# Learning fundamental analysis...



## Semillon (10 June 2009)

For the purposes of teaching myself a little about fundamental analysis I am looking into the big four banks. Since it is a learning exercise, where possible I am setting up a spreadsheet with my own formulas.

I would be very interested to hear opinions on the various metrics and how much weighting in general you would put into them. Does this vary by sector? If I have made a basic mistake in my interpretation of the terms or formulas please do point it out.

All data unless otherwise stated is sourced from the e-trade website.

*
Price To Book Ratio (P/B)*
Formula: Current share price / Book Value
Data source: Balance Sheet -> Per Share Statistics -> Book Value

ANZ: 16.41/12.55 = 1.31
CBA: 36.99/19.44 = 1.90
NAB: 21.7/18.16 = 1.19
WBC: 19.35/9.42 = 2.05

This metric in isolation suggests that based on the value of the assets owned by each company, NAB is the best value, followed by ANZ. I think this metric is not overly useful on its own, but may help form part of the bigger picture?

*
Price To Earnings Ratio (P/E)*
Formula: Current share price / Earnings Per Share (EPS)
Data source: Profile -> Earnings and Dividends Forecast -> EPS

Current
ANZ: 11.10
CBA: 10.74
NAB: 8.32
WBC: 9.84

2009 Forecast
ANZ: 12.51
CBA: 12.70
NAB: 10.64
WBC: 12.32

2010 Forecast
ANZ: 12.25
CBA: 12.35
NAB: 12.06
WBC: 12.15

With this measure, once again NAB is coming up as being the best value of the big four banks. 

As I understand it, there are problems with the calculation of EPS since creative accountants can manipulate the reported earnings (profit). Furthermore there are different ways you can calculate EPS. I think as long as the same method has been used and you approach comparing apples with apples then it still has some value?

The fact that the forecast P/E ratios converge in 2010 suggests to me that whoever calculated the forecast numbers has very little idea about what may actually happen, which is unsurprising - if anyone actually did have a good idea, why share it? I am curious to hear if people feel looking at forecast earnings and thus a forecast P/E has any value as well.

I still need to go and look at the historical P/E numbers to try and work out where I feel the ratio falls if a banks earnings are "correctly valued". Is there a generally accepted ratio or is it always relative?

*
Price / Cash EPS*
Formula: Current share price / Cashflow Per Share
Data source: Balance Sheet -> Per Share Statistics -> Cash Flow

ANZ, CBA and WBC all currently have negative cash flow so the results for them is somewhat meaningless. NAB has positive cash flow but nothing to compare the result against in this exercise.

Excuse my financial illiteracy here, but how can the banks with negative cash flow all be reporting a profit at the same time?

The reason I looked at Cash EPS is because I have heard it described as a "purer" number than other EPS calculations since earnings can be manipulated in reports more easily than cash flow.

Regardless, once again NAB seems to be coming out on top here.

*Yield*
Formula: Dividend Per Share (DPS) / Share Price
Data source: Profile -> Earnings and Dividends Forecast -> DPS

Usually the after tax dividend is more interesting here, however since we are comparing companies that are currently yielding fully franked dividends, I wont go there.

Current
ANZ: 8.29%
CBA: 7.19%
NAB: 8.94%
WBC: 7.34%

2009
ANZ: 6.12%
CBA: 6.16%
NAB: 6.73%
WBC: 5.87%

2010
ANZ: 6.12%
CBA: 6.16%
NAB: 6.73%
WBC: 5.94%

Once again NAB comes out in front and once again I am unsure if looking at the forecast dividends for the next two years has any comparative value?

*Return On Equity (ROE)*
Formula: Profit / Shareholders Equity

I didn't crunch the numbers here but simply read the values from e-trade.

ANZ: 11.60%
CBA: 18.30%
NAB: 13.90%
WBC: 21.30%

This is where WBC and CBA look a lot better, generating far more profit with your investment dollars. I am unsure what weighting to put into this measure.

*Shareholder Rate of Return (Avg Annual Rate)*

I take it this measure looks at capital gains/losses and dividends as a percentage of the investment over a given period.

