Business Fundamental Analysis For Reasons And Magnitude

Top down analysis

Describe about the Business Fundamental Analysis for Reasons and Magnitude.

Trying to quantify and identify the reasons and magnitude of movements in stock prices is one of the most important and challenging jobs for any financial analyst or advisory. Indeed, the movement is because of a lot of factors. Fundamental analysis is an extremely common and useful tool often employed to make some sense of this seemingly random activity as there are so many factors which contribute to stock price movements that identifying the factor perhaps becomes the biggest challenge. The fundamental analysis thus also seeks to find the “true value” of the company. As a thumb rule the companies which are more valuable than what the current market value is as per fundamental analysis are attractive investment opportunities and vice versa.

Top down analysis involves studying the macro factors and trying to gauge how it would affect the business, profits of the particular company in question and consequently also trying to gauge if any of the macro factors could have a significant effect on the future profits and price movements. For example, in economy with shrinking incomes and GDP and negative growth forecasts one can safely assume that a company which is in the business of selling luxury items might take a hit in its profits owing to the current economic scenario. For this purpose, we look at various data release statements from regulatory and authorised bodies such as RBA (Reserve Bank of Australia). The industry is obviously studied to gauge what conditions prevail in the industry and what the future might hold for the company. The recent developments and events in the particular industry can also help one determine what the future growth potential and future earnings might for a particular company in the same industry.  It is also important to study and know what the competitors are doing and what their market share is, what their core competencies are. For example, if a company in telecommunications sector is not having the adequate infrastructure in place to provide data services to its subscriber one can safely estimate that their profits might be hampered as a result of this, especially if the other players in the same industry have a well-managed infrastructure. For this purpose, the main analysis is quantitative and the source is various media articles available on the internet. Finally, the company’s financial statements and operating performance is analysed to see where the companies stand in terms of their competitors and the industry. For example, studying a company’s liquidity position would give an analyst an idea if the company is well equipped to leverage on an opportunity which might come its way. Financial ratios in that sense can play a very important and enlightening role, but they are not without their limitations. An ideal mix for fundamental analysis would be financial ratios, qualitative analysis and comparative analysis. For deriving the company’s current and recent financial and operating performance the best source is their annual report, usually available on their web-sites.

About the companies

The ultimate aim of fundamental analyst is to “arrive at a value or a set of values of a particular stock also called the intrinsic value” in technical jargon. (Abarbanell & Bushee, 1997) In essence every stock tends to revert to its intrinsic price. Hence If a stock is priced higher than intrinsic value it can be said to be “overpriced” while if it said to be priced lower than its intrinsic value it can be said to be “overpriced”. (Seng, 2012)

A brief about the two companies chosen for the study has been provided before we proceed for the fundamental analysis.

Santos Limited is Australia’s leading energy company and provides energy to homes, businesses and major industries in the Asia Pacific region. It was established in 1954 and is leading oil and gas producer. Santos when expanded actually means South Australia Northern Territory Oil Search.

Santos aspires to be a leading energy company globally and for that it aspires to gain a foothold in the South Asian markets.

Origin Energy is a leading Australian company in the energy sector and their main business is supply of energy and sleeping electricity and Gorging Energy considers it as their responsibility to provide a reliable, affordable and sustainable supply of energy to the communities we serve

For the top down analysis following are the parameters we have narrowed down to describe the overall health of the Australian economy. The figures are released by RBA.

Economic Growth: The RBA forecasts the economic growth of Australian economy at 3.3%. This is in sync with the growth rate which happened during 2015-16 also at 3.3%

GDP: The Australian GDP stands at 1.62 trillion in terms of US dollars as of 2015. The GDP is dominated by the services sector but significant contributions include those from mining, manufacturing and agriculture.

Inflation: Inflation stands at 1% as per September data released by RBA. The inflation during September last year was around 1.5% while over the last one year never did it fall below 1% and it didn’t exceed 1.7%. These are overall stable numbers.

