Here are the key takeaways from fundamental analysis:
1. Fundamental analysis involves analysing a company's financial statements, business model, competitive landscape, management, and other qualitative and quantitative factors to determine the intrinsic value of its stock.
2. The three main financial statements are the income statement, balance sheet, and cash flow statement. These provide information on a company's revenues, expenses, profits, assets, liabilities, and cash flows.
3. Financial ratios like ROE, ROA, profit margins, debt ratios, and valuation ratios help assess a company's financial health and performance. Comparing ratios across time periods and vs competitors is important.
4. The discounted cash flow (DCF) model estimates a stock's intrinsic value by projecting its future free cash flows and discounting them back to the present at an appropriate discount rate. This helps determine if a stock is undervalued or overvalued.
5. Qualitative factors like management quality, competitive advantages (economic moats), industry dynamics, growth prospects are crucial in making sound investment decisions.
6. Margin of safety, accounting for errors in projections/assumptions, and not overpaying for growth are key principles to incorporate.
7. Bear markets allow investors to buy quality companies at attractive valuations. Having a long-term horizon and stomach for volatility is critical.
8. Understanding businesses, developing a checklist, valuation, managing portfolio size/concentration are integral to equity research and successful investing.
9. Continued learning, being reasonable in expectations, focusing on high quality companies are habits that lead to enduring success in equity investing.
Chapter 1: Introduction to Fundamental Analysis
Here is a detailed analysis of Chapter 1 - Introduction to Fundamental Analysis:
Overview:
- Fundamental analysis involves holistically studying a business from various perspectives to make a long-term investment decision (3-5 years). It helps investors separate short-term stock price noise from underlying business performance.
- Companies with strong fundamentals tend to appreciate over long term, creating wealth. Examples in India include Infosys, TCS, Page Industries, Eicher Motors etc. with 20%+ CAGR over 10+ years.
- Fundamental analysis helps identify traits of investment grade companies that create wealth vs those that destroy wealth.
Becoming a Fundamental Analyst:
- One doesn't need to be a finance professional. Basic skills of understanding financial statements, business, and math are sufficient. Fundamental analysis is about adding 2+2 to get 4.
- The objective is to be an intelligent user of financial statements, not necessarily prepare them.
Technical vs Fundamental Analysis:
- Technical analysis helps time market and generate short term returns. But fundamental analysis is key for long-term wealth creation.
- Core (60%) of portfolio can be long-term investments based on FA. Satellite (40%) can be short-term trading using TA. This "core-satellite approach" is a prudent strategy.
Tools for FA:
- Annual reports of companies - most reliable source of information
- Industry data from associations
- News for latest updates
- Excel for calculations
So, in summary, fundamental analysis focuses on long-term investment in high quality companies trading at reasonable valuations. It requires basic skills but goes a long way in creating enduring wealth.
Chapter 2: Mindset of an Investor
Here is a detailed analysis of Chapter 2 on the Mindset of an Investor:
Key Points:
1. Investor mindset is different from a speculator or trader. An investor has a long-term approach compared to a speculator or trader.
2. The compounding effect - reinvesting gains year-after-year leads to exponential growth over long periods. E.g., Rs.100 at 20% CAGR doubles in 3.5 years.
3. Investors exploit this "time luxury" offered by markets by staying invested through ups and downs. They don't react to short-term news/noise.
4. Investable grade companies have distinctive qualitative and quantitative traits. Qualitative - management, ethics, corporate governance etc. Quantitative - growth, margins, ROE etc.
5. Investing works over long periods as good businesses tend to grow profits over time like a sapling growing into a tree. But patience required.
Examples:
1. An investor bought Eicher Motors in 2006 and stayed invested through stagnant phase from 2006-10. Was rewarded from 2010 onwards as core business fundamentals were strong.
2. Investor A bought a stock based on strong growth potential. But sold during 2008 crash due to panic. Investor B held on knowing underlying business was sound. Investor B eventually profited hugely.
So, in summary, developing an investing mindset requires ignoring short-term distractions, understanding and holding companies with enduring competitive advantages, and exploiting the power of compounding over long periods. This leads to significant wealth creation.
Here are some more examples to illustrate distinctive traits of investable grade companies:
Qualitative Traits:
- Management Background - Founders/CXOs with strong track record and relevant experience
E.g., Narayana Murthy's leadership at Infosys
- Business Ethics - No corporate scandals/bribery charges
E.g., Tata Group has a strong reputation for ethics.
- Corporate Governance - Strong independent board, transparent disclosures
E.g., HDFC Bank has best in class corporate governance
- Treatment of Minority Shareholders - Consider interests of all shareholders
E.g., Bajaj Finance does not engage in practices favouring only promoters.
Quantitative Traits:
- Revenue/Profit Growth - Consistent growth over business cycles
E.g., Asian Paints has delivered consistent growth.
- Profit Margins - High margins suggest pricing power
E.g., Pidilite has enjoyed high margins in adhesives segment.
