**Equity Research**

The objective of stock analysis or equity research is to find out good stock for investment and arrive at fair valuation of the stock. There are about more than 1500 stocks traded in NSE and more than 5000 stocks traded in BSE. How do we select a stock to analyze? There are two major approaches to narrow down the screening of stock. They are top-down and bottom-up approaches.

Top-down approach means first studying the economy then the industry and finally the stock in the particular industry. An analyst will first analyze the economy to find out which sector is likely to grow in a particular economic condition and then he/she will analyze the sectors that are likely to be benefited and then they will narrow down their search of stock within that sector.

Bottom-up approach is a process where a stock is first screened and then its financial and other aspects are analyzed with respect to the industry and economy it operates in.

Whether you follow a top-down or bottom-up approach, the stock analysis includes three steps as depicted in the below image.

**Analysis of past performance**

First and foremost requirement in stock analysis is to understand the business of the company you are analyzing. For example it is easy to understand the business of Britannia Industries which manufactures food products than to understand the business of engineering companies. It is because we know about the food products especially biscuits which is the main product of Britannia. We know what raw materials goes into producing biscuits and so on. Along with the products and manufacturing process, we need to know about the company's promoters, their future plans and the company's competitors etc. The best way to understand the business of a company is to read the annual report and browse through their website to know about their products and services, their mission etc.

Think of you starting a business and you wanted to set up a departmental store. You have to think and decide on the following:

- What will be the product you deal in?
- Where do you source the product from?
- Who will be your customer?
- Is there any competition from other stores in that area where you will be setting up your store?
- What is your plan to attract more customers?
- How big should be your store?
- How do your source the capital you need to set up a store?

And many more........

Similarly, when you have selected a stock to analyze read the annual report and understand their business. You can list down the following questions and try to get the answers:

- What is the product or service of the company?
- Who are the promoters of the company?
- When was the company started?
- Where is the factory or plant of the company located?
- What is the raw material required to manufacture company's products?
- How do the company source its raw materials? Is it available in India or it has to be imported?
- Who are the end user or customers of company's products?
- Who are the competitors of the company?
- What is the promoters shareholding percentage?
- What is the future plan of the company?
- Is the company's business vulnerable to government policies?
- What is the market share for company's products?
- What is the company's business model?
- What are the challenges the company face? And what is the management's plan to overcome the challenges?
- If there is any ongoing projects, what is the status of the projects?
- What is the installed capacity of plants?
- What is the capacity utilization of the plants?
- What is the product mix and which product contributes more to revenue?
- What is price realization for its products? And has it improved?

Above are some of the examples of questions for which you can find answer from the annual report. You can also know the latest developments in the company or latest news from the business news papers such as “The Economic Times” and others. Once you start delving into the company's annual report and latest news if any, more questions will arise in your mind for which you need an answer to understand the company better. However, as an individual investor we have access only to annual report. Or existing shareholder's have an opportunity to attend the company's annual general meeting held once in a year, where they can clarify their doubts if any with the management.

After reading the annual report you will get good sense of the company's business. Next thing you should do is to analyze the financial statements such as balance sheet, profit and loss statement and cash flow statement. We have already seen how to analyze the financial statements with the help of ratio analysis. Best way is to incorporate the P&L and balance sheet figures of last five years in a spreadsheet (excel) and calculate the ratios. Last five years data will help you to know the trend of the business growth and how well the company manages it. Though there are many ratios, it is not necessary that we should apply all the ratios. We will use only some of the important ratios to analyze the financial of Wabco India Ltd.

The important ratios which I personally apply are analyzed and explained below.

**Sales growth**

The sales revenue for Wabco has grown at a CAGR of minimum 20% in last 5 years. During 2015-16 the sales has grown by whopping 48% and the company has outpaced total industry average sales growth in that year. Below is the snapshot of yearly sales growth.

A CAGR of more than 20% is a good one. The fall in sales growth during 2017-18 and 2018-19 was due to slowdown in the economy and meltdown in auto sector particularly. Information on economy and industrial cycle can be got from daily newspapers and business TV channels which keep publishing the trends in economy and industry.

