trading smart with fundamental analysis

Please read carefully the important disclosures at the end of this publication.

Trading Smart with

FFUUNNDDAAMMEENNTTAALL

AAnnaallyyssiiss

MICA (P) 032/02/2011

Trading Smart with Fundamental Analysis May 2011 [ 2 ]

Contents

Chapter 1 Introduction 3

Chapter 2 Getting Started 5

Chapter 3 Breaking it Down 6

Chapter 4 Income Statement 9

Chapter 5 Balance Sheet 14

Chapter 6 Cash Flow Statement 25

Chapter 7 Important Attachments to the Financial Statements 29

Chapter 8 Valuation Analysis 31

Chapter 9 Checklist 42

Chapter 10 Glossary of Terms 45


1

Introduction

Have you ever wondered how equity analysts arrive at a recommendation or calculate their target price for a particular stock? Lost among the jargon used by analysts? This mini guide book tries to provide you with a foundation for understanding Fundamental Analysis, step by step.

While you may not be the next Warren Buffett after reading this book, you should have a better understanding of common financial terminologies and concepts behind equity analysis.

In contrast to Technical Analysis (see the excellent guide written by our award-winning chartists Trading smart with technical analysis), fundamental analysis is the foundation on which investing stands. In fact, if you are not acquainted with fundamental analysis, some would say you are not really investing.

The biggest hurdle in fundamental analysis involves the understanding of financial statements. This relates to the analysis of the income statement, balance sheet and cash flow statement of a company to gain insight to the companys financial health and prospective performance.

Fundamental analysis also has a qualitative side whereby one breaks down the intangible aspects of a company.


What is Fundamental Analysis?

Fundamental analysis uses underlying qualitative and quantitative factors such as financial performance and indicators to value a stocks share price and earnings in prospective periods.

Examples of questions one might ask while doing fundamental analysis are:

1) Is the company able to maintain its current revenue growth?

2) Will the company be profitable?

3) Does the company have superior margins to its peers?

4) Does the company have enough cash reserves and cash flow to pay off debts?

5) Is the company in a business with high barriers to entry?

Did you know?

The most famous and successful user of fundamental analysis is the Oracle of Omaha, Warren Buffett, who is known for his ability to employ fundamental analysis to pick securities that have made him the financial tycoon that he is today.


2

Getting Started

So, how do I get started?

Step 1: Read a wide variety of information sources such as:

Initial Public Offering Prospectuses Annual Reports Quarterly Results Statements Company Announcements

Press Articles from the Straits Times, Business Times, Wall Street Journal etc. Analysts Reports Websites: www.sgx.com.sg; www.research.sgx.com; and respective company websites

Step 2: After getting a rough idea of what the company does, analyse the companys prospects and earnings

drivers.

Step 3: For the more adventurous, try charting out its historical earnings on a Microsoft Excel sheet and examine

earnings and cost trends. You could even build your own forecasts and compare them with the actual results to see whether you are more accurate than the analysts!

Step 4: If you have industry contacts, talk to them on a frequent basis and find out what is happening in the

industry. Perhaps you could even take a drive and peek at the companys operations as a picture paints a thousand words. Along the way, you may even pick up useful information from the employees in the company.


3

Breaking it Down

Quantitative & Qualitative

As fundamental analysis involves the study of many fundamental factors, lets make things easier by breaking down these factors into two segments:

1) Quantitative as the name suggests, such factors can be expressed in numerical terms.

2) Qualitative anything else that is non-numerical!

While numbers form the basis of analysis, qualitative factors such as management quality and brand value are also important and these typically manifest themselves in the companys earnings quality, superior margins compared with peers or better ROEs (returns on equity).

As an example, when looking at Singapore Airlines, you may like to check quantitative factors such as its earnings per share, price-to-book ratio, dividend yield etc. to determine if its valuation is attractive. However, how does one value the brand name of Singapore Airlines, which is one of the worlds leading commercial passenger airlines? The fact that many associate a great flying experience with the airline contributes to the success of SIA.


What is Intrinsic Value?

Intrinsic value is the true value of a stock after evaluating its quantitative and qualitative factors. This concept is grounded in the assumption that the share price does not entirely reflect a stocks true value.

Investors would want to buy stocks that are trading below their intrinsic value.

However, the key concern for most investors is when the stock price will reach the intrinsic value? Alas, we do not have an answer as markets react to ongoing developments. It could be a day, a month, a year or even never as the environment is fluid.

By studying both quantitative and qualitative factors, an investor can estimate the intrinsic value of a stock and take the chance to buy the stock at a discount to that. If all goes according to plan, gains should be realized over time as the market catches up with fundamentals.

Qualitative Factors

Before jumping into quantitative jargon, lets first take a look at the qualitative factors of a company. Qualitative factors tend to be difficult to quantify, such as goodwill.

Some examples of qualitative factors:

Brand value

Quality of management integrity, credibility

Corporate governance

Quality of Management

If in the past five years, whenever Company As management gives earnings guidance for a financial period, the company never fails to meet the target given, such credibility in issuing earnings guidance could potentially translate to a higher valuation as opposed to similar peers as investors ascribe a price premium for uncertainty.


Quantitative Factors

Numbers are perplexing to many. So, it is no surprise that many investors do not know how to read financial statements and even find them intimidating. However, financial statements can offer you a world of information and help paint a clearer picture of the company. For a start, lets get acquainted with the different types of financial statements.

The three key Financial Statements:

1. Income Statement

2. Balance Sheet

3. Cash Flow Statement

These three statements are best used in conjunction.

Soon, I can calculate

the net profit of every

company!

Soon, I can calculate

the net profit of every

company!


4

Income Statement

Definition

The Income Statement (also known as Profit & Loss Statement) is a financial statement that summarises a companys revenues, costs and expenses incurred during a period of time. It also provides information on the companys ability to generate earnings and its cost structure.

