fundamental analysis

Assoc.Prof.Dr.Daiva Jurevičienė

FUNDAMENTAL ANALYSIS

VGTU -2009


Fundamental Analysis• To estimate the influence of state economy for

securities’ market• To evaluate perspective of each industry sector• Analyze companies

• To pick up the best companies form the top sectors, based on forecast of the state macro economy


Technical Analysis

• Expectation of market participants• Psychology of market participants


Stages of Fundamental Analysis

• Country’s analysis• Sector’s analysis• Company’s analysis


Country’s Analysis


Country’s Analysis• GDP• Unemployment • Inflation • Interest rates• Budget deficit• Sentiment


GNP• The flow of final goods and services• The sum of the elements of overall expenses

C + I + G + (X-M)• The sum of the elements of overall income


Real and Potential GNP• Real GDP - the sum in comparable

(basic period) prices• Potential GDP – Real GDP, produced

in case of full employment (natural unemployment rate)


GDP• The value of goods produced in side

the country,including the value produced inside

the country by foreignness, but excluding investment income,

received by citizens of a country abroad


Country Growth in Real GDP, 2001

Stock Market return, 2001 Local Currency

Stock Market return, 2001 $

Brazil 0,3 -16,1 -31,5

China 7,0 -29,8 -29,8

Hong Kong -0,3 -27,4 -27,4

Hungary 3,7 -1,9 0,4

India 5,3 -15,7 -18,4

Indonesia 3,5 1,7 -5,2

Israel -2,7 -10,5 -20,2

Mexico -1,6 16,4 21,6

Poland 0,8 -12,3 -12,0

Russia 4,9 110,3 97,5

Singapore -7,0 -13,1 -17,8

South Africa 0,1 28,0 -17,2

South Korea 1,8 40,9 36,0

Taiwan -4,2 15,7 9,5

Turkey -7,1 35,2 -34,1


Annual Change of Real GDP in Lithuania (%)

SEB Nordic Outlook 2009 February

In brackets SEB projections


-2

0

2

4

6

8

10

12

UK Germany France Italy Czech Republic Estonia Hungary Latvia Lithuania Poland Slovakia Euro zone

GDP, yearly change in percent

2007 2008 2009 2010


Financial Assets

• Indicate only the owner, • Not included in GDP (or GNP) • Do not create the real assets; • Note only the change of the owner


Financial Assets

• Aggregating balance sheets of all companies and individuals and cancelling out the claims, only real assets as the net wealth of the economy is left

• Profit or loss of financial assets fully depends on the income generated by real asset


Inflation and Unemployment• Governments expect to stimulate economy’s to obtain full employment, and avoid inflation processes


Interest Rates• High interest rates reduce the present value of future cash flows, thereby reducing the attractiveness of investment

opportunities


Budget Deficit • Large amounts of government borrowing can

force up interest rates by increasing the total demand for credit in the economy

• Excessive borrowing will “crowd out” private borrowing and investing by forcing up interest rates and choking off business investment


Sentiment • Consumers will be more willing to spend on

big-ticket items• Business will increase production and

inventory levels


Concept An economy with dominant automobile production industryPeople increase the length of time using their cars before

replacing themDescribe the effects on:1. GDP2. unemployment3. The government budget deficit4. Interest rates


INTEREST RATES Fundamental factors:• The supply of funds• The demand for funds• The government’s net supply or demand • The expected rate of inflation


INTEREST RATES

supply

demand

E

E’

Funds

Interest rate


INTEREST RATES• nominal interest rate = inflation rate +

equilibrium real rate of interest. • The inflation premium is necessary for

investors to maintain a given real rate of return on their investments


DEMAND SHOCKS

• Positive demand shocks:


DEMAND SHOCKS

• Positive demand shocks:• reduction in tax rates• increase in money supply • increase in government spending• increase in foreign export demand


SUPPLY SHOCKS


SUPPLY SHOCKS

- changes in the price of imported oil- freezes, floods, etc. that might destroy large

quantities of agricultural crops- changes in the educational level of an

economy’s workforce- changes in the wage rates at which the

workforce is willing to work


Macroeconomics predictions are notoriously unreliable

Any investment advantage you have will be a result only of better analysis – not better information


Tools of Government Policy


Tools of Government Policy– Demand:

1. Fiscal policy2. Monetary policy

– Supply:3. Stimulate to work4. Innovations 5. Changes in taxes6. Educational programs 7. Scientific research


Tools of Government Policy

Fiscal policy Monetary policy


Tools of Fiscal Policy


Tools of Fiscal Policy

Stimulating policy(decline)

Stemming policy(trough)