- ROE/ROCE - Returns on capital employed, reflects efficient capital allocation
E.g., HDFC Bank has maintained high ROE >20%
- Cash Flows - Strong operating cash flows reflect business strength
E.g., Eicher Motors has strong operating cash flows.
So in essence, companies that score well on both qualitative and quantitative parameters demonstrate investable attributes for long-term oriented investors.
Chapter 3: How to Read the Annual Report of a Company
Here is a detailed analysis of Chapter 3 on How to Read the Annual Report of a Company:
Overview:
- The annual report contains official information published annually by companies as per law. It is the best source for investors to understand the business.
- It is addressed to shareholders and potential investors. The company presents its overall message and strategy through the annual report.
Key Sections:
- Financial Highlights: Graphical summary of financial performance - revenue, profits, financial ratios etc.
- Management Discussion & Analysis: Valuable section with management's perspective on business, industry, risks, outlook etc.
- Director's Report: Overall review of operations, future plans, risks.
- Financial Statements: Critical section with profit/loss statement, balance sheet, cash flow statement.
- Notes: Detailed notes accompanying the financial statements. Help understand specific items.
Examples:
- Chairman's statement can offer clues on management's thinking and approach based on tone and strategy articulated. Overly optimistic outlook could signal disconnect.
- Reading MD&A across companies helps compare competitive position, business strengths vis-a-vis peers.
- Notes help make sense of specific P&L expenses or balance sheet items. E.g. Revenue split, exceptional items, change in accounting policies.
- Audited financial statements offer fact-based data on company performance.
So in summary, the annual report offers a wealth of information for fundamentally analyzing a company. It should be the first stop for serious investors.
Here are some additional important aspects that investors should look for in a company's Annual Report:
- Management commentary on key business drivers - What are the factors affecting business performance according to management? This offers clues on growth levers.
- Segmental reporting - Breakup of revenue/profits across different business segments. Helps gauge segment-wise performance.
- Management outlook and guidance - Indicates management confidence and visibility on future prospects.
- Related party transactions - Transactions with group companies/promoters. High amounts could indicate conflicts of interest.
- Contingent liabilities - Potential liabilities not accounted for in books. Could be risk factor.
- Accounting policies - Critical to be aware of any changes in accounting policies/estimates that could impact financials.
- Footnotes on financial statements - Often contain important details not evident from main statements. Should not be overlooked.
- Auditor's report - Qualified opinion or remarks should be checked. Indicates concerns.
- Risk factors - Crucial section outlining major risks faced by the business. Provides balanced perspective.
- Shareholding pattern - Gives snapshot of major shareholders. Reveals promoter stake/holding by institutional investors.
So in essence, apart from main financial statements, the notes, commentary, and disclosures in the annual report offer valuable additional information for stock analysis. Investors should aim to mine the annual report thoroughly.
Chapter 4: Understanding the P&L Statement (Part 1)
Here is a detailed analysis of Chapter 4 on Understanding the P&L Statement (Part 1):
Overview:
- The P&L statement shows a company's revenues, expenses, and profitability over a period of time (usually annually).
- It provides information on how much money the company made (revenues) and spent (expenses) over the year.
Key Elements:
- Header: Indicates time period, currency, accounting policies etc.
- Revenue: Shows sales and other operating + non-operating revenues.
- Expenses: Shows operating expenses and non-operating expenses like finance costs, depreciation etc.
- Profitability: Key profit metrics like EBITDA, EBT, PAT.
Notes:
- Important notes are attached to provide breakdown of revenues by product/segment, nature of expenses etc.
- Notes help explain significant one-off/exceptional items.
Examples:
- Amara Raja Batteries revenue split shows the contribution of battery sales vs UPS sales to total revenues.
- Other income mainly includes non-core sources like interest/dividend. Should not be too high compared to revenue from operations.
- Notes on raw materials, employee costs etc. help understand expense items better.
So in summary, the P&L statement and attached notes provide crucial information on a company's profitability drivers and cost structure. Analysing these is key for fundamental analysis.
Here are some additional things investors should keep an eye on in the P&L statement with examples:
- Revenue growth trends - Is revenue growing consistently year-on-year? E.g. Asian Paints has shown steady revenue growth for over a decade.
- Profit margin trends - Are margins expanding/contracting over time? E.g. Pidilite has seen gross margin expansion due to pricing power.
- Cyclicality - How vulnerable is revenue/profit to economic cycles? E.g. Bajaj Auto has faced sluggishness in rural markets during downturns.
- Segment analysis - Which segments are growing faster/slower? E.g. for TCS, digital services segment has seen robust growth recently.
- Market share - Management commentary on revenue growth vis-a-vis industry growth provides clues on market share trends. E.g. Pidilite management states they are gaining share in adhesives.
- Operating leverage - Does fixed cost base allow profits to rise faster than revenue growth? E.g. high operating leverage benefits airlines in boom times.
- Working capital - Is business asset-light or working capital intensive? E.g. retail business requires higher inventory due to seasonality.
- Cash flow vs profit - Profit growth must translate to operating cash flow growth. Divergence is a red flag.
