, Expenditure, Deficit:
- High Fiscal Deficit High Inflation
- High Growth Expenditure
- (i) To stimulate Economy; and
- (ii) Expenditure to a particular sector i.e., infrastructure , cement , IT etc.

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Economy Analysis

- Foreign Trade, BOP and Exchange Rate:
- BOT = Imports – Exports
- Balance on Current account = BOT + Invisible Items
- BOP Deficit
- = Balance on Current A/C + Loan Receipt /Repaid
- High BOP Deficit Rupee will depreciate Improves the competitive position of Indian product.

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Industry Analysis

- Industry Life Cycle:
- Pioneering Stage (Sunrise industries) [Bio-con, Sulzon (wind energy)]
- Risky Investment
- Expansion Stage (Tele communication, IT. Etc.) High Return at low risk
- Maturity Stage [FMCG, Leasing industry (during 80,s it was in pioneering stage )]
- Decay Stage (Type writer, Jute Industry, B&W TV) get out from the company before the onset of the decay stage

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Industry Analysis

- INDUSTRY CHARACTERISTIC
- Demand Supply Gap
- Competitive Conditions in the Industry
- Barriers to Entry:
- Product Differentiate (Buyers Preference for
- established firm)
- Absolute Cost Advance
- Economy of Scale

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Industry Analysis

- Attitude of Government
- - Alcoholic Drinks
- Cost structure
- Proportion of fixed cost to variable cost
- Higher fixed cost, higher B/E point

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Bottom-Up Approaches

- An investor who follows a bottom-up approach to investing focuses either on
- (1) technical aspects of the market
- or
- (2) the economic and financial analysis of individual companies,
- giving relatively less weight to the significance of economic and
- market cycles.
- The investor who pursues a bottom-up strategy based on certain technical aspects of the market is said to be basing stock selection on technical analysis.
- The primary research tool used for investing based on economic and financial analysis of companies is called security analysis.

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Three types of security analysis

- Traditional fundamental analysis
- Value based metrics analysis
- Quantitative fundamental analysis

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Traditional fundamental analysis

- Traditional fundamental analysis begins with the financial statement analysis to evaluate the financial solvency and profitability of the firm.
- The investor also looks at
- - the firm’s product lines
- - the economic outlook for the products (including
- existing and potential competitors), and
- - the industries in which the company operates.
- - the quality of management, brand image etc.
- Based on the growth prospects of earnings (or cash flows), the fundamental analysts attempts to determine the fair value or intrinsic value using P/E ratio (or DCF Technique).

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Value based metrics analysis

- Based on Economic Value Added (EVA) method developed by Stern Stewart & Company during the early 80’s.
- Fair market value should be equal to book value of assets plus present value of future EVA (MVA) i.e.,
- Fair market value
- =Book value of assets + PV of future EVA (MVA)

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Quantitative fundamental analysis

- Quantitative fundamental analysis seeks to assess the value of securities using a statistical model derived from historical information about security return.
- The most commonly used model is the fundamental multifactor risk model which may be as follows;
- E(R) = α + βM (market return) + β1(equity capitalisation)
- + β2 (book-to-price ratio) + β3(dividend yield)
- + β4(industrial) + β5(non-industrial)

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Traditional Fundamental Analysis:Sources of information

- The basic information about a company can be gleaned from publication (both print and Internet), annual reports, sources such as the commercial financial information providers [CMIE, Prowess data base, Indian Quotation Systems Pvt. Ltd. (Moneyline Telerate), RBI bulletin].

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The basic information about a company consists of the following

- Type of business (e.g., manufacturer, retailer, service, utility)
- Primary products
- Strategic objectives
- Financial condition and operating performance
- Major competitors (domestic and foreign)
- Competitiveness of the industry
- Position of the company in the industry (e.g., market share)
- Industry trend
- Regulatory issues
- Economic environment

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COMPANY ANALYSIS following

- Important Financial Statements
- Income Statement (P&L Account)
- Statement of Financial position (Balance Sheet)
- Fund Flow Statement
- Cash Flow Statement

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FINANCIAL RATIO ANALYSIS: following

- Liquidity Ratios
- Leverage/Capital Structure Ratio
- Turnover Ratio
- Profitability Ratio (Net Profit, Operating Profit, Non-Operating Profit)
- Common Stock Ratio (DPS, EPS, etc.)