1 Year Average
ANZ: -5.90%
CBA: -2.30%
NAB: -10.30%
WBC: 3.00%

3 Year Average
ANZ: -15.70%
CBA: -0.70%
NAB: -9.30%
WBC: -0.70%

5 Year Average
ANZ: 3.20%
CBA: 8.20%
NAB: -0.50%
WBC: 7.30%

Now it is not hard to see why NAB appears to be undervalued relative to the other banks, investors have lost out over the last 5 years. ANZ investors probably lost a bit after inflation, CBA and WBC investors turned a profit.

*Conclusions*
NAB appears to be the most undervalued and thus will have a greater upside risk, likewise a greater downside risk if recent history is anything to go by.

CBA appears to be solid as a rock, WBC quite similar assuming they can make the St George acquisition work.

ANZ appear to be overvalued at the current price compared with the other banks.

I have attached my dodgy spreadsheet for anyone that is interested. Which other metrics do you find useful?


----------



## kam75 (10 June 2009)

The only thing I've ever looked at were statements of cashflow for speculative mining and resource companies, to make sure they have enough operating capital.


----------



## Semillon (10 June 2009)

kam75 said:


> The only thing I've ever looked at were statements of cashflow for speculative mining and resource companies, to make sure they have enough operating capital.




So I take it you subscribe to the technical analysis approach? Or are you suggesting that you use top down fundamental analysis, eg: the world needs more of X mineral?


----------



## Krusty the Klown (10 June 2009)

Semillon said:


> I would be very interested to hear opinions on the various metrics and how much weighting in general you would put into them. Does this vary by sector?
> 
> I have attached my dodgy spreadsheet for anyone that is interested. Which other metrics do you find useful?




These are all good performance indicators for FA. One other crucial one to keep in mind is debt to equity ratios. Especially at this point in history where the debt markets are in turmoil. 

You have probably seen and heard about all the capital raisings lately. This is because companies are finding it difficult to borrow, as the lenders are reticent to lend or even refinance existing loans.

The banking sector always has a higher debt to equity ratio than other sectors, but that is just the nature of banks. They borrow money and lend it to others and make a profit on the difference.

But in non-bank sectors debt to equity is _very_ important. Companies that go bankrupt do so because they have too much debt. Companies with lower debt are seen as safer and more stable as they can survive situations such as the GFC.


----------



## Bushman (10 June 2009)

Have a look at their Tier 1 ratios - these will tell you if they need to raise capital.

Also I would be look at the level of provisioning required across their loan books. The bigger the loan book exposure to development proeprty, commerical property and the SME market, the bigger the hit. 

Be wary of historical ratios at turning points in the business, banking and property cycles. Can be misleading. 

NAB is undervalued but has done some dumbthings to deserves this. I would def want a higher ROE for NAB/ANZ compared to CBA/WBC.


----------



## KurwaJegoMac (10 June 2009)

Just a quick word before I start my post, the following is my opinion only and the way I interpret the data you presented.

*Price To Book Ratio (P/B)*
For large companies such as banks I tend to ignore this value. I use the price to book ratio for smaller companies who seem to be breaking out in order to see if they have the assets to cover their loans in case something goes wrong. If companies have too much debt relative to their assets and ability to repay their debt its clear they're not going to be around much longer. 

Personally I don't use the P/B value provided by brokers as most companies include goodwill and the like as their assets. Whilst this is technically not wrong, I don't include goodwill in my asset valuations because to me it's not a hard asset and can over-inflate the true asset value.

*Price To Earnings Ratio (P/E)*
I use the P/E to compare historic levels - for example, I may look at today's situation and say "The perception is that we're in a recessionary environment. What was the P/E ratio of these companies last time we were in a recession". If say, the P/E ratio was a lot lower last time around i'll induce tighter stop-losses on the stock. If the P/E ratio is much lower this time around, well this might be indicating the stock is undervalued.

Of course all this is based upon historic values and is by no means an indicator of future performance!

