How to Perform Fundamental Analysis of Stocks

In the previous section, we tried to understand what fundamental analysis means and how it is different from technical analysis. In

this section, we will get down to understanding the essential components of fundamental analysis. As described in the previous

section, in fundamental analysis, we try to assess a company’s future prospects based on a scrutiny of its financial statements. We

try to project its future earnings and based on them, estimate its value. We will take up these concepts individually in this section.

However, we will first explain a concept called efficient market hypothesis, which seeks to explain why investors line up to buy

stocks of companies that are expected to perform well and push their values up.

WHAT IS EFFICIENT MARKET HYPOTHESIS?

Equity investors, like you, like to invest in companies that they believe will achieve high earnings growth in the future. This is

because high growth companies come with a higher future dividend paying potential. This, in turn, invites more investors to buy

them. It ultimately leads to an appreciation of the stock price.

ASSUMPTIONS OF EFFICIENT MARKET HYPOTHESIS

This philosophy is based on three assumptions: other investors in the market have all the relevant information to form an opinion

about the future prospects of the company; they act upon this information, and this information gets reflected in market prices.

A market that displays these characteristics is called an efficient market. In such markets, all investors are privy to all the

information pertaining to a company. They all use the same set of information to make their investment decisions. As a result,

nobody can make more profit than the other and all the relevant information is reflects in market prices. This was the central idea of

Eugene Fama’s efficient market hypothesis of the 1960s.

Fundamental analysts use three categories of data—historical data, publically known information about the market (such as

announcements made by the management in the media and the annual reports released by it) and private information (or the

information known only to a select few, owing to their position with the organization).

According to Fama, in an efficient market, there is no private information. All the information is available for free and known to all.

As a result, all investors act on this common set of information and make equal profits. No one is able to ’beat the market’ or earn

‘abnormal profits’ based on special information or analysis. Also, there is no time lag between the release of the information and its

influence on prices.

Fama’s theory has earned widespread disrepute because what it proposed appears to be a fantasy. No two investors achieve the

same returns in a market. Every year, a horde of investors earn greater returns than benchmark indices, such as the BSE Sensex.

Further, not all information is available to everybody. There are people, such as top employees of the company that are privy to

classified information, not known to all. They sometimes use it unethically to make greater profits than other people. This practice is

called insider trading. It is punishable by law. Further, institutions like investment banks and stock brokerages, deduce vital

information from the analysis of companies. This is only available to their clients for a price. Thus, information is not free either. It is

clear that Fama’s treatise regarding markets being efficient is therefore questionable. Even so, his theory is appreciated because it

paints a picture of what could happen if market conditions were perfect. Just that probably, current market conditions aren’t perfect.

INTRODUCTION TO STOCK VALUATION

Now that we have established that the market conditions we operate under are not perfect, it is clear that equity analysis can

generate superior returns for you compared to the market. Let’s then proceed towards the process of analyzing companies. This

portion deals with the approaches to calculating the tfair or intrinsic value of a stock.

Fair or intrinsic value of a stock is the price the stock should actually be trading at according to your analysis. You can compare it

with its current market price to ascertain whether it is overvalued, undervalued or fairly valued. You would like to buy a stock that is

undervalued, because its price should appreciate to your estimate of fair value, earning you a profit in the process. If you own a

stock that you think is overvalued, you sell it. As for fairly valued stocks, you’d best leave them alone.

There are three techniques used for the valuation of equity shares:

PRESENT VALUE MODELS :

Present value models are based on the principal that since shareholders are joint-owners of the company, its future earnings

belong to them. The combined value of these earnings, in terms of today’s money, should therefore be the value of these equity

shares.

The value of money changes with time. $ 100 will not be worth the same in ten years’ time as it is today. Similarly, the value of

future income projected for a future period will be different today.

To account for this, future incomes are divided by a specific discount rate to calculate their value as of today. This is known as time

value of money. The present value model has different variants. Each of them uses a different concept of future income for

discounting. These include dividend, residual income and free cash flows. The model that uses dividends is the most straight

forward and commonly used. We will explain this in a later section.

RELATIVE VALUE (MULTIPLIER) MODELS :

A company can also be valued relative to the value of other, similar companies. In this case, the market price of its rivals is

compared with one of their fundamentals, such as sales, book value of equity and net income. The ratio is then applied to the

concerned company to estimate its value. The ratios used for this purpose are called price multiples.

ASSET-BASED VALUATION :

In this model, the value of a company is based on the market value of its assets and liabilities. The market value of liabilities (not

including equity) is subtracted from the market value of assets to arrive at the value of equity. For the model to work, most of the

assets of the company should be tangible long-term assets. This model is rarely used.

INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS

The financial performance of a company is organized and reported in the form of financial statements. There are three important

statements presented in the annual and quarterly reports of a company: the income statement, the balance sheet and the cash flow

statement. A brief description of each of these is present below.

THE INCOME STATEMENT :

The income statement deals with the incomes and expenses of a company during a given financial year. It classifies them into

various parts based on their nature. Expenses are subtracted from incomes to arrive at the profit for the year.

When analyzing the income statement, you should be concerned about the stability and future growth potential of incomes and

expenses. Companies are evaluated on the basis of income from their ‘core businesses’. Although companies also earn revenue

from other sources from time to time, these sources are not considered stable and truly representative of the efficiency of the

company’s operations.

Expenses-wise, you are again interested in looking at the categories of expenses, their criticality to the business, prospects of their

recurrence and their role in increasing future earnings.

THE CASH FLOW STATEMENT :

This statement specifically talks about the cash position of a company. It divides the company’ activities into three categories—

operating, investing and financing, and gives an account of the cash flowing in and out of the business on account of these.

The importance of the cash flow statement dwells on the fact that while a company earns and spends a lot of funds, as accounted

for in the income statement, a lot of these flow are non-cash. A lot of these flows inspire the hope of receiving or paying cash in

future, whereas others don’t entail a flow at all. The statement removes this confusion by specifically stating the sources and uses

of cash in the current period. Ideally, companies would be best placed if they generate enough cash from operations to finance their

investing activities. Bringing in cash from financing activities to fund the other two implies an increase in the level of liabilities.

THE BALANCE SHEET :

This is the other most critical financial statement. It talks about the assets and liabilities of the business. Unlike the income

statement, the balance sheet reflects the state of the assets and liabilities of a business at a particular point in time and not over a

period of time.

A company needs certain assets to run its business smoothly. These are financed by certain liabilities—debt and equity. For a

company to be profitable, the revenue generated from these assets should be greater than the amount required to repay the

liabilities incurred to acquire them.

This is what you should try and ascertain from the balance sheet. You are concerned about the nature of the assets and their future

revenue generation potential. At the same time, you are also concerned about the sustainability of debt. Too much debt will

pressurize the company to earn beyond its potential to repay this debt. This is a dangerous and unsustainable proposition.

Fundamentals of Industry Analysis

In this section, we will understand the first step of equity analysis – Industry analysis.

Industry analysis is concerned with the scrutiny of all factors that make up the industry in which a company operates. It includes an

analysis of the competitive environment, regulatory policies and nature of suppliers and customers, among others. Industry

environment is important because it helps shape up the strategies and policies of a business. The success of a business depends

on the extent to which it is able to exploit the opportunities and circumvent the challenges presented by its environment.

In this section, we will first start with a look at the components of an industry. We then move on to an explanation of various types

of market competition, before closing with the significance of industry analysis.

UNDERSTANDING THE KEY COMPONENTS OF AN INDUSTRY: CUSTOMERS, COMPETITION, REGULATORS, SUPPLIERS

An industry consists of many stakeholders. A company has to interact with them on a daily basis. Here, we look at the specific roles

they play in the industry and the ways in which they influence the working of companies.

CUSTOMERS :

This is perhaps the most important category of market participants for a company. Its revenues are a direct function of the extent to

which it can satisfy its customers. Thus, it must commit itself to first understanding what its customers need, and then catering to

these needs as best as it can. Who one’s customers are depends on the nature of one’s business. In some cases, they are final

consumers like us, who use their products for self-consumption. In others, they are companies from other industries, who use their

products for further production of goods and services. Customers can be further divided on the basis of their age-group, gender,

profession, income etc. While analyzing customer dynamics, you should look at the existing categories of customers as well as the

new categories of customers that can enter the market.

The ability to influence the price and nature of the offering in an industry is called bargaining power. It is critical to understand who

the bargaining power lies with in an industry – customers or producers. Companies will do well only if bargaining power rests with

them. If customers have greater bargaining power, they’ll be able to dictate the price of goods, as well as their quality, quantity and

other specifications. This will adversely affect the industry’s profits. Bargaining power will lie with customers if there are multiple

vendors offering similar goods in the industry. In such cases, if customers don’t get a good deal with one seller, they can easily go

to another. Other factors that give customers bargaining power are a small number of buyers in the market, large quantities

purchased by individual buyers and the ability of customers to integrate backwards. Backward integration takes place when

customers are able to start producing a product themselves, instead of buying it from the market.

This marginalizes the producers, who are slowly forced to either shut down their operations or move to other industries. Evaluating

these factors is critical to industry analysis.

REGULATORS :

In most industries, there is a body designated by the government to frame and enforce rules of participation. These are formulated

with a view of protecting customers, competitors, suppliers and shareholders from malpractices of companies. Understanding the

regulatory framework is important for investors like you, because it imposes certain restrictions on the activities of companies. The

future growth potential of the industry must be viewed in this context. As a general rule, you should stay away from industries that

are very highly regulated or little regulated.

This is because excessive regulation strangles industry growth while under-regulation offers little protection to shareholders from

the inconsiderate actions of companies. High regulation also imposes high entry barriers for new entrants into the industry. New

companies find it hard to keep up with regulatory requirements and don’t survive for long. Whereas most regulations are formed

specifically for each industry sector, some regulations are common for all sectors.

One such category of regulations is antitrust regulations. They seek to prevent companies from stifling competition by unfairly

cornering an unduly large market share. This adversely affects fellow competitors and customers.

COMPETITION :

Actions of other companies in an industry also influences a company’s prospects. Successful companies are able to meet the

needs of their customers better than other competitors. There are three degrees of competition that are possible in a market –

perfect competition, oligopoly and monopoly. Out of these, perfect competition is the most competitive and monopoly is the least

competitive. Perfect competition refers to a situation where there are many producers of the same product in the industry.

This limits a companies’ ability to change prices and product specifications without losing out to other competitors. Success of a

company depends on its ability to differentiate its products, diversify into new products (within the same umbrella) and making

operational changes that reduce its production cost. For such companies, advertising costs are generally high as they have to

present their products differently from their rivals.

You would like to invest in companies that operate in industries with low competition. Such companies generally exist in industries

where entry barriers are high and the nature of product is specialized or only meant for a niche customer class. We will look at the

different types of competition later in the piece.

SUPPLIERS :

Understanding the supply situation in an industry is important because unless a steady, cost-effective supply of inputs is ensured, it

is impossible for producers to consistently churn out products of the same quality and price. The supply situation in an industry is

satisfactory when there is an abundance of suppliers supplying similar inputs and there is no overdependence on a few suppliers. If

this case, companies have more influence over price of inputs. In the contrary situation, the bargaining power rests with suppliers.

They are able to develop a clout whereby, they deliver supplies based on their own specifications and prices. Like customers,

suppliers too have the ability to integrate. They may move to the next level of the value chain and instead of selling their output to

the industry, start using it themselves to produce the same goods.

This is called forward integration. It is harmful for the industry because it consolidates the operations of suppliers and allows them

to provide the same product at a lower cost to the final customers. Further, if suppliers use all the inputs themselves, existing

companies are starved of these, resulting in a shutdown of their operations.

TYPES OF INDUSTRIES: PERFECT, OLIGOPOLY, MONOPOLY

PERFECT :

As described above, an industry is in perfect competition when there are multiple companies producing similar products. This is the

most intensely competitive industry because products are so similar that consumers are indifferent between the offerings of

different producers. As a result, companies have very little ability to change product prices and specifications.

Any increase in price will lead to one’s customers changing over to a different producer. Similarly, an alteration in the quantity,

quality and technical attributes of the product also inspires changeovers. Since no company can earn more revenue by making

changes to its price or output, success of companies depends solely on how well they perform along certain other factors.

Companies can increase their earnings by differentiating the product from others, optimizing processes to cut their cost of

production and marketing their product differently. As an investor, you should look for a company’s exploits in these areas to

determine how well it can be expected to perform in a highly competitive market in the future.

OLIGOPOLY :

This market structure also consists of a number of firms. However, it is dominated by only a handful of them. As a result, there is no

single market leader but a small group of companies have an inordinately high market share. The remaining companies make up

the remainder of the market share. It is perhaps the most realistic market structure of all.

MONOPOLY :

Monopoly is a term used to describe a market where there is only one producer of a product. He caters to the entire market

demand for the product and has complete control over its price and specifications. Customers in such a market are only price

takers. They have no control over the price of the product and have to buy it at whatever price the monopolist sells it at.

Monopolies tend to get established when there are high entry barriers in an industry. Sometimes, a company is able to establish

such a dominant position in the market that it is able to produce and sell its output at a much lower cost than new companies can

even imagine to. This keeps them out of the market. Further, they tend to suck-up the entire supply of raw materials in the industry.

This also helps them perpetuate there position.

These practices sound unfair. For this reason, regulators tend to prevent monopolies from getting established. Generally,

companies are required to seek regulatory approval before going ahead with a merger. This is because mergers can result in a

company that is too big for others in the industry to compete against. Sometimes, companies use ploys to sidestep the regulator

and indulge in activities that give them an undue advantage in the industry. In such cases, regulators tend to initiate antitrust

proceedings against them and prevent them from establishing such a hold on the market.

As a result, monopoly is not a realistic concept any longer, other than in some cases where governments monopolize certain

strategic sectors, such as railways in India.

WHY INDUSTRY GROWTH, COMPETITION, REGULATION MATTER

INDUSTRY FORCES AFFECT COMPANIES :

We have established that a company’s current and future performance is to a very large extent affected by the industry

environment it operates in. The objective of conducting industry analysis is to recognize the forces within the industry that have a

significant bearing on a company and assessing their impact on the company’s future performance.

NEW PRODUCTS :

Lastly, industries grow as a whole when new uses of their products are discovered. These are some of the factors you should

consider while conducting an industry analysis. These products can then benefit or harm the company depending on its position.

This is why it is important to monitor the industry dynamics too.

COMPETITION MATTERS :

Industries expand, overall, when companies that constitute them find new, innovative ways to improve their products, streamline

their operations, find new uses of the product, or in general do something that will attract more customers and expand their market

share. These are actions that describe the competitive environment of an industry. Companies that excel in these areas will stay

above their competition and expand their market share, whereas the rest will falter. For someone who is conducting an industry

analysis, these are important points to consider.

INDUSTRY GROWS, COMPANY PROFITS :

If the industry grows as a whole, the size of the earnings pie will naturally expand. Even if a company is able to maintain a constant

market share, its slice of the pie will expand similarly. For most industries, high growth is obtained when the economy as a whole is

doing well. In such cases, the need for all kinds of goods and services increases.

This is largely owing to the high government spending that such economies witness. Additionally, governments offer incentives to

industries for the promotion of economic activity in general.

IDENTIFY LINKS WITH DIFFERENT INDUSTRIES :

Apart from this, industries grow at a high rate when there is a boom in the key sectors to which they cater. For example, if the

housing sector does well, the cement sector too will do well. These links would be beneficial while we try to predict the company’s

future performance.

REGULATION MATTERS :

One constraint to competition is regulation. Companies do all they can to increase market share. However, some of their activities

can unfairly affect others in the market. Regulators try to check such actions. An analysis of the regulatory framework of an industry

is, therefore, essential. Not only do you want to see what regulations govern a market, you must also diligently look at the extent to

which the regulator is able to impose himself on those who flout them and assess the loopholes in the regulatory system that

diminish his effectiveness.

A week regulator, after all is no better than no regulator at all!