The Income Statement is generally presented in a format shown below, that begins with an entry for revenue and subtracts from revenue the costs of running the business (i.e. cost of goods sold) to form the Gross Profit.

This is typically followed by Operating Expenses and Interest Expense is then netted off to derive the Pretax Profit. Net Profit, otherwise known as the bottom line, is the final derivative in the Income Statement after deducting Tax Expense.

Income Statement (S$, FYE Jun) 2007 2008 Revenue 284.2 433.7 Less: Cost of goods sold 200.0 350.0 Gross profit 84.2 83.7 Less: Operating expenses Selling, general and administrative 11.0 20.0 Legal and professional services 3.0 2.0 Interest expense 1.0 1.0 Pretax profit 69.2 60.7 Less: Tax 13.8 12.1 Net profit 55.3 48.6


Income Statement Breaking it down

Revenue

Revenue, otherwise known as sales, is generally the easiest part of the income statement to comprehend. Usually, it is just a single number that represents the total amount of money earned during a certain time period. Larger companies may break down the revenue figure into business segments or geographical sources in the Notes to the Financial Statements.

Points to note:

1. The best type of revenue is of a recurring nature, which means revenue that comes in regularly. One-off project wins or extraordinary gains that result in temporary increases in revenue are usually viewed less favourably.

2. Lumpy sales recognition makes earnings vary significantly from period to period. As such, one could see profit swings every year and this distorts P/E and P/E-to-growth valuations.

3. Look for sales growth in local-currency terms to see how the well the company is doing. A company could be selling in US$ and reporting good US$ sales growth but seeing revenue declines in S$ terms due to translation effects.

4. Also, analysts are interested to know the companys average capacity utilisation, quantity produced and sold, as well as average selling price (ASP) trends.


Expenses

There are many kinds of expenses, but the two most common are cost of goods sold (COGS) and selling, general and administrative expenses (SG&A). Cost of goods sold is the expense most directly involved in creating revenue. It represents the cost of producing or purchasing the goods or services sold by the company. For example, if NTUC pays a supplier $2 for a carton of milk, which it sells to customers for $5, NTUCs cost of goods sold for the carton of milk would be $2.

Next, costs involved in operating the business are classified under SG&A. This category includes marketing costs, salaries, utility bills, technology expenses and other general costs associated with running a business.

There are also financial costs, notably taxes and interest payments, which need to be considered.

Points to note:

1. Investors need to adjust expenses to see what the companys core profit from operations is. Given that exchange gains/losses and other non-core items such as gains from the sale of stocks and shares are now booked above the net profit line, there is a need to back out these numbers to see how the company is actually performing.

2. If times are bad and sales are decreasing, keep a close watch on the companys costs by looking at the yoy growth in expense.

3. Costs should also exhibit some relationship to sales (costs as a percentage of sales).

4. If similar listed peers are available, it would be useful to compare their cost structures.

5. Keep a tab on raw material cost trends, minimum wage laws and the supply/demand conditions of skilled workers.


Profits

Profit, most simply put, is equal to total revenue minus total expenses. However, there are several commonly used profit benchmarks that can tell investors how well or badly the company is performing. Gross profit is calculated as revenue minus cost of sales. Returning to the NTUC example, the gross profit from the sale of the milk would have been $3 ($5 sales price less $2 cost of goods sold = $3 gross profit).

Gross Prof it Margin = Gross Prof it / SalesGross Prof it Margin = Gross Prof it / Sales

Companies with high gross margins (expressed in percentage terms) will have substantial sums of money left over to spend on other business operations, such as R&D or marketing. However, do look out for margin erosion over time as this is usually the first symptom of stress to the bottom line, also known as net profit. When cost of goods sold rises rapidly, the rise is likely to lower gross profit margins - unless, of course, the company can pass on these costs to customers in the form of higher prices.

Points to note:

1. A companys ability to defend its margins by passing on costs to customers reflects the extent of its economic moat. If customers have no choice but to buy from a certain supplier and this supplier can enjoy price increases every year, its earnings model is strong.

2. This could mean a lack of substitute product or a high switching cost for customers.

Operating profit is equal to revenue minus the cost of sales, SG&A and other operating expenses. This number represents the profit a company makes from its actual operations, and typically, we would back out non-core items.

High operating margins can mean the company has effective control of costs, or that sales are increasing faster than operating costs.

Net profit, also known as net income, generally represents the company's profit after all expenses, including financial expenses such as interest and taxes, have been paid.


Points to note:

1. Financial expenses give an indication of whether the company is working for its bankers instead of shareholders. If the company has little profit that it can pass on to its shareholders after paying off interest on its loans, questions should be raised about its business model and capital structure. The company may have to consider alternative ways of financing such as convertible bonds and warrants.

2. Taxes are another area to keep an eye on. We should favour companies that can generate strong margins even if they do not enjoy tax benefits. Taking a practical case, most S-chips or companies that set up businesses in China used to enjoy 2-year tax holidays and three years of taxation at half the official rate. This form of protectionism is beneficial to a company only if it is able to use this period to develop its business in preparation for the expiry of such tax benefits. While it took the government a long time to finally implement tax unification, this eventually occurred and companies that were resting on their laurels with the benefit of zero or low tax rates saw their earnings suffer.


5

Balance Sheet

Definition

The Balance Sheet is a financial statement that summarises a company's assets, liabilities and shareholders' equity at a specified point in time. These three segments give investors an idea on what the company owns and owes, as well as the amount invested by shareholders. The balance sheet has to always abide by the following formula:

Assets = Liabili t ies + Shareholders' EquityAssets = Liabili t ies + Shareholders' Equity

Each of the three segments will have many accounts that document the value of each account. Accounts such as cash, inventory and property are on the assets side of the balance sheet, while on the liabilities side, there are accounts such as accounts payable or long-term debt. The exact accounts on a balance sheet will differ by company and by industry.


