Page 178 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 9: Fundamental Analysis 3: Company Analysis

Return on investment (ROI) is the measure of the firm’s operating result. Notes
EBIT EBIT Sales
ROI = = ×
Investment Sales Investment
There are two products:

(i) Profit margins on sale and
(ii) Turnover of assets
(b) Financing and Earnings: The two main sources of financing an enterprise are:
(i) Borrowings

(ii) 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:
i. Turnover of investment
ii. Margin on sales
iii. Effective interest rate (cost of borrowed funds)

iv. Debt equity ratio
v. Equity base
vi. Effective tax rate.
2. Determining the extent of change method: Different methods of forecasting earnings are
available. The two categories into which the methods fall are given below with a brief list
of some of the methods.

(a) Earlier methods
i. Earnings methods
ii. Market share/profit margin approach (breakeven analysis)
(b) Modern techniques

i. Regression and correlation analysis
ii. Trend analysis (time series analysis)
iii. Decision trees
iv. Simulation

The methods are briefly explained in the following sections:
(i) Earnings model: The ROI method which has been earlier introduced as a device for analyzing
the effects of and interaction between the earnings and assets can be used as a forecasting
tool. If predicted data relating to assets, operating income, interest, depreciation and
forces are available the new values can be substituted in the model and EAT can be
forecasted.

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