Understanding Market Shares & Business Models We briefly described the competitive landscape of a company in the section on ‘How Industries Work’.

In this section we look at how market competition shapes up a company’s strategy, what is a business model and the role a strong

model plays in a company’s success.

UNDERSTANDING MARKET SHARES: WHY COMPETITION MATTERS

Market share is described as the proportion of the overall industry sale in rupee terms that a company accounts for. It is a direct

function of the extent to which a company is able to satisfy the needs of its customers. This is because there are a lot of companies

in the market that produce similar products and earn their revenue from the same customer community. The one who is able to

satisfy customer needs the best ends up with the largest market share.

Customers look for value maximization when they buy a product. In other words, they choose a product depending upon what it

offers them in addition to other similar products produced by other companies. The revenues of a company therefore, depend on

the incremental value it can offer its customers over other companies. Value may be offered in the form of lower prices, better

features, faster delivery, more variants of the product and so on. Companies compete constantly for one-upmanship along these

parameters.

Some of the tactics they use to increase market share are

Discounts and free gifts

Additional features or better quality for the same price

Better delivery terms

New variants

Increase in the quantity offered

Better after sales service

Increased warranty

The competition for market share can prove to be highly depleting for companies. It leads to a shrinking of their profit margins as they are forced to cut prices and offer more privileges to customers. They are also compelled to spend extensively on advertising, research and operational improvements. Competition is at its worst when companies choose to compete over prices, according to Michael Porter, a renowned marketing expert. This is because lowering prices directly transfers money from the company to its customers.

How intense the struggle for market share is is also defined by the nature of competition in the industry. Higher the number of

competitors, more intense will the struggle be. Competition is the most grueling under perfect competition. Here, there is a

multiplicity of firms that offer the same product. This makes the customer indifferent between buying it from different customers.

Following are some of the characteristics that help determine the intensity of competition in a market:

NATURE OF PRODUCT :

When competitors offer products that can be used interchangeably, the struggle for market share is the highest. In such cases,

customers don’t have many reasons to pick one product over the other and it is the minutest of differences in price and

characteristics that shape their choices.

MARKET SIZE :

Market competition is more intense when there are very few customers in the market and the revenue earned from each of them is

high. This generally happens in case of industrial goods (i.e. goods produced for other companies and not final consumers). Such

goods, like machinery, are worth a lot of money and have few potential customers. Companies who sell such products try

aggressively to acquire these customers because they are hard to come by.

BARRIERS TO ENTRY :

Entry barriers refer to the restrictions on new companies from entering the industry. These restrictions may be in the form of high

investment requirements, stringent government regulations and economies of scale (i.e. the requirement to maintain a very high

level of production to reduce per unit production cost) etc. New companies bring innovation. Restricting their entry blocks this

innovation. This limits market competition to only companies that have existed for a long time. Thus, low entry barriers result in

higher market competition and vice versa.

SWITCHOVER COST :

Switchover cost is defined as the cost of shifting from one company’s product to another’s. It can be in the form of installation cost,

training cost, cost of purchasing new accessories etc. The higher this cost, lower is the incentive for customers to shift from one

product to another. This increases market competition because companies know that once they acquire a customer, the switchover

cost will make it hard for him to shift to another company.

INDUSTRY GROWTH POTENTIAL :

When industries reach a point where there is little opportunity for an increase in customer base or unit sales, companies can only

increase revenue by poaching each other’s customers. This leads to aggressive competition.

Companies may boost market share in the short run by aggressive marketing tactics. However, achieving a sustainable increase in

market share, over the long run is much more difficult and expensive. For the purpose of equity analysis, you should try to discover

companies that are adept at doing so. This can only be done by companies with a high quality management and a strong business

model. Such companies tend to spend heavily on research and new product development. Companies with deep pockets will

normally excel at this.

WHAT IS A BUSINESS MODEL AND WHY IT MATTERS

Put simply, a business model describes how a business will make money. Companies come into existence with lofty ideas and a

wide range of resources and capabilities at their disposal. However, unless they can leverage these in a way that will produce

profits for them, they cannot succeed. A model describes the strategy to be used for leveraging these resources in order to make

profits. It is not as descriptive as a business plan, which may even include projected financial figures. It only describes the basic

revenue-generation mechanism that a company seeks to employ. A good model will typically provide answers to the following.

COMPONENTS OF A BUSINESS MODEL WHAT IS THE PRODUCT? :

The idea for a new product is what usually brings a company into existence. It is the source from which it expects to generate its

revenue. Thus, a product is central to a business model. The product may be a new tangible item, a service, an improvement over

an existing product or an outright replacement of it.

WHAT ARE THE MAJOR SOURCES OF REVENUE?

While in most cases it is obvious that the revenue will come from those who buy the product, in some cases it is different. In case of

TV channels and websites, customers pay nothing and all the revenues are generated from advertisements. Additionally, even

when revenue comes from customers, the revenue models can vary. A revenue model can be chose out of the subscription,

commission, lease, brokerage, rent or barter model. Each of these has unique dynamics and must be matched with the product

they are intended for.

WHAT ARE THE PRINCIPAL MARKETING CHANNELS?

Once there is clarity as to the characteristics of the product and the costs associated with it, the next question of consequence is

the channels through which it will be delivered to the customer. Companies may choose out of the traditional brick and mortar

model (establishing physical stores), direct selling (physical or online) or selling through intermediaries such as wholesalers,

retailers and commission agents. Choice of channel is principally based on the nature of product, associated costs and extent of

oversight required.

WHAT ARE THE KEY OBSTACLES?

Running a business successfully is a challenging task as a lot of resources and people have to be brought together and

relationships created among them. Doing this places a lot of obstacles in the path of the management. These may be in the form of

things not coming together as originally planned or unexpected happenings that completely change the ambience in which the

business is to be conducted. Although not all of these are foreseeable, the more prominent ones must be identified beforehand. An

analysis of ‘what might go wrong?’ is not enough. Its expected impact on future revenues and possible remedies must also be

discovered in advance.

WHO ARE THE TARGET CUSTOMERS?

A product may be revolutionary but it will not generate revenue if there are no buyers for it. Companies decide the target customers

before they even conceive a product. This helps them decide its design and marketing strategy. Over time, new uses of a product

may emerge. This may lead to the target customer class changing completely. A model must be farsighted enough to spot potential

new customers and adapting the product accordingly.

WHAT WILL THE MAJOR COSTS BE?

Businesses incur a variety of costs. Some of them are fixed, irrespective of the number of units sold, while others vary with it. Some

are incurred for once upfront, whereas others recur periodically. An analysis of cost is important in a business model because the

profitability of a business can only be judged upon the estimation of costs. If a business is not profitable after subtracting expected

costs from expected revenues, it is not a viable business and must be scrapped.

WHO ARE THE COMPETITORS?

Business ideas are lucrative only when they have longevity. If an idea can be easily copied or bettered by others, the business will

not last long. Thus, when evaluating a model, it is important to see how it will generate a stream of revenue over multiple periods,

without attracting many competitors. Models that erect high entry barriers tend to display this quality. Entry barriers may be in the

form of high start-up costs, highly technical nature of the product, patents and copyrights and so on.

HOW FLEXIBLE IS THE MODEL?

The business environment is ever-changing. New competitors, customer categories, regulatory requirements etc. emerge in the

blink of an eye. In order to be successful, a model must be able to accommodate enough flexibility. Flexibility must be displayed by

ways of increasing/decreasing the scale of operations, tweaking product specifications, changing the channels of distribution,

opening up new markets/sources of revenue etc.

IMPORTANCE OF A BUSINESS MODEL

As seen above, a model provides a blueprint for future revenue generation. As an investor, you would like to understand whether a

company will continue making money in future and how clear its future vision is. A model caters to both these requirements. It

provides clarity on the future objectives of the company as well as its strategy for future revenue generation. This puts you in a

convenient position to decide whether or not to invest in the company.

It may be noted, however, that a business model is different from a business plan. It only lays down the broad contours of how a

business will work. A business plan, in contrast, is a much more detailed roadmap for a business, with specific details regarding

nature of products, production processes, suppliers, marketing strategy and revenue projections.

Fundamentals of Company Analysis In the previous section, we talked about the structure and components of an industry as a whole. In this section, we will proceed to

a deeper level of analysis, by looking at what makes a specific company that forms a part of the industry. This understanding is

important while performing company analysis.

MANAGEMENT, BOARD, STAKEHOLDERS, EMPLOYEES, SUPPLIERS, CUSTOMERS

Companies come into existence for the fulfillment of certain objectives. To help them do so, a number of stakeholders have to come

together and contribute.

Let’s take a look at the role played by certain key stakeholders of a company.

Following are some of the characteristics that help determine the intensity of competition in a market:

MANAGEMENT :

Management is the spearhead of a company. It consists of all the people responsible for formulating its policies and overseeing

their execution. The success of a company is therefore completely dependent on the quality of its management. The management

is expected to be committed to the shareholders of the company as they, being its owners, appointed the management. It must

therefore be the management’s foremost priority to maximise the wellbeing of shareholders.

Other things that define the quality of management include, the skills, knowledge and experience it has for the industry it is in, its

track record of policy formulation and execution and its moral character (i.e. history of involvement in unfair practices such as

embezzlement and incorrect financial reporting).

CUSTOMERS :

The importance of its customers to a business can never be overemphasised. They are the source of its income and it must,

therefore take pains to meet their every requirement. It must continuously innovate to provide better products, at a lower cost and

through more convenient channels to its customers. All these, put together can propel a company to the position of leadership in its

industry.

We have already looked at the dynamics of bargaining power that define the customer-company relationship. Like with suppliers,

the terms of business between a company and its customers are also critical. A tilt of bargaining power towards the company

allows it to offer shorter credit periods to its customers, thereby avoiding short-term borrowing to repay its suppliers. If the

bargaining power is tilted towards customers, this benefit goes away.

BOARD :

Company managements sometimes work at cross-purposes with shareholders to perpetuate their own position. The board of

directors protects the interests of shareholders in such situations. It is a periodically elected body that normally comprises large

shareholders, management representatives and independent directors of the company. It is particularly concerned with protecting

the interests of marginal investors, like you, who have little influence over the management and don’t always know what’s best for

them.

All important activities of the company, such as takeovers, require the explicit consent of the board. It also has the right to

investigate any matter regarding the company, upon its own initiative. Other powers of the board include summoning any member

of the top management for questioning, appointing the CEO, fixing the compensation of the top management, and so on. More

independent the board, the better it is for the shareholders.

STAKEHOLDERS :

Suppliers provide raw material and other inputs for the production of a company’s goods. It is important for companies to maintain a

steady supply of the right quality inputs, at a reasonable cost. In the last section, we discussed how suppliers can hold bargaining

power over individual companies in an industry. This happens when there are few suppliers and the nature of inputs they supply is

unique or highly specialized. What is also essential is the terms a company enjoys with its suppliers.

The time a company gets from its suppliers to pay their dues in lieu of materials purchased from them is called credit period.

Companies hope to enjoy longer credit periods with their suppliers than they offer their customers. This helps them pay off their

dues using the money received from customers, rather than borrow money for it. Again, the terms a company enjoys with its

suppliers is based on the distribution of bargaining power between the two.

WHO IS A PROMOTER?

A promoter is anyone who conceives the idea of starting a company, invests his own/ borrowed funds into it, is the principal

decision making authority in it and is accountable to the stakeholders for its activities. He may be an individual, a group of people or

another company. They hold a significant proportion of the company’s shares themselves or through their close relatives, such as

spouse and children. The top leadership of the company generally comprises of the promoters or individuals designated by them.

The entire lot of people and other companies that control a company in this way is called its promoter group. Their combined

shareholding is called promoter holding. Higher the promoter holding in a company, greater is the promoters’ control over it.

Promoters exercise their control by taking key decisions of the company and appointing people in ranking positions of its

management and board. They also provide the vision for the existence of the company and steer it to its fulfillment. It is, therefore,

necessary that the promoters continue to hold a dominant shareholding position in the company. A large promoter group also

provides stability to a company when other companies are trying to acquire it forcefully. A large promoter holding prevents such

companies from acquiring it. However, absolute authority can also make the promoter group autocratic. This can work to the

disadvantage of other stakeholders, who may be ignored at the behest of the selfish interests of the promoter group.

UNDERSTANDING OWNERSHIP AND INSIDER SALE

The promoters of a company are commonly referred to as its ‘owners’. However, for a variety of reasons, they have to sell parts of

their stake in the company at various points of time. Principal among these are the inability of the promoters to single-handedly

contribute all the money (called capital) for starting the company and the requirement for further capital as the company grows.

As a result, the following categories of investors emerge over time:

OWNERSHIP STRUCTURE OF A COMPANY

PROMOTER GROUP :

As discussed above, promoters are the people who conceive the idea of a company and put it into execution. They generally come

across as the face of the company as they hold key decision making positions in it. They may offload some stake in the company

over time, but tend to retain important positions in the management and dominate the board. When a company is acquired by

another company, the acquirer buys most of the promoter‘s stake.

By virtue of this, it becomes the new promoter. The corporate hierarchy of the resulting entity depends on the negotiations between

the promoters and the acquirer. Sometimes, the promoters sell their entire stake in the company and exit it. On other occasions,

they retain a small stake and continue holding key leadership positions and representation on the board of directors.

RETAIL INVESTORS :

This category is made up of common investors like you, who purchase small stakes in the company. Generally, this is one of the

largest categories of shareholders in a company. However, it is also at the greatest risk because it is the least technically-aware

investor class. Common investors know little about the working of a company and their shareholder rights. Additionally, since they

hold tiny individual stakes, they have the least amount of influence over the company’s management. Their importance to the

company owes itself exclusively to their large numbers. They buy and sell shares more frequently on the stock market than any

other category. As a result they have a major influence on the market price of the company’s shares.

INSTITUTIONAL INVESTORS :

This category mainly consists of financial institutions such as investment banks, private equity (PE) funds, insurance companies,

pension funds and venture capitalists (VCs), who acquire an interest in the company at various stages. Together, they are called

financial investors. The stake held by such institutions is only financial in nature. They don’t want to be a part of the company for

the long term. All they want is to make a profit by selling their stake in few years and exit the company. However, because their

stake is fairly substantial, they want to have a say in the management of the company.

For this reason, they have a presence on its board. Sometimes, promoters don’t have the necessary money to start a business.

Financial investors, such as PE funds and VCs like to invest in the company at this stage, in return for a stake. Others, such as

investment banks and pension funds have at their disposal a lot of money that belongs to their clients. They can invest this for few

years. They do so in companies that are relatively well established in the market and promise good returns in the medium to long

term. However, very few institutional investors stay invested in a company beyond a few years.

STRATEGIC INVESTORS :

This category of investors stays invested for longer period of time. Sometimes, other companies from the same industry invest in a

company. They may be above, below or at the same stage of the value chain. The objective if such an investment is to get a share

of the action from another stage of the value chain and is therefore called a ‘strategic interest’.

INSIDER SALE

We have established that retail investors are the most active class of company owners in the stock market. They rarely hold the

shares throughout the company’s lifecycle.

Does this mean that other categories of investors sit patiently on their shares for an indefinite period? No. The promoters and

management of a company frequently buy and sell shares of the company in the stock market. This is called insider sales.

Such transactions are done for three main reasons – for covering conversions, share repurchases and signaling. Companies issue

a lot of hybrid investment instruments such as warrants and bonds, with options that provide for their conversion into equity shares

in the future. Shares have to be bought for the conversion of these. Also, companies sometimes like to reward their shareholders

by buying back their shares at a high price. This is called share repurchase.

Lastly, investors take a cue from the management’s activities in the stock market. Sometimes companies like to buy shares when

their value is falling to signal to shareholders that they are confident of their future. Similarly, sometimes, they need money to invest

in a variety of projects. This too can be raised by selling their own shares. This is typically done when the stock price is high.

INSIDER SELLING V/S TRADING

It must be remembered though, that insider selling is unrelated to the illicit practice of insider trading. Here, companies trade in

shares with the full knowledge and consent of the market regulator (SEBI in India). In insider trading, company promoters, top

management or any of the employees buy and sell shares of the company based on material information not known to other

investors.