BALANCE SHEET (S$, FYE Jun) 2007 2008 Fixed assets 19.7 24.3 Intangible assets 4.6 4.6 Other long-term assets 22.8 22.1 Total non-current assets 47.1 51.0 Cash and equivalents 18.2 27.4 Stocks 79.9 137.7 Trade debtors 79.6 108.5 Other current assets 1.3 0.8 Total current assets 179.1 274.5 Trade creditors 22.0 31.0 Short-term borrowings 43.0 64.5 Other current liabilities 14.9 21.3 Total current liabilities 79.9 116.8 Long-term borrowings 0.0 3.7 Other long-term liabilities 1.9 1.9 Total long-term liabilities 1.9 5.6 Shareholders' funds 144.4 203.1

Balance sheet Breaking it down

Assets, liabilities and equity are the three main components of the balance sheet. When analysed together carefully, they can tell investors a lot about a company's fundamentals.

Assets

There are two main types of assets: current assets and non-current assets.

Current assets are those likely to be converted into cash or its equivalent usually within a year. Three very important current asset items found on the balance sheet are: cash, inventory and accounts receivables.

Non-current assets are defined as anything not classified as a current asset. They include items that are fixed, such as property, plant and equipment (PP&E). Such assets are usually carried at historical cost on the balance sheet less accumulated depreciation.


Cash Current assets

Investors normally are attracted to companies with plenty of cash on their balance sheets or are in net-cash positions (i.e. net cash = cash and its equivalents all interest bearing borrowings). After all, cash offers protection in recessionary times, and gives companies more options to grow.

Strong cash reserves are often a signal of good financial health. That said, if loads of cash are more or less a permanent feature of a company's balance sheet, investors would need to ask why the money is not being put to good use. Cash could be there because management has run out of investment opportunities or is too short-sighted to know what to do with the money. On the other hand, a depleting cash pile could be a sign of trouble.

Points to note:

1. A key disincentive for a company to hold cash is that returns from cash are low, resulting in a drag on the companys ROE. The best example of this is the scores of Japanese companies which are sitting on lots of cash and doing little with it.

2. Another worry about holding too much cash is that pressure from shareholders to do something could send management into hasty mergers and acquisitions that offer little benefit for the company or tempt management to venture outside its core businesses into unrelated businesses where they have no expertise.

3. Recently, for many S-chips, the issue of whether reported cash on the balance sheet is actually there has been raised. Other than auditors who have the duty to check if the cash is in the bank and the amounts are accurate, investors can perform a simple check by seeing if the interest income earned in relation to the cash balance makes sense.

4. One must also be careful about looking at the cash balance as the cash may be used for capital expenditure or have been ear-marked as deposits against bank borrowings.

5. Lastly, while one can understandably get excited over companies with huge cash (or net cash) as a percentage of market cap, usually as minority shareholders, one is not in a position to access this cash flow. As such, the unlocking of value typically comes from activist funds, corporate raiders or shareholders with substantial stakes in the company.


Inventories Current assets

Inventories are finished products that haven't yet been sold. As an investor, you would want to know if a company has too much money tied up in its inventory. Companies have limited funds available to invest in inventories. To generate the cash to pay bills and return a profit, they must sell the merchandise they have purchased from suppliers. Inventory turnover (i.e. inventory turnover = cost of goods sold divided by average inventory) measures how quickly the company is moving merchandise through the warehouse to customers. If inventory grows faster than sales, it is almost always a sign of deteriorating fundamentals.

Inventory represents a holding cost to the company as it means cash is tied up in products at its warehouse. When looking at inventories, one should pay attention to such aspects as shelf life (how long the inventory can be kept before it deteriorates), whether the inventory is generic and can be easily sold or specific and cannot be transferred to another customer (for example, the casing for a Nokia phone cannot be used in a Motorola phone) and the risk that the company needs to make a substantial provision for the inventory.


Receivables Current / Non-current assets

Receivables are outstanding cash waiting to be collected. The pace at which a company collects what it is owed can tell you a lot about the management of its credit policy. If a company's collection period is growing longer, it could mean problems ahead. The company may be letting customers stretch their credit in order to recognise greater sales and that can spell trouble later on, especially if customers face a cash crunch. Getting money right away is preferable to waiting for it - since some of what is owed may never get paid. The quicker a company gets its customers to make payments, the sooner it has cash to pay for salaries, merchandise, equipment, loans, and best of all, dividends and growth opportunities.

A commonly used measure is average receivable days outstanding.

Average receivables days outstanding = Average receivables/ Sales x 365Average receivables days outstanding = Average receivables/ Sales x 365

Points to note:

Long receivable days were a regular feature of many S-Chips. While this raises discomfort, the risk that these receivables may not be collected is lower when the weather is fair. However, with the global financial tsunami, one should look for companies actively shortening their credit policies and diligently collecting their receivables.

1. We should also look at related party transactions to analyse if the receivables are due from parties related to the major shareholders as this could be a mean to siphon cash from the listed entity.

2. Another area to look at is changes in other receivables. Investigate any significant increase in other receivables.

3. Also, take a look at the notes to the accounts in the annual report to see if the company has revealed the customer breakdown for its receivables as well as the aging of the receivables. In some cases, a company may have half of its receivables due from only one customer, significantly increasing its credit exposure risk.

Real Case

In its FY07 annual report, Company A highlighted that 47% of its receivables were due from one customer and another 28% were also due from one single customer.


Extract from Company As annual report Credit risk is limited to the risk arising from the inability of a debtor to make payments when due. The Group only deals with pre-approved counter parties with good credit rating and imposes a cap on the amount to be transacted with any country party so as to reduce its concentration of risk. Exposure to credit risk is monitored on an ongoing basis and credit evaluations are performed on all customers requiring credit over a certain amount.

