Fundamental Analysis Summary— Zerodha Varsity

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Ch.1 Introduction to Fundamental Analysis

Over the long term, the stock prices of a fundamentally strong company tend to appreciate, thereby creating wealth for its investors.

Fundamental Analysis is the technique that gives you the conviction to invest for a long term by helping you identify these attributes of wealth creating companies.

Can I be a fundamental analyst?

To become a fundamental analyst you will need few basic skills:

1. Understanding the basic financial statements
2. Understand businesses with respect to the industry in which it operates
3. Basic arithmetic operations such as addition, subtraction, division, and multiplication

TA is not an effective approach to create wealth. Wealth is created only by making intelligent long term investments.

Tools of FA

1. Annual report of the company — All the information that you need for FA is available in the annual report. You can download the annual report from the company’s website for free.
2. Industry related data — You will need industry data to see how the company under consideration is performing with respect to the industry. Basic data is available for free, and is usually published in the industry’s association website.
3. Access to news — Daily News helps you stay updated on latest developments happening both in the industry and the company you are interested in. A good business news paper or services such as Google Alert can help you stay abreast of the latest news.
4. MS Excel — Although not free, MS Excel can be extremely helpful in fundamental calculations.

Ch.2 Mindset of an Investor

All investments made based on fundamental analysis require the investors to stay committed for the long term. The investor has to develop this mindset while he chooses to invest.

Does investing work?

Think about a good business with healthy sales, great margins, innovative products, and an ethical management.

Investment in a good company defined by investable grade attributes will always yield results. However, one has to develop the appetite to digest short term market volatility.

Investible grade attributes

An investible grade company has a few distinguishable characteristics. These characteristics can be classified under two heads namely the ‘Qualitative aspect’ and the ‘Quantitative aspects’.

The process of evaluating a fundamentally strong company includes a study of both these aspects.

The Qualitative aspect mainly involves understanding the non numeric aspects of the business

1. Management’s background — Who are they, their background, experience, education, do they have the merit to run the business, any criminal cases against the promoters etc
2. Business ethics — is the management involved in scams, bribery, unfair business practices
3. Corporate governance — Appointment of directors, organization structure, transparency etc
4. Minority shareholders — How does the management treat minority shareholders, do they consider their interest while taking corporate actions
5. Share transactions — Is the management buying/selling shares of the company through clandestine promoter groups
6. Related party transactions — Is the company tendering financial favors to known entities such as promoter’s relatives, friends, vendors etc at the cost of the shareholders funds?
7. Salaries paid to promoters — Is the management paying themselves a hefty salary, usually a percentage of profits
8. Operator activity in stocks — Does the stock price display unusual price behaviour especially at a time when the promoter is transacting in the shares
9. Shareholders — Who are the significant shareholders in the firm, who are the people with above 1% of the outstanding shares of the company
10. Political affiliation — Is the company or its promoters too close to a political party? Does the business require constant political support?
11. Promoter lifestyle — Are the promoters too flamboyant and loud about their lifestyle? Do they like to display their wealth?

A red flag is raised when any of the factors mentioned above do not fall in the right place. Even if the company has great profit margins, malpractice is not acceptable

Qualitative aspects are not easy to uncover because these are very subtle matters. A diligent investor can easily figure this out by paying attention to annual report, management interviews, news reports etc

The quantitative aspects are matters related to financial numbers. Some of the quantitative aspects are straightforward while some of them are not

1. Profitability and its growth
2. Margins and its growth
3. Earnings and its growth
4. Matters related to expenses
5. Operating efficiency
6. Pricing power
7. Matters related to taxes
8. Dividends payout
9. Cash flow from various activities
10. Debt — both short term and long term
11. Working capital management
12. Asset growth
13. Investments
14. Financial Ratios

Ch.3 How to Read the Annual Report of a Company

Financial Highlights contain the bird’s eye view on how the financials of the company looks for the year gone by.

Management Statement and ‘Management Discussion & Analysis’ are quite important. Management Discussion & Analysis is broad based and generic (global economy, domestic economy, and industry trends.

Management Discussion & Analysis’ the annual report includes a series of other reports such as — Human Resources report, R&D report, Technology report etc.

