Elio D'Amato presentation - Australian Investors Association

Fundamental Analysis –
The bottom up approach
Elio D’Amato
Chief Executive Officer
AIA Conference - Sydney
1 September 2011

Important information
This presentation is provided for educational purposes only and has been prepared
without taking into account your personal circumstances, and you should therefore
consider its appropriateness in light of your objectives, financial situation and needs,
before acting on it. Investments can go up and down.
Information in this presentation is current as at date of presentation unless otherwise
stated. However, please bear in mind that shares or other investments may go up or
down in value, that past performance may not be repeated and that such information is
no guarantee of future performance.
For further ‘Important Information’ (e.g. relating to the Lincoln Australian Share Fund,
Testimonials, Disclosures of Interest and other disclaimers), please refer to the
“Important Information” section at the end of this presentation.

How do you ‘fundamental’?
Two approaches:
• Top down
• Start with the big picture (e.g. favourable markets)
• Drill down multiple levels to individual stock
selection that meets all the above criteria
• Bottom up
• Assess quality companies first and foremost
• Consider broader factors secondary to core
company’s business
3

Bottom up analysis
“The key to investing is not assessing how much
an industry is going to affect society, or how
much it will grow, but rather determining the
competitive advantage of any given company
and, above all, the durability of that advantage.”
Warren Buffett
4

Bottom up analysis
• So how do we apply this analysis?
• Financial Health – examine the financial structure of
the business
• Performance – consider management’s historical
performance and its drivers
• Company assessment – understand how the
business works, the sector it operates within and
assess its future going forward
• Valuation – quantify the value of the company,
accommodating for growth prospects going forward
5

Financial Health
6

Understanding financial statements
To be able to assess the Financial Health of
a company, it is first necessary to
understand the different financial statements
• Profit and Loss statement
• Balance Sheet
• Cash Flow statement
7

Profit and Loss statement
• The Profit and Loss statement (P&L) is also referred
to as the ‘Income Statement’
• It gives a summary of a company’s revenues and
expenses for a specified period of time
• The most important figure generated is the Net
Income and Earnings Per Share (EPS)
• Remove significant items and focus only on
recurring items to get a better picture
8

Balance Sheet
• The Balance Sheet is also referred to as a
‘Statement of Financial Position’
• It lists a company’s Assets, Liabilities and
Shareholders’ Equity as at a particular point in
time
9

Cash Flow statement
• The Cash Flow statement shows the movements
of cash and cash equivalents as affected by
changes in a company’s income and balance
sheet accounts
• It is usually divided into three parts:
• Cash flows from Operations
• Cash flows from Investing Activities
• Cash flows from Financing Activities
10

Financial ratios
• The task of determining the
health of a listed company by
looking at financial statements
seems daunting
• But it doesn’t really require special training or
countless hours of research!
• Even the novice investor can make sense of a
listed company’s Balance Sheet, Profit and Loss
and Cash Flow statement by using financial ratios
11

Financial ratio analysis
What is financial ratio analysis?
12
• When we take a financial figure and look at it relative to another
financial figure
• These ratios simplify the process of determining the health of a
listed company and make reported financial information more
meaningful and useful for investors
• It allows for comparison with previous years, other companies and
the industry sector
• First popularised by Benjamin Graham (considered by many as the
‘Father of fundamental analysis’)
• Ratios can measure many factors of a business

Liquidity ratios
• Liquidity ratios indicate whether a company has
the ability to pay off short-term debt obligations
(debts due to be paid within one year) as they
fall due
• Generally, a higher value is desired as this
indicates greater capacity to meet debt
obligations
13

Liquidity ratios
Operating Cash Flow to Current Liabilities (OCFCL)
• Operating cash flow to current liabilities pertains to the
cash generated from the operations of a company
(revenues less all operating expenses, plus
depreciation), in relation to short-term debt obligations
• Operating cash flow is a more accurate measure of a
company’s profitability than net income because it only
deducts actual cash expenses and therefore
demonstrates the strength of a company’s operations
• Consistently negative operating cash flow implies a
business is going backwards in relation to the cost to
conduct ordinary operations
14

Liquidity ratios
OCFCL ratio
Formula:
OCFCL Ratio =
Operating Cash Flow
Current Liabilities
• The higher the value of the OCFCL ratio, the lower
the level of risk
• A high value indicates that the company generates
sufficient cash from its operations to cover shortterm
liabilities
15