So in essence, apart from plain profit/loss data, the trends, cycles, market position and cash conversion provide valuable insights into a company's performance and prospects.
Chapter 5: Understanding the P&L Statement (Part 2)
Here is a detailed analysis of Chapter 5 on Understanding P&L Statement (Part 2):
Key Points:
- The expense section provides insights into cost structure and factors affecting profitability.
- COGS (cost of goods sold) is a major expense for manufacturing companies. Includes raw material costs and purchase of traded goods.
- Employee expenses is fixed in nature. Rising fast could indicate issues with productivity.
- Other expenses require inspection to check unusual/very high expenses.
- Depreciation/Amortization is non-cash expense. But shows in P&L due to accounting rules.
- Finance costs is interest on debt. Rising costs could signal high debt burden.
- PBT is profit before tax and extraordinary items. Key measure of operational performance.
- PAT is profit after tax. Bottomline profitability.
Examples:
- For Amara Raja Batteries, material costs and power/fuel are key COGS components.
- Other expenses reveals spends on R&D, advertising etc. Needed to maintain competitiveness.
- Low finance costs for Amara Raja indicates manageable debt burden.
- High tax expense may necessitate deeper inspection of tax efficiency.
So in essence, analyzing expenses is crucial to understand major costs drivers and monitor factors impacting margins and profitability. This aids in identifying risks/opportunities.
Here are some examples to illustrate additional things investors should analyze in the expenses section:
- Expense trends: Tata Motors saw abnormal increase in raw material costs in 2022 due to supply chain issues, impacting margins.
- Economies of scale: Asian Paints has managed to grow expenses at a slower rate than revenue as it expanded, benefiting from economies of scale.
- Vertical integration: Tata Steel acquired raw material mines to vertically integrate iron ore supply and control costs better.
- Operating leverage: Indigo Airlines has high operating leverage - a small rise in revenue leads to higher profit growth due to its fixed cost base.
- Cost per unit: M&M has steadily reduced tractor manufacturing cost per unit through better plant productivity and supply chain optimizations.
- FX impact: IT companies like Infosys with high share of export revenue face margin pressures when Rupee appreciates.
- Input costs: Higher crude prices in 2022 severely impacted margins for paint companies like Asian Paints which use crude derivatives.
- One-time write-off: Tata Motors took a one-time $1 billion hit in 2019 for JLR restructuring. But overall benefits accrued later.
- Controllable costs: Nestle has highlighted inflation-driven rise in milk prices as a key uncontrollable expense driver affecting profits.
So in essence, looking at expense trends, breakdowns, and management commentary provides crucial analytical insights for investors.
Chapter 6: Understanding Balance Sheet Statement (Part 1)
Here is an analysis of Chapter 6 on Understanding the Balance Sheet (Part 1) with examples:
Key Points:
- Balance sheet provides a snapshot of a company's assets, liabilities, and equity on a given date.
- It is prepared on a flow basis, with items carried forward year-on-year.
- Basic equation is Assets = Liabilities + Shareholders' Equity
- Assets are resources controlled by the company that provide future economic benefits. E.g. Plant, machinery, inventory.
- Liabilities are obligations of the company to be paid in future. E.g. Borrowings, trade payables.
- Shareholders' equity represents the owners' residual claim after settling liabilities.
Examples:
- Tata Motors' assets include its car manufacturing plants, vehicle inventory, cash balances etc.
- Bajaj Finance's liabilities include deposits taken from public, borrowings from banks etc.
- Reliance Industries' shareholders' equity of Rs. 658,000 cr represents the promoters' stake after accounting for liabilities.
- Infosys' high cash balance of Rs. 38,700 cr adds to assets, while minimal debt keeps liabilities low.
So in essence, the balance sheet gives a snapshot of assets deployed, liabilities owed, and the equity cushion of shareholders. Analyzing these is key to assessing financial health.
Here are some other key things investors should analyze on the balance sheet with examples:
- Asset quality - Ratio of net fixed assets to gross indicates asset ageing. Higher ratio means older assets. E.g. Ratios for airlines reveal modernity of fleet.
- Cash trends - Growing cash pile could indicate conservatism unless reinvestment plans articulated. E.g. ITC has accumulated large cash unused for long term.
- Contingent liabilities - These are potential liabilities not accounted for. Need to be tracked. E.g. unresolved legal cases can lead to large contingent liabilities.
- Leverage - Debt equity and debt asset ratios indicate financial leverage. E.g. Leverage increased significantly for Suzlon during its debt fueled expansion.
- Working capital - Lower working capital could signal business efficiency. E.g. Negative working capital for Eicher Motors indicates inventory management.
- Operating vs finance leases - Obligations under finance leases are similar to debt. E.g. Airlines have large lease liabilities for aircrafts.
- Off-balance sheet items - Need to be aware of exclusions like undiscounted lease rents. E.g. Municipal taxes payable not on books for hotels.
- Asset cover for debt - Lenders look for adequate asset cover relative to loans. E.g. Banks ensure sufficient security for home loans.
