Coming now to Equity Analysis. Here we'll have a very
high level discussion, because there is a full topic
on equity, and this material will be covered in detail
over there. The high level steps for equity valuation.
You need to understand the business and the existing
financial profile of the business. Forecast the company
performance. Select an appropriate valuation model,
and when you do equity analysis, you will notice
that we can have models based on ratios, models based
on discounted cash flows, models based on value of
assets, and liabilities. We, then convert the forecasts
into a valuation, and make an investment decision.
In this particular reading, we are focused on ratios,
and there is substantial evidence that ratios are
useful in forecasting earnings and stock returns.
Some of the important valuation ratios for equity
are price to earnings. This is the price per share
divided by the earnings per share, price per cash
flow, price per sale, and price per book value. The
book value of a company is also called the net asset
value, or the value of assets minus the value of liabilities.
We've already talked about some of these ratios
before. Basic EPS and diluted EPS. We did this in the
reading on the income statement. Cash flow per share
tells us the total cash flow from operations divided
by the weighted average number of shares. EBITDA. EBITDA is
sometimes used as a quick proxy for cash flow.
EBITDA per share is simply, EBITDA divided by the weighted
average number of shares. Dividends per share. This
is the common declared dividends divided by the average number
of ordinary shares outstanding. Industry-Specific
Ratios, some high level remarks over here. As has been mentioned before,
there is no universally accepted definition or
classification of ratios. Ratios, simply serve
as indicators of performance on value. Now, they
are aspects of performance which are relevant in
one industry, but which might be completely irrelevant
in another, hence, you will often notice the use of
industry specific ratios. From an exam perspective, I don't think
you need to memorize the industry-specific ratios,
but if you look at exhibit 19 in the curriculum,
it gives you a sense for the types of ratios that are
used in different industries. And as a quick example,
in the retail industry an important ratio is the
same store sales changes, because if you are a retail
analyst, and you are evaluating a particular retail
company you want to know how the sales are changing
in a particular store, because when revenue is going
up, very broadly speaking, revenue could be going
up, because more stores are being built, or revenue
could be going up, because the sales from a given store,
or the sales on a per store basis are going up. Clearly,
you would get much more excited if the sales on a per store
basis are going up. In the banking sector, a very important
ratio is the CAR, or Capital Adequacy Ratio. This
gives you a sense for how much capital a company, in
this case, a bank has relative to the risk that it is
taking. I don't think you need to know the details
of this ratio, but again, the high level point here
is that in every industry there will be some specific
ratios that are extremely relevant for that industry.
Credit analysis is the evaluation of credit risk.
The idea here is that you are considering lending
money to an entity. So, you might be thinking of buying
a bond, or you might be a bank and you are thinking of
lending money to this company, and then obviously
when you lend money to an entity, the entity needs
to make some promised payments. So, the entity would
promise to make interest payments and a principal
payment, or there might be multiple principal payments.
There is a risk that the entity might not make the
interest payments and/or the principal payments
on time. There is a risk that these payments will
not be made in full. The risk of the entity not meeting
its obligations to repay you is called credit risk,
and to evaluate credit risk ratios are used extensively.
Obviously, there is a lot more to credit risk, but
our focus here is on ratios, and some of the ratios
used to evaluate credit risk are shown over here.
We have EBITDA interest coverage, so this is EBITDA
divided by gross interest. The idea is that if an entity has
a relatively high EBITDA and a relatively low
gross interest then that is good, because low gross
interest implies a relatively low level of debt.
A high EBITDA means high cash flow so a company with a relatively
high cash flow is going to be good at repaying, so high
is good. Then we have funds which are generated from
operations divided by debt, so FFO divided by debt. Here again, high is
good, because we want relatively high funds generated
from operations divided by a low level of debt, so again high
is good. Then we have free operating cash flow to debt,
this is CFO minus capital expenditures divided by debt, again high
is good. EBIT margin. So this essentially is how much
EBIT earnings before interest and taxes are being
generated relative to total revenue, in general,
high margin numbers are good. So, the next ratio
also is a margin ratio, but this is EBITDA margin.
So in both these cases, high is good. Debt to EBITDA.
This is the only way shown over here. Low is good,
because here we want a low level of debt relative
to EBITDA, so here is low good. And then Return on capital,
this is EBIT divided by average capital, and here high is good. So,
as a simple way of remembering whether the high is good,
or low is good; if the numerator has some form of cash
flow then generally high is going to be good, because
you want the company generating high cash relative
to the level of debt, or you would want a company to
have a high profit margin, but if we have debt in
the numerator then low is good, because you would
want a relatively low level of debt compared to a
cash flow. Business and Geographic Segments. Often as an analyst, we need to evaluate the performance
of underlying business segments. If we take a business
like General Electric, this operates in several
different segments, and you want to evaluate how
each segment is performing. Let's say that the company
has three different segments and you evaluate that
A is doing extremely well, B is average, and C is under performing.
Then, a company announcement, that it's going to discontinue
or spin-off C, is going to be taken as positive news.
If you look at the various ratios, these are simply
ratios that you have studied before, but they are
expressed on a per segment basis. Even though companies
are not required to publish financial reports on
a segment basis, but both IFRS and US gaap require disclosures
related to each business segment, and there are
details, in the curriculum about exactly what needs
to be disclosed. Finally, Section 8, Model Building
and Forecasting. I have captured the essence of
what is explained in this picture. In order to come
up with a model which predicts future cash flows,
we need to forecast. The most important item to forecast
for a given company is the sales numbers, then we can
look at expected ratio, such as the gross profit
margin. If you have a prediction for the gross profit
margin, or you have an expected gross profit margin
based on your evaluation of the company, then you
can use the forecasted sales, and your prediction
of the gross profit margin to come up with your estimate
of cost of goods sold, and then you can come up with
the gross profit. Similarly, based on other ratios
you can predict other items on the income statement,
and eventually you can predict the net income. So, using
this method you can come up with forecast for net
income. You can use the same concept to come up with
forecast for cash flows, and then once you have these
forecastes you can then try to come up with a valuation
for the company that you are evaluating. That brings
us to the end of this reading. A quick summary. It is
extremely important that you learn all the ratios,
and here are the various categories that we have
talked about. In general, you can use these techniques
to remember the ratio. I have discussed this before,
so I won't say them again. The job for you is to make
sure that you can remember the ratios, and then you
need to, as I keep saying, practice lots of problems
so that you become comfortable using the ratios.
Read the summary. This is not as useful as some of
the other summaries, because your job really is to
make sure you know the ratios. Go over the learning
objectives. The curriculum has several examples,
some of them are short and sweet, but there are some
examples that are pretty long-winded. I would say
that if you have time go over those examples. If you
don't have much time just skim the examples, and make
sure you understand the bottom line points that
are being communicated through those examples.
The practice problems at the end of the reading are
very good, make sure you do them and also try to practice
questions from other sources. That is it.