Cash Rate: The official cash rate or the OCR as it is commonly called is an important tool deployed by the RBA to influence the monetary policy. It is most effective for countering inflation and influencing the demand patterns within the economy. The official cash rate is the main tool at the disposal of RBA which it used to influence and shape the monetary policy. The main usage of this is to control inflation and influence spending and investment patterns. OCR (Official Cash Rate) is updated every 4-5 weeks by the RBA. The current cash rate is 1.5% which is unchanged from the last release of August but an overall decrease of 33.33% if we compare it with the last year September figure of 2%. Overall there hasn’t been much fluctuation over the last year in OCR hinting at an overall stable environment. (RBA, 2016)

The Industry Analysis

AUD vs USD: The currency pair of AUD and USD was trading at 0.77 while writing this report. As per the report released by RBA on September 9 the AUD vs trading at 0.768 vs the US dollar. The on year average for this currency pair was around 0.72 with a low of of 0.68 and a high of 0.8. Overall there hasn’t been a fluctuation of very large or alarming proportions in the period.

Looking closely at all the parameters we can draw a conclusion that right now the Australian economy is in stable/low growth phase. For a saturated market economy like Australia the growth rate projection is fairly decent if not very optimistic. The AUD has done reasonably well despite the crisis in the mining industry which is the biggest determinant of its value. OCR, inflation rates etc. haven’t been volatile.

In that regard credit must be given to the Australian economy for remaining resilient and stable in the wake of the big upheavals in the mining industry which is such a big contributor to Australia’s GDP and economic wellbeing.

The overall conclusion that be drawn from top down analysis with respect to Santos and Origin Energy is that the macro economic factors aren’t going to play a major role in the growth potential and future earnings and consequently the share price movements.

Coal remains the main fuel source for majority of Australia’s power generation to the tune of almost 80% while hydroelectric power confutes for less than 10% and the rest is taken by other sources such as wind energy, solar power and nuclear power. Different states have different policies for power and all the states are committed to increase their generation of power from renewable sources in a bid to reduce their carbon footprints.

The Australian Energy sector like its global counterpart has to brace itself for some challenging times ahead. Some of the major challenges for this industry are:

Managing rapid change: Everyone is looking at lower emissions in the future. Hence there is pressure on the companies to switch to more and more renewable sources for generation of electricity while at the same time still sticking to the conventional fuels. The phasing out has to be gradual and one which requires a lot of investments upfront.

Reduction in operating costs: As the completive space becomes more dynamic it is the need of the hour for the companies to reduce their costs and provide services to end customers at the same rates.

Methodology: Bottom Down Analysis

Indeed, there are lot many challenges facing this industry but we describe the two main challenges which could seriously impact the financial stability of these companies

For the bottom down analysis we haven’t calculated all the financial ratios and instead only concentrated on those ratios which are important for studying whether the stock is overvalued or undervalued. That’s why the financial ratios that we have calculated are ROE, Price-Earnings (P/E ratio) and book-market value. The ratios have been defined and the methodology of their calculation is described as follows 

ROE or Return on Equity is considered as the main profitability ratio and is a measure of the return obtained as a percentage of the shareholder’s investments or equity in the company’s capital structure. Generally, as a thumb rule the ROE should be higher than the required rate of return on the stocks. ROE can be calculated by dividing the Net Income with the shareholder’s equity. Both these figures are available on the company’s annual report. (Damodaran, 2007)

Required rate of return on equity is calculated using the CAPM Model which is Re=Rf+β(Rm-Rf). Rf is the risk free return or the rate which the investors can get by investing in a security or an investment devoid of any risk. (Fama & French, 2004); generally, the rate on a 10-year Australian Bond is considered as the risk free rate. (Rf-Rm) is the risk premium which stockholders seek as a reward for investing in a risky investment like an equity. Here gain Rf as described earlier is the risk free return whereas Rm is the expected market return. Beta is the measure of the volatility of the stock. For our calculations we have taken Rf as 4.2% which is the yield on 10 year Govt Bonds as per Bloomberg’s and the Rm as 6.25%. (Damodaran, 2016)

As the name itself suggests EPS is a measure of earnings achieved by company per share. This is calculated by dividing Net income with number of shares outstanding. EPS in isolation tells us not much but it is the first step towards calculating P/E ratio which is a useful tool to study the premium shareholders place on a particular stock. (Wan-Ting (Alexandra) Wu, 2014) P/E ratio is calculated by dividing the current market price with the EPS. P/E ratio of any particular stock is compared against the industry average to ascertain how a shareholders perceive a stock. (Gottwald, 2012)

The book value of the share is obtained by dividing the book value of assets with the number of shares outstanding. Whereas market value is the currently traded price of a stock. A book-market value ratio is obviously the ratio between these two prices. (Oysazar, 2012) In basic terms if the ratio is more than 1 then the stock is undervalued and if it is more than 1 then the stock is overvalued. However, it is not always that simple and various factors such as the growth potential of the company, the industry in which the company operates and a lot many factors come into play while evaluating this ratio. (Kothari, 2004)

The data required to calculate the various indicators is summarised in the table below. The data is obtained from their annual reports, websites such as Yahoo Finance and Australian Stock Exchange.