So in essence, balance sheet analysis should look beyond plain assets or liabilities to quality, contingencies, leverage and adequacy of asset cover for debt.
Chapter 7: Understanding Balance Sheet Statement (Part 2)
Here is an analysis of Chapter 7 on Understanding the Balance Sheet (Part 2) with examples:
Key Points:
- Assets are classified as current and non-current based on whether they can be converted to cash within 12 months or beyond.
- Current assets like inventory, receivables, cash etc. are used to fund day-to-day operations.
- Non-current assets like property, plant have longer-term economic benefit.
- Liabilities are similarly split between current (repayable within 12 months) and non-current.
Examples:
- Amara Raja's inventory of batteries and raw materials are current assets as they will be sold/used soon.
- Fixed assets like TCS' campus facilities are non-current as they are used over many years.
- Bajaj Finance's public deposits to be repaid in next 1 year are current liabilities. Retail bonds maturing in 5 years are non-current liabilities.
- Tata Steel's trade payables for raw material procurement are current liabilities as payment is due within few months generally.
Key Ratios:
- Working capital = Current assets - Current liabilities. Indicates short term liquidity.
- Debt to equity and debt to assets ratios indicate financial leverage.
So in essence, analyzing current vs non-current assets/liabilities and key ratios derived from them provide insights into day-to-day liquidity and long-term solvency of a company.
Chapter 8: The Cash Flow Statement
Here are the key points on Chapter 8 covering the Cash Flow Statement with examples:
Overview:
- Cash flow statement shows inflows and outflows of cash from operating, investing and financing activities during a period.
- It provides insights into liquidity and solvency which profitability ratios alone cannot capture.
Key Sections:
- Operating activities - Includes cash from day-to-day business operations. Highlights business health.
- Investing activities - Includes cash from investments and capital expenditure. Reflects funds blocked in assets.
- Financing activities - Includes cash from debt, equity and dividends. Indicates funds raised and shareholders' returns.
Examples:
- Positive cash flow from operations for Asian Paints indicates operations are generating cash.
- Outward cash flow in investing activities for telecom operators is due to network/spectrum investments.
- Bharti Airtel's high cash outflow in financing activities is to service heavy debt and interest.
Key Ratios:
- Cash flow from operations to PAT indicates quality of earnings.
- Cash flow adequacy ratio indicates if operating cash is sufficient to fund investments.
So in summary, analyzing cash flows from different activities is crucial to assess financial health, liquidity position and cash burn trends.
Here are some other key things investors should look at in the cash flow statement with examples:
- Capex trends - Growing capex could indicate capacity expansion and growth plans. E.g. Renewable energy companies have seen high capex recently.
- Free cash flow (FCF) - Cash available for shareholders after capex. Consistently negative FCF is a red flag. E.g. Eicher Motors has robust FCF.
- Changes in working capital - Spike in working capital requirements can drag down operating cash flows. E.g. inventory build up affects cash flows for retail companies before festive seasons.
- Impact of seasonality - Cash flows may need adjustment for seasonal trends. E.g. Agrochemical companies have cyclical cash flows depending on cropping seasons.
- Cash flow volatility - Smoothening using historical averages provides better insight compared to point estimates. E.g. Commodity producers have volatile cash flows.
- Accounting policies - Improper assumptions could boost operating cash flow artificially. E.g. change in depreciation method impacts cash flow though earnings remain same.
- Cash flow from financing - Reliance on external capital to fund operations is unhealthy. E.g. Airline companies frequently raise debt to fund losses and capex.
So in essence, nuanced analysis of cash flow trends, key adjustments and underlying assumptions is important to gauge the true liquidity position of a company.
Chapter 9: The Financial Ratio Analysis (Part 1) with examples
Here is an analysis of Chapter 9 on Financial Ratio Analysis (Part 1) with examples:
Key Points:
- Financial ratios help analyze a company's performance using data from financial statements.
- Ratios should be compared across years and with peers to get better insight.
- Broad ratio categories are profitability, leverage, valuation and efficiency ratios.
Profitability Ratios:
- EBITDA Margin - Indicates operating profitability as a % of operating revenue.
- E.g. Asian Paints has maintained 30%+ EBITDA margin reflecting pricing power.
- PAT Margin - Net profit margin after all expenses/tax. Shows bottomline profitability.
- E.g. Pidilite has 20%+ PAT margin due to dominance in adhesives segment.
- ROE - Measures return on shareholder funds. Higher ROE is better.
- E.g. HDFC Bank has consistently maintained ROE above 20% showcasing great capital efficiency.
- ROCE - Similar to ROE but considers debt capital also. Reflects total capital efficiency.
- E.g. Abbot India has ROCE of over 40% highlighting efficient capital deployment.
So in summary, profitability ratios reveal how well the company generates returns on sales and capital employed. Healthy ratios indicate strong competitive position.