**Profit margins and growth**

Gross profit is calculated by subtracting the expenses that goes into manufacturing the products I.e cost of goods sold (CGS). But I used to take the other administrative and selling expenses and depreciation also while calculating gross profit. So, I have considered the earnings before interest and tax (EBIT) for this purpose.

Gross profit = Operating revenue – Expenses before interest and tax

and

Net profit = Operating revenue – Profit after tax

and

Profit margins will be calculated as follows:

Gross profit margin = Gross profit / Operating revenue

Net profit margin = Net profit / Operating revenue

In the below snapshot you can see that the gross profit (earnings before interest and tax) and net profit (profit after tax) has grown at a CAGR of 23.55% and 23.66% respectively as on March 2019. The growth in profit is more than the growth in sales despite weak demand due to slowdown in the economy during 2018-19. This shows that the company is able to maintain its overheads under control.

We can also check whether the profit growth is due to higher sales realization the company enjoys for its products. This can be known from the production and sales volume details if it is available in annual report.

**EPS growth**

We have already seen what is EPS when we discussed about ratios. It shows the earnings of the company in terms of number of shares. Wabco's earnings per share has grown in line with its net profit growth. The growth in net profit and EPS will differ only if there is any increase or decrease in number of shares. Since there is no fresh issue of shares in case of Wabco, the net profit and EPS growth are same. It is beneficial for existing shareholder's as it indicates higher returns for them.

From the above snapshot you can see that the year on year growth in EPS is fluctuating and at the end of March 2019 it is just 3.48% growth. But if you check the CAGR, it shows a compounded growth of 23.68% which is a good indicator for long term investors.

**Return on capital employed**

Return on capital employed shows how well the company uses its both debt and equity capital to generate profits. Wabco's return on capital employed though it fluctuates year on year, it is in a healthy range.

Remember the weak demand during 2018-19 has led to fall in sales revenue which in turn is reflected in returns ratio. So it has to be compared with returns of other companies operating in this industry to get the real sense. Otherwise the ROCE of 22.64% is generally a healthy returns.

**Debt equity ratio & interest coverage ratio**

Generally I will check these ratios. But in case of Wabco, since the company has no borrowings the necessity to check debt equity ratio and interest coverage ratio does not arise.

Do you remember when we discussed about ratios we had calculated debt equity ratio and interest coverage ratio for Tata Motors? Debt equity ratio was 0.79 which is healthy when considering the capital intensiveness of the industry. Generally a ratio upto 1.5 is considered to be good. However, it can be higher for banks and finance companies as their business involves borrowing and lending.

**Inventory turnover ratio**

For Wabco, I feel inventory turnover ratio and average collection period are important parameters to analyze given the slowdown in the economy. It shows how the company manages its inventory at times of weak demand.

We have discussed about this ratio in ratio analysis section. Now let us compare it with previous years.

Inventory turnover ratio = Cost of good sold / Average inventory

The inventory turnover ratio has increased from 8.21 in 2015-16 to 13.52 in 2018-19 which is very high. It means the company sells and replaces its inventory 13.52 times in a year. When comparing to industry average of 7-8 times this ratio is very high. It also means the company does not maintain enough inventory. You can also see from the snapshot above there is a fall in average inventory levels in 2018-19.

**Average collection period**

Average collection period shows how fast the company is able to collect its dues from its customers. Have a look at the snapshot of Wabco collection period for last 4 years.

Number of days is increased from 67 to 82 days along with increase in average receivables when compared to sales. So it means the company is facing problem in collecting its dues and more of its sales are blocked which is known from higher receivables.

**Interpretation**

We have completed the first step of equity research which involved reading the annual report and analyzing the financial statements with ratios. Through ratio analysis we have found that the company's sales has been growing at a healthy pace of more than 20%. Profit margin and growth has been good which shows the efficient management of overheads. The returns ratios and earnings per share also has been good. But we can sense some problem with working capital management which is essential for managing day to day liquidity issues. The inventory turnover ratio which is increasing and is more than industry average hints a problem the company faces. And the increasing collection period confirms the issue existing in the company's short term liquidity management.