Fundamentals of Corporate Governance & Shareholder Rights Investing in companies by buying shares is not just about making profits through stock trading. There is more to it. And this is

where stakeholder rights play an important role. You, as an investor in a company, have rights and duties. This can contribute a lot

to the company’s long-term growth. Here is a look:

CORPORATE GOVERNANCE AND STAKEHOLDER RIGHTS

Companies have realised that their success is not just an outcome of the management and large shareholders’ efforts. There are a

lot of shareholders who contribute to it. As a result, stakeholder rights are now very high on their list of priorities. The sum total of all

the mechanisms put in place by a company to protect stakeholder rights, in particular shareholders rights, is referred to as its

corporate governance structure. It consists of policies, procedures and regulations that define how the management must deal with

its stakeholders, and the remedies available to them in case of a violation.

SHAREHOLDER RIGHTS :

Shareholders are collective owners of a company. As such, they have a wide array of rights. Principal among them are the right to

timely and accurate receipt of information about its working, and the appropriate use of their funds. Accountability in this respect is

ensured through the submission of annual and quarterly reports. They talk in detail about the company’s activities during the period

and plans for the future.

Stakeholders have the right to, at any point, seek additional information from the management about any aspect of the company’s

business. They also have the right to weigh on significant matters through a vote.

Shareholder votes are sought on all significant matters of the company such as those related to business combinations (mergers

and acquisitions), major investments in assets and appointment of the board. Unless the shareholders ratify these proposals with

the required majority, the management can’t go ahead with these activities.

BOARD OF DIRECTORS :

The principal tool for governing shareholder rights in a company is its board of directors. It is a body elected by the stakeholders

periodically for explicitly looking into the protection of their interests. It is particularly useful for small stakeholders who neither have

the time to maintain active oversight on the management nor the expertise and influence to rein it in. Let’s look at how the board

ensures this.

FUNCTIONS OF THE BOARD :

The board is a means for the shareholders to exercise their authority. As their guardian, it is responsible for formulating and

enforcing the moral code and systems of governance for the company.

In addition to this, it exercises its power in the following ways:

Appointing the top leaders of the company and deciding its compensation.

Stating the goals and objectives of the company and ensuring compliance.

Summoning the management and interviewing it in special situations.

Reviewing the performance of the management and ensuring adherence to legal and regulatory pronouncements.

Setting up various committees to look into specific matters of the company.

Reviewing the takeover proposal in case of a hostile takeover.

Ensuring the stakeholder interests are met in all the activities of the company.

FUNCTIONS OF THE BOARD OF DIRECTORS

BOARD’S AUDIT FUNCTION :

One of the primary concerns of shareholders is the accuracy of financial reporting and the proper use of their money. In order to

ensure this, SEBI requires public listed companies to get their accounts verified by an external party before submitting them as a

part of their annual report. This is called external audit. A similar audit is performed in-house by companies before the external

audit. Quarterly reports are only audited internally. The board of directors forms an audit committee to look into all matters related

to internal and external audit.

The committee is responsible for the appointment of the external auditor, deciding its compensation, ensuring it obtains the full

cooperation of the management and is not influenced by it in any way. The audit committee is completely authorized to oversee the

internal audit. All auditors are supposed to directly report to the chairman of the committee. This ensures that not only the annual

and quarterly reports, but all other communications made by the company to the stakeholders is accurate and authentic. It is

essential however, for the audit committee to exclusively consist of independent directors with sound knowledge of accounting

standards.

BOARD INDEPENDENCE :

As mentioned earlier, the board is an elected body. It consists of a diverse background of directors, frequently including top

executives of the company, principal shareholders and independent directors. In order to devote themselves completely to the

cause of stakeholders, it is critical that board members are beyond the influence of the management. This can only be ensured if

the board has an overwhelming majority of independent directors.

However, this is not always the case. Company managements are frequently able to place people who are close to them on the

board. This includes members of the top management, friends, relatives and business partners. Whereas representation of top

management is necessary on the board to provide an insider’s perspective, others only contaminate the objectivity of the board by

passing for independent directors. Another reason why directors tend to work towards the management’s ends is because the

management has a say in their nomination and pays their compensation. People who are on the board for long come close to the

management. Frequent elections must be held to avoid this.

RIGHTS OF OTHER STAKEHOLDERS

In this segment, we will discuss the rights of two other important stakeholders in a company – lenders and customers.

LENDERS :

People who lend money to a company are its lenders. Companies may raise money in the form of loans from banks or bonds

issued to investors. What lenders are chiefly concerned about is the timely recovery of their money. Rights of lenders are protected

by a document called bond indenture. It contains positive and negative covenants that state the activities a company must and

must not indulge in, respectively. The indenture is enforceable by law.

If a company violates its covenants, the lenders have the right to revoke further credit lines and request the immediate repayment

of outstanding dues. Lenders’ rights are also protected by their preference over shareholders. Profits of a company are either used

to pay dividends to stakeholders or retained for further use. However, before they can be deployed to either use, they must be used

to repay the debt obligations for the period. This privilege also holds at the time of dissolution of the company.

CUSTOMERS :

Consumer rights is a subject of immense popularity these days. Companies earn their income from customers and must therefore

be sensitive towards their rights. They make a lot of efforts to ensure that there is transparency in their operations and consumers

can consult them immediately if they feel their rights have been violated in any way. Most companies have a dedicated customer

service team to look into such matters. However, the government plays a central role in ensuring the customer rights are not

abused. Customers are basically concerned about the quality of the product and the price at which it is sold.

Consumerrights.org categorizes consumer rights in India into the following categories:

The right to be protected from all kinds of hazardous goods and services

The right to be fully informed about the performance and quality of all goods and services

The right to free choice of goods and services

The right to be heard in all decision-making processes related to consumer interests

The right to seek redressal, whenever consumer rights have been infringed

The right to complete consumer education

In a world where business is increasingly being conducted over the internet, cybercrime and data security are vital concerns.

Companies are very active in fighting cyber abuse. Complex codes and encryptions are used to ensure cybersecurity. The

Information Technology Act, 2000 is the predominant legislation in this respect.

Most of the consumer rights in India are protected by The Consumer Protection Act, 1986. However, some other legislations also

spell out consumer rights in specific areas. Generally speaking, consumer rights are marginalized the most when a small group of

companies dominate the market. Such dominance is prevented by antitrust laws that ensure that no company becomes too big to

monopolize the market. In India, this is done through the Antitrust Act, 2002, the Competition Commission of India (CCI) and the

Competition Appellate Tribunal (CAT).

ALL ABOUT ANNUAL MEETINGS, SHAREHOLDER VOTES AND CONFERENCE CALLS

We have talked in great detail about stakeholder rights and corporate governance. Now, let’s look at the three mediums through

which shareholders get to directly interact with the management and express their opinion on various matters.

LENDERS :

An annual general meeting is held every year by a publically listed company to review its performance during the year and make

important decisions for the following year. The meeting is attended by the top management, board of directors and interested

stakeholders of the company. In India, regulations with respect to the AGM are provided in the Companies Act, 2013. According to

the Act, a company must hold an AGM in at the end of every financial year, within fifteen months of the previous AGM.

The company is responsible for sending a notice for the meeting, along with its agenda to every shareholder, irrespective of the

size of his holding. This must be done at least 21 days before the meeting in ordinary circumstances. The notice must also be sent

to the auditors and directors. Along with the notice, all relevant facts and data about the matters to be discussed must also be sent.

The meeting is required to have a quorum of two. This means that at least two stakeholders must be present at the AGM for it to be

valid. At the AGM, shareholders may be required to vote on a number of issues.

These include, compensation of senior management, new directors of the board, the proposed dividend, proposed new

investments and any other significant matter related to the working of the company. Stakeholders who are not present may vote

through a proxy, i.e. a representative, or electronically, if they so desire. Resolutions cannot go through till they obtain the required

shareholder votes. A report on the meeting has to be sent to the Registrar of Companies. A company may also call extraordinary

general meetings (EGMs) in case there is a matter that requires the urgent attention of stakeholders.

SHAREHOLDER VOTES :

As discussed above, the right to vote is perhaps the most important right enjoyed by stakeholders. They are required to vote on all

important decisions of the company. The majority required for different decisions is different. In India, for prospective business

combinations (i.e. mergers and acquisitions), a minimum approval of 75% of shareholders is required. Voting is done by both the

concerned companies, and the proposal only goes through when it is ratified by both sets of stakeholders. Votes for this are sought

at a special meeting i.e. EGM. Shareholders may be present to vote, vote online or by proxy.

Voting on other important matters is done at the AGM, as described above. AGMs are normally only attended by major

stakeholders. Others consider it an unimportant activity because they feel they don’t hold much sway with the management.

However, AGMs present a very good platform for smaller shareholders to present their opinion before the management and other

stakeholders, which they may not otherwise get. This is called shareholder activism. Management and large stakeholders may

sometimes work hand in glove at the cost of smaller shareholders. However, the AGM provides them the opportunity to join forces

with other small stakeholders and vote together against such resolutions. This phenomenon was brought to prominence recently by

shareholders of United Spirits, a leading winemaker.

CONFERENCE CALLS :

A conference call takes place at the end of every quarter, just as an AGM takes place at the end of every financial year. However,

unlike an AGM, it is conducted over a telephone rather than in person. It involves the company’s top management and legal

advisors, who interact with leading asset management companies and stock analysts. Traditionally, common shareholders are not

a part of conference calls. This is why they are sometimes called analyst calls. Conference calls begin with an address from the

management, where it discusses the company’s activities during the period and gives financial figures pertaining to it. The p lans for

the future are also discussed. Then, the floor is opened for the audiences to ask questions. Since there are no shareholders in a

conference call, no voting takes place.

Conference calls for major companies are broadcasted live on TV and are also available on the company websites. Although

companies anyway release their quarterly results at the end of the period, conference calls allow analysts to ask questions to the

management. This helps shareholders learn more about the company’s performance and take cues for the future. This results in

better investment decisions. Stakeholders also take conference calls as an opportunity to mail their concerns to the company, to

which managements frequently respond.

Basic Concepts of Financial Risk Management Now that we have seen how industries and companies work, we must ask ourselves why it is worth exerting so much effort in

understanding all this. Why should it matter? We seek answers to these questions in this section.

WHY THIS MATTERS?

Investors have picked stocks based on industry-company model for a very long time. This model forms the core of fundamental

analysis. There are thousands of companies listed on Indian exchanges. Trying to pick a handful of them to invest in is comparable

to finding a needle in a hay stack. You’d be completely lost. The industry-company approach, frequently referred to as the top-down

approach, lends a structure to the research. We mention some of its benefits below.

CALIBRATED APPROACH :

The top-down approach looks at the broad trends in the economy and uses them to select specific sectors that should do well.

Then, it allows you to zoom-in further, to the level of specific companies within the industry, and choose the best ones.

This gradual approach leads you to the right set of companies in a very sound and orderly fashion, without compelling you to look

at every company in exhaustive detail.

PROVIDES INSIGHT INTO THE FUTURE :

The top-down approach doesn’t only involve an analysis of the past data. It also uses relationships thus discovered, to comment

upon the future performance of the company. In most cases, investors use past data to extrapolate, i.e. project the future

performance of a company. This is important because current stock prices are a function of the expected future performance of a

company. If you can predict it somewhat reliably, you can judge as to whether the stock is worth buying at present or not.

FACILITATES RISK DETERMINATION :

If you can understand the factors that drive stock prices and make a reasonable assessment of what the future might hold, it is

easier to also determine what might go wrong. This is one of the greatest benefits of the top-down approach. It helps you sniff out

the red flags regarding a company’s future performance in advance and act on them. One doesn’t have to burn his hands later to

realise what he shouldn’t have done. He can do it in advance.

Naturally, some events, such as acts of god, cannot always be foreseen and guarded against. In such cases, one has to act

impromptu. However, a lot of warning signals with respect to a company and industry are visible in advance.

ENABLES INFORMED DECISION MAKING :

This approach is empirical in nature, i.e. it is based on profound experience and analysis. It allows you to use current and past data

and discover relationships between factors both, at the industry and the company level. This is the basis on which you can form an

opinion on the prospects of a company and decide whether to buy a stock at the current price.

For example, one may determine the impact of a change in a particular factor on the sales or profits of a company based on the

impact that it has had in the past. This assessment uses both qualitative and quantitative aspects. In other words, a top-down

approach makes company performance and price movements predictable to some extent. You can feel much more confident about

your investment decisions when they are based on such an approach.

PROVIDES A BROADER PERSPECTIVE :

When you start right from the top of the tree, your sphere of analysis incorporates all the industrial sectors in an economy. This is

akin to taking a hawk’s eye view of the economy to pick the best sectors.

Drilling down further by analyzing each of these specifically, then allows you to decide which of these is going to perform well under

what market conditions. You can diversify accordingly and reap the benefits of a stable return in all market conditions.

AIDS ACTIVE PORTFOLIO MANAGEMENT :

Earlier, we established that the top-down approach broadens ones perspective and brings all companies and industries into the fold

of his analysis. This allows him to change the allocation of his portfolio according to the developments that take place in the

economy.

No matter what the market conditions, you can always find something that will do well. Accordingly, you can increase the weightage

of such stocks in your portfolio and earn extra returns.

WHAT ARE BUSINESS, FINANCIAL RISKS

The top-down approach is not infallible. Things can always go wrong. Sometimes, unexpected occurrences change the outlook for

an industry/company completely and catch you off-guard. The ability of such events to induce a divergence from the expected

performance of a company. This is called risk. It must be noted though, that divergence can be positive and negative. When we

assess risk, we are predominantly concerned about the negative events that lead to negative divergence. For a business, risks

have been divided into two categories – business risk and financial risk. We will take these up individually.

BUSINESS RISK :

The impact of market conditions and a company’s internal operations on its profits is called business risk. There are two types of

business risks – sales risk and operating risk. Let’s look at them one by one.

Sales risk :

The sales revenue of a company is a product of the price at which it sells its products and the quantity of them it is able to sell. Any change in these will result in a change in a company’s sales revenue. Sales risk is higher for companies with a higher fixed cost structure and greater price elasticity. Fixed costs are costs that a company has to incur irrespective of its level of output. High fixed costs make it hard to cut prices, even when production is low. Any reduction in price will make the company unable to cover its production cost. This inability affects its sales. Price elasticity of demand is the extent to which the demand for a product changes when its price changes. For companies with a higher elasticity of demand, a small increase in price leads to a greater fall in demand. This results in a fall in overall sales revenue. Thus, such companies find increasing prices harder. All other factors that impact a company’s ability to increase prices and level of output also fall under this category of risks.

Operating risk :

Operating risk refers to the change in a company’s earnings due to internal factors. While sales have a direct impact on a company’s income, these factors have an indirect, although just as strong an effect. Operating risks are caused by anything that can lead to an internal breakdown in the company’s operations. Companies that have very old assets and don’t have strong, time tested structures in place are at the highest operational risk.

FINANCIAL RISK :

Financial risk refers to the risk of a fall in profits due to high financing costs. The revenue a company earns trickles down as profit

after a deduction of many expenses from it. One of these expenses is the cost of debt, i.e. interest a company has to pay on the

money it has borrowed. This amount is high if a company borrows a lot of money. It has to be paid irrespective of the level of sales

it is able to muster.

Thus, holding all other things constant, a company’s profit percentage gets magnified in the year when its sales revenues are high.

This is because interest cost doesn’t increase proportionately to sales. Similarly, in the year when its sales revenues fall, there is a

greater fall in its profit percentage owing to a constant interest cost. This is called financial leverage.

Let’s look at an example. Suppose a company earned $ 1,000 this year. After deducting a fixed interest amount of $ 300, its profit

would come out to $ 700. Now, suppose its sales increase by 50% to $ 1,500 next year, subtracting the same amount of interest, its

profit would be $ 1,200. This is an increase of 71.4% from the previous year, i.e. greater than the increase in sales. Now, assume

that the company can only manage sales of $ 800 next year, i.e. a fall of 20%. Its profit for the year would now be $ 500, implying a

fall of 29%, greater than the fall in sales.