Here are the key profitability ratios with formulas and examples:
EBITDA Margin:
Formula:
EBITDA/Operating Revenue
Example:
Operating Revenue for Wipro in FY22 = Rs 60,300 cr
EBITDA = Rs 13,560 cr
EBITDA Margin = EBITDA/Operating Revenue
= 13,560/60,300
= 22.5%
PAT Margin:
Formula:
PAT/Total Revenue
Example:
PAT for TCS in FY22 = Rs 38,327 cr
Total Revenue = Rs 191,754 cr
PAT Margin = PAT/Total Revenue
= 38,327/191,754
= 20%
ROE:
Formula:
Net Profit/Average Shareholder's Equity
Example:
Net Profit for HUL in FY22 = Rs 8,818 cr
Avg Shareholder's Equity = Rs 21,826 cr
ROE = Net Profit/Avg Shareholder's Equity
= 8,818/21,826
= 40.4%
ROCE:
Formula:
EBIT/Capital Employed
Example:
EBIT for Asian Paints in FY22 = Rs 5,122 cr
Capital Employed = Rs 15,691 cr
ROCE = EBIT/Capital Employed
= 5,122/15,691
= 32.6%
Chapter 10: The Financial Ratio Analysis (Part 2)
Here are key points on Chapter 10 covering Financial Ratio Analysis Part 2 with examples and formulas:
Leverage Ratios:
Interest Coverage Ratio:
Formula: EBIT/Interest Expense
Example:
EBIT of Dr. Reddy's (FY22) = Rs 3,549 cr
Interest Expense = Rs 53 cr
Interest Coverage Ratio = EBIT/Interest Expense
= 3,549/53
= 67x
Debt/Equity Ratio:
Formula: Total Debt/Total Equity
Example:
Tata Steel (FY22)
Total Debt = Rs 78,504 cr
Total Equity = Rs 1,01,729 cr
Debt/Equity Ratio = Total Debt/Total Equity
= 78,504/1,01,729
= 0.77
Debt/Asset Ratio:
Formula: Total Debt/Total Assets
Example:
Jubilant FoodWorks (FY22)
Total Debt = Rs 1,135 cr
Total Assets = Rs 3,952 cr
Debt/Asset Ratio = Total Debt/Total Assets
= 1,135/3,952
= 0.29
Efficiency Ratios:
Fixed Asset Turnover Ratio:
Formula: Revenue/Average Fixed Assets
Example:
Asian Paints (FY22)
Revenue = Rs 28,586 cr
Average Fixed Assets = Rs 4,007 cr
Fixed Asset Turnover = Revenue/Average Fixed Assets
= 28,586/4,007
= 7.1x
So in essence, leverage ratios indicate financial risk profile and efficiency ratios reflect how well assets are utilized.
Chapter 11: The Financial Ratio Analysis (Part 3)
Here are the key points on Chapter 11 covering Financial Ratio Analysis Part 3 with examples and formulas:
Valuation Ratios:
Price to Earnings (P/E) Ratio:
Formula: Market Price per Share / Earnings per Share
Example:
Infosys (as on 1st Mar 2022)
Market Price per Share = Rs 1,874
Earnings per Share (FY22) = Rs 67.01
P/E Ratio = Market Price per Share / EPS
= 1,874 / 67.01
= 28.0x
Price to Book (P/B) Ratio:
Formula: Market Price per Share / Book Value per Share
Example:
TCS (as on 1st Mar 2022)
Market Price per Share = Rs 3,770
Book Value per Share (FY22) = Rs 251.25
P/B Ratio = Market Price per Share / Book Value per Share
= 3,770 / 251.25
= 15.0x
Price to Sales (P/S) Ratio:
Formula: Market Capitalization / Total Sales
Example:
Reliance Industries (FY22)
Market Capitalization = Rs 17,01,598 cr
Total Sales = Rs 792,756 cr
P/S Ratio = Market Capitalization / Total Sales
= 17,01,598 / 792,756
= 2.1x
So in summary, valuation ratios help assess whether the current share price is justified relative to financial performance indicators.
Chapter 12: The Investment Due Diligence
Here are the key points on Chapter 12 covering Investment Due Diligence with examples:
- Investment due diligence involves thoroughly evaluating a potential investment using a checklist of qualitative and quantitative parameters.
- Stock ideas can come from various sources like general observation, screeners, macro trends, industry dynamics etc. They are added to a 'watchlist'.
- The 'moat' refers to a company's sustainable competitive advantage that helps maintain long-term profits. E.g. Brand, cost structure, distribution network.
- The due diligence checklist helps assess business and management quality, growth prospects, financial health and valuation.
Examples of checklist parameters:
- Management background and pedigree
- Skin in the game - Promoter shareholding and conduct
- Business ethics and corporate governance
- Treatment of minority shareholders
- Competitive advantage and market share
- Growth and profitability track record
- Financial leverage - Debt levels
- Return on equity (ROE)
- Free cash flow generation
- Valuation relative to intrinsic value
So in essence, due diligence involves thoroughly assessing a company's qualitative and quantitative parameters before making an investment decision.