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FINANCIAL RATIO ANALYSIS followingcan not tell the whole story

- So many assumptions.
- Other areas of concern
- - selection of an appropriate benchmark
- firm or firms for comparison purposes
- - interpretation of ratio.
- - pitfalls in forecasting future operating
- performance and financial condition
- based on past trends

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ACCOUNTING POLICY AND NOTES following

- Depreciation Policy: WDM, SLM
- Inventory Valuation: FIFO, LIFO, etc.
- Before comparing two companies, you must recast their comparison on the basis of uniform accounting policy.

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FUND FLOW STATEMENT ANALYSIS following

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Fund Flow ANALYSIS following

- What is the fund from operation (FFO)?
- Whether acquisition is from FFO.
- Whether the firm has used short term sources of funds to finance long-term investments.
- Level of Increase/Decrease in Working Capital. Is it justified?
- What is existing Current Ratio?
- Excessive Liquidity is bad.

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CASH FLOW STATEMENT following

- 1. Cash Flow from Operating Activities is expected to be positive.
- 2. Cash Flow from Investment Activities is expected to be negative.
- 3. Cash Flow from Financial Activities is expected to be positive.

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CASH FLOW STATEMENT ANALYSIS following

- Checking the Power of Cash Flow Engine (CF from operating activity):
- Whether it is increasing?
- Is it increasing at the cost of Working Capital?
- What is the qualities of Net Profit?
- Correlation between net profit and cash flow from operation.
- Whether cash flow from financing activity is now for investment activities or it is used to meet daily expense.
- Whether CFOP Activity is negative?

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BREAK-EVEN ANALYSIS AND CONTRIBUTION ANALYSIS following

- EBIT = TR – TC = PQ – (Va + F)
- = Q (p – v) – F
- At Break-even point EBIT = 0,
- Or QB/E = [F/(p – v)]
- = Fixed Cost/Contribution

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Margin of Safety following

- Margin of Safety
- = Actual Sale – Break-even sale
- Suppose B/E sale is 80% of actual sale.
- Margin of safety is 20%.
- Its sales can drop by 20% before it shows loss.

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Contribution Margin following

- Contribution Margin = contribution / sale
- Suppose sale = Rs50 per unit
- Variable cost =Rs20 per unit
- Contribution margin = (50 -20) / 50 = 60 i.e., 60%.
- This means that every rupee of additional sales will increase the pretax profit by 60 paise.
- The traditional financial ratio does not provide this information at all.
- Suppose we have got PBT to sales = 20%.
- Will profit increase by 20 paise for every rupee increase in sales?

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Limitation of contribution margin analysis following

- Since an investor is interested only on the profit of the firm, the forecasted sale or growth in sale can be translated into earnings growth with the help of contribution analysis.
- Two notes of caution are, however, in order.
- First, the contribution analysis is valid only as long as the existing capacity is adequate to meet the forecasted demand growth.
- Second, the traditional accounting statements do not provide adequate information about variable and fixed costs.

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FINANCIAL ANALYSIS AND MEASURES OF RISK following

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FINANCIAL ANALYSIS AND MEASURES OF RISK following

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FINANCIAL ANALYSIS AND MEASURES OF RISK following

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Interviewing company representatives following

- Interviewing representatives of company may produce additional information and insight into the company’s business.
- Because the analyst comes armed with knowledge of the company’s financial statements, the questions should focus on taking a closer look at the information provided by these disclosures:
- - Extraordinary or unusual revenues and expenses
- - Large differences between earnings and Cash Flows from
- operating activities.
- - Changes in accounting policy
- - How the company values itself versus the market’s valuation

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Other company specific factors following

- Age of Plant
- Quality of Management
- Brand Image
- Labour-Management relation

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ESTIMATION OF INTRINSIC VALUE followingEarning Analysis, dividend and dividend discount models

Value of a firm

=expected value of a future cash flow of the firm

As an alternative, what is typically done is to examine the

historical and current relation between stock prices and

some fundamental values, such as earnings, dividends,

using this relation to estimate the value of a share.