Financial Statement Analysis: A Key to Historical Performance

Financial statements give an account of a company’s performance during a given period. However, a single period’s performance

suggests little about the company when looked at in isolation. It must therefore, be looked at in conjunction with the company’s past

performance. A comparison in this way, brings out the strengths and weaknesses of the company and provides insight into its

future. This is called financial statement analysis.

In this section, we will look at the important financial statements of a company as well as their utility when used as a part of

historical analysis.

WHAT ARE THE DIFFERENT FINANCIAL STATEMENTS ISSUED BY COMPANIES

There are three basic financial statements that can be found in the annual and quarterly reports of a company. They are the income

statement, balance sheet and cash flow statement—the three pillars of financial statement analysis. There is also a section called

notes to accounts in every annual report. Here, each component of the three financial statements is explained in greater detail. We

will discuss the three financial statements one by one.

IMPORTANT FINANCIAL STATEMENTS OF A COMPANY

INCOME STATEMENTS :

All the incomes and expenses of a company are recorded in the income statements. It is sometimes also called the statement of

profit and loss. It starts with the company’s sales revenue for the period and keeps adjusting it for other incomes and expenses that

occurred during the period. The resulting figure is the net income/profit for the year. This is the portion of sales that is left behind

after all other incomes have been added to it and all the expanses subtracted from it. It is used to pay dividend to shareholders.

Whatever remains of it after the dividend has been paid is called retained earnings. It is reserved for later use in the business.

Incomes and expenses are divided into operating and non-operating, depending upon whether they have originated from the

company’s core operations or not. Operating items include depreciation, employee compensation, selling costs, costs of inputs

used for production etc. Non-operating items include, proceeds from the sale of an asset, interest cost etc. The amount we get after

all these have been subtracted from sales is called the pre-tax profit. On subtracting the period’s tax expense from this, we arrive at

net income or net profit. This is the amount we refer to when we talk about the profitability of a company.

CASH FLOW STATEMENTS :

All the expenses and incomes of a company are mentioned in the income statements. However, not all of these are in cash. For

example, the income statement reflects the period’s sales revenue as an income but doesn’t say what portion of this was actually

earned in cash and what in the form of future receivables. It is important for investors to know this configuration because non-cash

figures are either only notional or are promises that cash flows will occur in the future. In both cases, they are less liquid than cash

and highly uncertain. The cash flow statement removes this uncertainty by presenting the actual cash inflows and outflows of the

business during a period. It also divides cash flows by their nature into operating, investing and financing. This displays the major

sources that brought in cash and those that led to an outflow of it. We will discuss this in greater detail in the section on the cash

flow statement.

BALANCE SHEETS :

The balance sheet talks about the assets and liabilities that a company has at its disposal. Assets and liabilities are divided into

fixed and current. Fixed assets and liabilities stay with the company for a long time. Fixed assets include land, machine, building

and others that provide benefit in the long run. These assets, with the exception of land, lose value every year. This loss in value is

known as depreciation.

Long term liabilities of a company include long term debt and other obligations that it has to pay in the long run. Current assets and

liabilities exist only for short while. Current assets include, accounts receivable, inventories, short-term securities and cash,

whereas current liabilities include short-term loans and accounts payable. Some of the assets and liabilities mentioned on the

balance sheet are intangible as they do exist but not in tangible form. Examples include patents, copyrights, software programs in

case of IT companies, and deferred tax. We will look at these in detail in the section on the balance sheet.

Another figure mentioned on the balance sheet is equity. It is the sum of all the funds that shareholders offer the company in

exchange for its share. It mainly includes the book value of outstanding shares, retained earnings and some reserves. Please note

that the book value of the company’s shares is not the same as their current market price. This is because the amount mentioned

on the balance sheet is the original value of the shares, when they were sold/issued and not the value they subsequently rose to. A

company buys its assets using equity and the money it borrows in the form of debt. Thus, the value of a company’s assets is

always equal to the sum of its liabilities and equity.

CONCLUSION :

It must be noted that this description is based on the most commonly found financial statement formats. Companies can modify the

way they present these statements slightly, but the components in each case will be the same.

You will frequently find two sets of financial statements in an annual report – stand alone and consolidated statements. This

happens in the case of companies that have a parent – subsidiary structure. Standalone statements represent the figures of the

parent company alone. The revenues, profits, assets etc. of the subsidiaries are not a part of it. In the consolidated statements, all

these are included to the parent company’s statements.

WHY YOU NEED TO UNDERSTAND PAST COMPANY PERFORMANCE

The historical performance forms the basis for understanding the current financial statement of a company. Financial statements

only talk about a company’s performance in the present period. If they are viewed in light of similar statements from previous

periods, you can understand the interplay of factors that affects this performance. On this basis, one can not only evaluate the

present period’s performance but also comment upon the company’s future prospects. Otherwise financial statement analysis

would not be worthwhile. There are three

WHY TO UNDERSTAND COMPANY PAST PERFORMANCE TREND ANALYSIS :

Equity analysts like to observe changes in the values of various components of the financial statements from period to period and

discover patterns. They believe that such patterns are based on a cause-and-effect relationship. If they can dig deeper, they may

be able to reveal the underlying causes.

This can be of consequence in predicting the present and future performance of the company. Sometimes, a trend analysis reveals

a path-breaking new strategy or a radical shift in approach on the part of a company. This opens up a new layer of understanding

into the company’s operations and may change the outlook on it substantially.

BENCHMARKING :

An analyst may ascertain a benchmark for the company’s performance based on past data. The company’s present performance

may be compared with this benchmark to see how it has done. In case there is major divergence from the benchmark, one may

explore further to reveal the causes.

A very important tool for both benchmarking and trend analysis is ratio analysis. Certain financial ratios may be calculated for each

of the past periods. The comparison of these ratios with their present value sometimes reveals vital facts that otherwise might have

not come to attention at all.

FUTURE PROJECTIONS :

Equity investors project a company’s future performance to decide whether to buy its shares or not. Past economic performance

forms the basis of these projections. How do you know what the value of sales or fixed assets of the company will be over the next

ten years?

For making these calculations, trends such as growth rates of the past few years are observed. They are then adjusted for

improvements the company might introduce in the future. Based on these, values of these variables in future periods is calculated.

These values are used to calculate the fair price of the company’s stock as on the date.

NEED FOR FINANCIAL AND INFORMATION TRANSPARENCY

Investors, who use the financial statement analysis approach to stock picking, clearly depend on the reliability of data present in the

financial statement of a company. It is therefore imperative for companies to provide facts and figures honestly and, in general,

make a fair representation of their operations. Providing financial information accurately, explicitly and in a readily available fashion

to its users is called transparency. We saw in one of the earlier sections that free information flow is important for market efficiency.

A lack of transparency obstructs the free flow of information and hurts market efficiency. Transparency can be expected in two

ways.

FINANCIAL TRANSPARENCY :

Firstly, companies must be open about their operations and the uses to which they put shareholder funds. This is known as

financial transparency. Managements sometimes use shareholder funds in ways that are not necessarily complementary to

shareholder interests. This is generally done to perpetuate their own position and expand their sphere of influence.

This reflects in the form of lack of information and the presence of unusual items on the financial statement of a company. Investors

must look at this with suspicion. There are many red flags and warning signals available for shareholders on the financial statement

of a company. We have already looked at these in the previous section. Investors should be mindful of these.

INFORMATIONAL EFFICIENCY :

The other aspect of transparency deals with how freely and voluntarily the company makes information available to those who are

interested in it. This is called informational efficiency. Again, companies are less forthcoming when it comes to releasing information

when they have something to hide. Investors must be suspicious in such events and look for red flags.

The board of directors also has a central role to play in the maintenance of transparency. Thus, investors must ensure that the

board is as independent as possible.

A Primer on Financial Accounting Concepts

We have discussed the structural aspects of company analysis at length. Now, we will turn our attention to the quantitative aspect

of company analysis. In this section, we will first understand what is accounting, and then look at the basic accounting norms that

companies follow for financial reporting as well as understand account concepts such as accruals. We will also look at what is IFRS

and US GAAP.

WHAT IS ACCOUNTING?

Companies deal with lakhs and crores of rupees. This includes the money borrowed from lenders and shareholders, the amount it

takes to produce lakhs of goods and services, the payments to employees and suppliers as well as the money received from

clients. This is a complex process, where money is exchanged every minute or second of the day.

This is why, it is important to maintain strict records of the inflows as well as the outflows. This process of keeping a detailed

account of financial aspects of the company is called ‘accounting’.

ACCOUNTING BASICS: ACCRUALS, ADJUSTMENTS AND ASSUMPTIONS

We start our study of accounting norms with an understanding of the accruals, adjustments and assumptions used in prepareation

of the financial statements.

ACCRUALS :

An accrual is a financial obligation that is created when one of the parties in a transaction fulfills its obligation but is yet to receive its

compensation. It is a source of future income for a company when it has made the obligation, whereas, it is a source of future

expense, when it is yet to pay for the obligation. Since accruals are expected to lead to future cash flows, they are recorded as

assets or liabilities on the balance sheet. We will discuss this in detail in the next segment of this section.

For now, let’s look at some common categories of accruals found on the balance sheet:

TYPES OF ACCRUALS

ACCOUNTS RECEIVABLE AND PAYABLE :

These are created when a company sells/ buys goods but is yet to receive/pay for them. In case proceeds have to be received from

the customers for the goods sold, they are referred to as accounts receivable. In case payments are to be made to suppliers for

goods bought from them, it is called accounts payable. Receivables are recorded as an asset, whereas payables are recorded as a

liability on the balance sheet.

UNEARNED INCOME :

Sometimes a company receives income for rendering a service, such as selling goods, before it has actually rendered it. Income

thus received is called the unearned income. It is recorded as a liability on the balance sheet till the service has been performed.

This generally happens with companies that sell large products, such as machinery, that are produced on demand.

ACCRUED AND PREPAID EXPENSES :

Accrued expenses are similar to accounts payable. However, here, the company doesn’t owe money to its suppliers. Instead, it

owes money to somebody from whom it has received a service, but has not paid yet. Accrued expenses may include rent, interest,

wages etc.

Similarly, when a company pays for these services in advance and receives them later, it is called prepaid expenses.

ADJUSTMENTS :

Accountancy is based on the double entry system. For every transaction, a company’s accounts get effected in two places. For

example, when it buys something, the value of the purchase gets added to an asset account, and simultaneously, the same amount

gets deducted from the cash account. Accruals drive a wedge between the two. In case of accruals, what the company receives is

different from what it pays as of that moment. In the above example, if the company had purchased these goods on credit, the

entire value of the goods would have come into the company.

However, only a proportion of this would have gone out as cash. At the end of the accounting period, such as a quarter or a

financial year, the accounts would have to be adjusted for these differences. The entries passed for this are called adjusting entries

or adjustments. Let’s look at a couple of examples:

Say a company makes sales worth $1,000 million in a financial year. Till the last day of the year, it only receives $ 600 million out of

this. On the income statement, the company will record sales of $.1,000 million because it has genuinely made these sales.

However, on the balance sheet, under cash, it can only report $.600 million because this is all it has received in cash. The

remaining $400 million will be recorded as another asset called accounts receivable on the balance sheet. This is called the

adjusting entry. As and when this amount is recovered, accounts receivable will reduce. We will explain the rationale behind

recording accrued revenue as an asset later in this section.

Let’s look at another example. Assume a company operates from a rented office space. The monthly rent is $.250m. However, for

the previous month, the company has only been able to pay $.200m On the income statement, the company will show a rent

expense of $250m because the company has already used the premises during the period. However, on the balance sheet, cash

will only be reduced by $ 20m. The remaining $ 50 000 will be recorded on the liabilities side as an adjusting entry called accrued

rent. As the company keeps paying this, the cash amount will keep reducing, along with the accrued rent amount.

ASSUMPTIONS :

Accounts prepared by companies are based on four basic assumptions. They are:

Accounting entity assumption : according to this assumption, the company is a separate entity from its ‘owners’. The personal

possessions of the owner cannot be considered a part of the company. In case the business goes under and its assets have to be

auctioned, the owners’ personal assets will remain separate.

Money measurement assumption : This assumption states that while preparing a company’s books of accounts, only those

transactions that can be recorded in monetary terms will be recorded. For example, when a company obtains the services of an

employee, it gets his valuable traits such as honesty, punctuality and commitment. However, only the compensation offered to him

is recorded on the accounts of the company. These traits go unmentioned.

Going concern assumption : A company is assumed to last forever. The ‘owners’ may pass on, employees may leave, assets

may be replaced, but the company is an accounting entity that never ceases to exist. It is always managed by new people who

come in and new assets that are bought.

Accounting period assumption : The previous assumption states that a company is a going concern. If so, when do we evaluate

its performance? There must be a fixed interval of time for reporting performance. In most cases this period is one year, at the end

of which the books of the company are closed and an annual report that discusses its performance during the period is released.

Thus, one year is the assumed accounting period.

UNDERSTANDING ACCRUAL ACCOUNTING

As mentioned above, accruals occur when an obligation has been fulfilled but the income in lieu of it has not been received yet. As

such, accruals denote a future expense or income for the company.

ACCOUNTING TREATMENT :

By definition, anything, tangible or intangible, that a company owns and expects to generate future income from is its asset.

Similarly, anything that a company expects to incur a future outflow on account of, is its liability. As such, all accruals that are

expected to generate future income are assets. Examples include, accounts receivable, prepaid expenses and deferred tax asset.

Accruals that arise due to a counterparty fulfilling its obligations towards the company are recorded as liabilities. Examples include,

accounts payable, unearned income, deferred tax liability.

Most accrual-based assets and liabilities are recorded as current assets/liabilities, because the cash for such transactions is

expected to change hands soon. As and when they are settled, the combined value of that particular asset/ liability is reduced on

the balance sheet and a similar amount is shown as an operating income/expense on the income statement.

BENEFITS OF ACCRUAL ACCOUNTING :

The beauty of accrual accounting is that it provides a holistic picture of a company’s affairs. It accounts for what the company

‘should’ have received or paid in cash rather than what it actually has.

Also, it is futuristic in nature because it tells investors what they can expect the company to receive or pay in future. In the earlier

approach, only cash incomes and expenses were recorded in the financial statements.

DIFFERENT TYPES OF ACCOUNTING METHODS: IFRS, GAAP

Financial accounts are prepared by each company individually, in isolation with others. Allowing companies complete freedom with

respect to accounting would lead to differently structured financial statements for each company. This will make it hard for the

investors to compare them. To overcome this, a uniform set of accounting standards is developed and each company is required to

follow it. In India, this set of standards is called Indian Accounting Standards (IAS). Internationally, two sets of accounting rules are

popular – International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP). US

GAAP is followed by companies domiciled or listed on exchanges within the US, whereas IFRS is used in most other countries to

varying degrees.

WHAT IS IFRS :

IFRS was put together by the IASC between 1973 and 2001. The IASC has since been replaced by the IASB. IFRS requires the

inclusion of the balance sheet, income statement, statement of changes in equity and cash flow statement in every annual report. In

addition, it also requires a mention of the significant accounting policies of a company therein.

The principles it sets forth are:

Fair presentation

Going concern

Accrual basis

Consistency

Materiality

The consistency principal requires that once a company adopts an accounting approach, it sticks to it, unless it finds another one

that is an improvement over it. In that case, the change in principal must be mentioned in the notes to accounts. The materiality

principle states that a company may ignore an accounting principal if doing so will only have an insignificant numerical impact on its

financial statements.

IFRS also mention some presentation requirements:

Items of similar nature must fall under a common head in the financial statements.

Complete values of incomes and expenses, and assets and liabilities should be reported. They must not be netted-off against each other.

Items on the balance sheet must be classified into current and non-current.

The number of items to be mentioned on each financial statement is defined. Details must be given in notes to accounts

The historical values of each item on a financial statement should be given to facilitate comparison.

