2. Introduction
What is fundamental analysis
?
• Equity valuation
methodology utilizing
financial and economic
analysis.
• Used to determine intrinsic
value of a stock.
• Intrinsic value determines
whether investor should
buy, sell or hold the stock.
• Enables informed
investment decisions.
DEMO
Current
Market Price
Intrinsic
Value
Decision
100 120 Buy
100 90 Sell
100 100 Hold
5. Understanding the Basics
Time Value of Money
Present Value of money
An amount available today is worth
more than the same amount in future
due to its potential earning capacity.
For e.g. If you receive Rs 117 after 3
years, then the present value of this
amount today would be Rs 100.
This is because if today you invested
Rs 100 for a period of 3 years and you
earn a simple interest of 8% per
annum then the maturity amount
would be Rs117.
DEMO
Example
PV = FV 100
(1+r)t
FV = PV * (1+r)t
Where
PV = Present Value
FV = Future Value 117
r = Discount Rate 0.08
t = Time 2
6. Understanding the Basics
Future Value of Money
The value of an amount at a
specified date in the future
that is equivalent in value to a
specified sum today.
The future value of Rs 100
invested at 8% per annum
earning simple interest is Rs
117
DEMO
Example
FV = PV * (1+r)t 100
Where
PV = Present Value 100
FV = Future Value 117
r = Discount Rate 0.08
t = Time 2
7. Understanding the Basics
Interest rates and discount rates
• Interest rates provide the rate of return of an asset while
discount rates help us determine the present value of the
future earnings of an asset.
• To determine the appropriate interest rates to be used for
discounting future cash flows, understanding the following
concepts is important.
• Weighted Average Cost of Capital (WACC)
• Risk-free Rate
• Equity Risk Premium
• The Beta
DEMO
8. Understanding the Basics
Weighted Average Cost
of Capital (WACC)
WACC is the discount
rate of the cost of
capital required for
discounting future
cash flows to
determine present
value of the said cash
flows
DEMO
WACC = D * (1-t) + E * Ke + P * Kp
TC TC TC
Where
D = Debt portion of firm's total employed capital
TC = Firm's total capital employed (D+E+P)
Kd =
Firm's cost of
debt
t =
Firm's effective tax
rate
E = Equity portion of firm's total employed capital
P = Preferred equity portion of firm's total employed capital
Kp = Cost of firm's preferred equity capital
Ke = Cost of firm's equity
9. Understanding the Basics
Risk-Free Rate (RFR)
• The theoretical rate of return of
an investment with zero risk,
including default risk. The default
risk is the risk of an individual or
company or even a country would
be unable to pay its obligations to
its debt holders.
• The risk-free rate represents the
interest an investor would expect
from an absolutely risk-free
investment over a specified period
of time.
DEMO
In practice the RFR does
not exist, as even the
safest investments carry
a very small amount of
risk. Hence, often the
interest rate of a 3-
month U.S treasury bill
is used as the RFR.
10. Understanding the Basics
Equity Risk Premium
• The excess return provided by
a stock or the overall equity
market over the risk-free rate
(RFR). This is required to
compensate investors for the
relatively higher risk of the
stock.
• High risk equity investments
have higher risk premiums and
the premiums also change
constantly, thus reflecting the
changing market conditions.
DEMO
If the return on
a stock is 17% and the
risk-free rate over the
same period is 8% ( e.g.
GOI 10 year bond), the
equity-risk premium
would be 9% for this stock
over that period of time.
11. Understanding the Basics
The Beta
• Statistical measure indicating
the volatility of a stock’s price
relative to the price movement
of the entire market.
• Higher beta stocks have greater
price volatility with greater
riskiness however such stocks
have potential of providing
higher returns. Lower beta
stocks have lower risks and also
have lower returns.
DEMO
Beta
Market Stock Explanation
1 0 No correlation between stock
price and market
1 1 Perfect correlation between
stock price and market
1 < 1 Stock price less volatile than
the market
1 >1 Stock price more volatile than
the market
12. Understanding the Basics
Risk Adjusted Return (Sharpe Ratio)
• Calculated by subtracting the risk-
free rate - such as that of the 10-
year GOI bond - from the rate of
return for a portfolio and dividing
the result by the standard
deviation of the portfolio returns.
• Enables comparable portfolio
analysis by adjusting for risk.
• Helps to determine whether
portfolio returns are due to skilful
stock picking or due to excessive
risk taking.
DEMO
S = R - Rf
σ
S = Sharpe Ratio
R = Stock return
Rf = Risk free return
σ =
Standard
deviation of
the stock
Sharpe Ratio Remark
1 - 2 Good
2 - 3 Very Good
> 3 Excellent
15. Financial Statement Analysis
Management Discussion &
Analysis
The MDA includes an analysis
of the results of operations and
discusses management’s
opinion about current and
future performance. It
compares the prior year’s
operations with the current
year’s and their impact on the
company’s financials. It also
contains an analysis of the
firm’s financial condition.
DEMO
17. Financial Statement Analysis
The Auditor’s Report
Before issuing annual
statements, all
publicly held
corporations are
required to have an
independent audit of
their financial
statements. The
CPAs who conduct
the audit render an
opinion as to the
fairness of the
statements.
DEMO