For example, if I am reading through a manufacturing company annual report, I would be particularly interested in the human resources report to understand if the company has any labor issues.

The Financial Statements

1. The Profit and Loss statement
2. The Balance Sheet and
3. The Cash flow statement

Financial statements come in two forms.

1. Standalone financial statement or simply standalone numbers and
2. Consolidated financial statement or simply consolidated numbers

Standalone Financial statements represent the standalone numbers/ financials of the company itself and do not include the financials of its subsidiaries. However the consolidated numbers includes the companies (i.e.standalone financials) and its subsidiaries financial statements.

Ch.4 Understanding the P&L Statement (Part 1)

You can think about the financial statements from two different angles:

1. From the maker’s perspective
2. From the user’s perspective

A maker prepares the financial statements. He is typically a person with an accounting background. His job involves preparing ledger entries, matching bills and receipts, tallying the inflows versus the outflows, auditing etc.

The user on the other hand just needs to be in a position to understand what the maker has prepared.

There are three main financial statements that a company showcases to represent its performance.

1. The Profit and Loss statement
2. The Balance Sheet
3. The Cash flow statement

The Profit and Loss statement

The Profit and Loss statement shows what has transpired during a time period.

The P&L statement reports information on:

1. The revenue of the company for the given period (yearly or quarterly)
2. The expenses incurred to generate the revenues.
3. Tax and depreciation.
4. The earnings per share number.

Other income includes income that is not related to the main business of the company. It includes interest on bank deposits, dividends, insurance claims, royalty income etc. Usually the other income forms (and it should) a small portion of the total income. A large ‘other income’ usually draws a red flag and it would demand a further investigation.

The Expense Details

Cost of materials consumed: This is invariably the cost of raw material that the company requires to manufacture finished goods.

Finance cost is interest costs and other costs that an entity pays when it borrows funds. The interest is paid to the lenders of the company. The lenders could be banks or private lenders.

A tangible asset is one which has a physical form and provides an economic value to the company. For example a laptop, a printer, a car, plants, machinery, buildings etc.

An intangible asset is something that does not have a physical form but still provides an economic value to the company such as brand value, trademarks, copyrights, patents, franchises, customer lists etc.

The depreciation equivalent for non tangible assets is called amortisation.

Profit before Tax

Profit before Tax = Total Revenues — Total Operating Expenses

Exceptional items/ extraordinary items are expenses occurring at one odd time for the company and the company does not foresee this as a recurring expense

Net Profit After Tax

Current tax is the corporate tax applicable for the given year.

The EPS is one of the most frequently used statistics in financial analysis. The earnings per share (EPS) is a very sacred number which indicates how much the company is earning per face value of the ordinary share

Ch.6 Understanding Balance Sheet Statement

While the P&L statement gives us information pertaining to the profitability of the company, the balance sheet gives us information pertaining to the assets, liabilities, and the shareholders equity.

The balance sheet however is prepared on a flow basis, meaning, it has financial information pertaining to the company right from the time it was incorporated.

An asset is a resource controlled by the company, and is expected to have an economic value in the future. Typical examples of assets include plants, machinery, cash, brands, patents etc.

Liability on the other hand represents the company’s obligation. Liability in simple words is the loan that the company has taken and it is therefore obligated to repay back.

Typical examples of obligation include short term borrowing, long term borrowing, payments due etc.

Everything that a company owns (Assets) has to be purchased either from either the owner’s capital or liabilities.

Owners Capital is the difference between the Assets and Liabilities. It is also called the ‘Shareholders Equity’ or the ‘Net worth’. Representing this in the form of an equation :

Share holders equity = Assets — Liabilities

Shareholders’ funds do not belong to the company as it rightfully belongs to the company’s shareholders’. Hence from the company’s perspective the shareholders’ funds are an obligation payable to shareholders

The Liability Side of Balance Sheet

Within liabilities there are three sub sections — shareholders’ fund, non-current liabilities, and current liabilities.

Reserves are usually money earmarked by the company for specific purposes. Surplus is where all the profits of the company reside.