WHAT IS US GAAP :

US GAAP has been adopted by the US Securities Exchange Commission (SEC) and is currently in force in the US. The standards

were presented as one consolidated document, called FASB Accounting Standards Codification, by the Federal Accounting

Standards Board (FASB) in 2008. While the general ideology and purpose of GAAP and IFRS is the same, there are some

technical differences between the two.

For example, US GAAP, unlike IFRS, allows the last-in first-out (LIFO) method of inventory recognition.

Hereby, companies are allowed to calculate the cost of goods sold (COGS) on the basis of the price of the most recent units of

inventory, rather than the oldest ones. Some of the other key differences include differences regarding the recognition of intangible

assets and the reversal of write downs.

The principals of GAAP were formulated with the objective of enabling financial statements to provide all the necessary information

for stakeholders to take rational, informed decisions.

As world markets become more and more integrated, countries have realized the need for a common set of accounting rules to

foster comparability across the paradigm. Today, most countries are at various stages of adopting IFRS. In India, IFRS was

supposed to be implemented in 2012.

However, there has been little progress. Since 2002, FASB and IASB have been working towards the convergence of IFRS and US

GAAP. However, there are some reservations regarding this convergence.

The SEC has expressed little faith in either accounting standard. It has called for a completely new approach to accounting to cope

with the needs of the new, dynamic, technology-driven business environment.

DON’T FALL FOR THE NUMBERS: HOW TO FIND LOOPHOLES, RED FLAGS

Even though financial reporting is based on a uniform set of accounting standards, there is sufficient freedom for companies with

respect to reporting certain items. This, coupled with the malpractice of deliberately misreporting to give a better picture of the

company, allows companies to produce financial statements that don’t depict a company’s performance accurately. Investors must

look at numbers in the financial statements for signs of foul play. These signs are called red signs.

Some of them are:

OUT-OF-LINE SALES GROWTH :

A company’s sales growth must be more or less in-line with that of the industry. In case the growth is far higher, it presents a

suspicious case.

Acute growth in non-cash sales :

The accrued revenue of a company must increase in-line with increase in sales. If the increase in accrued earnings is greater than

the increase in sales, it is a sign of foul play.

Low quality of cash flows :

A large proportion of a company’s cash flows should be contributed by operating inflows. A larger proportion of investing or

financing cash inflows means the company is not generating enough revenue from its operations. It is trying to expand its balance

sheet by raising cash from borrowing, issuing more shares and selling its assets.

NON-OPERATING INCOMES CLASSIFIED AS OPERATING INCOME :

Earnings are considered healthy when they are largely made up of sales and other recurring, operating sources. Companies

sometimes classify non-operating incomes as operating to show high earnings quality. Thus, sources of operating income must be

carefully inspected.

Peculiar categories of assets :

Recall that assets are reported on a company’s balance sheet and are depreciated each year. This depreciation is recorded on the

income statement as an expense. As such, the entire value of the asset is expensed, but over a period of time and not in one go.

Companies sometimes like to use the same strategy for large expenses. Instead of reporting them as an expense in one year and

suffering a blow to the year’s profit (net income), companies report the expense as an asset on the balance sheet and report it on

the income statement by and by, over many years. This is called amortization. It is an unfair practice.

To check for this, one should look at the assets mentioned on the balance sheet. Unusual assets and a high proportion of intangible

assets (other than in industries such as IT, where intangible assets are a major component of the balance sheet) could be a

consequence of spreading such large expenses over an extended period.

What is Cash Flow Statement

The income statement tells us what a company has earned and spent during a year. Owing to the practice of accrual accounting,

not all of these incomes and expenses are cash-based. Investors value information about cash-based inflows and outflows

because these have already taken place. Accruals, on the other hand, have an element of uncertainty attached to them. The

information about cash-based transactions is provided by the cash flow statement. Reading the cash flow statement and finding out

trends is called cash flow analysis. This even helps you in cash flow forecasting.

Let’s find out a bit more about it.

READING A CASH FLOW STATEMENT

First, let us look at what is cash flow. Imagine your bank account statement. You will see two different columns – credit and debit.

Each line in the statement is when money has either been deposited or withdrawn. This is your cash flow. Now consider the

company’s ledger. Every time the company actually receives or spends money in cash form, the ledger would be updated. These

are called cash flows. The financial statement, which takes into account only the cash flows, and not the money promised or owed,

is called the cash flow statement.

We’ll start understanding the cash flow statement by looking at its significance, structure and components.

This is why, it is important to maintain strict records of the inflows as well as the outflows. This process of keeping a detailed

account of financial aspects of the company is called ‘accounting’.

ACCOUNTING BASICS: ACCRUALS, ADJUSTMENTS AND ASSUMPTIONS

We start our study of accounting norms with an understanding of the accruals, adjustments and assumptions used in preparation of

the financial statements.

SIGNIFICANCE OF THE CASH FLOW STATEMENT :

What if you sold something to someone and they requested for three months to pay for it? You would consider the sale completed

and count the money as yours, but where is the guarantee that they will pay you duly, or even pay at all? Something similar

happens with the companies. They record non-cash incomes and expenses on the income statement but are not always sure

whether the cash exchange will ever happen. Such transactions result in no immediate change in their cash position. They are

recorded as receivables or payables on the balance sheet.

Apart from these, there are some articles on the income statement, such as depreciation, which are only notional. They are

reported as an expense (or income), but no flow of cash ever happens on their count. Such items are known as non-cash items.

They only inflate the income and expense figures for the period. The cash flow statement eliminates the impact of all such figures

and only talks about the transactions that took place in cash. Its scope extends beyond the income statement and also incorporates

cash-based changes in balance sheet items, i.e. assets and liabilities.

Understanding the cash flow statement helps you understand how effectively the company is using its cash. If the company gets

cash after great delays, while its expenses have to be met immediately, it is natural that the company would be under severe

financial stress. It will then have to borrow money to meet its short-term needs. This is additional liability on the company. This is

why the cash flow analysis is important.

During the times of economic stress, the cash flow statement can give you a better idea of how the company is performing in

comparison with the income statement. If you see cash inflows are slowing down, you can predict the company’s near-term future

too. This is called cash flow forecasting. This is very important, after all the stock markets react today in anticipation of the future.

STRUCTURE OF THE CASH FLOW STATEMENT :

Companies can choose one of the two formats to present the cash flow statement—direct and indirect. The direct method begins

with cash sales, i.e. the proportion of sales revenue that was received in cash. It then adds to it all the cash inflows that occurred on

account of operating, investing and financing inflows and subtracts from it all the corresponding outflows. In the end, the cash

balance at the end of last year is added. This is because the current year’s cash balance is the sum of cash balance at the end of

the previous year and the net cash inflows this year. The resulting amount is the cash balance for the year, the same as found in

the balance sheet.

The indirect method begins with the net income for the year, as mentioned in the income statement. Recall that for arriving at net

income, we adjusted earnings before taxes and non-operating items (EBT) for some non-operating incomes and expenses

(including tax). To show cash-based incomes and expenses, we must reverse this. So, we add back non-operating expenses and

subtract non-operating incomes.

The resulting figure is EBT. Next, we adjust for non-cash items. We start by adding back non-cash expenses, such as depreciation

and subtracting non-cash incomes. After this, we move to the balance sheet. We will adjust for changes in the current assets (other

than cash) and liabilities. Increases in current assets and decrease in current liabilities represent an outflow of cash. They will

therefore be subtracted. Similarly, increase in current liabilities and decreases in current assets are added back. The net value of

these is called changes in working capital. After this, the statement progresses like the direct method, as can be seen in the

illustration below.

In most annual reports, the cash flow statement is presented in the indirect format. However, it starts with EBT instead of net

income. The adjustments to net income that we talked about are not shown. A pro forma cash flow statement using either approach

is presented below.

COMPONENTS OF THE CASH FLOW STATEMENT :

As seen in the illustration, cash flows are divided into three categories—operating, investing and financing. This categorization is

common to both the formats. The only difference between the formats is the way of presenting operating cash flows. The

presentation of the other two categories is the same for both approaches.

Operating cash flows :

This represents all categories of cash flows that are a part of the company’s core operations. The contents of operating cash flows

differ according to the presentation format used. This can be seen in the illustration.

Investing cash flows :

This category represents all the cash flows that occur on account of investment in fixed physical assets (such as land, buildings and

machinery) and financial assets (such as shares and bonds of other companies).

These cash flows are in the form of:

Cash flow from the sale/purchase of a fixed asset, such as land

Cash flows from the sale/ purchase of entire business units

Cash flows from the sale/purchase of strategic stakes in other companies

Cash flows from sale and purchase of financial assets, such as shares, bonds and mutual funds

Dividends/ interest received from the investment in financial assets

FINANCING CASH FLOWS :

This category includes all the cash inflows and outflows that are related to raising/repaying capital used in the business.

Financing cash flows include:

Fresh debt capital raised

Fresh equity (share) capital raised

Repayment of debt

Interest paid to creditors

Share repurchases

Dividends paid to shareholders

Out of these, fresh capital raised through debt and equity is treated as an inflow and added. All outflows on account of repayments

of debt and equity capital as well as payment of interest and dividends are subtracted.

WHY OPERATING CASH FLOW MATTERS

MEASURES PROFITABILITY :

When looking at a cash flow statement, investors tend to look at the component of operating cash flows with the greatest interest.

As with the income statement, investors like companies that raise cash predominantly from operating sources.

The other two activities should ideally be financed in totality by operating cash flows. Investors don’t mind negative investing and

financing flows as long as the figure for operating cash flows is positive and greater than the combined outflows on account of the

other two. (Although negative values must be investigated further.)

If this is the case, it means that the company has raised enough money from its operations to finance its investments, as well as

repay money to creditors and shareholders. Such a company must be doing rather well!

CASH FLOW FORECASTING :

In case operating cash flows are negative and investing cash flows are positive, it means the company has sold its assets to raise

money for its ailing operations.

In extreme cases, it may even be facing prospects of a shutdown, and is therefore selling parts of its business to support its

operations and repay capital.

In case financing cash flows are positive and operating cash flows are negative, it may again mean that the company doesn’t have

sound operations and therefore has to raise fresh capital to finance them. Shareholders are very sensitive about negative operating

cash flows.

INVESTING V/S OPERATING CASH FLOWS :

Negative investing cash flows generally signify that the company is expanding its operations or replacing old, worn-out assets. In

such cases, you must be concerned as to the purpose of these investments. Negative investing cash flows are frequently found

together with large, positive financing cash flows. This is because funding for these investments comes from financing inflows. You

may be interested in the source of this funding—debt or equity. Sometimes, there is no increase in either. This means the company

is using its retained earnings to finance these investments. In the section on the income statement, we defined retained earnings as

the pool of net income not distributed as dividend over the years. This is the best and the cheapest source of financing.

WHY OPERATING CASH FLOW MATTERS

An extension of the concept of cash flows is the concept of free cash flows. It is an important part of cash flow analysis. We just

discussed how a company should ideally use its operating cash flows to finance investments in new opportunities (i.e. fixed assets).

In very crude terms, the portion of cash flows that is left after making such investments and fulfilling all other cash obligations is

called free cash flows. There are two types of free cash flows—free cash flows to firm (FCFF) and free cash flow to equity (FCFE).

The cash flows available to the company after all its investing needs are met are free to be used for the third avenue of outflows –

financing outflows. The financing (or capital) for running the company is provided by two categories of investors – creditors and

equity shareholders. Together, the funding provided by them therefore, forms the company, i.e., the firm. The cash flows available

for distributing to capital providers are therefore called free cash flows to the firm.

The formula for the calculation of FCFF is presented below:

Since shareholders are owners of the company, creditors always have the first right over FCFF. As such, FCFF should be first

directed towards making interest and principal payments. Post-tax interest expense has been added here because interest anyway

goes to creditors. Thus, it should be a part of the funds available for them. However, interest is subtracted in the income statement

while calculating net income. Since net income is the starting point of operating cash flows, interest is not able to flow into operating

income. For this reason it has to be added back.

What remains of FCFF after providing for creditors can be directed to equity holders. This amount is therefore called free cash flow

to equity or FCFE.

The formula for this is presented below.

We subtract post-tax interest and repaid debt from FCFF because this amount has been paid off to creditors out of FCFF. However,

the company may also raise fresh debt during the year. This also provides cash for repayment to shareholders. It is therefore

added in the calculation of FCFE.

It must be noted, that FCFF and FCFE are only estimates of what CAN go to debt and equity holders. They don’t represent what

ACTUALLY goes to them. Free cash flows are therefore only a tool for assessing whether the company has generated enough

cash to meet its obligations towards creditors and shareholders. FCFF is of particular interest to those who lend money to the

company in the form of bonds or loans. It provides them an estimate of the company’s ability to cover its obligations towards them.

FCFE on the other hand, is used by equity holders. It gives them an estimate of the safety of their dividend. Expected future values

of FCFE are also used by equity investors to calculate the fair value of an equity share of the company. We will talk about this later,

in the section on the relationship between stock price and dividends.

Understanding Balance Sheet Analysis

In this section, we will look at the third important financial statement- the balance sheet. The balance sheet is a statement that gives

an account of the assets, liabilities and equity of a company.

Let’s find out a bit more about it.

UNDERSTANDING BALANCE SHEETS : ASSETS AND LIABILITIES

A company needs assets to run its operations. To buy them, it has to raise money. This comes from two sources- debt (borrowings)

and equity. Debt brings about an obligation on the company, which it has to settle in the future. It is therefore recorded as a liability.

Equity on the other hand is contributed by shareholders. It too is money that the company has to repay, but it is not a liability in the

traditional sense because it also confers rights of ownership on the shareholders. It is therefore recorded separately. Since assets

are completely financed by these two sources, the value of assets must be equal to the combined value of debt and equity. The

balance sheet is nothing but a detailed representation of this simple relationship.

Therefore, the basic balance sheet equation is:

As it can be seen in the pro forma balance sheet below, assets are also referred to as uses of funds, whereas liabilities and equity,

together are called sources of funds. Let’s discuss these concepts in greater detail.

STRUCTURE OF A BALANCE SHEET

UNDERSTANDING ASSETS

An asset is anything that a company owns that is expected to generate revenue for it in the future. Accounting standards require an

asset to be recognized only if its value can be measured reliably and it can be sold by the company in the future. It’s not

compulsory for an asset to be tangible. Companies own a lot of intangible assets (i.e. assets that cannot be touched or felt) that

bring them tremendous amount of revenue. Another way of distinguishing assets is on the basis of their useful life. Fixed assets are

more permanent and provide benefits over a long period of time. Current assets are less enduring. They provide benefit over a

short period of time (say upto one year). More information about these categories is presented below.

FIXED ASSETS :

As mentioned above, fixed assets are those assets that are expected to serve the company over a long period of time. While

companies draw benefits from both tangible and intangible assets over the long run, the term fixed assets is only used to refer to

tangible fixed assets.

These are also sometimes referred to as ‘hard assets’. Common examples include plant & machinery, land, building and furniture.

Companies also like to report long term financial assets, such as long term loans advanced and long term financial investments as

fixed assets.

All fixed assets, with the exception of land and financial assets, lose a part of their value every year. This is called depreciation.

Annual depreciation is reported as an expense on the income statement each year. The accumulated amount of depreciation for

each asset is recorded on the balance sheet. The reported value of the asset is net of this value.

CURRENT ASSETS :

Assets that only provide benefit or are expected to be realized in the short run are called current assets. They are not depreciated

because most of them are not physical in nature and they don’t stay long enough to endure wear and tear.

Current assets include:

CASH FLOW FORECASTING :

This category includes all long-term assets that cannot be touched or felt. Common examples are- patents, copyrights, software

products and goodwill. Since they cannot be seen, it is hard to demonstrate their revenue generating potential. Companies can very

easily exploit this inability by reporting non-existent intangible assets on their balance sheet and artificially expanding it. Accounting

standards are stringent regarding the recognition of intangible assets. They are normally only recorded when they have been

purchased from outside.