1. Increase of expenses2. Decrease of taxes3. Both

1. Decrease of expenses2. Increase of taxes3. Both


Consequences (of stimulating)1. Increase of deficit

2. Increase of demand3. Decrease of unemployment

Debt increases Money emission

1. Investments decreases2. Consumption decreases

Government expenditures do not effect

investments and consumption

Interest rate increasesCompete with private


Consequences (of stimulating)1. Increase of deficit

2. Increase of demand3. Decrease of unemployment

Debt increases Money emission

1. Investments decreases2. Consumption decreases

Government expenditures do not effect

investments and consumption

Interest rate increasesCompete with private

bad good


Consequences (of stemming)1. Decrease of deficit

2. Decrease of demand3. Increase of unemployment

Debt decreases Freeze of budget surplus

Surplus returns to the market

Inflation increases Inflation decreases

Surplus do not return to the market


Consequences (of stemming)1. Decrease of deficit

2. Decrease of demand3. Increase of unemployment

Debt decreases Freeze of budget surplus

Surplus returns to the market

Inflation increases Inflation decreases

Surplus do not return to the market

bad good


Monetary policy


• Works through its impact on interest rate• Increases in the money supply lower short-term

interest rates• Encourages investment and consumption demand • Over longer periods does not have a permanent effect

on economic activities• Expansionary monetary policy will lower interest

rates and thereby stimulate investment and some consumption demand in the short run, but will lead to higher prices

Monetary policy


• Open market operations• Discount rate• Reserve requirements

Tools of Monetary Policy


Banking multiplicatorbankbank new depositnew deposit new loannew loan reservesreservesFirst bank 1000,00 800,00 200,00Second bank 800,00 640,00 160,00Third bank 640,00 512,00 128,00Fourth bank 512,00 409,60 102,40Fifth bank 409,60 327,68 81,92Sixth bank 327,68 262,14 65,54Seventh bank 262,14 209,72 52,42Eighth bank 209,72 167,77 41,95Ninth bank 167,77 134,22 33,55Tenth bank 134,22 107,37 26,85In total first 10 banks 4463,13 3570,50 892,63Amount of other banks 536,87 429,50 107,37Total in banking sector 5000,00 4000,00 1000,00


Case

Suppose the government wants to stimulate the economy without increasing interest rates.

What combination of fiscal and monetary policy might accomplish this goal?


Business cycle

contraction

trough(depression)

expansion

peakGDP

time

peak


Reasons of cyclical fluctuations

– Changes in consumption – Government expenses – Changes in export – Investments


Industry Analysis


Industry Analysis

– Cyclical sectors– Defensive sectors


-80

-60

-40

-20

0

20

40

60

80

basic

cycl

good

s

nonc

ycl g

oods

cyc s

erv

nonc

ysl s

erv

finan

ces

industr IT

resou

r

pub u

tilit

perc

ent c

hang

e fr

om p

revi

ous

year

20012002

Estimates of earnings growth rates


-34,7

-21,9

-28

-31,7

-7

-2,4

-50,3

-22,7

-1

-2,3

0,3

3,3

-4,9

-3,1

-15

25

-0,5

-9,1

-21

-12

-14,7

-36,1

1,2

-27,3

-9

-25

0,4

-60 -50 -40 -30 -20 -10 0 10 20 30

1

grąž

a pr

oc.

bankininkystėbiotechnologija

brokeriaikompiuteriai

gynybavystymo komunikacijos

elektronika

energijaenergijos paslaugosfin. paslaugos

maistas ir ž.ū.auksas

sveikatos apsauganamų finansai

draudimas

laisvalaikismed. priemonėsmed. Pristatymas

multimediadujos

tinklų infrastruktūramažeminė prekyba

komp.programos ir aptarn.

technologija telekomunikacijoskomunlinis ūkis

bevielis ryšys2001 m. akcijų kainos

The stock price performance of industries in 2001


19 19

60,5

20,3

-0,9

14,5

-100

10203040506070

bank

ing

fnanc

servi

ces

insura

nce

inves

tmen

ts

leasin

g

savin

gs and

loanspe

rcen

t cha

nge

from

200

1Estimates of Earnings Growth in

2002 for Finance Firms


Factors, determining sensitivity of a firm’s earnings to the

business cycle• Sensitivity of sales • Operating leverage • Financial leverage


sector rotation

contraction

trough(depression)

expansion

peakGDP

time

peak


Case

In which of the business cycle would you expect the following industries to enjoy their best performances?

newspapers machine tools beverages timber


industry life cycle

Start-up Maturity Conso-lidation

Relative decline

sales

Rapid andIncreasing

stableslowing

minimal ornegative


Peter Lynch says:

Many people prefer to invest in a high growth industry, where there’s a lot of sound and fury. Not me. I prefer to invest in a low-growth industry… In a low-growth industry, especially one that’s boring and upsets people [such as funeral homes or oil-drum retrieval business], there’s no problem with competition. You don’t have to protect your flanks from potential rivals…and this gives you the leeway to continue to grow.