1. Capital reserves — Usually earmarked for long term projects.
2. Securities premium reserve / account — This is where the premium over and above the face/par value of the shares sits.
3. General reserve — This is where all the accumulated profits of the company which is not yet distributed to the shareholder reside.

Surplus holds the profits made during the year

The first thing a company does is it transfers some money from the surplus to general reserves so that it will come handy for future use.

The total shareholders’ fund is a sum of share capital and reserves & surplus.

Non-Current Liabilities

Non-current liabilities represent the long term obligations, which the company intends to settle/ pay off not within 365 days/ 12 months of the balance sheet date.

Company has no debt, you must also question as to why there is no debt? Is it because the banks are refusing to lend to the company? or is it because the company is not taking initiatives to expand their business operations.

The deferred tax liability is basically a provision for future tax payments. The company foresees a situation where it may have to pay additional taxes in the future; hence they set aside some funds for this purpose.

Deferred tax liability arises due to the treatment of depreciation.

Long term provisions are usually money set aside for employee benefits such as gratuity; leave encashment, provident funds, etc.

Current liabilities (< 365 days)

if you buy a mobile phone on EMI (via a credit card) you obviously plan to repay your credit card company within a few months. This becomes your ‘current liability’. However if you buy an apartment by seeking a 15 year home loan from a housing finance company, it becomes your ‘non-current liability’.

Trade Payable (also called account payable)

These are obligations payable to vendors who supply to the company. The vendors could be raw material suppliers, utility companies providing services, stationary companies etc.

Other current Liabilities’ are obligations associated with the statutory requirements and obligations that are not directly related to the operations of the company.

Short term provisions is quite similar to long term provisions, both of which deals with setting aside funds for employee benefits such as gratuity, leave encashment, provident funds etc.

From the user of a financial statement perspective all you need to know is that these line items (short and long term provisions) deal with the employee and related benefits.

Total Liability = Shareholders’ Funds + Non Current Liabilities + Current Liabilities

The Assets side of Balance Sheet

The Asset side shows us all the assets the company owns (in different forms) right from its inception. Assets in simple terms are the resources held by a company, which help in generating the revenues.

Non-current assets (Fixed Assets)

Non-current assets talks about the assets that the company owns, the economic benefit of which is enjoyed over a long period (beyond 365 days).

Fixed assets are assets (both tangible and intangible) that the company owns which cannot be converted to cash easily or which cannot be liquidated easily. Typical examples of fixed assets are land, plant and machinery, vehicles, building etc. Intangible assets are also considered fixed assets because they benefit companies over a long period of time.

Intangible assets are assets which have an economic value, but do not have a physical nature. This usually includes patents, copyrights, trademarks, designs etc.

When the company acquires an asset it is called the ‘Gross Block’.

Net Block = Gross Block — Accumulated Depreciation

Depreciation should be deducted from the Gross block, after which we can arrive at the ‘Net Block’.

Current assets

Current assets are assets that can be easily converted to cash and the company foresees a situation of consuming these assets within 365 days.

Inventory includes all the finished goods manufactured by the company, raw materials in stock, goods that are manufactured incompletely etc.

Trade Receivables also referred to as ‘Accounts Receivables. This represents the amount of money that the company is expected to receive from its distributors, customers and other related parties.

Short-term loans and advances (within 365 days). It includes various items such as advances to suppliers, loans to customers, loans to employees, advance tax payments (income tax, wealth tax) etc.

Asset = Shareholders’ Funds + Liabilities

Ch.8 The Cash Flow statement

Every company’s financial performance is not so much dependent on the profits earned during a period, but more realistically on liquidity or cash flows.

1. Operational activities (OA):
   Activities that are directly related to the daily core business operations are called operational activities. Typical operating activities include sales, marketing, manufacturing, technology upgrade, resource hiring etc.
2. Investing activities (IA):
   Activities pertaining to investments that the company makes with an intention of reaping benefits at a later stage. Examples include parking money in interest bearing instruments, investing in equity shares, investing in land, property, plant and equipment, intangibles and other non current assets etc.
3. Financing activities (FA):
   Activities pertaining to all financial transactions of the company such as distributing dividends, paying interest to service debt, raising fresh debt, issuing corporate bonds etc.