Internally developed intangible assets need to be thoroughly scrutinized before only a part of their cost can be reported on the

balance sheet. Else, it is reported as an expense on the income statement.

Like fixed assets, intangible assets, with the exception of goodwill, too lose value annually. This is called amortization. It’s treated

identically to depreciation.

Goodwill is the surplus amount a company pays to acquire another company, over the combined value of its assets.

This is considered to be the price of the extra revenue generating potential the combination will bring, over the combined individual

potentials of the two companies. Goodwill is not amortized. It is tested annually for impairment. Its value is reduced if it is

considered impaired.

Cash and cash equivalents :

This includes cash held by the company at hand, at bank and in the form of short-term investment products such as commercial

papers, t-bills and certificates of deposit (CDs). All these are highly liquid (i.e. can be converted into cash immediately) and safe

(i.e. there is a high probability of money being recovered out of these.).

Inventories :

Unsold goods, raw material and unfinished goods held by the company fall under this category. We discussed their valuation at

length in the section on the income statement.

Accounts receivable :

This item represents the amount a company is yet to receive from its customers. The cash component of annual sales is added to

the cash balance. The non-cash component is recorded here. The balance of accounts receivable increases when a company sells

goods on credit and decreases when it receives money from its customers.

Short term loans :

This represents all the excess short terms funds that a company deploys as loans. It is an asset because it will bring revenue in the

form of interest.

WHAT IS STOCKHOLDER’S EQUITY

Equity is defined as the portion of capital that is contributed by the equity holders in exchange for shares of the company. Equity

capital is initially contributed by promoters. As the business grows, more funds are required to run it. Promoters raise these by

listing the company on a stock exchange and selling a part of their stake in it for a higher price than its original value. This process

is called an initial public offer (IPO). The value reported on the income statements is the original value of these shares. It also

includes shares sold subsequently by the company. The surplus money received from the sale of these shares is recorded under

the name ‘securities premium’. The sum of these two values is called ‘issued, subscribed and paid-up capital’.

Over time, as the activities of the company grow, other things also get added to equity. All these put together form the book value of

equity. It is different from the market value of the company’s shares. Other components of equity include:

RETAINED EARNINGS :

This represents the proportion of a company’s net income that hasn’t been distributed to shareholders or used for share buybacks.

It is retained by the company for future use.

OTHER RESERVES :

Just like capital reserve, investors set aside funds to meet some other future requirements. One such reserve is the general

reserve, which is set up to meet unexpected future needs. Other reserves may be dedicated to other specific needs. Together,

along with the capital reserve, they are recorded under the name ‘reserves and surplus’.

CAPITAL RESERVE :

Companies need to invest in long term fixed assets in order to grow. To finance these investments without raising fresh equity or

debt, companies set aside a part of their retained earnings as capital reserve.

TREASURY STOCK :

At various points in time, companies buy back their shares from investors in the stock market. These are subsequently

extinguished. The value of these shares is recorded as treasury stock under equities. Companies may initiate share buybacks as a

means to reward shareholders, to support market prices or to ward-off the prospects of a hostile takeover.

UNDERSTANDING COMPANY DEBT, LIABILITIES

The second component of capital is called debt. This is the portion of capital raised by a company by issuing bonds (generally

called debentures) and raising loans through banks. It is recorded on the balance sheet as a liability. Companies also record other

liabilities on the balance sheet, however, debt is the only significant long term liability. It is therefore recorded under the name long-

term debt. Other categories of liabilities are more or less current liabilities, i.e. ones that are expected to be settled fairly soon.

Commonly reported current liabilities include :

SHORT TERM DEBT AND CURRENT PORTION OF LONG TERM DEBT :

This includes the funds borrowed by a company to meet its short term needs. It also includes the proportion of long-term debt that

will fall due within one year.

ACCRUED LIABILITIES :

Accrued liabilities arise when the company has received a service but is yet to pay for it. This represents obligations other than

those that lead to accounts payable. Things that fall under this include accrued wages, rent etc.

ACCOUNTS PAYABLE :

This represents the amount that a company is yet to pay its suppliers in lieu of the inputs purchased from them. The company

expects to pay this amount within one year. Thus, it is recorded as a current liability.

Accounting theory is based on the concept of matching-off the maturities of assets and liabilities. This principal is used in the

balance sheets by matching-off current assets against current liabilities and long-term assets against long-term liabilities. A

violation of this norm could lead to repayment problems for the company.

This is because the revenues generated by the assets are used for the repayment of liabilities. A small amount of matching assets

means that the company may not be able to generate enough funds in time to repay the liabilities. Investors like to test companies

on the application of this concept in the short term.

This is done by calculating the difference between current assets and current liabilities. The resulting amount is known as working

capital. Normally, a moderately positive value of working capital (i.e. a surplus of current assets over current liabilities) is

considered healthy. A very high value means that the company has borrowed long term funds and over-blocked them in working

capital. A negative value of working capital means that the company has too much short term borrowings and doesn't have enough

current resources to repay them.

CAPITAL STRUCTURE DECISION

Both debt and equity come with their own benefits and limitations. A company must weigh these against each other to decide their

optimum proportion in its capital. The relative proportions of debt and equity financing used by a company is known as its capital

structure.

Debt capital is raised in the form of loans. The suppliers of this capital are therefore, not a part of the company and have no rights

of ownership. Their interest is limited to recovering their money. However, interest payments (technically known a cost of debt) on

loans are fixed.

This works as both an advantage and a disadvantage. On the one hand, companies have to pay this when the time comes,

irrespective of their income for the period. On the other hand, an increase in income doesn’t lead to an increase in interest-related

expectations of lenders. They know that this is all they are entitled to, irrespective of the revenue for the period.

Equity holders are co-owners of the company and have a role in taking key decisions of the company. They can also respond to

unpopular decisions of the management by influencing share prices. This makes them a force to contend with. When a company

raises money by selling more equity, it dilutes the promoters’ control further and makes shareholders stronger. No such dilution is

required for raising fresh debt.

On the other hand, the cost of equity is the dividend that companies pay shareholders. Companies can change the dividend in less

profitable periods or in times when cash is required. They can also choose to not pay the dividend for a period at all. This privilege

is not allowed with debt. It is a different matter that shareholders look at dividends as a signal of the health of a company and can

react adversely to its reduction or omission.

Companies balance all these factors and decide on their capital structure. Naturally, they also take advantage of situations such as

a fall in interest rates or a surge in the stock market to change their capital structure if needed.

Calculation of Dividend Payout Ratio through Stock Prices

In the previous section, we discussed how to analyses an annual report. The solitary objective of this exercise is to evaluate the

dividend potential and security of the company. Dividend potential is the ability of a company to pay dividends to its shareholders in

the future. It is directly related to the company’s expected future earnings growth. Dividend security refers to the extent to which

investors can be confident that future dividends will not differ materially from their expectations. Dividend safety is a function of

expenses, particularly interest expenses, which companies have to incur. Higher interest expenses means that only a small

proportion of earnings will be left to distribute among shareholders in future periods.

This will make dividends highly unpredictable, especially during the periods of volatile earnings. Understanding future dividend

patterns is important because dividend expectations directly affect the company’s stock price. In this section, we will see how

expected future dividends are used to value equity shares.

CALCULATING VALUATION THROUGH DIVIDEND DISTRIBUTION (DIVIDEND DISCOUNT MODEL)

Investors receive two kinds of income from investing in a stock:

Income from appreciation in stock price

Dividend income paid by the company

Whether or not investors buy a stock, depends on its expected performance along with these two factors. Why investors should buy

stocks that promise dividends is self-explanatory. Dividends provide relative assurance of future income and the stock price is the

cost of this. Stock prices only appreciate if a company’s earnings are expected to increase in future. This is because, as owtners,

investors expect to receive their share in this earnings growth in cash.

The share is technically known as dividend. Thus, directly or indirectly, investors eventually look at the future dividend potential

when investing in a stock. It logically follows that if the value of a stock is directly based on its expected future dividends, its price

should be equal to the sum of all future dividends. This is a perfectly accurate deduction, except for two things. First, how can one

accurately predict all future dividends? It would require assumptions about income, expenses and dividend payout ratio (i.e. the

proportion of net income that will be distributed as dividend) for all future periods.

Secondly, the time value of money weighs in. Suppose you were to receive a sum of $1000 today. Would you be indifferent

between receiving it today itself and say in five years from now? Probably not. This is because factors such as inflation come into

play and reduce the effective value of the same amount of money received at a later date as compared to today. This is known as

the time value of money. To cope with this, the dividend discount model uses expected future dividends and adjusts them for the

time value of money before adding them up to obtain the fair value of the company’s stock as of today.

CALCULATING FUTURE DIVIDEND :

Expected value of future dividends is estimated using a method called extrapolation. One may simply take historical annual

dividend growth rates and project future dividends on that basis. Alternatively, you may use a much more laborious, but hopefully

more accurate method, whereby you project all the financial statements by extrapolating the values of all of its components, starting

with sales.

Based on this, you arrive at the net income of the company for all future years. You then makes assumptions regarding future

dividend payout ratios and calculates expected dividends based on them. This is called financial modelling. It is done using a

spreadsheet. You may tweak projections based on personal judgments or new developments.

PROVIDING FOR TIME VALUE OF MONEY :

Now we’ll see how to tackle the time value of money. For this, we use the concept of discounting. Let’s say you want to find the

value of $100 invested today in three years from now.

You expect its value to appreciate by 10% each year. Using this growth rate, you will find the future amount by compounding for a

period of three years.

This is done as follows :

Value after three years = 100 x (1+10%) 3 → 100 x (1.1)3

Where, $100 is the amount you have invested today, 10% (i.e. 10/100) is the growth rate and the superscript 3 represents the

number of years. This method is called compounding because the value of money is increasing each year.

When calculating the present value of future dividends, we will have to do the reverse. This is because we will receive this money in

the future and have to find its value as of today.

This is called discounting. Assuming a dividend amount of Rs.5 per share and the same discount rate of 10%, our formula

would be:

Present value of dividend received after 3 years = 5/ (1.1)3

Similarly, for dividend received after 4 years it would be:

5/ (1.1)4

We will have to do this for all future dividends. Then, by adding the present value of all the dividends we can find the value of the

company’s stock as of today. The rate used is for discounting is called the discount rate or the required rate of return. It is also

referred to as the cost of equity of the company. It is calculated using a variety of approaches which use factors like inflation and

the stock’s correlation with the overall market as base figures.

Another problem with this model is that a company is expected to be a going concern. If this is the case, the company will continue

to pay dividends into eternity. How then can you discount all future dividends? To deal with this, one has to assume a terminal

value, i.e. a price at which you will sell the stock at the end of your investment horizon. This is calculated assuming that the

dividend will grow at a constant rate from the terminal year onwards. This is done using the second dividend discount model, called

the constant growth model.

CONSTANT GROWTH MODEL :

This model assumes that the company’s earnings will grow at a constant rate forever and its dividend payout ratio will also remain

constant. The result of these assumptions is that the dividend will continue to grow at a constant rate. In such a case, each period’s

dividend need not be discounted separately.

A single formula can be used to calculate the value of the stock:

Fair value of the stock = D (1+g)/r-g

Here, D is the present period’s dividend, g is the constant growth rate of dividend and r is the required rate of return or the cost of

equity. This model was given by Myron J. Gordon and is therefore called the Gordon Growth Model. It is based on the assumption

that the cost of equity for the company is greater than the growth rate of dividend, I.e. r>g. If this assumption is violated, the

denominator will be zero or negative and no meaningful value for the share can be obtained.

The Gordon model is used independently for companies that have been in operation for many years, have a stable market share

and can therefore be expected to grow at a stable rate in the future. For companies whose dividends are expected to be

inconsistent for some length of time, it can be used in conjunction with the model described earlier. In such a scenario, each

dividend is discounted individually up to the terminal year and then the Gordon model is used to calculate the terminal value.

Let’s look at an example.

Let’s say a company is expected to pay a dividend of $4, $ 6 and $ 8 over the next three years. From the fourth year onwards, its

dividend is expected to increase at 8% per annum. Cost of equity or required rate of return for the company is 12% per annum. To

value the stock, we will first calculate the present value of the dividends by discounting them at the cost of equity for the number of

years after which they will be received.

Thus:

Present value of dividends = 4/ (1.12) + 6/ (1.12)2 + 8/ (1.12)3 =Rs.14.05

Next, we will calculate the terminal value using the Gordon Model. For this, we will use the terminal year dividend of Rs.8 and the

dividend growth rate of 8%.

Thus:

Terminal value = 8(1.08)/ (0.12 - 0.08) = Rs.216

The denominator in the above equation is the difference between the cost of equity and the dividend growth rate. Since we will

receive this terminal value at the end of the third year, it too will have to be discounted using the same discount rate.

Thus:

Present value of the terminal value = 216/ (1.12)3 = Rs.153.74

The sum of the two present values calculated above is the fair value of the share.

Thus:

Fair value of the stock = 14.05 + 153.74 = Rs.167.79

As an investor you must only by the stock if its market value is below this. Else, you may leave it alone.

The life cycle of a company broadly consist of four stages: growth, maturity, stagnation and decline. The growth rates for all three

stages are different. The terminal phase is sometimes called the mature phase. Post this phase, the growth rate is believed to fall

and remain constant. In the above example, we have predicted the dividend amount up to the mature phase. We could also use a

specific growth rate for this phase and then a different one from the maturity phase onwards.

The Gordon model can only be used from the mature phase onwards. Investors sometimes also like to use a multi-stage model

with many different growth rates (instead of just two) for companies with multiple phases of their life remaining. The assumed

dividend growth rate in each of these stages is different.

A recap of the steps involved in the dividend discount model is given below.

WHAT IS THE DISCOUNTED CASH FLOW MODEL

Recall that in one of the previous sections, we discussed how dividend is only one part of the net cash income (free cash flows) of a

company. The other part is retained by the company for later use. The combination of these two is called FCFE and represents the

true dividend paying potential of the company. This may suggest that equity valuation based exclusively on dividend discounting is

incomplete. The part retained by the company should also be discounted because it too belongs to shareholders and influences

share prices. The logic behind not using it is that this part will presumably be used by the company later to invest in more fixed

assets and new projects. This will lead to an increase in its future income and thereby future dividends. As such, it will anyway

enter the calculations later on as dividends. Accommodating it now will lead to double counting.

Further, the decision regarding the use of retained earnings is reserved with the management and large shareholders. Smaller

retail shareholders have little influence on them. They can only estimate the impact of these on future dividends and decide

whether or not to buy the share. The discounted cash flow model is therefore only used by investors who have the ability to acquire

a large stake in the company. This is particularly true of investors who are looking to acquire the company outright. For retail

investors like you, the free cash flow approach is useful when the company doesn’t pay dividends or its dividends are far below its

FCFE. In such situations, dividends don’t truly reflect the company’s dividend paying potential.

Both the models that are used for dividend discounting are also used for cash flow discounting. The only difference is that the value

discounted is FCFE and not dividend. Also, the expected growth rate (g) is for the FCFE and not dividend. The cash flow

concept used FCFE is and not FCFF because FCFE represents the free cash flows available to pay equity holders. FCFE is

available first to the lenders and then to equity holders. FCFF is therefore used when we want to find the value of the entire firm

(i.e. lenders + shareholders) and not merely shareholders. To find the value of equity shares from this, we have to subtract the

current value (and not present value) of the outstanding debt of the company. Also, FCFF is discounted using the weighted average

cost of overall capital (i.e. debt + equity) and not purely the cost of equity.

Income Statement & its Major Components

All you need to know about income statements Income statement is the first of the three major financial statements presented by companies in their annual reports. In this section,

we will understand income statements in great detail:

ALL YOU NEED TO KNOW ABOUT INCOME STATEMENTS

The income statement, or the statement of profit and loss, is a statement of the incomes and expenses of a company during a

period. It records all these in a defined order, starting with sales revenue and eventually arriving at the net income/profit for the

period. This is the portion of sales that is left behind after all other incomes for the period have been added to it and all the

expanses subtracted from it.