The Group and Companys concentration of credit risk with any single or group of customers are as follows:

Collections from the above customers are very much dependent on market acceptance of the Groups products and these customers ability to pay is dependent on their ability to collect from their debtors. Additionally, Customer B is also a customer of Customer A. Accordingly, Customer As ability to pay is also dependent on its ability to collect from Customer B.

There were events occurring after the balance sheet date (Note 38) which may have a direct impact on the ability of the above customers to pay their debts in future.


Source: Companys FY07 Annual Report

Subsequently. Company A announced that its major customer had defaulted on its payments. This resulted in bankers calling in their loans and Company As ability to continue as a going concern came into question.


Liabilities

There are current liabilities and non-current liabilities. Current liabilities are obligations a firm must pay within a year, such as payments owing to suppliers. Non-current liabilities, meanwhile, represent what the company owes in a year or more time. Typically, non-current liabilities represent bank and bondholder debt.

Investors typically look at average payable days with a higher number being favoured as this means the company is able to hold off paying suppliers longer.

Average Payables Days = Average Payables/ Sales x 365Average Payables Days = Average Payables/ Sales x 365

Investors usually want to see a manageable amount of debt. When debt levels are falling, that's a good sign. Generally speaking, if a company has more assets than liabilities, it is in a decent condition. By contrast, a company with a large amount of liabilities relative to assets ought to be examined with more diligence. Having too much debt relative to the cash flows required to pay for interest and debt repayments is one way a company can go insolvent.


Some ratios to help you analyse

A common ratio used to assess a companys liquidity is the Current Ratio.

Current Rat ioCurrent Rat io

Current AssetsCurrent Assets

Current Liabili t iesCurrent Liabili t ies

=Current Rat ioCurrent Rat io

Current AssetsCurrent Assets


=

A ratio greater than 1.0x is desired as that means the current assets exceed current liabilities.

A further derivative of the Current Ratio is the Quick Ratio. This ratio is calculated by subtracting inventory from current assets and then dividing by current liabilities. If the ratio is 1 or higher, the company has enough cash and liquid assets to cover its short-term debt obligations.

The rationale for subtracting inventories is that inventories may not be liquid and may be forced-sold at lower prices.

Quick Rat ioQuick Rat io

Current Assets InventoriesCurrent Assets Inventories


=Quick Rat ioQuick Rat io

Current Assets InventoriesCurrent Assets Inventories


=


Gearing Risk

Analysts use net gearing to determine the leverage risk of a company.

Net Gearing (x)Net Gearing (x)

All interest bearing debt-cashAll interest bearing debt-cash

EquityEquity

=Net Gearing (x)Net Gearing (x)

All interest bearing debt-cashAll interest bearing debt-cash

EquityEquity

=

A net gearing of more than 1.0x is a warning sign. The key risk is that bankers may not refinance the company when its loans are due.

Company B

Based on its 1HFY6/08 balance sheet, net gearing was 0.52x which was not particularly alarming.

Cash and fixed deposits = Rmb 1.0bn

Short-term interest bearing debt = Rmb 2.3bn

Long term interest bearing debt = Rmb 2.2bn

Equity = Rmb6.7bbn

In this case, we should back out goodwill from the equity which yields an equity of Rmb2.9bn. If the goodwill was not backed out, equity would have been Rmb6.7bn and net gearing would have been 0.5x.

This companys problem started when its cash flow was not sufficient to repay its bankers who pulled back their loans. This led to a suspension of trading in its shares as the companys ability to continue as a going concern was thrown into question.

In addition, the company was on thin ice with a current ratio of 1.0x and a quick ratio of 0.6x. A demand for faster repayments by its suppliers would have easily toppled the company.

Net Gearing = (2.3+2.2-1.0)/ 2.9 = 1.2xNet Gearing = (2.3+2.2-1.0)/ 2.9 = 1.2x


Equity

Equity represents what shareholders own, so it is often called shareholders equity. As described previously, equity is the residual value after total liabilities is subtracted from total assets.

Equity = Total Assets Total Liabili t iesEquity = Total Assets Total Liabili t ies

The two important equity items are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders inject into a company. Retained earnings are a tally of the money the company has reinvested in the business rather than pay to its shareholders. Investors should look closely at how a company puts retained capital to use and how it generates a return on it.


6

Cash Flow Statement

Definition

The Cash Flow statement shows whether a company is generating positive cash from operations, how the cash generated is being used or how the cash deficit is being financed.

Looking at the cash flow statement can help us determine if the company needs financing.

The cash coming into the business is called cash inflow, and the cash going out is called cash outflow. The statement shows how changes in the Balance Sheet and Income Statement affect cash, and breaks the analysis down to operating, investing, and financing activities. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills.

Cash flow is akin to blood in humans and as such, particular attention should be paid to the cash flow statement.


CASH FLOW (S$, FYE Jun) 2007 2008Pretax profit 31.2 45.1

Depreciation & non-cash adjustments 7.1 13.4

Working capital changes (43.8) (74.4)

Cash tax paid (3.8) (6.7)

Others 0.2 0.2

Cash flow from operations (9.1) (22.3)

Capex (3.5) (6.1)

Net investments & sale of FA 5.1 0.4

Others 0.8 0.2

Cash flow from investing 2.4 (5.6)

Debt raised/(repaid) 25.5 25.2

Equity raised/(repaid) (0.2) 39.3

Dividends paid (9.5) (25.0)

Cash interest & others (2.0) (2.4)

Cash flow from financing 13.8 37.1

Change in cash 7.1 9.2

Change in net cash/(debt) (18.4) (16.0)


Cash Flow Statement Breaking it down

Cash is used and accumulated by a company in many ways. As such, the cash flow statement is divided into three sections: 1) cash flows from operations; 2) cash flows from financing; 3) cash flows from investing.