Net Income/Loss	(2698) million AUD
Number of Shares Outstanding	1.77 billion
Total Assets	21,926 million AUD
Market Price	2.7 AUD
Total shareholder’s equity	10,202 million AUD
Beta	2.65

The calculation of the various ratios and indicators for Santos is summarised in the table below. Wherever applicable and available figures have been directly transported from annual reports. If not available, they have been calculated with the calculations clearly shown.

ROE
Required return on equity	=4.2+2.65*(6.25-4.2) 9.64%
EPS	(234.2) cents
P/E ratio
Book Value per share	10,202/1.77 5.76
Book-Market ratio	2.13

The data required to calculate the various indicators is summarised in the table below. The data is obtained from their annual reports, websites such as Yahoo Finance and Australian Stock Exchange.

Net Income/Loss	(449) million AUD
Number of Shares Outstanding	1.75 Billion
Total Assets	33,367 Million AUD
Market Price	5.03 AUD
Total shareholder’s equity	14,159 million AUD
Beta	0.88

The calculation of the various ratios and indicators for Origin Energy is summarised in the table below. Wherever applicable and available figures have been directly transported from annual reports. If not available, they have been calculated with the calculations clearly shown.

ROE
Required return on equity	4.2+0.88*2.05 6.05%
EPS	(59.5) cents
P/E ratio
Book Value per share	=14159/1.75 8.1 AUD
Book-Market ratio	1.6

For the year 2015, both the companies made losses and hence a lot of parameters such as ROE and P/E ratio cannot be calculated. Hence most of our analysis is qualitative and based on the market-book ratio. Both the companies have gone through a challenging year marked by low oil prices and reduction/restriction in their exploration activities and the landscape of the industry shall remain challenging for some time.

It wouldn’t be recommended for any new share holder to invest right in either of the tow companies because the future looks uncertain and certainly even though the stock may seem outpriced at the outset the earnings right now are negative per share which doesn’t bode well.

For the existing share holder, the recommendation would be to adopt a “wait and watch strategy”. The book value is higher than the market value for both shares indicating that the share is undervalued and rightly so, considering that earnings of late have been in negative.

Due to the fact that required return is lesser and the book market ratio is lower for Origin Energy than Santos one might conclude that right now investor confidence is tilted more towards Origin Energy.

Conclusion

Various quantitative and quantitative analyses were carried to do fundamental analyses of the two chosen companies. Right now both the companies are struggling due to the negative outlook and scenario prevalent in the industry. It wouldn’t be ideal for a new investor to get in the company while for the existing investor one might wait and watch.

References

Abarbanell, J. S. & Bushee, B. J., 1997. Fundamental Analysis, Future Earnings, and Stock Prices. Journal of Accounting Research, 35(1), pp. 1-12.

Damodaran, A., 2007. Return on Capital (ROC), Return on Invested Capital (ROIC), s.l.: Stern School of Business.

Damodaran, A., 2016. Default Spreads and Risk Premiums, New York: Stern.

Fama, E. F. & French, K. R., 2004. The Capital Asset Pricing Model:Theory and Evidence. Journal of Economic Perspectives—Volume 18, Number 3—Summer 2004—Pages 25–46, 18(3), pp. 25-46.

Gottwald, R., 2012. The Use of the P/E Ratio to Stock Valuation. Grant, pp. 21-24.

Kothari, S. P., 2004. Financial Statement Analysis, s.l.: MIT Sloan School of Management.

Oysazar, H., 2012. Advantages and Disadvantages of Financial Ratios. [Online]
Available at: https://yourbusiness.azcentral.com/advantages-disadvantages-financial-ratios-1679.html

RBA, 2016. Cash rate. [Online]
Available at: https://www.rba.gov.au/statistics/cash-rate/

Seng, D., 2012. Fundamental Analysis and the Prediction of Earnings. International Journal of Business and Management, 7(3), pp. 32-46.

Wan-Ting (Alexandra) Wu, 2014. The P/E Ratio And Profitability. Journal of Business & Economics Research, 12(1), pp. 67-76.