**Forecasting future earnings**

Having studied the past performance of Wabco, now let us forecast the future earnings by using cash flow statements. As we have found the growth rate of sales turnover and profit margin etc one method is to forecast the future earnings at same growth rate. These traditional methods will be just an extrapolation of figures and it will not give a true picture. This can be understood by the fact that the sales and profit and earnings growth looked impressive from the profit and loss statement and balance sheet. Net current asset was also good which meant the company has more current asset than current liabilities and this can take care of the short term liquidity. But from working capital ratios such as inventory turnover ratio and average collection period we sensed some problems in short term liquidity.

Hence, forecasting future cash flows is important to arrive at fair estimate of future earnings. For this let us first understand what is cash flow statement. Cash flow statement shows the actual inflow and outflow of cash. It shows how much cash is generated by the company through its various activities. The company's activities are classified into three viz., operating activities, investing activities and financing activities. Operating activities include production, sales and marketing and everything related to day to day operations of the core business. Remember, the funds which is required for day-to-day operations is called working capital. Investing activities includes all capital expenditure incurred towards purchase of capital assets such as building, plants and machinery etc. Financing activities include payment of dividend to shareholders, sourcing or refpaying debt capital and equity capital for the company.

Why it is so important to check the cash flow statement of a company? To understand the importance let us assume for example, a company's sales may increase year on year. But if majority of the sales are done on credit basis for which the company receives payment later then the company may not have enough cash for its day-to-day operations. All the sales income would have been blocked as receivables. And if the company takes more number of days to collect its dues from the customer, it leaves the company with no cash to meet its day-to-day expenses. This may lead to more borrowings by the company which in turn lead to higher outflow of money by way of interest on borrowings.

The company's cash flow is negative for last 4 years. If we check the reason for the negative cash flow, we can find that the company has parked more funds in investment in mutual funds which is a more risky investment. This investment is a current asset and it is a component of working capital. As we have already seen that operating activities includes cash flow from day-to-day operations which is called working capital. Finally, Wabco's cash flow is negative and when it is read with the inventory turnover ratios and average collection period which we discussed above already, the company seems to be facing some short term liquidity issues. But remember, this should be compared with other companies in the same industry to understand whether this is s cyclical issue that faces the industry or it is company specific.

As the cash flow from operating activities itself is negative for last 2 years, we cannot proceed with further analysis or forecast of future earnings. We need to get more information to study the company further and as retail investors we have only limited access to information. Hence, let us not indulge in forecasting future earnings of Wabco. But I would not turn totally negative towards the company's growth because we understood about the qualitative aspect such as management of the company and their policies by reading the annual report and by analyzing the balance sheet we know it is a cash rich company with huge cash of Rs.1770.49 crores as reserves against very low equity base of Rs. 9. 48 crores and a totally debt free company.

Since we could not continue with Wabco let us now consider Asian Paints to understand fully about forecasting and valuation using “Discounted cash flow” method.

**Discounted Cash Flow Method**

At this stage, I will introduce you to widely used concept of discounted cash flow (DCF). Discounted Cash flow is a process of calculating the present value of future cash flow. We have seen that cash flow statement shows how much cash is generated by the company from its activities. A healthy cash flow will reflect the ability of the company to sustain during times of downturn. Using DCF method we will calculate the average cash flow Asian Paints has generated over last 4 years. It is always advisable to consider at least last 4 or five years data to weed out any anomalies. And based on the average cash flow we will forecast the future cash flows. The number of years we going to forecast will be infinite because, generally it is assumed that the company will continue to be existing for "n" number of years.

**Step 1**

The first step under DCF method is to calculate average cash flow. To calculate the average cash flow we are going to consider only the "Free cash flow (FCF)". Free cash flow (FCF) means the cash available after considering the capital expenditure and investment.

The formula to calculate free cash flow will be:

FCF = Net cash generated from operating activities - Capital expenditure & other investments

Below is the extract of cash flow statement of Asian Paints for the years 2018-19.

Below is the extract of cash flow statement of Asian Paints for the years 2016-17.

In the above extract I have marked the net cash from operating activities and capital expenditure and other investments with an arrow. With these figures I have calculated free cash flow and average cash flow over last 4 years and presented in the below image.

