Quantitative and Qualitative Analysis

An introduction
 When it comes to accumulation of wealth few subjects are more
talked about than stocks.
 Many new investors believe that there is some infallible strategy
that will guarantee success.
 There is no foolproof system of picking stocks.
 There are innumerable factors that effect a company’s health.
 A lot of information is intangible and cannot be measured.
 It is difficult to measure qualitative factors such as employee
quality, competitive advantage, reputation etc.

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 An introduction
 The combination of tangible and intangible aspects makes stock
picking a highly subjective process.
 Because of the human element inherent in the forces that move
the market, stocks do not always behave as per expectations.
 Emotions can change quickly and unpredictably and when
confidence turns into fear stock market can be a dangerous place.
 The bottom line is that there is no one way to pick stocks.

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 Fundamental Valuation
 The objective of FV is to find a stocks intrinsic value
 If intrinsic value is more than the current share price it makes
sense to buy the stock.
 Although methodology differs the basic presumption is the same –
the company is worth the sum of its discounted cash flows (DCF).
 DCF looks great in theory but implementing it in real life can be
quite difficult.
 Forecasting future cash flows can be a daunting task.
 Dividend Discount Model (DDM) is commonly used to arrive at
present valuation.

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 Qualitative Analysis
 Valuing company not only involves crunching numbers and
predicting cash flows but also looking at the general more
subjective qualities of the company.

Who is at the helm of affairs ?

How good is the quality of the Management?
Do they have a good track record ?
What is the management’s philosophy ?

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 Qualitative Analysis
Understand the business model.
Analyze the general characteristics of the industry such as its
growth potential.
A mediocre company in a great industry can provide solid return
than a good company in a poor industry.
Market Share
Economies of scale
Entry barriers
Brand names
Keep it simple

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 Factors to consider

Price To Earning Ratio (P/E)

Price Earning to Growth Ratio (PEG)
Return on Capital Employed (ROCE)
Return On Equity (ROE)

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 Price to Earning Multiple
The Price to Earning Ratio or the P/E Multiple.

P/E = CMP/EPS
where CMP is the current market price and
EPS is PAT/No of shares

The P/E tells us how many times the earnings are the investors
willing to pay for the share.
P/E can vary from industry to industry and even within stocks
from the same industry.

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 Price to Earning Multiple
Why do some companies enjoy high P/E multiples ?

Higher Growth Potential

Good Management
Higher Operating Margins
Higher Return on Equity
Higher Return on Capital Employed
Negligible Leverage
High Entry Barriers
Large Market Share

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 Price to Earning Multiple
What are the reasons for lower P/E multiples ?

Limited Growth Prospects.

Poor Corporate Governance
High Debt Component.
Mediocre Profitability Ratios.
Intensive Competition.
Declining Market Share.

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 THE PEG RATIO

PEG = PE/Expected Earnings growth

The PEG uses the P/E of the company and compares it with the
company’s annual growth rate.
The PEG ratio is an improvement over the standard PE ratio in
determining whether a stock is overvalued, undervalued or fairly
priced.
If a stock is fairly priced, then its P/E ratio should equal its annual
growth rate.
The expected growth rate is an assumption and can be projected
based on its recent performance.
A PEG of 1 would indicate that the market has fairly priced in the
anticipated growth

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 THE PEG RATIO
Example
A stock trades at 24 times its earnings while the expected growth
rate for the nest few years is 16%.
The PEG ratio in this case would be 24/16 = 1.5.
The market is giving a higher P/E multiple compared to its
anticipated growth rate.
The stock is trading in a dangerous territory relative to its
valuation.
There is undue hype over the stock with the markets probably
expecting higher growth rate.
If the company fails to deliver on the growth front then the stock is
highly susceptible to a deep correction.

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 THE PEG RATIO
Example
A stock trades at 20 times its earnings while the expected growth
rate for the nest few years is 25%.
The PEG ratio in this case would be 20/25 = 0.80
The market is giving a lower P/E multiple relative to its anticipated
growth rate.
The stock is trading relatively cheap compared to its earnings
growth.
The markets have not fully priced in the growth potential.
If the growth comes in as expected the stock can appreciate
substantially from current levels.

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 THE PEG RATIO
If the PEG ratio is greater than one, it would indicate -
The markets expectation of growth is higher than the analysts
estimate.
The stock is currently overvalued due to excessive hype.

A PEG ratio is lesser than one, it would indicate -

The markets are underestimating the projected growth and the
stock is thus undervalued.
Analysts estimate of future earnings growth is set too high.

