### Fundamental Analysis – Part 2

**Income Statement**

The income statement of a company represents the accumulated balance of income and expenditure of the company and is very important when it comes to value and analyze a company.

The components of the income statement depend on the sector that we are analyzing, but include:

• Gross margin: includes sales and the cost of the same (cost of production including cost of raw materials).

• Operating margin: is gross margin less the expenses of personnel, overheads, depreciation and operational provisions. Collects the profitability of the operational activity of the company, regardless of their financial situation and financing.

• Gross profit: financial situation of the company on the side of expenses and incomes, more possible extraordinary.

• Net profit: is gross profit less taxation and minority participation (participation of third party affiliates consolidated globally).

These margins, measured on sales of the company, give an idea of the profitability of each of the parts of the income statement.

Thus, the operating margin on sales is operating profitability of the company and if the company reflects its typical activity gets the necessary profit.

The net profit on the sales would give us the total margin of society.

The net profit on own resources give us the ROE which measures the profitability of the shareholders.

The net profit on the total asset is what we call ROA which represents the profitability of invested assets to obtain this benefit.

Tracking the evolution of items in the income statement is essential for good work of analysis and estimates of future.

**Valuation methods**

There are no general rules for all sectors, but different methods of valuation.

We can highlight:

1. Absolute valuation using free cash flow discount

2. Relative valuation using multipliers (stock ratios)

**Discounted Free Cash Flows**

Discount Cash Flow (DCF), is to bring today, discount, every penny that the company will generate in the future.

We tried to assess is the total of the assets; will that later we subtract the total liabilities to equity. Therefore, we must deduct an annual flow that serves to reward the shareholders as well as borrowers, since it then you subtract debts. The cash flow or funds generated to compensate both parties is the operating margin (before financial), adjusted for taxes, adding (not is a cash outflow), minus investments and changes in working capital.

Annual cash flow that it is necessary to discount: EBIT (Earnings before interest and taxes) – operating taxes + depreciation – investments – variation of the working capital.

This is the definition of free cash flow (before financial and dividends), with this flow there are remunerated the foreign and own resources.

The higher the value of the company the greater the cash flow generated each year. In short, what I value are the amounts that the business will in future, I subtract what you owe and that’s what counts.

So to calculate it, we would have to calculate the Net Present Value (NPV) of a cash flow over time.

These cash flows would be only those free cash flows of the company, ie available funds after meeting reinvestment needs in fixed assets and working capital requirements.

The difficulties of the estimates are many to estimate…:

a) Free cash flow (F): as we have described previously.

b) Calculate the rate of discount or WACC r: the normal thing is to use a rate of weighted capital. This means that an estimated a rate of own resources and one of total liabilities and they were weighted by the relative weight optimal (y ó 1-y) of each item in the balance sheet.

Discount rate = y * own resources rate + (1-y) * Callable Passive Rate

The rate of total liabilities is the average rate on borrowings at cost (Cp) reviewed by the tax effect (multiplied by one minus the tax rate of the company), as financial expenses are deductible and therefore have tax shield effect on dividends.

Callable Passive Rate = (1-T) * Cp

The equity rate is the risk-free interest rate plus a premium: the beta value for the differential returns between that rate and the average expected return of the market.

Own recourses rate = risk-free interest rate + ßeta * (RTAB average expected – risk-free interest rate)

This adds to the risk-free rate the risk of investing in that action: historical differential return earned by equities over fixed income multiplied by the specific volatility of that value over the overall situation.)

c) Time (n) where we have to estimate as many years as necessary to create the profitability of the investments made by the company to stabilize.

d) Calculation of Residual Value (RV), which is perhaps the greatest difficulty presented, based on the growth rate to infinity g (subjective), for it is advisable to conduct a sensitivity analysis

VR (residual value) = (Fn*(1+g)) * PER theorist)

PER theorist = 1/(r-g)

g = ROE (1 – Pay out)

With this formula we see future growth (the growth rate to infinity g) It will depend on the profitability of the own resources (ROE) and of the funds that it leaves in the company (1-payout).

After analyzing the company’s total value obtained by discounted free cash flows, and financial debt valued at market interest rates, we divide it by the number of shares of the company and obtain its price target on the company.

Once we have the target price, compared to the stock price in the market to see if it is “cheap” or “expensive” and issue a recommendation.

**Relative valuation using multipliers (stock ratios)**

This type of valuation tries to see if a company is expensive or cheap in terms relative to the market.

This method provides limitations since it has a validity limited in space (compare same sector, companies with a similar structure, similar geographical expansion…), and time (possible change of structure or mix of business determines the temporal comparison), if it is in benefits…

We must also pay attention since the market can be wrong (inefficiency, investor irrationality).