Examples

1. Display advertisements to attract new customers — OA
2. Hire fitness instructors to help customers with their fitness workout — OA
3. Buy new fitness equipment to replace worn out equipments — OA
4. Seek a short term loan from bankers — FA
5. Issue a certificate of deposit (CD) for raising funds — FA
6. Issue new shares to few known friends to raise fresh capital for expansion (also called preferential allotment) — FA
7. Invest in a startup company working towards innovative fitness regimes — IA
8. Park excess money (if any) in fixed deposit — IA
9. Invest in a building coming up in the neighbourhood for opening a new fitness center sometime in the future — IA
10. Upgrade the sound system for better workout experience- OA

Whenever the liabilities of the company increases the cash balance also increases.
This means if the liabilities decreases, the cash balance also decreases.

Whenever the asset of the company increases, the cash balance decreases.
This means if the assets decreases, the cash balance increases

Cash Flow of the company = Net cash flow from operating activities + Net Cash flow from investing activities + Net cash flow from financing activities.

Note, a company which has a positive cash flow from operating activities is always a sign of financial well being.

Ch.9 The Financial Ratio Analysis

The ratio makes sense only when you compare the ratio with another company of a similar size or when you look into the trend of the financial ratio.

The Financial Ratios

1. Profitability Ratios
2. Leverage Ratios
3. Valuation Ratios
4. Operating Ratios

The Profitability ratios

They help the analyst measure the profitability of the company. The ratios convey how well the company is able to perform in terms of generating profits. Profitability of a company also signals the competitiveness of the management. As the profits are needed for business expansion and to pay dividends to its shareholders a company’s profitability is an important consideration for the shareholders.

The Leverage ratios

Also referred to as solvency ratios/ gearing ratios measures the company’s ability (in the long term) to sustain its day to day operations. Leverage ratios measure the extent to which the company uses the debt to finance growth.

Solvency ratios help us understand the company’s long term sustainability, keeping its obligation in perspective.

The Valuation ratios

They compare the stock price of the company with either the profitability of the company or the overall value of company to get a sense of how cheap or expensive the stock is trading.

The Operating Ratios

Also called the ‘Activity Ratios’ measures the efficiency at which a business can convert its assets (both current and non-current) into revenues. This ratio helps us understand how efficient the management of the company is.

The Profitability Ratios

1. EBITDA Margin:

The Earnings before Interest Tax Depreciation & Amortisation (EBITDA) Margin indicates the efficiency of the management.

EBITDA Margin tells us how profitable (in percentage terms) the company is at an operating level. It always makes sense to compare the EBITDA margin of the company versus its competitor to get a sense of the management’s efficiency in terms of managing their expense.

A financial ratio on its own conveys very little information. To make sense of it, we should either see the trend or compare it with its peers.

2. PAT Margin

PAT Margin = [PAT/Total Revenues]

3. Return on Equity (RoE):

RoE measures the entity’s ability to generate profits from the shareholders investments.

RoE shows the efficiency of the company in terms of generating profits to its shareholders.

Higher the RoE, the better it is for the shareholders. Invest in companies that have a RoE of 18% upwards.

RoE = [Net Profit / Shareholders Equity* 100]

A high RoE is great, but certainly not at the cost of high debt.

ROE as per DuPont model:

A low Net profit margin would indicate higher costs and increased competition.

Asset turnover ratio is an efficiency ratio that indicates how efficiently the company is using its assets to generate revenue. Higher the ratio, it means the company is using its assets more efficiently.

Financial Leverage

For every unit of shareholders equity, how many units of assets does the company have.

Higher the financial leverage along with increased amounts of debt, will indicate the company is highly leveraged and hence the investor should exercise caution.

4. Return on Asset (RoA):

Return on Assets (RoA) evaluates the effectiveness of the entity’s ability to use the assets to create profits.

A well managed entity limits investments in non productive assets. Higher the RoA, the better it is.

5. Return on Capital Employed (ROCE):

The Return on Capital employed indicates the profitability of the company taking into consideration the overall capital it employs.

The Leverage Ratios

1. Interest Coverage Ratio:

The interest coverage ratio helps us understand how much the company is earning relative to the interest burden of the company.