Financial Health exercise
OCFCL ratio
Example: RCG Corporation Limited (RCG) – Rounded to ‘000s
OCFCL Ratio =
$7,690
$9,409
OCFCL Ratio =
0.82
16

Liquidity ratios
Cash Balance to Total Liabilities (CBTL)
• Measures a company’s ability to meet total debt commitments
using its current cash balance
• This measures the company’s ability to absorb liquidity shocks
should profitability drop or debt covenants breached
• A lower value indicates a company may be susceptible to failing
to meet its commitments due to low cash reserves
17

Liquidity ratios
CBTL ratio
Formula:
CBTL =
Cash Balance
Total Liabilities
• A ratio of 1 is usually considered the benchmark,
but could vary across industries
• A ratio of less than 1 suggests the company may not
have sufficient resources to settle its debt
obligations if they fell due today
18

Financial Health exercise
CBTL ratio
Example: RCG Corporation Limited (RCG) – Rounded to ‘000s
CBTL =
$17,172
$10,067
Current Ratio =
1.70
19

Leverage ratios
• Leverage ratios, also referred to as gearing
ratios, measure the extent to which a company
utilises debt to finance growth
• Can provide an indication of a company’s longterm
solvency
• While most financial experts will acknowledge
that debt is a cheaper form of financing than
equity, debt carries risks and investors need to
be aware of the extent of this risk
20

Leverage ratios
Total Liabilities to Total Tangible Assets (TLTAI)
• Provides an indication of a company’s capital
structure and whether the company is more reliant on
borrowings (debt) or shareholder capital (equity) to
fund assets and activities
• Contrary to what many believe, debt is not necessarily
a bad thing. Debt can be positive, provided it is used
for productive purposes such as purchasing assets
and improving processes to increase net profits
• Acceptable TLTAI ratios may also vary across
industries
21

Leverage ratios
TLTAI ratio
Formula:
TLTAI Ratio =
Total Liabilities
Total Assets - Intangibles
• A higher ratio generally indicates greater risk
• Greater debt can result in volatile earnings due to
additional interest expense as well as increased
vulnerability to business downturns
22

Financial Health exercise
TLTAI ratio
Example: RCG Corporation Limited (RCG)
TLTAI Ratio =
$10,067
($53,215 – $18,642)
TLTAI Ratio = 0.29
23

Leverage ratios
Interest Cover ratio
• A company’s interest cover ratio measures its ability
to meet interest expenses on debt using profits
• Generally, a ratio of greater than two is regarded as a
healthy position to cover interest
Formula:
Interest Cover Ratio =
Net Profit Before
Tax + Interest
(EBIT)
Interest
24

Financial Health exercise
Interest Cover ratio
Example: RCG Corporation Limited (RCG) – Rounded to ‘000s
Interest Cover Ratio =
Interest Cover Ratio =
133.27
$13,024 - $97
$97
25

Financial Health exercise
• Summary RCG Corporation Limited (RCG)
• OCFCL ratio: 0.82
• CBTL ratio: 1.70
• TLTAI ratio: 0.29
• Interest Cover ratio: 133.27
• What does this tell us about RCG as a whole?
26
The company is a profit-making that has little interest
bearing debt. RCG generates sufficient cash flow in a
year to repay short term obligations. RCG has
excellent debt-serving ability on the back of its very
strong interest cover (ie no debt)

Performance
27

Assessing company performance
• Also an assessment of management performance
• Can be carried out by reviewing some profitability
ratios
• Should be compared across time and against
industry peers
• May also be compared against companies globally
within the same industry
28

Management assessment
Return on Assets (ROA)
29
• ROA is a measurement of management performance
• It tells the investor how well a company uses its
assets to generate income
• Technically, a company should produce an ROA
higher than the risk free rate of return to be rewarded
for the additional risks involved in operating the
business. If a company’s ROA is equal or even less
than the risk free rate, investors should think twice as
they would be better off just purchasing a bond with a
guaranteed yield

Management assessment
Return on Assets
Formula:
Return on Assets =
Net Income
Average Total Assets
• A higher ROA denotes a higher level of management
performance but must still be compared with peers
• A rising ROA may initially appear good but can turn
out to be unimpressive if other companies in its
industry have been posting higher returns and greater
improvements in ROA
30

Management assessment
Return on Assets
Example: RCG Corporation Limited (RCG) – Rounded to ‘000s
Return on Assets =
Return on Assets =
17.5%
$8,937
($53,215 + $49,453) / 2
31

