Fundamental Analysis in Depth

Level: professional. This guide goes deeper than the overview in the EllTec Analysis Framework. It shows how every important figure is calculated from the financial statements, what it really means, how the figures depend on each other, how the macro environment and risk enter the picture, how sectors differ and how everything is combined into a valuation. All examples use a fictional company, Example Corp, so that every number can be followed step by step. 1. What Fundamental Analysis Is For A share is a claim on the future cash flows of a business. Fundamental analysis asks three questions about those cash flows: how large are they today, how fast and how reliably will they grow, and what are they worth today given the risk and the level of interest rates. Price and value can drift apart for years, which is why EllTec Analysis combines fundamentals with the macro backdrop, correlations, seasonality and market structure. But over the long run, the price of a share follows the development of its earnings and cash flows, and fundamentals decide whether a falling price is an opportunity or a warning. Two directions of work complement each other. Top-down starts with the economy (growth, rates, inflation, currency), moves to the sector and ends with the company. Bottom-up starts with the company's own numbers and competitive position. A good analysis does both: a strong company in a sector that faces a recession, rising rates and a strong currency can still be a poor investment for the next year. 2. The Three Financial Statements and How They Connect Every figure in this guide comes from three statements that a listed company publishes every quarter. They are connected: the profit of the income statement flows into equity on the balance sheet, depreciation links the income statement with the fixed assets, and the cash flow statement explains why the cash balance changed. StatementWhat it showsFigures derived from it Income statement Revenue, costs, profit over a period Margins, growth, EPS, P/E Balance sheet Assets, debt and equity on one day Leverage, liquidity, book value, ROE, ROIC Cash flow statement Cash in and out from operations, investing and financing Operating cash flow, capex, free cash flow, buybacks, dividends 3. From Revenue to Free Cash Flow: the Profit Bridge Example Corp sells goods for 10,000 million USD a year. The table walks down from revenue to the cash that is really left for the owners. Each step has its own margin, and each margin answers a different question. LineUSD mMarginWhat it tells Revenue 10,000 100% Size of the business − Cost of goods sold -6,000 = Gross profit 4,000 40.0% Pricing power, production efficiency − Operating costs (sales, admin, research), without depreciation -2,000 = EBITDA 2,000 20.0% Operating earnings before depreciation − Depreciation and amortisation -400 = EBIT (operating profit) 1,600 16.0% Profitability of the core business − Interest -200 = Pretax profit 1,400 14.0% − Tax (25 %) -350 = Net income 1,050 10.5% EPS = 1,050 ÷ 500 m shares = 2.10 USD + Depreciation (no cash outflow) 400 − Increase in working capital -150 Cash tied up in inventory and receivables = Operating cash flow 1,300 13.0% − Capital expenditure -500 = Free cash flow 800 8.0% Cash conversion FCF ÷ net income = 0.76 Example Corp converts only 76 % of its net income into free cash flow, because growth ties up working capital and investments exceed depreciation. That is normal for a growing company; it becomes a warning when the gap persists for years without growth to show for it. 4. Quality of Earnings: Can the Numbers Be Trusted? Reported profit is an accounting result; cash is a fact. The same business can show very different profits depending on accounting choices, one-off items and what management calls “adjusted”. A professional reads the numbers behind the headline: Red flagWhat may be behind it Cash conversion persistently below 0.7 Profits are not turning into cash: rising receivables, inventory or capitalised costs Large gap between adjusted and reported (GAAP) earnings Recurring “one-off” costs, high stock-based compensation, restructuring every year Net income above operating income Gains from asset sales, tax credits or investments that do not recur Receivables growing faster than revenue Sales pulled forward or customers paying later Inventory growing faster than revenue Demand weaker than expected; discounts and write-downs may follow Rising share count Stock compensation and capital raises dilute owners Frequent changes of auditor or accounting policy A classic warning sign 5. Profitability in Depth: DuPont, ROIC and the Cost of Capital The return on equity of Example Corp is 21.0% (1,050 ÷ 5,000). The DuPont decomposition shows where it comes from, and therefore whether it is a sign of quality or of debt: DriverFormulaExample Corp Net margin Net income ÷ revenue 10.5% × Asset turnover Revenue ÷ total assets 0.83 × Financial leverage Total assets ÷ equity 2.40 = Return on equity 21.0% Two companies with the same ROE can be completely different: one earns it with high margins (pricing power), one with fast turnover (efficiency, typical for retail), one with a lot of debt (risk). The last kind of ROE disappears quickly when rates rise or profits fall. The cleanest measure of business quality is the return on invested capital (ROIC): the operating profit after tax (NOPAT = EBIT × (1 − tax rate) = 1,200) divided by the capital the business needs (equity + net debt = 8,000). Example Corp earns a ROIC of 15.0%. Whether that is good depends on what the capital costs, the weighted average cost of capital (WACC): ComponentExample Corp Risk-free rate (10-year government bond) 4.0% × Beta of the stock 1.10 × Equity risk premium 5.0% = Cost of equity (CAPM: risk-free + beta × premium) 9.5% Cost of debt before tax (interest ÷ debt) 5.7% Cost of debt after tax 4.3% Weight of equity (market value) 81.1% Weight of debt 18.9% = WACC 8.5% With a ROIC of 15.0% against a WACC of 8.5%, Example Corp creates value: every dollar it reinvests earns more than investors demand. The spread of 6.5 percentage points on 8,000 million of capital is an economic profit of about 519 million a year. A company whose ROIC sits below its WACC destroys value with every dollar of growth, however impressive the revenue growth looks. Note how the WACC depends on interest rates: when the risk-free rate rises by one point, the cost of equity rises with it and the value of all future cash flows falls. 6. Growth: Where It Comes From and What It Is Worth Revenue grows from five sources: more volume, higher prices, a better product mix, acquisitions and currency effects. Only the first three are repeatable without new capital; acquisitions and currency should be separated out (organic growth). Growth turns into profit through operating leverage: when costs are partly fixed, profit grows faster than revenue. If Example Corp grows revenue by 10 % and half of its operating costs are fixed, EBIT grows by far more than 10 %; the same mechanism works in reverse in a downturn, which is why cyclical companies with high fixed costs see their profits collapse in recessions. How fast can a company grow from its own resources? The sustainable growth rate is the share of profit that is retained, multiplied by the return on equity: (1 − payout ratio) × ROE = (1 − 40%) × 21.0% = 12.6%. Growth above this rate must be financed with debt or new shares. For the valuation, growth is only worth something if it earns more than the cost of capital: growth at a ROIC below WACC lowers the value of a company. 7. Balance Sheet Strength and the Risk of Failure Example Corp has 3,500 million of debt and 500 million of cash, so net debt of 3,000 million, which is 1.5 times its EBITDA. Its operating profit covers its interest 8.0 times, and debt to equity is 0.70. Those are comfortable values. Leverage turns dangerous in combination: high debt, falling profits, rising rates and debt that must be refinanced soon. Always look at the maturity profile: a moderate debt load that falls due in one year in a market with closed credit windows is more dangerous than a high debt load due in ten years at a fixed rate. The Altman Z-Score condenses five ratios into one estimate of bankruptcy risk. For Example Corp: 1.2 × working capital ÷ assets (0.083) + 1.4 × retained earnings ÷ assets (0.250) + 3.3 × EBIT ÷ assets (0.133) + 0.6 × market value of equity ÷ liabilities (2.143) + 1.0 × revenue ÷ assets (0.833) = 3.01, just in the safe zone above 3. The model was built for industrial companies; for banks, insurers and groups with their own finance arm it gives misleading results. The Piotroski F-Score checks with nine yes-or-no tests whether the financial situation is improving: #AreaTest (1 point each) 1 Profitability Net income positive 2 Profitability Operating cash flow positive 3 Profitability Return on assets higher than a year ago 4 Profitability Operating cash flow above net income 5 Financing Long-term debt ratio lower than a year ago 6 Financing Current ratio higher than a year ago 7 Financing No new shares issued 8 Efficiency Gross margin higher than a year ago 9 Efficiency Asset turnover higher than a year ago 8. Valuation: Multiples, the Link to Interest Rates and the DCF At a share price of 30.00 USD, Example Corp is worth 15,000 million on the stock market and, including net debt, 18,000 million as a whole business (enterprise value). Its multiples: MultipleExample CorpNote P/E 14.3 Price ÷ EPS Earnings yield 7.0% Compare with the bond yield PEG 1.79 P/E ÷ expected EPS growth of 8% EV/EBITDA 9.0 EV/EBIT 11.25 P/S 1.50 P/B 3.00 P/FCF 18.75 FCF yield 5.3% Dividend yield 2.8% 0.84 USD dividend, payout ratio 40% Which multiple fits depends on the business. Using the wrong one is one of the most common mistakes: Type of businessMost useful measures Mature, profitable companies P/E, FCF yield, EV/EBIT Capital-intensive companies, different debt levels