A low interest coverage ratio could mean a higher debt burden and a greater possibility of bankruptcy or default.

2. Debt to Equity Ratio:

A value of 1 on this ratio indicates an equal amount of debt and equity capital. Higher debt to equity (more than 1) indicates higher leverage and hence one needs to be careful. Lower than 1 indicates a relatively bigger equity base with respect to the debt.

3. Debt to Asset Ratio:

This ratio helps us understand the asset financing pattern of the company. It conveys to us how much of the total assets are financed through debt capital. Needless to say, higher the percentage the more concerned the investor would be as it indicates higher leverage and risk.

4. Financial Leverage Ratio

The financial leverage ratio gives us an indication, to what extent the assets are supported by equity.

Operating Ratios

Operating Ratios also called ‘Activity ratios’ or the ‘Management ratios’ indicate the efficiency of the company’s operational activity. To some degree, the operating ratios reveal the management’s efficiency as well.

1. Fixed Assets Turnover

The ratio measures the extent of the revenue generated in comparison to its investment in fixed assets.

Fixed assets include the property, plant and equipment. Higher the ratio, it means the company is effectively and efficiently managing its fixed assets.

2. Working Capital Turnover

Working Capital = Current Assets — Current Liabilities

If the working capital is a positive number, it implies that the company has working capital surplus and can easily manage its day to day operations. However if the working capital is negative, it means the company has a working capital deficit. Usually if the company has a working capital deficit, they seek a working capital loan from their bankers.

The working capital turnover indicates how much revenue the company generates for every unit of working capital. Suppose the ratio is 4, then it indicates that the company generates Rs.4 in revenue for every Rs.1 of working capital… higher the number, better it is.

3. Total Assets Turnover

It indicates the company’s capability to generate revenues with the given amount of assets.

A higher total asset turnover ratio compared to its historical data and competitor data means the company is using its assets well to generate more sales.

4. Inventory Turnover Ratio

If a company is selling popular products, then the goods in the inventory gets cleared rapidly, and the company has to replenish the inventory time and again. This is called the ‘Inventory turnover’.

To get a true sense of how good or bad this number is, one should compare it with its competitor’s numbers.

5. Inventory Number of days

Lesser the number of days, the better it is.

A short inventory number of day’s number implies, the company’s products are fast moving.

6. Accounts Receivable Turnover Ratio

The receivable turnover ratio indicates how many times in a given period the company receives money/cash from its debtors and customers.

Naturally a high number indicates that the company collects cash more frequently.

7. Days Sales Outstanding (DSO) )/ Average Collection Period/ Day Sales in Receivables

The days sales outstanding ratio illustrates the average cash collection period i.e the time lag between billing and collection. This calculation shows the efficiency of the company’s collection department.

Quicker/faster the cash is collected from the creditors, faster the cash can be used for other activities.

The Valuation Ratio

The valuation ratios help us develop a sense on how the stock price is valued by the market participants.

Valuation ratios of a company should be evaluated alongside the company’s competitors.

1. Price to Sales (P/S) Ratio

In many cases, investors may use sales instead of earnings to value their investments. Higher the P/S ratio, higher is the valuation of the firm.

Hence if Company A is trading at a higher P/S, then the valuation maybe justified, simply because every rupee of sales Company A generates, a higher profit is retained.

Whenever you feel a particular company is trading at a higher valuation from the P/S ratio perspective, do remember to check the profit margin for cues.

2. Price to Book Value (P/BV) Ratio

Consider a situation where the company has to close down its business and liquidate all its assets. What is the minimum value the company receives upon liquidation? The answer to this lies in the “Book Value” of the firm.

BV = [Share Capital + Reserves (excluding revaluation reserves) / Total Number of shares]

Clearly the higher the ratio, the more expensive the stock is.

3. Price to Earning (P/E) Ratio

The P/E of a stock is calculated by dividing the current stock price by the Earning Per share (EPS).

EPS measures the profitability of a company on a per share basis.

Higher the EPS, better it is for its shareholders.

The P/E ratio measures the willingness of the market participants to pay for the stock, for every rupee of profit that the company generates. For example if the P/E of a certain firm is 15, then it simply means that for every unit of profit the company earns, the market participants are willing to pay 15 times. Higher the P/E, more expensive is the stock.