Management assessment
Return on Equity (ROE)
• ROE is another measurement of management
performance
• It tells the investor how well a company has used
capital from shareholders to generate profits
32

Management assessment
Return on Equity
Formula:
Return on Equity =
Net Income
Average Shareholders’ Equity
• Similar to the ROA ratio, a higher ROE denotes a
higher level of management performance
33

Management assessment
Return on Equity
Example: RCG Corporation Limited (RCG) – Rounded to ‘000s
Return on Equity =
$8,937
($43,148 + $42,152) / 2
Return on Equity =
21%
34

Management assessment
Earnings growth
• Another way to gauge management’s performance is
to look at a company earnings growth
• Net profit after tax may be used but a better indicator
would be Earnings Per Share (EPS) as this would
take into account any increases in the number of
shares
• Look for an increasing trend as this would indicate
improvement in shareholder value
• Can apply a minimum target e.g. EPS growth > 8%
35

Management assessment
EPS growth
Formula:
EPS growth =
EPS Present - EPS Previous
EPS Previous
• Should be observed over several periods
• Look for companies with consistent EPS growth
• Prefer increasing EPS growth trend
36

Management assessment
Earnings Growth
Example: RCG Corporation Limited (RCG)
EPS Growth =
(3.65 – 2.84 cents)
2.84 cents
EPS Growth =
29%
37

Profitability ratios
Gross Profit margin
• Gross profit margin tells us what percentage of a
company's sales revenue would remain after
deducting the cost of goods sold
• This is important as it helps to determine whether the
company would still have enough funds to cover
operating expenses such as employee benefits, lease
payments, advertising, and so on
38

Profitability ratios
Gross Profit margin
Formula:
Gross Profit margin =
Sales – Cost of Sales
Sales
• A company’s gross profit margin may also be
viewed as a measurement of production efficiency
• A company with a gross profit margin higher than
that of its competitors, or the industry average, is
deemed to be more efficient and is therefore, all
things being equal, preferred
39

Management assessment exercise
Gross Profit margin
Example: RCG Corporation Limited (RCG) – Rounded to ‘000s
Gross Profit margin =
($42,339 – $14,876)
$42,339
Gross Profit margin =
64.9%
40

Management assessment exercise
• Summary: RCG Corporation Limited (RCG)
• Return on Assets: 17.5%
• Return on Equity: 21%
• EPS Growth: 29%
• Gross Profit Margin: 64.9%
• What does this tell us about RCG’s performance?
41
The company has been performing strongly. The high
ROA and ROE is reflective of efficient operations. High
EPS growth indicates the company’s operations
continue to grow strongly and gross profit margins are
indicative of high profitability of the business

Let’s take a break
See you shortly
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Company assessment
43

Deconstructing a company
• Understand how a company operates and
generates its profits
• Determine the company’s key competitive
advantage
• Identify key risks in the company’s business model
• Assess the attractiveness of the sector the
company operates within
44

Company operations
• Advantages of understanding a company’s
business model and how its profits are made:
• The ability to comprehend the company’s
announcements and its impact on performance
• The foresight to apply broader economic news and
views when gauging a company’s prospects
• Identify key risk exposures of the company and your
overall portfolio
• Confidence in making investment decisions for your
portfolio
45

Key competitive advantage
• Crucial when comparing a company to its peers
• The three generic competitive strategies are:
• Cost leadership – the lowest cost producer of a
substitutable product
• Differentiation – product perception that it is not easily
substituted and a resulting premium can be charged
• Niche focus – provides a product aimed for a subcategory
of the market
46

Key competitive advantage
• A company’s key competitive advantage can be
distilled from the generic strategies
• e.g. cost leadership due to economies of scale, efficient
distribution networks or vertical integration
• The more difficult it is for competitors to replicate
this advantage the stronger the long term impact of
this advantage
• e.g. through strong branding, Coca-Cola Amatil Limited
(CCL) has been able to differentiate their product from
generic cola beverages to charge higher prices over the
long term
47

Identifying key risks
• Unfortunately, no business model is perfect and
key risks for a business have to be identified
• This is related to both understanding a business
and its sector
• Some risks will be specific to the business and
others apply to the overall sector
48

