Page 138 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 4: Fundamental Analysis

(c) Land and natural resources to be shown at net realizable value (current market Notes
price-future development, selling or interest costs.

(d) Plant & machinery at replacement cost.
(e) Goodwill
(f) R & D expenses
2. Liabilities Side:

(a) Debt. In future, at the time of maturity it is repaid in cheaper money units (rupees).
It is a gain to shareholders.

(b) Deferred taxes.
(c) Retained earnings.
3. Forecasting Earnings: It is necessary to estimate a stock’s future income because the value
of the share is the present value of its future income. This can be done by focussing on:
(a) Identification of variables which will have impact on income, and
(b) Determining the extent of change in income due to change in the identified variables,
by employing appropriate method of forecasting.
(a) Identification of variables: Basically changes in income result from changes in:

(i) Operations and Earnings: The operating cycle of a firm starts with cash
converted into inventory. Inventory turns into sale and accounts receivables,
which finally become cash.
Return on investment (ROI) is the measure of the firm’s operating result.
EBIT EBIT Sales
ROI = = ×
Investment Sales Investment
There are two products

(a) Profit margins on sale, and (b) Turnover of assets
(ii) Financing and Earnings: The two main sources of financing an enterprise are
(1) Borrowings
(2) Issue of new shares.
Debt financing provides leverage to common shareholders. It raised the
earnings per share but also risk. Equity financing is advisable where new
shares can be sold at a price in excess of asset value per share, as it improves
EPS. This is possible only when the company management can maintain a
reasonably higher ROI.

From the above, it is clear that EPS and changes in earnings are function of
(1) Turnover of investment
(2) Margin on sales
(3) Effective interest rate (cost of borrowed funds)
(4) Debt equity ratio

(5) Equity base
(6) Effective tax rate.

LOVELY PROFESSIONAL UNIVERSITY 133