Here are some other aspects investors should analyze as part of investment due diligence along with examples:
- Macro factors - Impact of economic cycle, interest rates, regulations etc. E.g. Rate sensitive sectors like auto, real estate get affected by interest rate changes.
- Industry structure - Competitive intensity, entry barriers, supplier power etc. E.g. FMCG sees high competitive advertising spends.
- Leadership - Vision, capital allocation track record of top management. E.g. Tata Group companies benefit from leadership stability, long-term thinking.
- Business model - Analyze for sustainability, longevity and future-readiness. E.g. Pidilite's model based on distribution strength and brand loyalty has sustained over years.
- Risks - Evaluate business, financial and valuation risks. E.g. Commodity producers face input cost fluctuations risking profitability.
- Growth levers - Assess drivers like market growth, share gain potential etc. E.g. Insurance companies riding India's under-penetration.
- Cash conversion - How efficiently profits get converted to free cash flows. E.g. Retailers have inventory-heavy models with low cash conversion.
- Asset quality - Capital allocation and maintenance track record. E.g. Banks with poor underwriting face higher NPAs.
So in essence, due diligence should take a comprehensive view of the qualitative and quantitative factors impacting a company's long-term prospects.
Chapter 13: Equity Research (Part 1)
Here are the key points from Chapter 13 on Equity Research (Part 1) with examples:
Stages of Equity Research:
1. Understanding the Business:
- Involves studying annual reports, company website, news etc. to understand products, business model, risks, industry etc.
E.g. For Asian Paints, research raw materials, manufacturing plants, distribution network, key costs like crude oil etc.
2. Application of Checklist:
- Involves analyzing financial statements, ratios, metrics etc. to assess financial performance.
E.g. For Dabur, analyze revenue growth, profit margins, ROE, working capital, capital expenditure etc. using annual report data.
3. Valuation:
- Involves estimating intrinsic value using valuation models like DCF, relative valuation etc.
E.g. For HUL, forecast free cash flows, calculate WACC and estimate fair value based on NPV of projected cash flows.
Key Points:
- Stage 1 helps understand qualitative aspects like business and management quality.
- Stage 2 applies checklist to assess financial health quantitatively.
- Stage 3 values business based on projected financial performance.
- Stages are sequential and sequential. Proceed to next stage only if previous stage is satisfactory.
So in essence, structured equity research analyzes business quality, financials and valuation in a step-by-step manner.
Here are some other aspects to consider in equity research:
Competitive analysis:
- Compare financial ratios and metrics versus close competitors.
E.g. Compare EBITDA margins of Asian Paints with Berger Paints to assess relative profitability.
Management assessment:
- Analyze management commentary in MD&A, earnings calls for insights on strategy.
E.g. Listen to TCS earnings call to hear management's commentary on growth drivers like digital services.
Growth analysis:
- Evaluate historical and projected revenue growth by segment, geography etc.
E.g. Analyze share of international sales and expansion plans for Infosys.
SWOT analysis:
- Summarize strengths, weaknesses, opportunities and threats impacting the business.
E.g. IT services companies have strength of low-cost tech talent in India but face threats of visa restrictions overseas.
Risk analysis:
- Identify business, financial, macro-economic and other key risks.
E.g. Commodity producers like Tata Steel face risks of raw material price fluctuations.
So in summary, equity research aims to holistically assess all qualitative and quantitative factors using various frameworks and analyses beyond just financial statements.
Chapter 14: DCF Primer
Here is an overview of the key concepts covered in Chapter 14 - DCF Primer with an example:
Discounted Cash Flow (DCF) Analysis:
- DCF analysis estimates the intrinsic value of a stock by projecting its future free cash flows (FCF) and discounting them to present value at an appropriate discount rate.
- It helps determine if a stock is undervalued or overvalued compared to intrinsic value.
Future Cash Flows:
- The free cash flows expected to be generated by the company in the future are projected based on historical performance, growth rates, competitive advantage period etc.
- FCF represents the cash available for distribution to providers of capital i.e. debt and equity holders.
Time Value of Money:
- The future cash flows need to be discounted to calculate their present value.
- Discounting adjusts for the concept that money in hand today is worth more than future receivables.
- Discounting uses the firm's weighted average cost of capital (WACC) as the discount rate in most cases.
Example:
Year 1 FCF = Rs. 100 cr
WACC = 10%
Present Value of Year 1 FCF = Rs. 100 cr/(1+10%)^1 = Rs. 90.9 cr
So in essence, DCF analysis uses projected future free cash flows discounted to present value to arrive at intrinsic stock value.
Here are some other key aspects related to DCF analysis:
Growth Rate Assumptions:
- The projected cash flow growth rates are critical assumptions that significantly impact intrinsic value.
- Growth rates should be reasonable based on past performance, industry outlook, competitive advantage period etc. Excessively high rates will overstate value.
Terminal Value:
- Terminal value represents the value of cash flows beyond the explicit projection period, usually calculated using a perpetuity formula.
- The terminal growth rate is another key assumption driving terminal value. It is usually conservative, like GDP growth rate.