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ESTIMATION OF INTRINSIC VALUE following

- Estimate the expected earnings per share (EPS).
- Establish a P/E Ratio.
- Develop a value anchor and a value range.

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1. Estimate the expected earnings per share. following

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Can earnings be managed? following

- There is a possibility that reported financial information may be managed or manipulated by the judicious choice of accounting methods and timing.
- Earnings can be manipulated using a number of devices
- including the selection of Depreciation Policy:
- WDM, SLM
- Inventory Valuation: FIFO, LIFO, etc.

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- There are many pressures that a company may face that affect the likelihood of manipulation. These pressures include:
- - Reporting ever-increasing earnings, especially when
- the business is subject to variations in the business
- cycle
- - Meeting or beating analyst forecasts
- - Executive compensation based on earnings targets

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Earnings Per Share the likelihood of manipulation. These pressures include:

- EPS = EAT / Number of common shares outstanding
- What is there to interpret?
- EAT is the net income available to shareholders. It is pretty clear.
- What about the number of common shares outstanding?
- Can that change during the period of time under consideration?
- Diluted shares.
- Basic EPS vs. Diluted EPS

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Establish a P/E Ratio. the likelihood of manipulation. These pressures include:

- The P/E ratio may be derived from
- 1. The constant growth dividend model, or
- 2. Historical analysis

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1. DIVIDEND GROWTH MODEL the likelihood of manipulation. These pressures include:

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- Calculate P/E ratio on the basis of above formula. ……(1) the likelihood of manipulation. These pressures include:
- Historical P/E ratio for 5 year (average) ..(2)
- Weighted Average P/E ratio
- = (1+2)/2

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DETERMINE A VALUE ANCHOR AND A VALUE RANGE the likelihood of manipulation. These pressures include:

- Projected EPS x Appropriate P/E Ratio
- Suppose it is = 5 x 6.8 = Rs.34
- Intrinsic Value Range = Rs.32 – Rs.36

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Buy-hold and sale decision the likelihood of manipulation. These pressures include:

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Some Tools for judging undervaluation or overvaluation the likelihood of manipulation. These pressures include:

- ROE
- Low High
- Low
- PBV
- ratio
- High

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Value Based Metric Analysis the likelihood of manipulation. These pressures include:

- ECONOMIC VALUE ADDED

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- Economic Value Added (EVA) the likelihood of manipulation. These pressures include: is a residual income that subtracts the cost of capital from the operating profits generated by a business.
- The term EVA is a registered trademark of a New York based consulting firm Stern Stewart & Co.

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- One of the earliest to define residual income was Alfred Marshall way back in 1890.
- Marshall defined economic profit as total net gains less the interest on invested capital at the current rate (A Marshall, 1890, Principles of Economics, The MacMillan Press Ltd.)

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DEFINING EVA Marshall way back in 1890.

- EVA essentially seeks to measure a company’s actual rate of return as against the required rate of return. To put it simply, EVA is the difference between Net Operating Profit after Tax (NOPAT) and the capital charge for both debt and equity (overall cost of capital).
- If NOPAT > the capital charge, EVA is positive
- If NOPAT < the capital charge, EVA is negative.

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- NOPAT is the return on capital employed. Marshall way back in 1890.
- Thus, if r is the rate of return on capital employed,
- the NOPAT = r x capital
- Capital charge is the overall cost of capital.
- Thus, if c is the rate of cost of capital,
- the capital charge = c x capital

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- Thus Marshall way back in 1890.EVA = NOPAT – capital charge
- = r x capital – c x capital
- = (r – c) x capital
- = (rate of return – cost of capital) capital
- If, for example, NOPAT is Rs 250, capital is Rs 1,000, and c is 15%, then r is 25% (NOPAT/capital ) and EVA is Rs 100.
- EVA =(r – c) x capital
- = (25% - 15%) x Rs 1,000 = Rs 100

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NET OPERATING PROFIT AFTER TAX (NOPAT) Marshall way back in 1890.