*Price / Cash EPS*
I think you're on the right track using cashflow as an indicator relative to earnings. There are various accounting tricks that can be used to present positive earnings when cashflow is negative. You asked the question yourself - 'Excuse my financial illiteracy here, but how can the banks with negative cash flow all be reporting a profit at the same time?'. That's right - how can they?

I'm not an accountant and by all means i'm not an expert. I know there are reasons why they are reporting profits but to me the key underlying point is that their cashflows are in decline - i don't care if this quarter or year a company has maintained earnings, if their cashflow is dropping that means their future earnings will drop. You can't earn more money when you have less money coming in every month!

*Yield*
I compare the historic dividend payout policy of the company i'm looking at. If they have a history of never dropping their dividend during the tough times, I usually buy some shares if the yield is high (for example I went out and bought shares in some of the banks during march at yields of between 9-11% however those same banks cut their dividend so it just goes to show, don't rely 100% on past data!)

I find that yield can sometimes be an indicator of a resistance level for a stock price i.e. when you start getting yields of 7-10% you'll find a lot of long term investors tend to snap up the stock just for the dividend return. If a stock price starts to fall through this value, Ifind that more often than not it's a sign that the company is in deep trouble (DYOR as always!!) because the long term investors dont believe the company will recover for a very long time.

*Return On Equity (ROE)* & *Shareholder Rate of Return (Avg Annual Rate)*
I put these together as I believe they go hand in hand. If you look at the ROE of CBA and WBC, you'll notice that they have the highest ROE of the big 4 and also the best shareholder ROR. Compare the other banks and the worst ROE (NAB) also has the worst shareholder RoR. If a company can do more with the money it gets from investors, expect investors to want to buy that stock and drive its price higher.

NAB might look undervalued relative to its peers and that's because investors would rather have CBA over NAB because CBA has a track record of much better performance.

This does not mean that NAB is a bad investment, rather, find out what's caused NAB to have such a low ROE and then monitor the company to see if they change the causes for their low ROE (some examples are bad debts/provisions, bad management, lawsuits, inefficient operations, etc). If the company changes and that reason for the low ROE has gone, expect to see headlines with increased profits and dividends and see the stock go up from there.

As I said at the start of my post, this is all just my opinion and they way I see these things. I hope the information is useful in some way, if for no other reason but to give you another viewpoint!

As always DYOR and the information I present here does not constitute financial advice.


----------



## Semillon (10 June 2009)

Bushman said:


> Have a look at their Tier 1 ratios - these will tell you if they need to raise capital.
> 
> Also I would be look at the level of provisioning required across their loan books. The bigger the loan book exposure to development proeprty, commerical property and the SME market, the bigger the hit.




Could you point me in the direction of where I might source the Tier 1 ratio data? I have trolled through the e-trade site and cannot find it there, though perhaps it is labeled as something entirely different?

Unfortunately I do not understand your second point about provisioning, the terminology is foreign to me.


----------



## Semillon (10 June 2009)

KurwaJegoMac your detailed response was most helpful.


----------



## Bushman (10 June 2009)

Investor presentations are a good starting point. 

http://www.asx.com.au/asxpdf/20090428/pdf/31h835rxkzv08n.pdf

Above link is to the NAB half-year presentation. 

See page 6 for Tier 1 summary. 

Also here is a definition: 

*Tier 1 capital:*
Tier 1 capital comprises the highest quality components of capital that fully satisfy all of the following essential characteristics: 
- provide a permanent and unrestricted commitment of funds; 
- are freely available to absorb losses; 
- do not impose any unavoidable servicing charge against earnings; and 
- rank behind the claims of depositors and other creditors in the event of winding-up.

So it is the core funding for a banks operations. 

In terms of provisions, see the p&l on page 9 for the impact of bad and doubtful debts on banking profits. So the charge in Mar'08 was $0.7b vs $1.8b in Mar'09. So the question is does this charge reflect the full risk in the banking portfolio loan book? In laymans terms, are there any other loand to dodgy property developers (i.e Centro) that needs to be written-off. 