Key risks
• Like competitive advantages, there are numerous
risks to running a business
• Key is to identify the risks which would be the most
pertinent to a business:
• Magnitude of failure – e.g. for a wheat farmer, the price of
wheat is a key risk and substantially impacts the
profitability of the business
• Likelihood of failure – e.g. likelihood for a fall in the price
of wheat is reasonable as global crop yields can vary
significantly but global demand is relatively stable
49

Understanding the sector
• This process is similar to applying a top down
approach
• Examine country and macroeconomic impacts
• e.g. the recent carbon tax proposal will significantly
impact the profitability of energy intensive industries
in Australia if legislated. This creates uncertainty
making Australian industries like aluminum,
agriculture, steel and manufacturing less attractive
• Assess the attractiveness of the sector via
‘Porter’s five forces’
50

Porter’s five forces
51

Porter’s five forces
• An attractive sector will exhibit a combination of
these characteristics:
• low threat of new entrants, thanks to high barriers to
entry, including government regulations and high
start up costs
• low power of suppliers, thanks to available
substitutes and a large number of suppliers
• low power of buyers, due to a large number of buyers
• low threat of substitutes due to absence of similar
products or services
52

Company assessment exercise
• What does RCG Corporation do?
• Investment holding company which owns and operates
a number of footwear businesses
• Businesses include The Athlete’s Foot, Shoe Superstore
and RCG Brands Pty Ltd
• How does it generate its profits?
• Sale of the footwear and apparel through its specialty
stores, and through its wholesale and distribution
subsidiary, RCG Brands
53

Company assessment exercise
• What is RCG Corporation Limited’s (RCG) key
competitive advantage?
• RCG is a niche retailer with unique market position
• RCG differentiates itself on utilitarian and comfort
shoes, hence it is less susceptible to fashion trends
• RCG has a strong and capable management team
who have been successful at turning the company
around and positioning it for growth
54

Company assessment exercise
• What are the key business specific risks for RCG?
• Management has been instrumental in turning the
business around, hence key personnel risk
• Execution risk of new stores rollout for the Athlete’s Foot
and Shoe Superstore
• What are the key sector risks that impact RCG?
• Cost pressure – rising raw material costs will increase the
cost of goods sold (COGS)
• Weak consumer sentiment – higher interest rates and
rising petrol costs may force consumers to trim
discretionary spending
55

Company assessment exercise
• What country or macroeconomic factors are affecting
RCG?
• Rising labor cost – wages in China have been increased
significantly over the past 12 months
• Currency headwind – Chinese Yuan is a highly undervalued
currency, expected to appreciate strongly over time
• Using ‘Porter’s five forces’ what makes RCG’s sector
attractive?
• Power of suppliers is low due to the large number of manufacturers
• High power of buyers as demand for footwear is relatively elastic
• Unfortunately, there is a high threat of new entrants and substitutes,
due to low startup costs and the wide variety of footwear available
56

Valuations
57

Valuations
• Investors should determine an intrinsic valuation
when making investment decisions
• Purchase undervalued shares
• Dispose overvalued shares
• Warren Buffett says
“Price is what you pay, value is what you get”
58

How is a valuation determined?
• There are several widely
accepted methods utilised
to do this
• Each has their strengths
and weaknesses
• However, all methodologies
will rely on assumptions and
estimates
59

Valuation methodologies
• Ratio valuation – historical or relative
• Price / Earnings ratio (P/E)
• P/E / Earnings Growth ratio (PEG)
• Price / Cash Flow ratio (P/CF)
• Price / Book Value ratio (P/BV)
• Enterprise Value
• Dividend Discount model (Gordon Growth model)
• Discounted Cash Flow model
60

Ratio valuation calculation
• Ratio valuations are the mostly widely used
valuation tool due to the simplicity of their
calculation
P/E ratio =
Current Price
Estimated Annual Earnings
P/E Ratio
PEG ratio =
Estimated Annual Earnings Growth
61

Ratio valuation calculation
P/BV ratio =
Current Price
Estimated Book Value
P/CF ratio =
Current Price
Estimated Annual Cash Flows
62

Ratio valuation - Historical
• Historical ratio valuation assumes that the
relationship between the company’s share price
and earnings (cash flow or book value
respectively) should be constant over time
• In other words, each dollar invested should be
worth a fixed percentage of earnings e.g.
• Company A’s historical P/E is 15
• Company A’s current P/E is 20
• Investors should sell Company A as the current
market price is high relative to its earnings
63