1. P/E indicates how expensive or cheap the stock is trading at. Never buy stocks that are trading at high valuations. I personally do not like to buy stocks that are trading beyond 25 or at the most 30 times its earnings, irrespective of the company and the sector it belongs to.
2. The denominator in P/E ratio is the ‘Earnings’, and the earnings can be manipulated
3. Make sure the company is not changing its accounting policy too often — this is one of the ways the company tries to manipulate its earnings.
4. Pay attention to the way depreciation is treated. Provision for lesser depreciation can boost earnings.
5. If the company’s earnings are increasing but not its cash flows and sales, then clearly something is not right.

The Index Valuation

1. One has to be cautious while investing in stocks when the market’s P/E valuations is above 22x.
2. Historically the best time to invest in the markets is when the valuations are around 16x or below.

Ch. 12 The Investment Due Diligence

Taking stock

Investable grade attributes simply define the prerequisites of a company that needs to be validated before making an investment decision.

Each investor has to build his own checklist based on his investment experience. However, one has to ensure that each item on the checklist is qualified based on sound logic.

Generating a stock idea

1. General Observation

Observe what people are buying and selling, see what products are being consumed, keep an eye on the neighborhoods to see what people are talking about.

2. Stock screener

A stock screener is very helpful tool when you want to shortlist a handful of investment ideas from a big basket of stocks. Google finance’s stock screener and screener.in

3. Macro Trends: Keeping a general tab on the macroeconomic trend is a great way of identifying good stocks.

As of today there is a great push for infrastructure projects in India. An obvious beneficiary of this push would be the cement companies operating in India. Hence, I would look through all the cement companies and apply the checklist to identify which amongst all the cement companies are well positioned to leverage this macro trend.

4. Sectoral Trends: One needs to track sectors to identify emerging trends and companies within the sector that can benefit from.

5. Special Situation

6. Circle of Competence: This is a highly recommended technique for a newbie investor. This method requires you to identify stocks within your professional domain.

When you feel a particular stock looks interesting, just add it to your list.

The Moat

After selecting a stock, one has to run the checklist to investigate the stock further. This is called the “Investment due diligence”.

The term simply refers to the company’s competitive advantage (over its competitors). A company with a strong moat, ensures the company’s long term profits are safeguarded.

A company which possesses wider moat characteristics (such as better brand name, pricing power, and better market share) would be more sustainable, and it would be difficult for the company’s rivals to eat away its market share.

The Due Diligence

1. Understanding the business — requires reading the annual reports
2. Application of the checklist and
3. Valuation — to estimate the intrinsic value of the business

Make a list of questions: What business is the company involved in?

Do not go to Google and search, instead look for it in the company’s latest Annual Report or their website.

Lastly, a company could satisfy each and every point mentioned in the checklist above, but if the stock is not trading at the right price in the market, then there is no point buying the stock.

Ch. 13 Equity Research

Equity research process in 3 stages-

1. Understanding the Business
2. Application of the checklist
3. Intrinsic Value estimation (Valuation) to understand the fair price of the stock

Stock Price vs Business Fundamentals

Just analyzing the stock price is great if you have a short term perspective. However for long term investments, understanding the business is essential.

During bear markets, the prices react and not the business fundamentals.

We need to study at least the last 5 year annual report to understand how the company is evolving across business cycles.

If you find red flags (or something not right about the company) while discovering the answers, I would advise you to drop researching the company further irrespective of how attractive the business looks.

Revenue & Pat Growth

1. Year on Year growth: If a company has a flat growth, it is ok. However just make sure you check the competition as well to ensure the growth is flat industry wide.

2. Compounded Annual Growth Rate (CAGR) : The CAGR gives us a sense of how the company is evolving and growing across business cycles. A good, investable grade company is usually the first company to overcome the shifts in business cycles.

Prefer to invest in companies that are growing (Revenue and PAT) over and above 15% on a CAGR basis.

Earnings per Share (EPS)

The EPS and PAT growing at a similar rate indicates that the company is not diluting the earnings by issuing new shares, which is good for the existing shareholders.