EV/EBITDA together with capex Fast-growing, still unprofitable companies EV/Sales with gross margin, rule of 40 (growth + FCF margin above 40 %) Banks P/B against return on equity, P/E Insurers P/B, P/E, combined ratio, solvency ratio Real estate companies (REITs) Price to FFO (funds from operations), discount to net asset value, loan-to-value Cyclical companies (steel, cars, chemicals, semiconductors) Normalised earnings over a full cycle, P/B, EV/EBITDA at mid-cycle Commodity producers EV/EBITDA, cost position (all-in sustaining cost), reserves The cyclical paradox: cyclical stocks often look cheapest on the P/E at the top of the cycle (record profits) and most expensive at the bottom (depressed profits). That is why EllTec Analysis reads them on normalised earnings and why the EllTec Analysis Score has a guard against extreme trailing earnings. Why interest rates move valuations The simplest valuation model explains a large part of the market. If a company pays out a share of its profit and grows forever at a constant rate, its fair P/E is: P/E = payout ratio × (1 + growth) ÷ (required return − growth). With a payout of 40 % and growth of 5 %, the fair P/E reacts strongly to the required return, which rises and falls with interest rates: Required returnFair P/E 8.5% 12.0 9.5% 9.3 10.5% 7.6 One percentage point less required return lifts the fair P/E from 9.3 to 12.0, a gain of about 29 % without any change in the business. This is the mechanism behind the strong reaction of growth stocks to bond yields: the further in the future the profits lie, the more sensitive the value is to the discount rate (the equity “duration”). The discounted cash flow (DCF) model step by step A DCF values the business as the sum of all future free cash flows, discounted at the WACC. For Example Corp we assume free cash flow grows by 8 % a year for five years and by 2.5 % forever afterwards, discounted at 8.5%: Free cash flow / valuePresent value Year 1 864 796 Year 2 933 793 Year 3 1,008 789 Year 4 1,088 785 Year 5 1,175 782 Terminal value (year 5) 20,081 13,355 = Enterprise value 17,300 − Net debt -3,000 = Equity value 14,300 ÷ 500 m shares = value per share 28.60 USD The terminal value is the cash flow of year 6 divided by (WACC − long-term growth) and makes up 77 % of the result. That is typical and it is the weakness of every DCF: small changes in the assumptions move the value a lot. A professional therefore never works with one number but with a range: WACC \ long-term growth2.0%2.5%3.0% 7.5% 32.48 35.68 39.59 8.5% 26.42 28.60 31.17 9.5% 21.99 23.54 25.34 At the share price of 30.00 USD the market pays roughly what the base case is worth; the range from 21.99 to 39.59 USD shows how much depends on rates and long-term growth. A reverse DCF turns the question around: which growth does today's price imply? If the implied growth is far above anything the company has achieved, the share is priced for perfection. Scenario valuation Instead of one fair value, EllTec Analysis thinks in scenarios, just as in the technical analysis. Each scenario combines earnings and a multiple, and each gets a probability: ScenarioProbabilityEPSP/EValue per share Downside 25% 1.80 11.0 19.80 USD Base 50% 2.27 14.0 31.75 USD Upside 25% 2.60 18.0 46.80 USD Probability-weighted value 32.53 USD The weighted value of 32.53 USD is only slightly above the price of 30.00 USD, but the range is wide: 19.80 to 46.80 USD. The asymmetry between downside and upside, not the single number, decides whether an idea is attractive. This is exactly the logic of the EllTec Analysis Risk/Reward Score. 9. Comparing Sectors: Typical Ranges A figure only becomes meaningful in comparison. A gross margin of 40 % is excellent for a retailer and weak for a software company. The table gives rough long-term ranges as orientation; individual companies and market phases can lie far outside. The EllTec Analysis Score therefore compares every stock with about 40 companies of its own sector. SectorGross marginOperating marginROICNet debt/EBITDAP/EEV/EBITDA Software 70–90 % 20–40 % 15–40 % < 1 25–45 15–30 Semiconductors 45–65 % 20–40 % 15–30 % < 1 15–30 10–20 Consumer brands, staples 40–60 % 15–25 % 12–20 % 1.5–3 18–25 12–17 Retail 20–40 % 3–10 % 8–15 % 1–2.5 12–20 6–10 Industrials, machinery 25–40 % 8–15 % 8–15 % 1–2.5 15–22 9–13 Cars 12–20 % 4–10 % 5–10 % own bank: n/a 5–10 3–6 Chemicals, materials 20–35 % 8–15 % 6–12 % 1.5–3 10–18 6–10 Energy (oil and gas) varies 8–20 % 6–15 % 0.5–2 8–14 4–7 Utilities varies 15–25 % 4–7 % 4–6 14–20 9–12 Telecom, cable 50–65 % 15–25 % 5–9 % 2.5–4.5 10–18 6–9 Pharma, healthcare 60–80 % 20–35 % 10–25 % 1–2.5 14–22 11–16 Banks n/a cost/income 45–65 % ROE 8–15 % n/a 8–12 P/B 0.7–1.5 Special models Business modelKey figures beyond the standard set Banks Net interest margin, cost/income ratio, return on tangible equity, core tier 1 capital ratio (CET1), non-performing loans, cost of risk Insurers Combined ratio (below 100 % = underwriting profit), solvency …