Write-offs also impair the Tier 1, requiring banks to raise capital to ensure their capital adequacy ratios are adequate (as required by Basel and APRA). They also a good indicator that banks will need to cut dividends (amongst other capital initiatives). 

LOL; might sound a bit confusing at first but I suggest that you understand the banking business, and the impact of an Australian recession/property downturn on it, a bit better first before investing in it (as opposed to trading). It will provide context for all your ratios etc.


----------



## awg (10 June 2009)

One factor that been alluded to here, but with more detail on other threads, is that the banks are fairly specialised in their fundamental analysis,

in that they have issues that are complex to the layman.


----------



## soren_lorensen (10 June 2009)

a great mechanism for fundamental analysis i've found is using the investor toolbox, from businessweek, its got a phase 1 and phase 2 indicator and it has and will assess stocks free, you put in the ticker on 3 stocks and then can compare the results.

if the fundamentals look good and technical analysis good for you and your strategy go for it, 

the problem here is there is no analysis for aussie stocks but it gives you a good idea of ways to score FA.  there is plenty of info on their website

check out investools free stock analysis


----------



## kam75 (10 June 2009)

Semillon said:


> So I take it you subscribe to the technical analysis approach? Or are you suggesting that you use top down fundamental analysis, eg: the world needs more of X mineral?




That's correct, all my entries and exits are based on technical analysis.
But sometimes it helps to get a feel for what a company actually does and has in its pipeline.


----------



## dhukka (10 June 2009)

Interesting discussion, here is my 

No metric in isolation is going to give you an accurate picture of a company's intrinsic value. Citing a low Price to book ratio as a reason to buy a stock is folly. I'm not saying that that is what you are doing, nor am I saying price to book ratios are useless, just that in isolation it is not much good. If you find a stock with a low price to book, the next thing you should ask is why is that the case. There could be a plethora of reasons.

The Price Earnings ratio (PE) is *NOT* a Valuation metric, I can't stress this enough. If you believe that the value of a stock and the price of a stock are too different things, then how can you use price in the calculation of value? A stock with a P/E of 30x can be cheaper than a stock with a P/E of 10x. All a P/E tells you is what investors are willing to pay for a stock at any point in time. 

You are right to be skeptical of analyst earnings forecasts, you might as well ask a cab driver. With respect to banks, you need to be careful. You should always use *cash profit or cash eps*. Thankfully the analyst community did not accept the nonsensical models the banks used to value their life insurance companies in the early part of this decade. Cash eps excludes this nonsense. Don't confuse cash eps with cashflow per share, two different things.

As stated above, no one metric is going act as a silver bullet but if I had to pick the most important for fundamental analysis I'd say ROE. This tells you the return the company is getting on it's shareholder(your) funds. You also need to pay attention to what percentage of earnings are reinvested and what percentage are paid out as dividends. A company that is able to retain a high percentage of it's earnings and reinvest them at high rates of return is preferable. 

It is also useful for evaluating acquisitions. Companies like to talk about synergies and cost savings and the acquisition as being eps accretive. But none of that matters if it destroys your return on equity. Just look at Wesfarmers for an example of  a company that paid too much for an acquisition and has thus significantly lowered returns to shareholders. 

It's best to average Return on equity using the equity at the beginning and end of each period. If a company issues a significant amount of stock right at the end of their financial year, return on equity using the closing values will be misleadingly low. 

With respect to dividends, every major bank has cut their dividends by 20 -25%, go back two years and see if any bank analysts were forecasting that. I can save you the trouble, they weren't.  This feeds in to what other posters have alluded to, for banks you want to have a look at non-performing loans as a percentage of net advances or more simply the percentage of loans going bad. The attached chart is from ANZ's latest report, as you can see, non-performing loans are going exponential. However ANZ barely raised their provisions, thus I believe they overstated earnings in the last half, ie the results were worse than they looked and they already looked pretty bad. 

Banks are entering the worst part of the cycle, the good news is that they have been able to raise capital, the question is, are they done or is there more capital raising and dividend cuts on the way? 