Basically, the sections on operations and financing show how the company gets its cash, while the investing section shows how the company spends its cash.

Cash Flows from Operating Activities

Cash flows from operating activities, also known as operating cash flows show how much cash comes from the sale of the company's goods and services, less the amount of cash needed to make and sell those goods and services. Investors tend to prefer companies that produce a net positive cash flow from operating activities. High-growth companies, such as technology firms, tend to show negative cash flow from operations in their formative years. At the same time, changes in cash flow from operations typically offer a preview of changes in net future income. Normally, it's a good sign when it goes up. Do look out for a burgeoning gap between a company's net income and its cash flow from operating activities. If net income is much higher than cash flow, the company may be speeding or slowing its booking of income or costs.

Cash Flows from Investing Activities

Cash flows from investing activities largely reflect the amount of cash the company is spending on capex expenditures, such as new property, plant and equipment or anything else that is needed to keep the business going. It also encompasses the acquisitions of other businesses and monetary investments such as money market funds. As an investor, you would want to see a company re-invest capital in its business by at least the rate of depreciation expenses each year. If no re-investment is made, the companys cash flows may show artificially high cash inflows in the current year which may not be sustainable.

Cash Flow From Financing Activities

Cash flows from financing activities describe the movement of cash associated with outside financing activities. Typical sources of cash inflow would be cash raised by selling stock and bonds or by bank borrowings. Likewise, paying back a bank loan would show up as a use of cash flow, as would dividend payments and common stock repurchases.


Other tips pertaining to the Cash Flow Statement

Many fund managers and financially-attuned investors are attracted to companies that produce positive free cash flows (FCF). Free cash flow signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of the business. Free cash flow, which is essentially the excess cash produced by a company, can be returned to shareholders or invested in new growth opportunities without hurting existing operations. The most common method of calculating free cash flow is:

Net Income

+ Amort izat ion / Depreciat ion

Change in Working Capital

Capital Expenditure

= Free Cash Flow

Net Income



Capital Expenditure

= Free Cash Flow

Net Income



Capital Expenditure

= Free Cash Flow

Net Income



Capital Expenditure

= Free Cash Flow

Ideally, investors would like to see that a company can pay for its investments without the need to rely on outside financing. A company's ability to pay for its own operations and growth signals to investors that it has very strong fundamentals.

Points to note:

1. Balance sheet and cash flow were given less importance before the Asian Financial Crisis as investors were looking for earnings growth driven by capacity and economic expansion. The Asian Financial Crisis jolted the investment community into giving more respect to balance-sheet strength and cash-flow-generating capability.

2. A key difference to note is the operating cash flow before and after working capital requirements. Typically, distributors suffer from a poor cash cycle. It takes them a long time to collect payments from customers, they are saddled with inventory by their suppliers and at the same time, suppliers demand to be paid fast. As such, distributors tend to have glowing operating cash flow before working capital and less flattering operating cash flow after working capital.

3. Since cash flow is usually derived from pretax profit, a prerequisite for strong cash flow is strong profitability, which is in turn driven by higher sales and lower costs.

4. Look for companies with sustainable free cash flow as this provides the foundation for a consistent dividend payout policy and can be used to check if attractive dividend yields are sustainable or just one-off.


7

Important Attachments to the

Financial Statements

Financial statements, however, are not the only parts of an annual report that you should read. In fact, the ancillary sections behind the numbers help fill in the gaps. The following are examples of such sections.

Notes to the Financial Statements

This section usually comes right after the Financial Statements. They serve to tie up the loose ends and complete the jigsaw puzzle. The Notes help link up ones understanding of the three financial statements Income Statement, Balance Sheet and Cash Flow Statement. If you dont read them, you could be missing out on a big part of the picture. For example, they may show you the breakdown of revenue from different countries or segments as well as the maturity date of outstanding debt, sensitivity analysis, depreciation policies, how sales are recognised etc.

Auditors report

The auditors' job is to express an opinion on whether the financial statements are reasonably accurate and provide adequate disclosure. This is the purpose behind the auditor's report. An auditor's report is meant to scrutinize the company and identify anything that might undermine the integrity of the financial statements. While the auditor's report won't uncover any financial bombshells, audits give credibility to the figures reported by management. Investors should exercise caution if the financial statements have not been given the green light by the auditors.


Management Discussion & Analysis (MD&A)

As a preface to the financial statements, a company's management will typically spend a few pages talking about the recent year and providing a background on the company. This is referred to as the MD&A. In addition to providing investors with a clearer picture of what the company does, the MD&A points out some key areas in which the company has performed well and more importantly, the outlook and strategies going forward.


8

Valuation Analysis

As the name suggests, valuation analysis involves ascribing a value to a stock usually in monetary terms. The analysis typically involves looking at historical financials and making projections. However, while analysts and investors may agree on the use of a certain valuation metric, they are unlikely to agree on the exact value of the stock. For instance, Analyst A might think a stock should be valued at 3x P/E while Analyst B may opt for 4x.

For equities, the most common valuation metric used is the price-to-earnings ratio (P/E), expressed as a multiple (x). Other valuation methods include:

1) Ratio Valuation a. P/E-to-growth (PEG x); b. Price-To-Book (P/BV - x)

2) Discounted Cash Flow (DCF) such as free cash flow valuation, dividend discount model 3) Sum-of-parts Valuation 4) Revalued Net Asset Value (RNAV - used typically for property stocks).


Ratio Valuation

Financial ratios are formula-based calculations using figures mainly from the financial statements. The ratios are generally analysed for an idea of a company's valuation and financial performance.

The P/E ratio compares the market price of a stock to its earnings per share (EPS), usually over a 12-month period.