The ratios to be highlighted are:

• PER (price earnings ratio): market capitalization / Net income = Quotation/ BPA

So we have a PER of “n” times are the times that contains the information referred to in the share price.

A PER more low usually amount to cheaper shares.

• PCF (Price cash flow): market capitalization / Net CF = Quotation / CFPA

The PCF are usually lower than the PER, because the cash flows generated by the companies outweigh the benefits (net profit plus depreciation).

The PCF is very important in sectors such as banking, where provisions (non-cash) are of great importance.

• AVP (accountant value price): market capitalization / accountant value = Quotation /AVPA

These are the times that are contained in the equity price per share.

Unless the company presents a very negative outlook, it is unusual to find one lower AVP: AVP values less than unity and with good prospects are usually opportunity of buying.

• PPD (Profitability per dividend): Dividend / Cap = DPA / Quotation

The percentage that the price represents the total gross dividend paid by a company in a year. Annual liquid yield is assured at the time of purchase.

• EV (Enterprise value): Market Capitalization + Net Financial Debt

This ratio can take others as: EV/Sales, EV/EBIT and EV/EBITDA

• ROE Adjusted : is calculated by an equivalence between two ratios: quote on net value per share and ROE on cost of capital. The net value per share is understood as the book value adjusted for goodwill, goodwill, excess/default provisions, i.e. the book value adjusted to market prices. The equivalence between ratios suggests that the relationship between what the company gets profitability from its own resources and its cost of capital, or opportunity (ROE / cost of capital) must be equivalent to the relationship between the market price and the adjusted book value. It is often used as a means of assessment, since obtaining ROE, capital and book value adjusted per share cost can be calculated the price or theoretical value.

**Other Ratios: From Balance Sheet and Profit and Loss Account**

**Balance Sheet Ratios**

• Fund of maneuver on sales: Fund of maneuver is the difference between current assets and current liabilities, which measures short-term position of the company. By calculating sales shows the effectiveness of the use of assets, and their impact on sales generation. Level close to 15% is generally normal.

• Fund of maneuver on current assets: It interprets the degree of coverage of the bottom of maneuver.

• Leverage: Measures the debt situation of a company. Only considered cost debt. You can measure the total assets or equity.

• Interest-bearing debt on liability: Shows the percentage of liabilities that have cost.

• Rotations: Analyze the agility of a company in charge, pay or liquidate inventories, this ability will be reflected in the position of working capital or borrowing short term.

• Inventory turnover: Is the cost of goods sold on the average level of inventories in the year. Reflects the number of times we rotate stock.

• Circulating: It analyses the situation of the company in the short term. It is current assets over current liabilities; a procedure for putting the working capital ratio-shaped and measure it in the form of times rather than pesetas. Thus discussed and compared in absolute figures.

• Rate of accumulated amortization: percentage tangible gross already amortized. It helps to study future investment plans of the company.

**Ratios of the income statement**

• Cash-flow on debt: gives an idea of the funds generated on the level of debt to society. As we get closer to the cash flow free cash flow, annual capacity may involve having the company to pay back some debt with cost.

• Expenses financial on PBIT (profit before interest and taxes): assesses financial expenses coverage. Ratios higher than the unit mean that more of the proceeds by the typical activity of the company are intended to pay its debt.

• Amortization rate: It is the weight of the endowment of amortization on the brute average tangible assets.

• ROE: Measures the distributable net income of the average number of own resources, ie the return earned by shareholders (net profit) of funds invested in the company (equity).

• ROA: It is the same concept but on average total assets. Try to analyze the profitability of these assets and the level of enterprise infrastructure.

• Extraordinary on PBIT: The extra weight should never be greater than unity except in exceptional years.

• Market capitalization sales: Match the quote with the activity of the company. Extreme levels should alarm us because it could be assumed that the company is equipped with a structure too big for its level of sales, so the return on assets is low, or cheap a listed company, which will be a good opportunity to buy.

• Net profit on sales: Measures the profitability of income after all charges in the income statement. It gives an overview of the total return.

• Pay-out: Percentage of net profit dedicated to dividends. Elevated levels of payout are dangerous, unless that match companies with low profitability, in which case it is advisable. If the company gets a lower average return to capital cost, it is recommended to increase the payout and transferred to the shareholders and the investment decision.

• Dividend on cash-flow: percentage of the generated funds that are allocated annually to dividends. It gives us an idea of the strength of the financial situation of a company and how committed is in compensation to their shareholders. Cuts in the investment plan to maintain the dividend should be seen negatively by inverter, unless they are companies with low profitability.

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#### Erick Gálvez

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