Lastly I would encourage you to pore over annual reports (with a very skeptical eye) to get your data rather than rely on e-trade. It may take you longer but it gives you valuable experience in reading financial statements.


----------



## beamstas (10 June 2009)

Just a question for you fundamental gurus, how do you screen/select companies to look through the balance sheets of?

The are 1900 odd companies listed on the asx, it would take quit a while to go through and find all of these statistics. Last year i did a university assignment on Crane Group Ltd and it took me quite a while to get 3 years worth of fundamental ratios (like acid test etc).

Do you just concentrate on say the ASX 20? Or a hot performing sector? Or do you scan somehow to find these companies.

Cheers
Brad


----------



## prawn_86 (10 June 2009)

Personally when doing fundy analysis i break it down by sector and then run a quick scan for basic figures like PE, ROE, DE etc and cast the ones that dont suit asde and look further into more.

Or else when someone i trust suggests a co i will look into it further myself.

Really its no diff to TA, all you tech gurus have the same amount of stocks to work with...


----------



## dhukka (10 June 2009)

beamstas said:


> Just a question for you fundamental gurus, how do you screen/select companies to look through the balance sheets of?
> 
> The are 1900 odd companies listed on the asx, it would take quit a while to go through and find all of these statistics. Last year i did a university assignment on Crane Group Ltd and it took me quite a while to get 3 years worth of fundamental ratios (like acid test etc).
> 
> ...




Brad,

I use comsec, so I can do a data dump of all companies based on certain criteria. I tend to screen companies based ROE, if it is below 15% then I forget about it unless I have some reason to expect it to improve significantly.


----------



## beamstas (10 June 2009)

Cheers for the responses guys

Another question i have for you fundamental fellas 

I've always perceived fundamental trading as medium to long term, ie, 6 months to forever (ie: buffet)

Do you ever do any short term trades that are say, less than a week?
For example you have been following company X and they look like they are very close to striking oil, do you buy in hope they hit oil very soon, hoping they have like a news release or something so more poeple buy? Im not really sure if this is a good example but im struggling to think of one right now.

Thanks guys
Brad


----------



## prawn_86 (10 June 2009)

beamstas said:


> Do you ever do any short term trades that are say, less than a week?
> For example you have been following company X and they look like they are very close to striking oil, do you buy in hope they hit oil very soon, hoping they have like a news release or something so more poeple buy? Im not really sure if this is a good example but im struggling to think of one right now.




Fundies are generally longer term, due to the fact that the market can reamin 'irrational' for long periods of time (or its your valuation thats wrong, not the markets  ).

Short term examples would be arbitrage, such as buying in for a cap raising or bonus options issue.

Dividend scalping (search for Rosellas thread) is another example, where you buy a month or so beforehand in expectation that the price will be bought up as people want the div, then sell before the div date.

For oilers I like (but haven't used) the strategy theat the user BESBSPlayer employs. As his name suggests he 'Buys Early and Sells Before the Spud' of the well. If you buy say 3 months before a well is due to spud, more often then not the price will get bid up as the ruslts are getting close as the market is hoping for a discovery. This is similar to dividend scalping.

Hope that helps


----------



## Bushman (10 June 2009)

beamstas said:


> Cheers for the responses guys
> 
> Another question i have for you fundamental fellas
> 
> ...





In terms of resources, it depends on the free float (i.e. liquidity of the share) and the materiality of the find. So with your penny dreadful miner, if you have been following the quarterlies and think there might be a drill campaign that could be a company maker, then taking a small stake could well mean a 20-50% capital return if the news is positive and there are not too many shares on offer. For the PDs though, the funding environment is dire so it is unlikely that the noise will be sustained. 

However, it is a risky strategy as the geology of a deposit is dependent on the vagaries of mother nature!  

I agree with the comment about financial statements, especially balance sheets and cash flow statements as these highlight your going concern risk.


----------



## MRC & Co (10 June 2009)

You can also trade fundamentals on a global macro scale.  This way, you are constantly re-adjusting weightings of shorts and longs on commodities, currencies, bonds and equities, whereby shorter-term trading can become very useful.