The P/BV ratio compares the market price of a stock to its book value per share.

Points to note:

1. For P/E ratios, you need to have an E, that is, this method only works if the company is profitable. Also, as there could be many Es, you need to understand what goes into the derivation of the earnings. At the same time, if the company has substantial dilutive instruments such as convertible bonds, warrants etc, it would be a good idea to determine the fully-diluted EPS as well.

2. For P/BV ratios, companies should generally trade above their book value. The exception is when the market senses that the company is heading for a period of declining ROEs or an extended period of losses. If the companys ROE cannot exceed its cost of equity, a case can be made for investors to pay less than book value.

3. Also, be wary of companies with substantial intangibles such as goodwill since companies are required to test their goodwill for impairment yearly. In such cases, it would be useful to determine the P/NTA ratio (price to net tangible asset ratio).

4. In many cases, intangibles such as goodwill only occur in the case of an acquisition and it may be hard to quantify if the goodwill is justifiable.


Price-Earnings Ratio (P/E Ratio)

The P/E ratio is one of the most common ways of valuing equity. The ratio is also known by names such as price multiple and earnings multiple. It can be calculated as:

For instance, if a company is trading at S$4 a share and its earnings per share (EPS) over the last 12 months were S$0.50, its trailing P/E ratio would be 8x.

Investors typically look at prospective P/Es. For example, analysts will usually value a stock by pegging a P/E multiple to their earnings forecasts (e.g. 5x FY09 or CY09 EPS).

Market Value Per ShareMarket Value Per Share

=

Earnings Per Share (EPS)Earnings Per Share (EPS)

Market Value Per ShareMarket Value Per Share

=

Earnings Per Share (EPS)Earnings Per Share (EPS)

Going deeper

A high P/E ratio implies that investors expect higher earnings growth in prospective periods from the company as compared to one with a lower P/E. However, the P/E ratio is unable to provide a full picture. Typically, it is more useful to compare the P/E ratio of a company with others in the same industry and of a similar market capitalisation.

However, nothing is perfect in this world. Investors should note an important problem that can arise with the P/E ratio. The denominator, EPS, is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

P/E ratios are also compared to the sector average (peer valuation) as well as the companys own past trading history to provide some sense of relative valuation.


Points to note:

1. Peer valuation is a relative valuation measure. The way this works is that analysts typically calculate the sector average P/E ratio and peg a target price to the stock they are recommending based on a premium or discount to the sector average as justified by differences in the market cap, ROEs, margins, dividend yields or net gearing. However, if the valuation of the basket of stocks changes, the P/E multiple also changes, even if there are no changes for the stock being recommended.

2. A more meaningful way for analysts to upgrade their target prices would be via convictions in their earnings estimates. Keeping the same P/E multiple, stocks could be worth more if they can generate higher earnings and thus higher EPS.

3. In using historical valuations, stocks are cheap if they are trading below the low P/Es that they had tested in previous downturns. The important thing to remember is that every downturn is different. History provides only a mirror; it does not guarantee that the low P/E or P/BV ratios in the past cannot be exceeded.


Price-To-Book Ratio (P/BV Ratio)

The P/BV ratio is used to compare a stocks market value with its book value. It is calculated using the following formula:

P/ BV = Market Price / Book Value Per ShareP/ BV = Market Price / Book Value Per Share

Equity (ie. Assets Liabili t ies)Equity (ie. Assets Liabili t ies)

=

Number of Shares OutstandingNumber of Shares Outstanding

Where Book

Value Per Share

Where Book

Value Per Share

Equity (ie. Assets Liabili t ies)Equity (ie. Assets Liabili t ies)

=


Where Book

Value Per Share

Where Book

Value Per Share

Going deeper

A lower P/BV ratio typically suggests that a stock is undervalued.


Price-To-NTA Ratio (P/NTA Ratio)

Another commonly used ratio is P/NTA.

Market PriceMarket Price

=

NTA Per ShareNTA Per Share

P/ NTAP/ NTA

Market PriceMarket Price

=

NTA Per ShareNTA Per Share

P/ NTAP/ NTA

Net Tangible Assets (ie. Tangible Assets Liabili t ies)Net Tangible Assets (ie. Tangible Assets Liabili t ies)

=


Where NTA Per ShareWhere NTA Per Share

Net Tangible Assets (ie. Tangible Assets Liabili t ies)Net Tangible Assets (ie. Tangible Assets Liabili t ies)

=


Where NTA Per ShareWhere NTA Per Share

Tangible assets exclude goodwill and other form of intangibles such as brand value etc.


Discounted Cash Flow (DCF)

Though the concept of DCF analysis is simple, its practical application is not. The premise of the discounted cash flow method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders. Its calculation is as follows:

CF1CF1

=DCFDCF

(1 + r)1(1 + r)1

CF2CF2

+

(1 + r)2(1 + r)2

CFnCFn

+ +

(1 + r)n(1 + r)n

CF = Cash Flow, r = Discount Rate (WACC)

CF1CF1

=DCFDCF

(1 + r)1(1 + r)1

CF2CF2

+

(1 + r)2(1 + r)2

CFnCFn

+ +

(1 + r)n(1 + r)n

CF = Cash Flow, r = Discount Rate (WACC)

For example, if we know that Company A will generate $1 per share in cash flow for its shareholders every year into the future, we can calculate how much this cash flow is worth today. This value is then compared to the current value of the company to determine whether the company is a good investment, depending on whether it is undervalued or overvalued.

There are several techniques within DCF, depending on the type of cash flow used in the analysis. The dividend discount model focuses on the dividends a company pays to shareholders, while the cash flow model looks at the cash that can be paid to shareholders after all expenses, reinvestments and debt repayments have been made. But conceptually, they are the same, as it is the present value of these streams that are taken into consideration. The difficulty lies in the implementation of the model as it involves a lot of estimation and assumptions. Just imagine, forecasting the revenue and expenses for a firm three or five years into the future is difficult enough, let alone 10 years.