Peter Lynch industry classification

• slow growers• stalwarts• fast growers• cyclicals• turnarounds• asset plays


conclusions • Macroeconomic policy aims to maintain the

economy near full employment without aggravating inflationary pressures

• Expansionary fiscal policy can stimulate the economy and increase GDP but tends to increase interest rates

• Expansionary monetary policy works by lowering interest rates

• Industries differ in their sensitivity to the business cycle


Company's Analysis


Financial statements

• Balance sheet• Income statement• Cash flow statement


Balance sheet

- a visit card - a photo of company’s financial data at

a certain moment


Balance sheet

Indicates “where we are?”:-what part of assets is financed by the owners- what part of assets is financed by the lenders

-where and in what form are the money of money suppliers'’


Profit/loss account- where have we been? - could the company manage risk? - It’s a theoretical measure


Profit/loss account

- What happens to profit: how much was paid for taxes, dividends, how much reinvested in business

- The company will not pay back neither interests, nor debts


Profit/loss account

Shows:- Profit from goods and services- Profit before taxes- Net profit


Cash flows

a) short-term - Liquidity – is oxygen

b) long term - Productivity – food


Shows “where are we going to?”-How much money generates business-Whether profit is in cash-If the business makes enough profit

Cash flows


Ratios

• Liquidity ratios• Profitability ratios• Turnover ratios• Market ratios


Valuation theory


Valuation Theory

To value any asset you need:• Estimate the steam of expected returns• Estimate the required rate of return• Investment decision process


Estimate the steam of expected returns

Returns or cash flows can take any form:• Earnings• Dividends• Interest payments• Rents• Capital gains


Estimate the steam of expected returns

Any analyst must forecast:• The form and amount of each cash flow• The time pattern over which these cash

flows will occur


Estimate the required rate of return

(1 + R real rate) (1 + I infl prem) (1 + P risk prem)

Approx req rate of return = = R real rate + I infl prem + P risk prem

Nominal risk free rates of interest, R risk free:R real rate + I infl prem


Estimate the required rate of returnRisk free premium can be broken down:• Internal sources of risk (diversifiable):

– Business risk– Financial risk– Liquidity risk– Exchange rate risk– Country risk

• External source of risk:– Market risk


Estimate the required rate of return

Required rate of return of stock (CAPM):

k stock = = R risk free + Beta stock (R market – R risk free)


Investment decision processIf estimated value > Market priceIf estimated value < Market price


Investment decision processIf estimated value > Market price, BuyIf estimated value < Market price, Don’t buy


Valuation of Alternative Investments


Valuation of BondsValue a 20-year semi annual 7 per cent coupon, $1 000 par value bond with a rating BB.The nominal risk-free rate is of interest is 5 percent. The

risk premium curve for 20-year corporates over the nominal risk-free rate is:

1% for AAs2% for As3% for BBs4% for Bs


Valuation of Bonds1. Determine the required rate of return2. Do the math3. Compute the bond’s value


Valuation of Bonds1. Determine the required rate of return

5% +3% = 8%2. Do the math

n = 20 * 2 = 40;PMT = $70/2 = $ 35i = 8/2 = 4FV = $1 000

3. Compute the bond’s value= PV = $901.04


Valuation of Preferred StockValue the preferred of a company that pays $5

annual dividend. The firm's bonds are currently yielding 8.5 % and preferred shares are selling to yield fifty basis points below the firm’s bond yield.


Valuation of Preferred Stock1. Determine the discount rate

2. Value the preferred


Valuation of Preferred Stock1. Determine the discount rate

8.5% - 0.5% = 8%2. Value the preferred

D/kp = $ 5/ 0.08 = $ 62.50


Valuation of Common StockNotes:• If an investor sells stock, the buyer is just

buying the remaining dividend streamthe stock’s value is still determined by the dividends it pays.


Valuation of Common StockNotes:2. If a company declares it will never pay

dividends, the shares of the company should be worthless.if the shares have value, it indicates that stockholders are expecting in the future to receive some value, like liquidating dividend


Valuation of Common StockOne-year holding period

1. Forecast this year’s dividend.2. Forecast the year-end sale price3. Estimate the equity discount rate



What is the value of stock that last year paid a $1 dividend, if you think next year’s dividend will be 10% higher;

The stock will be selling for $25 at last year-end;The risk free rate of interest is 5 %, The market return is 10% andThe stock’s beta is 1.2?



1. Solve the discount rate2. Find the PV of the future dividend3. Find the PV of the future price4. Sum steps 2 and 3



1. Solve the discount rateke = 0.05 + (1.2)(0.1) – 0.05) = 11%

2. Find the PV of the future dividendFV = D = $1 (1.1) = $ 1.10n =1; i = 11; PV =$0.99

3. Find the PV of the future priceFV = $25; n = 1; i = 11; PV = $22.52

4. Sum steps 2 and 3price based on investor’s expectations is:$0.99 = $22.52 = $23.51


Valuation of Common Stockmultiple-year holding period


Thank you

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