PRO FORMA INCOME STATEMENT

Accounting standards prescribe a specific structure for income statements to promote comparability. All income statements

invariably start with the sales revenue for the period and end up with net income after adding some other incomes and subtracting a

host of expenses from sales. The following is the pro forma structure of the income statement.

Structure of the Income Statement Accounting standards grant companies some freedom regarding the presentation of their income statements. In most cases,

companies conform to the format presented here. However, sometimes, they like to use their own conventions. This may lead to

slight differences in the presentation of certain items. However, the net effect of all these on operating income, net income and EPS

is always the same.We will discuss each of the components of income statements in detail in the rest of this section.

MAJOR COMPONENTS OF THE INCOME STATEMENT

Sales revenue: The sales revenue of a company is the product of the number of units of its output sold by it during the period

and their sales price per unit. In case of routine goods, there is an inverse relationship between price and quantity produced. As one increases, the other falls. Companies therefore have to juggle between the two to achieve the optimum combination that maximizes revenue.

Cost of goods sold (COGS): This is the first figure to be subtracted from sales (after subtracting sales returns and excise

duty) in income statements. COGS is the amount that a company spends on the production/purchase of the goods that it sells during a period. The figure we get upon the subtraction of COGS from sales is called gross profit. Naturally, companies like to keep COGS to a minimum to boost their gross profit. This can be achieved by maintaining the delicate balance between input costs and output quality. We will discuss COGS at length in the next section.

Operating incomes and expenses: The next category of incomes and expenses found in the incomes statement is operating

incomes and expenses. This includes all the incomes and expenses that occur in the routine course of a company’s operations. Some common examples are: depreciation, amortization, rent and wages and salaries. They are all related to the company’s ‘core business’. Upon adjusting gross profit for these, we arrive at operating profit or earnings before interest and taxes (EBIT). Some companies like to combine operating incomes with sales and call it ‘total revenue from operations’. They then subtract all the operating expenses (including COGS) from it and arrive at the same figure of EBIT. This is just an accounting norm.

They being core to its operations, companies have the hardest time reducing operating expenses. Any indiscriminate reduction

in these could lead to serious consequences for the quality, quantity and price of its products. Its adverse effect on sales is not

hard to imagine. The quality of management of a company is judged on the basis of its ability to reduce operating costs,

without affecting a company’s operations. Operating costs normally go down as a company progresses along the experience

curve and increases its scale of operations, resulting in most of these costs being shared by a larger level of output. The latter

is referred to as economies of scale.

Depreciation and amortization: Imagine you just bought a new car. As time passes, you’ll be able to sell it for an increasingly

smaller sum of money in the market. At the end of say ten years, you will receive next to nothing for it. The fall in the value of the car with each passing year is called depreciation. All tangible, long-lived assets of a company, with the exception of land,

too are depreciated annually. Depreciation can be calculated using a number of methods. These include: the straight-line method- under which an equal amount is depreciated each year; the accelerated method, under which higher depreciation is charged in the initial years and it keeps tapering off thereon; and the units of production method, under which annual depreciation is charged proportionately to the units of output produced in that year. In all cases, depreciation is recorded as an expense on the income statement. Depreciation charged for intangible, long-lived assets, such as patents and copyrights, is called amortization. It is calculation and treatment in the same way as depreciation

Non-operating incomes and expenses: On deducting depreciation, amortization, interest on the year’s outstanding loan

amount and taxes from EBITDA (earnings before interest, tax, depreciation and amortization), we arrive at profit after tax (PAT). The next category of deductions is called non-operating incomes and expenses. Non-operating items include all the incomes and expenses that are not part of the core business of the company. It is generally not a category that is explicitly mentioned on income statements. However, you may find items like profit from the sale of an old building or a non-core business, a one-time tax benefit or any other unusual incomes and expenses that are not related to the main business of the company, on the income statement. All these are non-operating items. Since they are recorded after income tax has been deducted, their values reported are net of tax. Some companies like to mention non-operating items before the deduction of income tax. In that case, their values are pre-tax and are taxed together with EBT to arrive at PAT.

The trouble with non-operating items is their unpredictability. Since they aren’t intrinsic to a company’s business, it is hard to

say when they will occur and what their value will be. For this reason, investors usually eliminate them for the assessment of

income.

Net income: Net income is the figure we refer to when we talk about the profitability of a business in routine conversation. It is

the residual figure achieved after the summation of all the incomes and deduction of all the expenses from the period’s sales. Investors are interested in this number because it forms the basis for the payment of dividends and retention for future use in the business. In either case, it is used for the benefit of shareholders. Dividend payments are directly credited to shareholders. Retention and future reinvestment leads to more income for the company in the future and an increase in the price of its shares. Companies may also use net income to buy back some of its shares from shareholders. This is another way of repaying them for their faith in the company, just like dividends. This is called share repurchase.

Other items: From time to time, you may also encounter some other items, such as revaluation gain/ loss, impairment

gain/loss and minority interest on income statements. These may fall under operating items or may just be standalone figures. They are slightly more complex to understand and generally do not represent a large amount of money. We will therefore exclude them from our assessment.

UNDERSTANDING INVENTORIES, COGS

COGS is the expense incurred by a company on the production of the goods it sold during a year. It is the first major deduction

from sales revenue. Expenses like cost of purchase (including taxes) and transportation of raw materials and their conversion into

the final product are all included in COGS.

COGS is closely related to inventories. A company produces its output throughout the year. Some of it is sold and the rest is left

behind. The production cost of the units that are sold is reported as COGS on the income statement, while the rest is recorded as

inventory balance on the balance sheet. The problem arises in deciding which units to count as a part of COGS and which as

inventory. This is because the price of inputs changes throughout the year. This results in a difference in the cost of production of

different units. The allocation of output to goods sold and inventory therefore has a bearing on the company’s profits.

Four methods are commonly used for inventory valuation:

INVENTORY VALUATION METHODS

First-in, first-out (FIFO): Under this method, the units produced first are also considered to have been sold first. As a result,

COGS is based on the production cost of older units of output, while inventory balance is based on the production cost of the more recent units of output.

Last-in, first-out (LIFO): This method assumes that the recently produced units of outputs were sold first and the older ones

make up the inventory. LIFO is allowed only under GAAP and not under IFRS.

Weighted average cost: Companies that use this method calculate the total cost incurred on the production of goods

throughout the year and allocate it to all the units produced. This results in the same cost for each unit, irrespective of whether it is a part of inventory or sales.

Specific identification: Specific identification can only be used when the specific cost of production of each unit can be

calculated separately. In this case, cost of goods sold is the sum of the actual cost of production of each individual unit of output sold. Similarly, the inventory balance is the sum of the actual cost of production of each individual unit of output that remained unsold during the year.

Each method has its own impact on the profits of the company. Assuming that prices of inputs and production costs increase with

time due to inflation, LIFO results in the highest COGS and smallest profits. In contrast, FIFO results in the lowest COGS and

highest profits. This is because when prices increase, the cost of production of the most recent goods will be the highest and the

cost of production of the oldest goods will be the lowest. Weighted average cost method is not effected by inflation at all because

the same production cost is allocated to each unit of output.

ALL YOU NEED TO KNOW ABOUT EBITDA

THE RELATION BETWEEN NET INCOME AND EBITDA

We discussed the calculation of EBITDA earlier. It is what remains after subtracting all the operating expenses from sales. For this

reason, it is also sometimes referred to as operating income. However, technically, depreciation and amortization too have to be

subtracted from EBITDA to arrive at operating income (i.e. EBIT). EBITDA is a measure of the operating efficiency of a company. It

measures the amount of profit a company is able to make after incurring all the necessary expenses for the production and

distribution of its goods and services. Non-operating expenses are not a part of the calculation of EBITDA. More efficient a

company’s operations, lower will its operating expenses be. Consequently, for the same sales revenue, the company with the

lowest operating expenses will have the highest EBITDA.

Equity analysts sometimes prefer EBITDA over net income as a measure of profitability. This is because to arrive at net income

from EBITDA, a number of other incomes and expenses have to be added and subtracted. These incomes and expenses are not a

part of a company’s core operations. They occur as a consequence of other factors like the capital structure of a company, its fixed

assets portfolio and the way in which it deploys its surplus funds. Net income therefore, presents a distorted picture of a company’s

efficiency. EBITDA dispels these distortions by removing the contaminants of profitability, so to speak. It presents a purer picture of

operational efficiency and management quality. There are three items that separate EBITDA from net income:

Depreciation: Depreciation is charged annually on fixed assets. More the fixed assets owned by a company and higher their

value, higher will the amount of depreciation be. Depreciation expense for a given period also depends on the method of calculating depreciation that is used by a company. The difference in depreciation amounts caused by these factors is reflected in net income. When comparing companies from different sectors, depreciation amounts also differ because of the fixed asset requirement of each sector. For example, financial services companies generally require a much smaller investment in fixed assets compared to oil and gas producers. As a result, their depreciation expense is much lower than the later. This leads to a higher net income, all else held constant.

Non-operating incomes and expenses: Non-operating items do not form the core of a business and are not always

expected to recur. Thus, companies that have big net incomes on account of high revenues or low expenses of this nature aren’t necessarily more profitable in the long run. To eliminate the impact of non-operating items on profitability assessment, it is best to make comparisons on the basis of EBITDA.

Interest expenses: As we will see in the section on balance sheet analysis, capital, i.e. the money required for running a

business, is obtained from two principal sources- debt (including bonds) and owners’ equity. Interest expenses will be higher for companies that resort to debt to a larger extent compared to other companies. This doesn’t always mean that these companies are bad. Debt, if raised in manageable quantities, can, in fact, increase the return to shareholders. This is because more debt capital means that the company will need fewer shareholders. Each of them will, therefore, get a larger share of the company’s earnings. However, in absolute terms, higher the interest expense, lower is the net income of a company. To remove the impact of interest cost, it is best to use EBITDA instead of net income.

OTHER CONCEPTS OF PROFIT

Apart from net income and EBITDA, investors use two other concepts of profitability for the purpose of profitability analysis- EBIT

and EBT. However, just like net income these are also not completely free of contaminants. EBIT is calculated by subtracting

depreciation and amortization from EBITDA. As such, it is not free from the biases imparted by the deduction of depreciation. EBT

is also contaminated by differences in interest expenses of two companies in addition to depreciation. EBITDA is therefore

preferred to both these. It may be noted however, that nothing mentioned in this conversation should lead you to discount the

importance of profitability measures other than EBITDA. Net income provides vital information about the performance of a

company. It is directly related to your dividends, as we will discover in the next segment. Also, concepts like depreciation reveal

important information about the quality and age of a company’s assets. Sometimes, certain non-operating items reveal information

about a company’s strategic intent. Some categories of non-operating items may recur in the case of specific companies. For

example, companies that are going through a consolidation process may frequently sell strategically less important assets and

business verticals. The gains/losses from the sale of these are accounted for as non-operating items. They reflect the strategic

intent of the company.

ACCOUNTING FOR YOUR DIVIDENDS: UNDERSTANDING EPS, DILUTED EPS

If you were told that a company whose 1000 stocks you own has earned a net income of $5 billion for a year, you wouldn’t learn

much about its effect on your wealth. What if you were also told that the company currently has 1 billion shares outstanding? You

would then be able to say that the company’s net income per share is $ 5 (5 billion/ 1 billion). Thus, you can expect your wealth to

go up by $5000 (5x1000 shares) if it pays all of it as dividend. Similarly, if you were expecting a dividend of say $3 per share, you

can consider it to be pretty safe. This amount of $5 is called a company’s earnings per share or EPS. EPS is calculated by dividing

net income by the number of shares of a company that are currently outstanding. It tells one exactly how much money per share a

company has made and what amount one could expect as dividend. You can then comment on whether your dividend expectations

can be met or not.

You will normally find two kinds of EPS in an annual report- basic and diluted. What we just calculated is basic EPS. Sometimes

companies issue complex investment products such as warrants and convertibles. These allow their buyer to convert them into

shares of the company at a definite point in the future. Companies also provide their employees the option of receiving a fixed

quantity of its shares as compensation in the future, at a time of their choice. This is called employee stock options (ESOPs). The

combined effect of the exercise of these privileges is an increase in the number of shares of the company. This increase will lead to

a decrease in the company’s EPS. The EPS calculated after including these new shares in the calculation is called diluted EPS.

Company Annual Reports The entire process of equity analysis boils down to the annual report. The annual report is released by every listed company at the

end of its financial year. It talks about the company’s performance during the period and its prospects for the future. Most of the

data for equity analysis are taken from the annual report. In this section, we will look at the parts of the annual report that are most

relevant to you and explain what to make of the information therein.

COMPANY ANNUAL REPORTS: WHAT TO READ

Annual reports are big documents. They generally run into over a hundred pages. Not all the information they contain is relevant to

equity investors. Some of the relevant information is rather technical and can only be broken down by seasoned market players.

Here, we have mentioned some of its sections that are of direct interest to you. They are mentioned in the same order as the one

you would find them in in an annual report.

Key Components of the Annual Report Company information: This is normally the first significant section of the annual report. It gives all the vital information about

a company, such as its – objectives, strategic intent, products, market position, management etc. This section should be read with care because it helps us understand what the company has set out to achieve and whether it has the right people and resources to achieve these objectives. It also helps us understand the image a company is trying to create for itself in the market and the kind of customers it wants to cater to. All this is critical for you to ascertain the external factors that could affect a company’s business in the future and develop future expectations based on them. You may also evaluate future activities of the company on the basis of whether or not they are in line with these broad objectives.

Director’s report: The board of directors (BOD) watches over the activities of a company on an ongoing basis on behalf of its

shareholders. Director’s report is a summary of what went on in the company throughout the year, how the company faired in the opinion of the directors and what significant activities investors should lookout for in the future. It starts with a summary of the company’s financial performance during the year and explains why figures look the way they do. It also discusses the major corporate developments that took place during the year and their impact on current and future earnings. Lastly, it gives a peep into the future by giving an account of the management’s plans and how they might auger for the company. A similar assessment is presented in the ‘management discussion and analysis (MD&A)’ section of the annual report; however, it is authored by the Managing Director. Since the board is supposed to be closer to the shareholders and fairly detached from the management, shareholders have more faith in the director’s report.

Corporate governance report: This section talks about the internal governance mechanism of the company. Since the board

is the principal source of internal governance, most of the information about the board and its members can be found here. In most annual reports, a list of the board members is given right at the outset. This must be used to verify their independence. Board members must not be related to the management in any way – members, close relatives, friends, suppliers, close customers etc. The board will naturally include the representatives of the largest shareholders, promoters and some members of the management. However, their percentage must be very small. Other things that you must ascertain about the board members is their qualification, experience, compensation, stake in the company, membership of boards of other companies and commitment to the company, as evidenced by their presence in board meetings. All this can be found in the corporate governance section of the annual report. In general, board members who have a stake in the company and are members of only a couple of other boards at best, will be able to devote themselves more to the company’s shareholders. The corporate governance section also gives an account of the activities of the board during the year. The board sets up a number of committees, such as the compensation, audit and finance committees. The corporate governance report contains information about the structure, membership and accomplishments of these committees. From this, one can evaluate the efficiency and transparency of the board.

Auditor’s report:To ensure that all financial statements and notes to them are reported accurately and honestly in the annual

report, security market regulators require them to be reviewed by a qualified external auditor. The report of the audit has to be presented before the financial statements in the annual report. It contains a brief note on the scope of the audit, the auditor’s views on the reported financial figures and his major points of concern, if any. Companies are also required to have in place a mechanism of internal control and audit to ensure the adoption of ethical business practices and honest financial reporting. External auditors assume that these mechanisms are working efficiently, without necessarily scrutinize them. Investors should go through the auditor’s report to ensure that everything mentioned in the financial statements is accurate and reliable, to the best knowledge of the company. They must ensure that the auditors are independent, i.e. not partial to the management in any way. Auditor impartiality can be questioned if the audit firm is in anyway related to the management—friends and family, customers, business partners etc. over the years there have been many instances of companies going bust subsequent to auditors not being able to present an entirely satisfactory view of their financials. It must be noted though, that auditors can only do their job based on the information provided to them by the management.