Points to note:

1. DCF is useful as it forces one to think about the companys future cash-flow-generating capability. This means pondering over its future capex, sales growth, margin sustainability, how long its high growth can last etc.

2. It is useful to check the implied prospective P/E and P/BV using the DCF-derived target price.

3. One should also look at the sensitivity analysis table to see how the DCF value changes with different terminal growth rates and discount rates.

4. Beware of DCF forecasts with high sales growth in the future and ever increasing operating margins. Also, look out for high terminal growth rates as a large chunk of the DCF-derived value comes from the terminal value. The higher the terminal growth rate, the higher the terminal value and hence the higher the DCF-derived target price. A company should eventually only grow as fast as the economy, in general.

5. DCF requires steady cash flows and should not be used on start-ups or companies in the early growth stage.

6. Remember that DCF is a mathematical discounting model. Garbage in, garbage out.


Sum-of-parts Valuation

Basically, this valuation method involves valuing a company, which usually has many disparate business divisions, by determining how much these individual divisions are worth should the company be broken up and spun off or acquired by another company.

Different valuation methods can be applied to each division before a final value of the whole group is derived.

Example:


Re-valued Net Asset Value (RNAV)

Investors investing in property stocks will usually come across the term RNAV. This is derived using the analysts assumptions for construction costs per square foot, land cost, selling price per square foot, units sold and revenue recognition schedule.

The RNAV measure allows analysts to adjust their earnings estimates for the property developers based on whether the property market is hot or cold. It is useful as a tool to determine if there is greater value in buying physical property or buying property stocks.


Some parting tips: Understand what you buy

Before you scurry off to buy your next stock, remember that if you dont understand what a company does, dont buy it.

The following are some guidelines before calling your broker to make the trade:

What is the business nature of the company

What are its principal business activities

Key products and services

Source of revenue

Where are its key markets and the economic outlook for the respective markets

Major customers and suppliers

Business environment

Where is its base of operations? Would the region be susceptible to any political risks or natural disasters?

Management quality

Major shareholders

While sell-side research is no doubt useful to help you keep abreast of key company and industry developments, it should NEVER be taken as a substitute for independent analysis and assessment! All the best!


9

Checklist

Step 1:

Look through the stock list and decide which stocks interest you. These will be the stocks that you aim to specialise in. It would be ideal if you could match the stocks you pick to your personal interests as this would make the understanding process a whole lot easier.

Another advantage is to invest in companies that are engaged in businesses you are familiar with. For example, if you are a healthcare professional, you would probably have an idea how the healthcare business works. Thus, stocks such as Parkway Holdings and Raffles Medical Holdings could be companies you may consider investing in.

Step 2:

Strike off the stocks that are barely traded in the market as share prices work on the theory of demand and supply. If no one buys and no one sells, the share prices will basically remain the same. Buying illiquid stocks can cause you heartache when you need to sell in a hurry but there is no buyer.

Step 3:

Read relevant industry reports issued by the press and analysts reports to better understand the industry cycle and the factors that move it. In addition, do spend some time checking the SGX website for company announcements in the last few months to understand the companys latest focus and developments.

A good way to invest would be to keep a stock log or journal and pencil down the reasons you are buying a particular stock, your exit price, course of action if the price falls after you have bought the stocks.

Recommendations from third parties should not be the sole consideration. Remember that at the end of the day, you are putting in your hard-earned money. As such, you need to be aware of your own risk profile and cash-flow requirements.


Step 4:

Scan the financial statements and check the key financial ratios to determine if a company is in a healthy position. It would also be good to do a peer comparison with a similar company and see where each stands.

Understand that there is a difference between speculating (trading) and investing. If you are trading, you would be going for concept plays, rumours, high volumes and establish strict take-profit and cut-loss levels.

If you are investing, you would be looking for companies with a strong balance sheet, growth, good dividend yields, high ROEs etc.

Step 5:

Call your broker or place your trade online.


Useful websites

www.fallstreet.com www.prudentbear.com

www.financialsense.com

www.dailyreckoning.com

www.fool.com

www.investopedia.com

www.frontlinethoughts.com

www.fullermoney.com

www.gmo.com

Suggested books

The Intelligent Investor

Investing the Templeton Way

The Traders Guide to key Economic Indicators

Damodaran on Valuation

Bull! A history of the boom 1980 1999
http://www.fallstreet.com/http://www.prudentbear.com/http://www.financialsense.com/http://www.dailyreckoning.com/http://www.motleyfool.com/http://www.investopedia.com/http://www.frontlinethoughts.com/http://www.fullermoney.com/http://www.gmo.com/


10

Glossary of Terms

Financial Terms & Definitions

Terms Definition

Asset utilisation Sales / Average assets

Capital employed Shareholders funds + Minority Interest + Total debt - Book value of associates

Cash Flow Per Share (Net profit + Depreciation - Associates contribution net of tax + Dividends from associates net of tax) / Weighted no. of shares

Creditors turnover (Opening trade creditors + Closing trade creditors) / 2 / Turnover x 365 days

Dividend Per Share (DPS) Gross dividend per share

Dividend payout Net DPS / EPS

Dividend Yield Gross DPS / Share price

Debtors Turnover (Opening trade debtors + Closing trade debtors) / 2 / Turnover x 365 days

EBIT Pretax - Net interest income / (expense) - Associates contribution - Exceptionals

EBITDA Pretax Net interest income/(expense) + Depreciation & amortisation Associates contribution Exceptionals

Equity multiplier Average assets / Average equity

Earnings Per Share (EPS) Profit after tax, minorities and preferred dividends but before extraordinaries / Weighted average number of common shares