Debt level — Balance Sheet check

Growth at the cost of financial leverage is quite dangerous. Also do remember, a large debt on balance sheets means a large finance cost charge.

Inventory Check

1. Raising inventory with raising PAT indicates are signs of a growing company.
2. A stable inventory number of days indicates management’s operational efficiency to some extent.

Sales vs Receivables

A sale backed by receivables is not an encouraging sign.

It signifies credit sales and therefore many questions arise out of it. For instance — are the company sales personal force selling products on credit? Is the company offering attractive (but not sustainable) credit to suppliers to push sales?

Cash flow from Operations

This is in fact one of the most important checks one needs to run before deciding to invest in a company. The company should generate cash flows from operations.

A company which is draining cash from operations raises some sort of red flag.

Ch. 14 DCF Primer

The Stock Price

“It is perfectly fine to buy a mediocre business, as long as you are buying it at a great price.”

Discounted Cash Flow (DCF) method to calculate the intrinsic value of the company.

The future cash flow

How much is the cash flow of the future worth in today’s terms?

The answer to these questions lies in the realms of the “Time value of money”.

Time Value of Money (TMV)

Think of the ‘Time value of money’ as the engine of a car, with the car itself being the “Financial World”.

The concept of time value of money revolves around the fact that, the value of money does not remain the same across time. Meaning, the value of Rs.100 today is not really Rs.100, 2 years from now. Inversely, the value of Rs.100, 2 years from now is not really Rs.100 as of today.

Whenever there is passage of time, there is an element of opportunity. Money has to be accounted (adjusted) for that opportunity.

If we have to evaluate, what would be the value of money that we have today sometime in the future, then we need to move the ‘money today’ through the future. This is called the “Future Value (FV)” of the money.

Likewise, if we have to evaluate the value of money that we are expected to receive in the future in today’s terms, then we have to move the future money back to today’s terms. This is called the “Present Value (PV)” of money”.

This adjustment is called “Compounding” when we have to calculate the future value of money. It is called “Discounting” when we have to calculate the present value of money.

Example 1 — How much is Rs.5000/- in today’s terms (2014) worth five years later assuming an opportunity cost of 8.5%?

Future Value = Amount * (1+ opportunity cost rate) ^ Number of years.

= 5000 *(1 + 8.5%) ^ 5

= 7518.3

Example 2 — How much is Rs.10,000/- receivable after 6 years, worth in today’s terms assuming an opportunity cost of 8.5%?

Present Value = Amount / (1+Discount Rate) ^ Number of years

= 10,000 / (1+ 8.5% ) ^ 6

= 6129.5

The Net Present Value of cash flows

The sum of all the present values of the future cash flow is called “The Net Present Value (NPV)”

Ch. 15 Equity Research

NPV plays a very important role in the DCF valuation model.

The Free Cash Flow (FCF)

The cash flow that we need to consider for the DCF Analysis is called the “Free Cash flow (FCF)” of the company.

Definition: The free cash flow is basically the excess operating cash that the company generates after accounting for capital expenditures such as buying land, building and equipment.

The mark of a healthy business eventually depends on how much free cash it can generate.

Thus, the free cash is the amount of cash the company is left with after it has paid all its expenses including investments.

When the company has free cash flows, it indicates the company is a healthy company. Hence investors often look out of such companies whose share prices are undervalued but who have high or rising free cash flow, as they believe over time the disparity will disappear as the share price will soon increase. Thus the Free cash flow helps us know if the company has generated earnings in a year or not.

FCF = Cash from Operating Activities — Capital Expenditures

The Terminal Value

The rate at which the free cash flow grows beyond 10 years (2024 onwards) is called the “Terminal Growth Rate”.

The “Terminal Value” is the sum of all the future free cash flow, beyond the 10th year, also called the terminal year.

Modelling Error & the intrinsic value band

1. If the stock price is below the lower intrinsic value band, then we consider the stock to be undervalued, hence one should look at buying the stock.
2. If the stock price is within the intrinsic value band, then the stock is considered fairly valued. While no fresh buy is advisable, one can continue to hold on to the stock if not for adding more to the existing positions.
3. If the stock price is above the higher intrinsic value band, the stock is considered overvalued. The investor can either book profits at these levels or continue to stay put. But should certainly not buy at these levels.