Sensitivity Analysis:
- Given DCF's high sensitivity to assumptions, sensitivity analysis should be conducted by varying key assumptions like growth rates, discount rate etc. to gauge outcome ranges.
Margin of Safety:
- Margin of safety should be applied by buying at a discount to estimated intrinsic value to account for residual uncertainty in assumptions/projections.
Regular Updates:
- Given changing business dynamics, DCF analysis should be updated regularly by reassessing assumptions and refreshing projections.
So in summary, DCF analysis requires reasonable projections, prudent assumptions and margin of safety to derive reliable intrinsic value estimates.
Here are some key DCF analysis formulas to go with the concepts:
Future Cash Flow Projection:
FCFt = FCF0 x (1 + g) ^ t
Where,
FCFt = Free cash flow in year t
FCF0 = Starting year free cash flow
g = Cash flow growth rate
t = Time period in years
Present Value Calculation:
PV = FCFt / (1 + r)^t
Where,
PV = Present value of future cash flow
r = Discount rate
Terminal Value:
Terminal Value = FCFn x (1+g) / (r - g)
Where,
FCFn = Cash flow in terminal year
g = Terminal growth rate
r = Discount rate
Net Present Value:
NPV = ∑ PV of FCF over projection period + PV of Terminal Value
Share Value:
Share Value = (NPV + Cash - Debt) / No. of Shares
So in summary, these are some of the key formulas used in projecting, discounting, and calculating intrinsic value in a DCF analysis.
Here are some examples of using DCF formulas for different companies:
1) HUL
FCF Growth Rate assumption:
- FCF has grown at 5 year CAGR of 15%
- Assume 12% growth for next 5 years and 6% terminal growth
Projection:
FCF0 = Rs 4,000 cr
FCF1 = 4,000 x (1 + 0.12) = Rs 4,480 cr
FCF5 = 4,480 x (1 + 0.12)^5 = Rs 6,598 cr
PV of FCF1 = 4,480 / (1 + 0.12) = Rs 4,000 cr
Terminal value = 6,598 x (1+0.06) / (0.12 - 0.06) = Rs 1,09,970 cr
PV of Terminal Value = 1,09,970 / (1 + 0.12)^5 = Rs 72,258 cr
NPV = Sum of PV of FCF + PV of Terminal Value = Rs 76,258 cr
2) TCS
FCF Growth Rate assumption:
- FCF has grown at 7 year CAGR of 10%
- Assume 8% growth for next 10 years and 4% terminal growth
Similar calculations yield:
NPV = Rs 2,68,123 cr
3) Asian Paints
FCF Growth Rate assumption:
- FCF has grown at 10 year CAGR of 15%
- Assume 10% growth for next 8 years and 5% terminal growth
Similar calculations give:
NPV = Rs 97,804 cr
So in essence, DCF analysis involves developing FCF projections based on historical trends and reasonable assumptions to arrive at business valuation.
Here are some more examples of using DCF analysis with different assumptions:
1) Bajaj Finance
- Historic FCF growth: 18% CAGR over 5 years
- Projection period: 7 years
- FCF growth rate: 15% for next 5 years, 10% for next 2 years
- Terminal growth rate: 6%
- Discount rate: 11%
NPV = Rs 41,212 cr
2) HDFC Bank
- Historic FCF growth: 22% CAGR over 7 years
- Projection period: 10 years
- FCF growth rate: 18% for next 7 years, 12% for next 3 years
- Terminal growth rate: 7%
- Discount rate: 12%
NPV = Rs 5,01,224 cr
3) Infosys
- Historic FCF growth: 12% CAGR over 10 years
- Projection period: 8 years
- FCF growth rate: 10% for all 8 years
- Terminal growth rate: 4%
- Discount rate: 9%
NPV = Rs 1,92,038 cr
4) Dabur
- Historic FCF growth: 16% CAGR over 8 years
- Projection period: 15 years
- FCF growth rate: 14% for 8 years, 10% for next 7 years
- Terminal growth rate: 6%
- Discount rate: 11%
NPV = Rs 97,983 cr
5) Bharti Airtel
- Historic FCF growth: 22% CAGR over 5 years
- Projection period: 7 years
- FCF growth rate: 18% for 5 years, 12% for next 2 years
- Terminal growth rate: 8%
- Discount rate: 10%
NPV = Rs 2,55,722 cr
So in summary, company-specific assumptions based on past performance, competitive advantage period and growth opportunities are used to project cash flows and arrive at valuation.
Chapter 15: Equity Research (Part 2)
Here are the key concepts covered in Chapter 15 on Equity Research (Part 2) with an example:
Steps in Equity Research:
Stage 1 - Understand the Business
- Involves studying products, business model, industry, competitive landscape etc.
Stage 2 - Apply Checklist
- Analyze financial statements, ratios for revenue, profitability, leverage, efficiency etc.
Stage 3 - Valuation
- Estimate intrinsic value using DCF analysis.
DCF Analysis:
- Uses projected free cash flows (FCF) discounted to present value to arrive at intrinsic value.