Enterprise Value Market capitalisation Net cash/(debt) Book value of associates

Free cash flow (FCF) EBIT Cash taxes on EBIT + Depreciation Change in working capital Capex + Investments

Interest burden Pretax / EBIT


Interest cover (Pretax profit + Interest expense) / Interest expense

Net debt / equity (Short term debt + Long term debt Cash and near cash items) / (Shareholders funds + Minority interest)

Net investment income Dividend income + Interest income / (expense)

Net Tangible Assets Shareholders funds goodwill

PEG Prospective P/E / 3-year EPS CAGR

ROCE (Pretax + Interest expense Associates contribution Exceptionals) / Average capital employed

ROE Net profit after tax and minority interest but before extraordinary items / Average shareholders funds

Shareholders funds Share capital + Reserves

Stock turnover (Opening stocks + Closing stocks) / 2 / Turnover x 365 days

Tax retention Net profit / Pretax


Common Banking Terms & Definitions

Terms Definition

Capital base Total capital less Investment in subsidiaries and holdings of other banking institutions capital

Core capital ratio Tier 1 capital / Risk-weighted assets

Cost-income ratio Overheads / Total income

Cost of funds Interest expense / Average interest-bearing liabilities

General provisions General provisions made on total loan portfolio

Interest-earning assets Cash and short term funds, securities purchased under resale agreement, deposits with FIs, dealing securities, investment securities, loans and advances

Interest-bearing liabilities Customer deposits, deposits and placements with FIs, obligation on securities sold under repurchase agreements, bills payables, amount due to Cagamas, subordinated bonds, borrowings

Interest-in-suspense (IIS) Interest in arrears for non-performing loans

Loan book Gross loans

Loan loss reserve Specific provisions + Interest-in-suspense + general provisions/ NPLs

Loan-deposit ratio Net loans / Total deposits

Loan loss provisions (LLP) General provisions + Specific provisions

Net interest margin (NIM) Net interest income / Average interest-earning assets

Non-performing loans (NPL) Loans (principal and interest) in arrears for specified time

Risk-weighted capital ratio (RWCR)

Capital base / Risk-weighted assets

Specific provisions Provisions made on specific accounts that are deemed sub-standard, doubtful or bad

Statutory reserve requirement (SRR)

Amount (a percentage of eligible liabilities) maintained in the form of cash reserves with central bank

Tier-1 capital Paid-up capital, preference shares, share premium, statutory reserve fund, general reserve fund, retained profits, surplus/loss arising from sale of fixed and long-term investments and minority interests less goodwill

Tier-2 capital Hybrid capital instruments, minority interests arising from preference shares, subordinated term debt, revaluation reserves and general provisions

Total capital Tier-1 capital + Eligible Tier-2 capital


Insurance Terms & Definitions

Terms Definition

Expense rate Total expenses / Total premium income (excluding single premiums) & Annuity premiums

Forfeiture rate Annual premiums forfeited in a year / Weighted average of new annual premiums for that year and two preceding years

Net interest Returns on investments Rates & taxes

Net interest rate (2 x Net interest earnings) / (Policy owners fund brought forward + Policy owners fund carried forward Net interest earnings)

Surrender rate Total sums insured discontinued by surrender year

Claims ratio Net claims incurred / Earned premium income

Earned premiums Net premiums Provision for RUR at year-end + RUR at start of year

Gross direct premiums Premiums on original gross rate charged to clients before deduction of commission or brokerage

Gross premiums Gross direct premiums + Reinsurance accepted premiums Reinsurance within country

Incurred but not reported (IBNR) claims

Losses that have occurred during a period but not reported to insurer by that date

Net claims incurred Net claims paid Provisions for outstanding claims at start of year + Provisions for outstanding claims at year-end

Net premiums Gross premiums Reinsurance premiums payable

Reserves for unexpired risks (RUR)

Premiums already received for risks still unexpired at end of period

Retention ratio Net premiums / Gross premiums

Underwriting gain/loss Earned premium income Net claims Commissions & management expenses


Notes:


DISCLAIMER

The publisher and author of this book makes no representation or warranty (express or implied) and shall have no responsibility or liability in respect of any information contained herein for its adequacy, accuracy, completeness, reliability, fairness or suitability for any purpose and no representation or warranty is made or is to be implied that such information will remain unchanged or that its accuracy, completeness, fairness or suitability will be affected by other information or events. In particular, but without limiting the foregoing, whilst information and methodologies contained in this book represents the current views of the author none of the author or the published will warrant, or in any way accept liability for, their accuracy. The author and the publisher has no, and will not accept any, obligation to check or ensure that the information and methodologies remains current, reliable or relevant. The publisher and author of this book do not accept responsibility for any loss (including but not limited to any direct, indirect or consequential losses, loss of profits and damages) incurred by any person through actions or inactions arising from any information in this book. This information in this book is general in nature and has been prepared for information purposes only. This book (and its contents) does not constitute (or shall be construed to constitute) financial and/or investment advice of any nature whatsoever. This information in this book does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person or entity. The information in this book are not and should not be construed or considered as an offer, recommendation or solicitation to buy or sell investments or securities (or interests in such investments or securities), related investments or other financial instruments thereof or to take any course of action (including the dealing in securities). In particular, nothing in this book shall be, or shall be construed to be, a direction or instruction to undertake any course of action. You are advised to make their own independent evaluation of the information contained in this book, consider their own individual investment objectives, financial situation and particular needs and consult your own professional and financial advisers as to the legal, business, financial, tax and other aspects before participating in any transaction in respect of the securities. References to real companies in this book are made for the purpose illustrating concepts only. CIMB-GK Research Pte Ltd and its affiliates, directors, associates, connected parties and/or employees may own or have interest in the securities covered in this book if any.

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