Ch. 16 The Finale

The follies of DCF Analysis

1. DCF requires us to forecast. This is a challenge, let alone for a fundamental analyst but also for the top management of the company.

2. Highly sensitive to the Terminal Growth rate. A small change in the terminal growth rate would lead to a large difference in the final output i.e. the per share value.

3. Constant Updates — Once the model is built, the analyst needs to constantly modify and align the model with new data (quarterly and yearly data) that comes in. Both the inputs and the assumptions of the DCF model needs to be updated on a regular basis.

4. Long term focus — DCF is heavily focused on long term investing, and thus it does not offer anything to investors who have a short term focus. (i.e. 1 year investment horizon.)

the only way to overcome the drawbacks of the DCF Model is by being as conservative as possible while making the assumptions.

1. FCF (Free Cash Flow) growth rate — The rate at which you grow the FCF year on year has to be around 20%. Companies can barely sustain growing their free cash flow beyond 20%.
   If a company is young and belongs to the high growth sector, then probably a little under 20% is justified, but no company deserves a FCF growth rate of over 20%.
2. Number of years — This is a bit tricky, while longer the duration, the better it is. At the same time longer the duration, there would be more room for errors. I generally prefer to use a 10 year 2 stage DCF approach.
3. 2 stage DCF valuation — It is always a good practice to split the DCF analysis into 2 stages. ,In stage 1 I would grow the FCF at a certain rate, and in stage 2 I would grow the FCF at a rate lower than the one used in stage 1.
4. Terminal Growth Rate. Simple thumb rule here — keep it as low as possible. I personally prefer to keep it around 4% and never beyond it.

Margin of Safety

The margin of safety thought process was popularised by Benjamin Graham in his seminal book titled “Intelligent Investor.

The ‘margin of safety’ simply suggests that an investor should buy stocks only when it is available at a discount to the estimated intrinsic value calculation. Following the Margin of Safety does not imply successful investments, but would provide a buffer for errors in calculation.

The Margin of Safety advocates us to further discount the intrinsic value. I usually like to discount the intrinsic value by another 30% at least.

Going back to the case of ARBL –

1. Intrinsic value is Rs.368/-
2. Accounting for modelling errors @10% the lower intrinsic band value is Rs.331/-
3. Discounting it further by another 30%, in order to accommodate for the margin of safety, the intrinsic value would be around Rs.230/-
4. At 230/- I would be a buyer in this stock with great conviction.

When quality stocks falls way below its intrinsic value they get picked up by value investors.

Good stocks will be available at great discounts mostly in a bear market, when people are extremely pessimistic about stocks.

When to sell?

Ans: Disruption in investible grade attributes.

If a stock does not showcase investible grade attributes we do not buy. Therefore going by that logic, we hold on to stocks as long as the investible grade attributes stays intact.

The point is, as long as the attributes are intact, we stay invested in the stock. By virtue of these attributes the stock price naturally increases, thereby creating wealth for you. The moment these attributes shows signs of crumbling down, one can consider selling the stock.

How many stocks in the portfolio?

• Seth Karman — 10 to 15 stocks
• Warren Buffet — 5 to 10 stocks
• Ben Graham — 10 to 30 stocks
• John Keynes — 2 to 3 stocks

Final Conclusion

1. Be reasonable — Markets are volatile; it is the nature of the beast. However if you have the patience to stay put, markets can reward you fairly well. When I say “reward you fairly well” I have a CAGR of about 15–18% in mind.
2. Long term approach. Remember, money compounds faster the longer you stay invested.
3. Look for investible grade attributes. Book profits when you think the company no longer has these attributes.
4. Respect Qualitative Research — Character is more important than numbers. Always look at investing in companies whose promoters exhibit good character.
5. Cut the noise, apply the checklist.
6. Respect the margin of safety — As this literally works like a safety net against bad luck.
7. IPO’s — Avoid buying into IPOs. IPOs are usually overpriced. However if you were compelled to buy into an IPO then analyse the IPO in the same 3 stage equity research methodology.
8. Continued Learning.