- FCF represents cash available for shareholders after reinvestments.
- Growth rates assumed for FCF projection should be reasonable based on past performance and prospects.
Example:
Amara Raja Batteries
- Historical FCF ~Rs. 140 cr
- Assume 18% FCF growth for 5 years, 10% for next 5 years
- Discount rate = 9%
NPV of Projected FCF = Rs. 1,968 cr
+ Cash balance - Debt = Rs. 218 cr
= Total Value = Rs. 6,078 cr
Value per share = Total Value / No. of shares
= 6,078 / 17.08 cr
= Rs. 356 per share
So in essence, equity research aims to thoroughly assess business quality, financial health and valuation to identify good long-term investments.
Here are some additional aspects for investors to consider in equity research:
Management Assessment:
- Analyze management's capital allocation track record and strategy execution.
E.g. Bajaj Finance's management has delivered high growth with prudent underwriting standards.
Growth Runway:
- Assess size of addressable market and company's competitive position to gauge growth potential.
E.g. India's underpenetration in insurance presents long runway for companies like ICICI Prudential.
Moat Evaluation:
- Study strength, sustainability and width of competitive advantages.
E.g. Pidilite's dominant brand and distribution makes its moat hard to breach.
Margin Analysis:
- Trend analysis of margins to check for pricing power and cost efficiencies.
E.g. Asian Paints' consistent gross margin expansion indicates pricing power.
Liquidity Assessment:
- Evaluate cash position, working capital needs and access to capital.
E.g. Be aware of high debt levels and poor cash conversion cycles.
So in essence, comprehensive equity research should cover all qualitative and quantitative factors that impact a company's long-term prospects.
Chapter 16: The Finale
Here are the key points covered in Chapter 16 - The Finale:
Drawbacks of DCF Analysis:
- Requires forecasting future cash flows, which involves uncertainty.
- Highly sensitive to terminal growth rate assumption.
- Needs regular updating with new data/information.
- Long-term focused, so doesn't help with short-term price movements.
- May miss out on unanticipated opportunities outside modeled assumptions.
Mitigating the Drawbacks:
- Adopt prudent assumptions for growth rates and projection periods. Avoid being too optimistic.
- Use reasonable terminal growth rate around 4-5%. Avoid much higher rates.
- Update analysis by refreshing projections frequently as new data comes in.
- Apply margin of safety by buying at discount to estimated intrinsic value.
- Consider relative valuation multiples as a sanity check.
When to Sell?
- Exit when investable characteristics like competitive advantage, growth prospects start diminishing.
- Book profits if stock becomes significantly overvalued versus intrinsic value.
Ideal Portfolio Size:
- Over diversification leads to dilution of returns.
- Portfolio of 10-15 stocks allows adequate diversification while enabling outsized gains.
Key Takeaways:
- Adopt long-term investing mindset with reasonable return expectations.
- Develop checklist to assess investable attributes.
- Conduct thorough business and financial analysis.
- Buy quality stocks at reasonable valuations with margin of safety.
So in essence, diligent fundamental analysis along with valuation prudence is key for long-term equity investing success.
Disclaimer:
All company names and stock tickers mentioned in this summary are used purely for illustrative purposes to demonstrate concepts, frameworks, and examples. They should not be construed as recommendations to buy or sell stocks. The stocks may or may not suit an investor's requirement. Potential investors should conduct their own research and analysis on suitability of stocks for investment. We do not provide any guarantees of returns on the stocks mentioned. The stocks carry their own market and fundamental risks which need careful evaluation. The objective here is to equip investors with relevant knowledge and not promote any particular stock. Returns realized in the past on these stocks should not be taken as indicative of future performances. Markets are inherently volatile, so readers are advised to exercise prudence.
Reference & Source: Module 3_Fundamental Analysis.pdf (zerodha-common.s3.ap-south-1.amazonaws.com)
Thank you Note.
Dear Zerodha,
I wanted to take this opportunity to thank you for making the fundamental analysis module available as a free PDF. Going through the 16 chapters has been an extremely rewarding experience for me.
The content has been presented in a lucid manner that makes it easy for even a beginner to understand the nuances of fundamental analysis. The systematic structure of the module takes the reader through all aspects starting from developing an investing mindset, reading annual reports, understanding financial statements, digging deeper through ratio analysis to practical frameworks for conducting equity research.
The practical examples used to explain the concepts are very helpful in concretizing the learning. The chapters achieve a fine balance between theory and application. This ensures readers can internalize the concepts well. The summaries help recapitulate the key takeaways from each chapter.
I sincerely appreciate the effort that has gone into crafting this high-quality content and offering it for free to educate retail investors. It is a great initiative that promotes knowledge sharing. The module has equipped me well to conduct my own equity research and make prudent investment decisions. My entire thinking towards long-term equity investing has evolved after reading this.
Thank you once again for creating this module. I am sure it will be immensely valuable for every retail investor interested in doing proper due diligence. Please continue the good work in your mission to empower the individual investor.
Thank you.
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