Financial statements and notes: The three principal financial statements—the income statement, balance sheet and cash

flow statement are presented in the annual report. They are presented on standalone and consolidated basis, i.e. exclusively for the company and for the company, including its subsidiaries. We have discussed financial statement analysis at length in

previous sections. Notes to accounts are presented after the financial statements to elaborate on their contents. Changes in the company’s accounting practices, such as the method for calculating depreciation and inventory, too are mentioned in the notes. A figure that appears very impressive on a financial statement may completely lose its charm upon looking at the notes to accounts. For example, a company may have reported very high sales on the income statement. However, upon looking at the notes, it may be discovered that most of these are credit sales. This is an unhealthy proposition. This is why it is important to go through the notes.

Shareholding pattern: The shareholding pattern is mentioned as a note to the equity section of the balance sheet. It contains

a list of all shareholders who hold more than 5% stake in the company, along with their exact percentage holding. It is important for investors to know this because larger shareholders have a greater ability to influence the company’s important decisions. They can also put their own representatives on the board and influence its working. This can be injurious to smaller shareholders, particularly if the promoters’ stake is also relatively small. A company comes into existence because of the promoters’ vision. It is therefore ideal for them to continue steering it forward. Their holding must always be the highest. A smaller share will strip them off their freedom. Another category of investors that can be menacing is institutional investors. Corporate strategies are formed with long term objectives in mind. Financial institutions have a shorter term perspective. They want to make money fairly quickly and exit. Consequently, they may block decisions that could prove beneficial in the long run if they affect short term profitability. Also, if they exit abruptly, the market price of the company’s stock can take a beating.

Historical comparison: Annual reports contain a summary of the company’s performance over the past five to ten years. This

may be found at the beginning or at the end of the report. It is important to examine it because it tells us about the progress of the company over the concerned period. You may compare trends of sales and profits, fixed asset growth, major sources of income and expenses, cash position etc. over the period and spot areas of improvement and deterioration. Sometimes past trends also indicate a shift in the company’s strategy. These must be identified.

WHAT IS MANAGEMENT DISCUSSION AND ANALYSIS

Finally, we will look at the management discussion and analysis or MD&A section of the annual report. This section, along with

financial statements, is considered by some to be the most important section of the annual report. It is written by the chairman and

managing directors of the company and talks about the company’s performance during the period and guidance for the future. It

generally consists of the following sections:

COMPONENTS OF THE MANAGEMENT DISCUSSION & ANALYSIS SECTION

Review of the previous year: The MD&A section begins with a brief description of the company’s performance during the

year. It predominantly talks about financial highlights, such as the sales revenue for the year, EBITDA and net profit margins, new customers acquired etc. In case the company has many verticals or subsidiaries, the performance of each of them is also discussed. The performance is compared with the previous year and key reasons for the change are highlighted.

Business environment: The discussion then moves to the environmental factors that dictated the company’s performance

during the period. It starts with the state of the overall economy in which the company operates. This includes the inflation rate, demand patterns, input costs, exchange rates, economic growth rate etc. It then gives an account of the changes in government policy, geo-political factors and industry-specific factors that influenced the company’s working.

Keys to success:In this segment, the management talks about the pillars that led to the company’s success, given the state

of its environment. These may include strategic changes made by the company, new control mechanisms introduced, diversification in products, acquisition of new categories of customers, moving into new geographies and operational changes adopted.

New initiatives: A company may have taken new initiatives, such as starting a new product line, forming key alliances,

investing in new assets, forming new collaborations etc. These are discussed in this section. It states when these initiatives are

expected to be completed, how they impacted the current year’s performance (if complete); and how they may impact future performance (if not yet complete).

Future plans, challenges and opportunities: In this section, the management discusses what the future holds for the

company. It discusses the new strategy the company is going to adopt, the new assets it’s going to invest in, new markets and verticals it may enter, strategies to cut costs, new hiring plans, new capability development etc. The section also contains information on the future challenges and opportunities that the management is able to see and how it intends to deal with them. All this is critical because it directly affects future earnings and consequently the stock price.

Understanding Ratio Analysis with Various Financial Ratios In the previous section, we looked at equity valuation using present value models. Another approach to equity valuation is the

relative value approach. Under this approach, investors decide whether or not to buy a company’s stock by comparing it with stocks

of other companies on the basis of certain financial ratios. In this section we will explore this approach.

VALUATIONS THROUGH FINANCIAL RATIOS: INTRODUCTION

If you wanted to buy something and had two differently priced alternatives to choose from, will you simply go ahead and pick the

cheaper one? You would probably like to compare their prices vis-à-vis their benefits before selecting one. You would then pick the

one that provides the greatest value for the given price. A similar cost-benefit analysis is performed when shopping for stocks.

Investors like to know what benefits they will receive for the price they are paying for them. Fortunately, the benefits of owning

stocks are quantifiable, unlike the features of other products you might buy. These benefits are in the form of a share in the future

income, cash flows or dividends of the company; as well as in the form of a share in its assets or book value. To calculate the cost-

benefit trade-off, the price of the stock is divided by these values. The ratios thus calculated are called price multiples. These

multiples are then compared across similar companies to discover which of them offers the greatest value. Since this approach is

based on a comparison between different companies, it is called the relative value approach. The idea here is that in an efficient

market, share prices reflect company fundamentals perfectly. If there is inconsistency between the two, investors will spot them

quickly and prices will soon appreciate to reflect what fundamentals warrant.

WHAT ARE PE, PB RATIOS

Traditionally, many price multiples are used for stock-picking. They include: price-to-sales (PS), price-to-cash flows (PCF) and

price-to-dividends. However, the ones used the most are price-to-earnings (PE) and price-to-book value (PB). Let’s look at these

individually.

Price-to-earnings (PE): The PE ratio is calculated by dividing the market price per share of a company with its earnings per

share (EPS). EPS is the proportion of net income that can be theoretically allocated equally to each individual share. It is calculated by dividing net income by the number of shares outstanding. As such, EPS is essentially net income per share. It may be historical or forward, based on whether it is calculated using previous period’s earnings or the next one’s. Since current prices are a function of expected future earnings, investors prefer calculating forward PEs. In case a company’s forward earnings are unpredictable for some reason, historical PEs are used.

How to Calculate PE Ratio Forward PE calculates the price an investor effectively has to pay for each rupee of future earnings of the company. Net

income belongs to shareholders of the company, whether it pays it out as dividend or retains and reinvests it in the future,

thereby leading to an increase in future dividends. This is why investors want to know exactly how much they are paying for

each unit of earnings. Smaller the price, the better it is for investors.

Price-to-book value (PB): One limitation of price multiples based on flow variables, such as net income and cash flows, is

that they are volatile. It is possible for these variables to be very high in one period and negative in the next. A volatile or negative denominator doesn’t make a meaningful multiple. To cope with this, investors sometimes use balance sheet figures as they are more stable and predictable. The figure used most commonly is the book value. As discussed in the section on the balance sheet, book value is the total value of the company’s equity. It includes the face value of its shares, retained earnings, certain reserves and comprehensive incomes that escape the income statement and go directly to the balance sheet. As in the case of EPS, book value too is converted into a per share form by dividing it by the number of outstanding shares. The current share price is then divided by this value to calculate PB. As with PE and all other price multiples, a low value for PB is considered better because it means that the investor is required to pay less per unit book value.

The trouble with using multiples is that a low price multiple doesn’t always indicate a good investment opportunity. Sometimes, it is

a true reflection of poor company fundamentals. Similarly, a high multiple is also sometimes justified. For instance, if a company is

investing in a new facility or undertaking another venture that will lead to a major boost in future earnings, a high PE may be

warranted. Similarly, a very low PE may also be justified by certain factors. This calls for further investigation. In the following

segment, we will discuss certain ratios that are used for this investigation.

UNDERSTANDING FINANCIAL RATIOS: PROFITABILITY, LIQUIDITY, EFFICIENCY, RISK RATIOS

Equity holders are principally concerned about the recovery of their investment, along with the dividend due on it. To verify the

safety of their investments and ascertain its growth potential, they seek answers to four questions:

Is the business making enough profits to meet its obligations towards shareholders?

Does the business have enough cash readily available to meet its short term requirements?

Is the business conducting its operations in the most optimum way, so as to maximize profits at the lowest possible cost?

Is the business left with enough funds after meeting its necessary expenses to cover its capital charges?

These questions are answered by calculating four categories of ratios—profitability, liquidity, efficiency and risk (coverage) ratios.

Companies that perform well along these parameters generally have justifiably high price multiples.

TYPES OF FINANCIAL RATIOS Profitability ratios: These ratios seek to measure the profitability of a company based on measures like gross profit, operating

profit, net profit and return on equity. Higher the profitability ratios of a company, the better it is. Commonly used profitability ratios include: o Gross profit margin = Gross profit for the period/ sales revenue for the period

o Operating profit margin = Operating profit for the period/ sales revenue for the period

o Net profit margin = Net profit for the period/ sales revenue for the period

o Return on equity (ROE) = Net profit for the period/ average book value of equity*

Liquidity ratios:These ratios measure whether the company has enough short-term assets to finance its short term liabilities.

Recall the discussion on working capital in the section on the income statement. These ratios seek to measure whether the company’s working capital is positive. A value in excess of one is considered to be good for these ratios. However, a very high value is also not healthy as it indicates overinvestment in working capital. Some popular liquidity ratios are: o Current ratio = current assets/ current liabilities

o Quick ratio = (cash + short term investments + accounts receivable)/ current liabilities

o Cash ratio = (cash + short term investments)/ current liabilities

Efficiency (activity) ratios:These ratios comment upon the efficiency of a company’s operations. Efficiency is estimated by how

quickly a company can convert its inventory into sales and use this money to repay its suppliers. This process is called the cash conversion cycle. More quickly a company is able to complete this cycle, more will be the number of cycles it will complete in a year and higher will be its revenue. To ascertain this, efficiency at every stage of the cycle – from inventory to sales, from sales to accounts receivables and from accounts receivable to payment to suppliers is measured.

As mentioned above, efficiency is measured in two ways—the length of each cycle and the number of cycles completed in the year.

The ratios that estimate the first are:

o Inventory turnover = COGS/ average inventory*.

o Receivables turnover = sales revenue/ average accounts receivable*.

o Payables turnover: (COGS +opening inventory balance – closing inventory balance)/ average accounts payable*

The other category of efficiency ratios calculate the number of days it takes for each cycle to get completed. They include:

o Days of inventory on hand (DOH) = 365/ inventory turnover ratio.

o Days of sales outstanding (DSO) = 365/ receivables turnover ratio.

o Number of days of payables (DOP): 365/ payables turnover ratio.

Notice that each of the above ratios evaluates efficiency at one of the stages talked about earlier. Finally, we need to measure the

total number of days taken in the completion of the entire cycle. This is done by adding the DOH and DSO and subtracting DOP

from it:

o Cash conversion cycle: DOH + DSO - DOP

*All averages in the above mentioned formulas are calculated by dividing the sum of opening and closing values of the

asset/liability by 2. For example, average book value of equity is the sum of book value at the beginning and the end of the year,

divided by 2.

Risk ratios: These ratios assess the proportion of debt in the company’s capital structure and its ability to meet its periodic debt

obligations. It is primarily of interest to lenders but also interest shareholders. For shareholders, high debt represents an element of risk. This is because lenders always get paid before shareholders. If the proportion of debt is too high, there are chances that whatever remains of the company’s income after meeting all other expenses will go to lenders and shareholders will get nothing in the way of dividends. Also, if the company has to wind-up, debtors will get all of what remains and nothing will go to the shareholders. Important risk ratios include: o Debt to total capital = total debt/ (total equity + total debt)

o Debt to equity = total debt/ total equity

o Interest coverage ratio = EBIT/ interest expense for the period

o Fixed cost coverage ratio = (EBIT + periodic lease expenses)/(interest + periodic lease expenses)

WHAT ARE THE LIMITATIONS OF FINANCIAL RATIOS

Thus far, we have only discussed the blessings of ratio analysis. A word of caution is in order before we move ahead in this section.

Following are some of the limitations of ratio analysis.

Ratio analysis is based on comparison between companies to find out which one is the best. However, no two companies, even within the same industry, are identical. Companies may differ in terms of size, strategy, product types, stage of growth etc. This prevents ratio analysis from being a like to like comparison.

Accounting standards provide companies with a fair amount of freedom to choose among alternative methods for the calculation and reporting of the same values. Using different accounting approaches hinders comparability among companies.

There is no good or bad value for a ratio. It purely depends on the general industry environment and the management’s ability to manage the company’s operations. Thus, ratios alone tell us nothing. They have to be looked at together with other ratios to get the complete picture. Even then, they leave scope for qualitative analysis.

When ratios are calculated using current or previous period data, they are not always indicative of future trends. When expected future data are used, like in the case of forward PE, it may not cover for unexpected future events. This makes the dependability of ratio analysis questionable.

GUIDE TO VALUE INVESTING

Value investing is the style of investing where investors pick stocks that they feel are undervalued or ‘cheap’, relative to the ir peers

or in light of their own future prospects. This approach contrasts with growth investing, where investors are not much concerned

about the price of the stock. They pick stocks that they believe will appreciate because the company will realize exceptional

earnings growth in the future.

Value investing is based on the concept of intrinsic value. Intrinsic value is the price investors, in general, feel the company’s

shares should trade at, given its fundamentals. A value investor invests in a stock when its market price is below the intrinsic value

because he expects the price to appreciate to intrinsic value over time. Intrinsic value is estimated using price multiples. This is

done in two ways:

In the first approach, an investor selects a company and calculates the price multiples for it and a group of its closest competitors. Then, he averages the value of the multiple for its competitors and compares it with the company’s multiple. If the company is trading at a lower multiple than its competitors, it is deemed to be undervalued. He buys the stock and waits for it to appreciate.

In the second approach, the investor calculates the average of the competitors’ multiples, just as in the first case. Then, he uses this multiple to calculate the fair value of the company’s stock. If the market price of the stock is below this, he considers it undervalued and buys it. Let’s look at an example.

Assume that a company is trading at a forward PE multiple of 12 while a group of its competitors are trading at an average multiple

of 15. This means that for every unit of forward earnings of the company, you have to pay $ 12, whereas for its competitors, it is $

15. since the company is cheaper than its competitors, you may buy it.

For the second approach, let’s assume that the company has an estimated forward EPS of $ 20 and is currently priced $ 360 per

share. The competitors’ PE is the same. Now, we can calculate the intrinsic value of the company by multiplying the competitor’s

PE with the company’s EPS. This comes out to $300. Since the market price is above this, you may leave the stock alone.

Instead of using competitors’ multiples, a comparison can also be made with the historical values of the company’s own multiples.

Further, investors generally like to use a host of multiples rather than just the one to calculate intrinsic value.

As mentioned earlier, investors must not rely on numerical values alone. They must employ their logic and evaluate why the

company’s multiples are different from the industry’s. In some cases, on doing so, they may realize that even a higher multiple for

the company is attractive owing to its fundamentals. On other occasions, a much lower price multiple may also not be attractive

enough, as the stock may never appreciate owing to limited potential. Investors who get attracted by low price multiples and invest

in such stocks may never see them appreciate. This is called the value trap.

NOTED of the day :

it’s true that charts are more accurate on doing intraday trading , but the scanners/screeners are founded on fundamentals , technical and

analytical so you can’t just by pass fundamentals .you cannot survive trading if one is missing . Also because big players are focus on

fundamentals so it well reflect on the prices that are being plot in the technical charting. Also the price of a stock it first Offer on Public is based

on fundamentals.

: - ) there will be no price if you do it first on technical. Stock price is born from fundamentals. Technical existed only after few numbers of

transaction on open market...... that's why IPO is based on the research company to evaluate the company before offering.