The average cash flow is Rs.442.23 crores

**Step 2**

As next step, we have to calculate future cash flow based on the average cash flow which we arrived as Rs.442.23 crores. For this we should decide a growth rate we want to apply. I have decided the growth rate as 15% for the first 10 years and 5% for the remaining infinite years. The growth rate I have decided by taking into consideration the last 10 years growth rate of Asian Paints which is 19.5%. Last 10 years financial snapshot is provided in the annual report.

The cash flow in the first year that is 2019-20 will be as follows:

Past average cash flow * (1+ growth rate)

= 442.23 * (1+ 15%)

= 442.2.3 * 115%

= Rs.508.56 crores

Estimated cash flow for next year 2020-21 will be:

= 508.56 * 115%

= Rs.584.85 crores

In the similar way you can calculate for next 8 years totaling 10 years together. I have calculated it and presented it in below table.

From the table above, we can find that the future cash flow value at the end of 10th year will be Rs. 1789.07 crores.

For the remaining infinite years we should calculate with different formula as it requires to be calculated for infinite number of years. The cash flow that is forecast for beyond 10 years is called "Terminal Value and the growth rate that is applied to calculate the terminal value is called" Terminal growth rate". Generally, the terminal growth rate applied will be lesser than the rates applied for first 10 years because as the company grows and matures the rate of growth is bound to reduce. The formula to calculate terminal value will be as follows:

Terminal value = Free cash flow at 10th year * (1+ Terminal growth rate) / (Discount rate - Terminal growth rate)

As we going to calculate terminal value for beyond 10th year, we should take the free cash flow that was estimated for 10th year. Terminal growth rate I have decided to take is 5%. Now what is the new item "Discount rate" in this formula?

In simple terms discount rate is the rate of returns you expect over a period of time. On what basis you will expect the returns? If you are investing for longer period it means you are taking more risk as future is always uncertain. And you need compensation for the risk you take. Hence you expect more returns as you take more risk. Second do you remember what is time value of money and opportunity cost? We discussed this in first chapter of module 1. Let us recollect briefly. We understood that the value of Rs. 100/= after 2 years will not be the same as it is now. Money loses its purchasing power over a period of time due to inflation and opportunity cost. Let us recollect what is opportunity cost to understand the discount rate. We always have choices in this world for everything. When we choose one and fore go the other we will be missing on something that the foregone thing has. Refer here the example of opportunity cost explained in module 1. So the discount rate should be the risk free rate of return you expect. To arrive at risk free rate of return, I will consider the interest rate on long term government securities which is a zero risk investment. Generally, it will range between 7-8% per annum. So I decide to have a discount rate of 7% to calculate terminal value. Now let us apply this to the formula to find out the terminal value for Asian Paints.

Terminal value = Free cash flow * (1+ Terminal growth rate) / (Discount rate - Terminal growth rate)

= 1789.07 * (1+5%) / (7% - 5%)

= Rs.93926.02 crores

Add this terminal value and future cash value at the end of 10th year to arrive at total value of future cash flows.

= 1789.07 + 93926.02

= Rs. 95715.08 crores

**Step 3**

We have forecast future cash flows of Asian Paints as Rs. 95715.08 crores. Now comes the next step to find out how much this future cash flow will be equal to at today's money value? This process is known as finding the present value of expected future cash flow. Present value is one component of finding the value of a stock. It will help to find out whether the company's shares are currently undervalued or overvalued. And based on this you can decide whether to buy the stock at current traded price or not. But before moving on to valuation of stock let us now find the net present value of future cash flows estimated for Asian Paints.

The formula to calculate net present value is as follows:

Present value = Cash flow for the period / (1 + r)^n

Where:

R = discount rate

N = Number of years

Please note that net present value for the first 10 years should be calculated for each year separately and the sum of net present value for the period of 10 years is arrived. The net present value so arrived is presented in below table.

Net present value for terminal value will be as follows::

PV = Terminal value / (1+7%)^10

= 93926.02 / (1+7%)^10

= Rs. 47747.22 crores

Total of net present value for first 10 years and for terminal value will be:

= 6716.59 + 47747.22

= Rs. 54463.81 crores

The total net present value of all future cash flows including terminal value is called "Enterprise Value".