----------



## Kez180 (10 June 2009)

Not so much with banks, but with things like retailers this can be very useful:

ROE                  = Trading Margin  * Turnover       * Leverage

Net Profit/Equity = Net Profit/Sales * Sales/Assets * Assets/Equity

If 2 company's have the same ROE, but one has massive leverage and the other has a high margin, this will clearly differentiate them...

The other posts are full of useful hints as well!


----------



## Semillon (10 June 2009)

Dhukka - thank you for the considered response.



dhukka said:


> Don't confuse cash eps with cashflow per share, two different things.




I had definitely made this mistake.



dhukka said:


> The Price Earnings ratio (PE) is NOT a Valuation metric, I can't stress this enough. If you believe that the value of a stock and the price of a stock are too different things, then how can you use price in the calculation of value? A stock with a P/E of 30x can be cheaper than a stock with a P/E of 10x. All a P/E tells you is what investors are willing to pay for a stock at any point in time




Do you feel it is useful for comparing similar companies, eg BHP & RIO or for comparing the current figures with historical ones?



dhukka said:


> Lastly I would encourage you to pore over annual reports (with a very skeptical eye) to get your data rather than rely on e-trade. It may take you longer but it gives you valuable experience in reading financial statements.




Part of the reason I started with the data on e-trade was because I was led to believe that different companies would use different definitions for calculations, EPS being an obvious example. My hope was that the data source for e-trade has been compiled to allow us to compare apples with apples.

Furthermore most of the terminology used in annual reports was foreign to me until this week, hopefully now I will be able to make sense of the relevant sections and compile my own data as you suggest.


----------



## Krusty the Klown (10 June 2009)

beamstas said:


> Just a question for you fundamental gurus, how do you screen/select companies to look through the balance sheets of?
> 
> The are 1900 odd companies listed on the asx, it would take quit a while to go through and find all of these statistics.
> 
> ...




One way is to look in the share tables of the Financial Review. They list major ratios/indicators for each listed company. You can use this to screen, and then dig deeper if something appeals. They can be downloaded as an excel file.


----------



## Krusty the Klown (10 June 2009)

Semillon said:


> Which other metrics do you find useful?




Another indicator to look for is Net Tangible Assets (NTA). It is the measure of cash left if the company was liquidated and all real assets sold off at market value, then all debts paid out.

For example if you bought a share for $1 and it has NTA of $1.20 and it went belly up next week. You would get your capital back + a 20% profit. 

I like to use this as a starting point, it's a good safety measure. It does change over time and needs to be monitored.

In terms of banks you are studying, banks usually don't have a positive NTA as borrowing capital is a corner stone of their business, and they don't really have a lot of real assets, so it is more important in non-bank sectors.


----------



## dhukka (10 June 2009)

Semillon said:


> Do you feel it is useful for comparing similar companies, eg BHP & RIO or for comparing the current figures with historical ones?




What is the purpose of the comparison? If you are making the comparison to determine which one is better value I would say absolutely not.




> Part of the reason I started with the data on e-trade was because I was led to believe that different companies would use different definitions for calculations, EPS being an obvious example. My hope was that the data source for e-trade has been compiled to allow us to compare apples with apples.
> 
> Furthermore most of the terminology used in annual reports was foreign to me until this week, hopefully now I will be able to make sense of the relevant sections and compile my own data as you suggest.




I don't want to be dogmatic about it. If you are confident that you understand the e-trade data and are comfortable with the methodology that e-trade uses then by all means use it. Comsec uses Huntley's data and they provide definitions of each term, Huntleys have been around for some time, I know people who have worked there and I am confident of the integrity of the data. However if I get interested enough in a company to analyze it, I'll go back to the financial statements themselves.

If you really want to analyze things up close you'll find yourself going to the source (financial statements) for more info because you just don't get the full picture with data providers, such as the notes to the accounts which can be particularly useful. Banks are peculiar beasts and there is lot of pertinent information that you just won't find on e-trade with respect to tier ratios and nonperforming loans - crucial components of analyzing bank stocks.


----------