Ratio valuation - Relative
• Relative ratio valuation is used to compare
different companies with similar operations. e.g.
• Assume Company A and B are identical
• Company A’s P/E is 20, Company B’s P/E is 15
• Investors should purchase Company B
• Reasoning – Company B’s earnings cost comparatively
less than Company A
• Note that the P/E ratio is calculated in the same
way as a historical ratio valuation
64

When do we use different ratios?
• P/E ratios are the most widely used, as the relationship
between a company’s earnings performance and stock
returns are well documented
• Other ratios were derived in response to limitations of the
P/E ratio:
• PEG ratio allowed comparison of companies different growth profiles.
Traditional P/E assumes companies have similar growth
• P/CF ratio catered for the argument that company’s will use creative
accounting to boost nominal profits. Cash flow is hard to manipulate
and P/CF is used for companies with consistent cash flows
• P/BV was created for similar reasons as P/CF. This ratio is used to
determine the value of a company if it liquidated immediately. This
ratio is more useful for asset heavy companies. Book value is also
commonly referred to as Net Tangible Assets (NTA)
65

Valuation exercise
• RCG Corporation Limited (RCG)
• Current share price is $0.50
• Expected earnings is 4.5 cents per share
• Historical P/E of 17
• Average retail sector P/E of 12
• What is RCG’s current P/E?
• P/E = $0.50 / $0.045 = 11
• Is RCG cheap compared to its historical P/E?
• Is RCG cheap compared to its sector’s P/E?
66

Valuation exercise
• RCG Corporation Limited (RCG)
• Current P/E is 11
• Expected earnings growth is 23%
• Oroton Group Limited (ORL) PEG is 4.36
• What is RCG’s PEG?
• PEG = 11 / 23 = 0.48
• Is RCG cheap compared to ORL?
67

Enterprise value
• Enterprise Value is an economic measure used to
determine the market value of a business
• Enterprise Value is commonly known as the
theoretical takeover price. An acquirer would have
to take on the company’s debt but will be able to
pocket its cash
• It is used as an alternative to Market Capitalisation
when valuing a company as a whole
• It is also used as an alternative to Price for ratio
valuation. e.g. EV/EBITDA as an alternative to P/E
68

Enterprise value
Enterprise
Value
=
Market Value of Ordinary Shares
+
Market Value of Preference Shares
+
Market Value of Debt
+
Market Value of Minority Interest
-
Market Value of Associate Company
-
Cash and Cash Equivalents
69

Dividend discount model
• The dividend discount model (DDM) values
companies based on their return to shareholders
in the form of dividends
• A simple example of a dividend discount model
is the Gordon Growth model, which values a
security based on a constant dividend growth
and a constant required rate of return
• This can be expanded to a two-stage model
where an initial level of growth is assumed and
then another after time
70

Gordon Growth model
• Note that even a simple dividend discount
model like the Gordon Growth model requires a
number of assumptions and estimates
Valuation =
Expected Dividend Amount
Required
Rate of Return
-
Expected
Dividend
Growth
71

Valuation exercise
• RCG Corporation Limited (RCG):
• Is expected to pay 3 cents of dividends
• This dividend is expected to grow 6% going forward
• Our current required rate of return for a company of
RCG’s risk profile is 10%
• How much is RCG worth according to a
Gordon Growth model?
• RCG’s valuation = $0.03 / ( 0.1 – 0.06 ) = $0.75
72

Discounted cash flow model
• The discounted cash flow (DCF) model is based
on a similar premise as the dividend growth
model
• This valuation model examines the cash flows a
company is expected to generate in future
periods
• These individual cash flows are ‘discounted’
back to the current period to determine the
intrinsic value of the company
73

Bringing it all together
74

Things to remember
• Check the Financial Health
• Use liquidity, leverage and profitability ratios
• Review past performance
• Tells you about the efficiency and effectiveness of
management
• Assess the company
• Understand the company – its operations, strengths,
weaknesses and risks
• Determine the Valuation
• Use price multiples, EV, DDM, and DCF
75

Fundamental checklist
76

Nine Golden Rules
Your intellectual framework
1. Financial Health
2. Management Assessment
3. Outlook / Forecast
4. Share Price Value
5. Share Price Trend/Sentiment
6. Liquidity and size
7. Company Activities
8. News/Announcements
9. Follow the above rules
77

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Information in this presentation is current as at date of presentation unless otherwise stated. It is
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