- NOPAT is equivalent to income available to shareholders plus interest expenses (after tax).
- Suppose, OPERATING PROFIT BEFORE INTEREST AND TAX = EBIT = Rs3,000. If interest is Rs1,000 and tax rate is 40%, then PAT is Rs1200:
- EBIT = Rs3,000
- Interest = Rs1,000
- PAIBT = Rs2000
- Tax (40%)= Rs800
- PAT = Rs1200

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NOPAT is equivalent to income available to shareholders plus interest expenses (after tax).

- Income available to shareholders = PAT = Rs1200
- Interest expenses (after tax)
- = effective interest = interest – interest tax shield
- = Rs1,000 – 40% x Rs1,000
- = Rs1,000 – Rs400 = Rs600
- NOPAT = Rs1200 + Rs600 = Rs1,800

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- If before tax cost of debt is k interest expenses (after tax).d = 10% ,Debt capital = Rs1000 ,Cost of equity capital (ke) = 12% and Equity capital = Rs5000:
- Total capital charge
- = after tax cost of debt + cost of equity
- = kd (1 –t) x Rs10,000 + ke x Rs5000
- = 10%(1 - .40) x Rs10,000 + 12% x Rs5000
- = Rs600 + Rs600 = Rs1200
- Thus, EVA = NOPAT – capital charge
- = Rs1,800 – Rs1200 = Rs 600

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Alternatively EVA can be calculated as follows: interest expenses (after tax).

- EVA = NOPAT( which is equivalent to income available to shareholders plus actual interest expenses) – actual cost of capital (which is before tax cost of debt plus after tax cost of equity capital)
- Or EVA = NOPAT(Rs1200 + Rs1000) –actual cost of capital(10%x Rs10,000 + 12% x Rs5000 = Rs1000 + Rs600 = Rs1600) = Rs2200 – Rs1600 = Rs600

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www.pptmart.com interest expenses (after tax).

www.pptmart.com interest expenses (after tax).

www.pptmart.com interest expenses (after tax).

www.pptmart.com interest expenses (after tax).

www.pptmart.com interest expenses (after tax).

- EVA = NOPAT – capital charge interest expenses (after tax).
- = r x capital – c x capital
- = (r – c) x capital
- = (rate of return – cost of capital) capital
- EVA / capital = rate of return – cost of capital
- = excess return on invested capital

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- MV of equity = book value of equity + MVA interest expenses (after tax).
- MV of equity + Debt = book value of equity + debt+ MVA
- MV of company = book value of company + MVA
- Or MV of company / book value of company
- = 1 + MVA / book value of company
- Tobin’s q = 1 + MVA / book value of company

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Company selection using EVA interest expenses (after tax).

- Excess return to invested capital (EVA / book value of capital)
- Best fitted line
- x x x x xx
- x x x x
- x xx x xx x
- x x
- x Y x x
- Z x
- x
- xx Ratio of market value to book value or replacement cost (q)
- x x x x
- x x

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- The above figure shows the “excess return on invested capital” versus the “market Value of Invested capital-to-Replacement Cost of Invested Capital” for a number of hypothetical companies.
- The data points that lie above the ‘best fitted line’ represent potentially undervalued companies (or shares), while those data points that fall below the ‘best fitted line’ represent potentially overvalued companies.

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Company selection using EVA capital” versus the “market Value of Invested capital-to-Replacement Cost of Invested Capital” for a number of hypothetical companies.

- Excess return to invested capital
- 4 4
- 2
- 1.5 2 Ratio of market value to replacement cost (q)

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- Tobin’s q = MV of company / book value of company capital” versus the “market Value of Invested capital-to-Replacement Cost of Invested Capital” for a number of hypothetical companies.
- Consider the following situations:
- For firm Y , MP = fair value (FV)
- For firm X, MP < FV , the firm is under priced
- For firm Z, MP > FV, the firm is overpriced.

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