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 THE PEG RATIO
Advantages of using the PEG ratio
Investors prefer PEG because it gives an entirely new dimension in
valuing a company.
PEG differentiates between an over-hyped company and the one in
which a high P/E is supported by ensuing growth.
Disadvantages of using the PEG ratio
Cannot be used meaningfully for tracking companies which do not
enjoy high growth rates.
A company’s growth rate is only an estimate and is subject to
limitations of projecting future events.

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 RETURN ON CAPITAL
EMPLOYED
Return on Capital Employed (ROCE) reflects a company’s ability to
earn a return on its total capital.

ROCE = EBIT/Capital Employed

 EBIT is the operating income and is the net revenue after all the
operating expenses have been deducted.
 Capital employed consists of all source of funding including
ordinary and preferred shares, reserves and surplus, short term
and long-term debt

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 RETURN ON CAPITAL
EMPLOYED
Capital employed can also be represented as total assets minus
current liabilities.
ROCE therefore represents the efficiency and profitability of the
company’s capital investments.
ROCE is a useful measurement for comparing the relative
profitability of companies.
ROCE does not consider profit margins alone but also considers
the amount of capital utilized for these profits to happen.
Some companies may have higher profit margins but its ability to
get better return on its capital may be lower.
ROCE therefore is a better measure of efficiency.

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 RETURN ON CAPITAL
EMPLOYED
Example
ABC makes a profit of Rs. 10 crs while XYZ makes a profit of Rs. 15
crs on sales of Rs. 100 crs.
In terms of pure profitability ABC has a profit margin of 10% while
XYZ has a profit margin of 15%.
However, let us assume that ABC has used 50 crs of capital while
XYZ has used 100 crs to generate their respective profit figures.
Therefore, ROCE of ABC is 10/50*100 = 20% while ROCE of B is
15/100 *100 = 15%.
ROCE shows that ABC makes better use of its capital although its
profit margins are lower.

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 RETURN ON CAPITAL
EMPLOYED
ABC is able to squeeze more earnings out of every rupee of capital
it employs than XYZ.
In general ROCE should always be higher than the cost of capital.
Any increase in company’s borrowings will put an additional debt
burden on the company and will also reduce shareholders
earnings.
Therefore, as a thumb rule ROCE of 20% and above is considered
quite good.
If a company has low ROCE, it means that it is using its resources
inefficiently even if its profit margins are high.

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 RETURN ON EQUITY
Return on Equity (ROE) is the amount of net income returned as a
percentage of shareholders equity.
ROE = Net Income /Shareholders Equity where
Net income is PAT less preference dividends and
Shareholder's equity excludes preference shares.
ROE measures the company’s profitability by revealing how much
profit the company generates with the money the shareholders
have invested.
ROE is useful in comparing the profitability of a company to that of
other firms in the same industry.

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 RETURN ON EQUITY
Example
ABC earns a net income of Rs. 4 crs on a shareholders equity of Rs.
20 crs.
This gives a ROE of 20% for ABC.
In other words, for each rupee invested by shareholders, 20% was
returned in the form of earnings.
ROE measures how much a shareholder gets on his investment.
From a shareholders perspective ROE is a relatively better measure
of profitability than ROCE.

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 RETURN ON EQUITY
ROE v/s ROCE
ROCE considers total capital which is in the form of both equity
and debt such as loans and borrowings.
ROE considers only the equity shareholdings to judge the
profitability of the company.
ROCE is an appropriate measure to get an idea about the overall
profitability of the company’s operations.
ROE is an appropriate measure to judge the returns a shareholder
gets on his investment.
Some of the most successful investors like Warren Buffet give
more importance to ROE.

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 FOCUS AREAS FOR INVESTORS

The Strength of the franchise.

The Quality of the financial statements.
The Promoter’s competence.
The Promoter’s integrity.

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 Strength of the Franchise

Distinctive Capabilities
Brands and Reputations
Architecture
Innovations

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 Strength of the Franchise

Strategic Assets
Intellectual Property
License and Regulatory Permissions
Access to Natural Resources
Political Connections
Sunk Costs incurred by first mover
Natural Monopolies

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 Strength of the Franchise

Strategic Assets
Intellectual Property
License and Regulatory Permissions
Access to Natural Resources
Political Connections
Sunk Costs incurred by first mover
Natural Monopolies

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 Strength of the Franchise

Understanding Sustainable Competitive Advantage

Price leader in the market.
Best employer in the sector.
Strongest regulatory and political connections.
Which company has best after sales service in this market?
Best track record of signing up new distributors
Longest queue of applicants for distributorship.

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 Quality of Financial Statements

Cash Conversion Ratio.

 Cash Tax Rate.
 Loans and Advances.
 Identity of the Auditors

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 Management Qualilty

Promoter’s Competence
Promoter’s Integrity.

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THANK YOU

2010 BSE Institute Limited