We have arrived at the net present value of future cash flows of Asian Paints now let us move on to find the valuation of its stock price.

**Valuation of stock**

Valuation of stock is done to find out the shareholders value. Hence, some adjustments are made to the net present value to arrive at a clear valuation of stock. The non-core assets and liabilities that was not included in cash flow statement is added or subtracted from the net present value.

Asian Paints has a very negligible borrowings of Rs. 10 crores which is an interest free loan from Haryana government on which the company actually earns some income. This is shown in the below extract from annual report.

Since Asian Paints is a debt free company adjustments are not necessary. However, for companies which has debt capital, the net debt should be adjusted. Net debt is nothing but total debt minus cash balance. This is done to arrive at net shareholder's value after accounting for company's borrowings which is not a shareholders fund.

The formula to calculate net debt is as follows:

Net debt = Total debt in the year - Cash and cash balances

Total debt and cash balances can be found in balance sheet.

There are other items that can be adjusted such as lease liabilities, pension liabilities etc. However, net debt is the most commonly adjusted as it forms major part for many companies.

Now let us arrive at the fair value per share for Asian Paints. The formula for this is:

Share price value = Total net present value / Total number of shares

The net present value is the total value of the enterprise. To find out the value per share which is of interest to individual shareholders, we divide the net present value by total number of shares. You can know the total number of shares from the annual report under schedule to equity shares. The extract of Asian Paints is given below:

Total number of shares is 95, 91, 97, 790. For calculation purpose I am taking it as 95. 92 crores of shares as the net present value is in crores. Therefore, fair price of the stock will be:

= 54463.81/ 95. 92

= Rs. 567.80

The fair price value we have arrived is called "intrinsic value of stock". So can we buy the stock at this price? Wait, we all know that no one can forecast the future accurately. There is bound to be some errors and unforeseen events happening. Hence it is better to decide the price band after providing for deviation. If we apply 10% deviation from the intrinsic value of Rs.567.80, the price band works out to Rs. 511 and Rs. 624.58 on both upper and lower side of the intrinsic value.

After arriving at intrinsic value band one should check the current market price to determine whether it is undervalued or overvalued or fairly valued.

If the stock is trading above the intrinsic value band it is said to be overvalued

If the stock is trading below the intrinsic value band it is said to be undervalued

If the stock is trading within the intrinsic value band it is said to be fairly valued

Let us check the market price of Asian Paints on this day 16. 09. 2019.

The closing rate on 16.09.2019 was Rs.1548.20 which was well above the intrinsic value band. The stock is extremely overvalued at current market price. This is due to the higher discounting the stock enjoys historically. Investors who are contemplating to invest in the stock can wait for it to correct and enter either at intrinsic value band or well below the intrinsic value.

**Key points to remember**

- Discounted cash flow is a valuation method under which the free cash flow of the company is forecast for future years and discounted with expected rate of return to find out the present value of future cash flows.
- The net present value so arrived is divided by the outstanding number of shares to find out the intrinsic value of stock.
- The intrinsic value of stock so arrived is compared with prevailing market price of the stock to find out whether the stock is overvalued or undervalued at current price.
- Investors can invest in the stock if it is trading at discount to intrinsic value or at least at intrinsic value.

**Round Up**

Fundamental analysis is a study of a company's qualitative and quantitative factors and forecasting its future earnings to make an investment decision. As first step, the past performance of the company should be analyzed thoroughly with the help of ratios. The performance of the company should be compared with other companies operating in same industry to find out the competitiveness. Next step is to forecast its future earnings. This can be done by forecasting its production, sales revenue and expenditure. Discounted cash flow (DCF) is a method under which future cash flows and present value of future earnings is arrived to find out the intrinsic value of the company. Then it is divided by the number of shares to arrive at intrinsic value of the stock. By this method we can find out whether the stock is undervalued or overvalued. The stock can be considered for investment if it is trading at discount to intrinsic value.

**Suggested readings**

“Equity Research & Valuations” by Dun & Bradstreet

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