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General Instructions for Analysis and Valuatum Excel
Model
Index
 Where
to get information about companies?
What
is important analyst should try to estimate?
How
far should I estimate in quarter level (net sales and
EBIT)?
Seasonal
variation in estimates
Estimating
long-term growth and profitability
How
to set value for Tangible assets / net sales %?
Estimating
Working capital
General
info about providing comments in company forums
Commenting
and providing arguments for the estimates of current year
Setting
and arguing recommendation
Description
of competitive situation and position in markets
The
track-record and creditability of current management
WACC
- Parameter guidance
Setting
fair value and the meaning of DCF
Where to get information about companies?
You can find information to be used in the analysis from
following sources:
1) Company stock exchange releases and news releases
2) Annual reports, Company www-pages
3) Newspapers, newsletters
4) From company directly (Investor Relations)
5) Company infos, CMD, other visits to company
6) Other sources like: company sales/cust service, customers,
competitors
Some information and hints for all of these:
1) Company stock exchange releases and news releases
Company stock exchange releases can be found from company
www-pages and always also from stock exchange www-pages.
Stock exchange is of course the best place to get these
as it is regulated as has to contain all of the releases
and the releases have to be published there first. It
is also practical that all the companies you follow have
their releases in one place.
Some companies however, publish also news releases. These
releases might contain some interesting information about
their new products, received orders etc. even though the
company has themselves characterized them as "not
containing some essential information which might have
direct stock price effect". If they would contain
such information, then they should of course be published
as stock exchange releases. E.g. Nokia publishes about
one
press release per day but only few stock
exchange releases or "company disclosures"
per month.
Often companies have also a service that as you have
registered as a subscriber, then you get all the releases
that the company publishes directly to your own e-mail
address. There are also third party services which collect
and distribute at least stock exchange releases. E.g.
Hugin
Online offers a free service where the subscribers
can get releses directly to their e-mail from companies
they want to follow (Notice however, that the service
does not seem to work for every company: at least I did
not receive any releases from such Finnish companies as
Lassila&Tikanoja and Exel although the service seems
to work for all the other companies I selected and although
those two companies are still there listed so you are
able to select them at the Hugin service... Also notice
that sometimes the releseas are shortened versions of
the original releases - however in those cases it is normally
mentioned in the shortened release itself that the original
version can be found at...)
2) Annual reports, Company www-pages
Annual reports and company www-pages offer of course a
lot of such relevant information about the company that
can not be found from any releases. By browsing these
sources you can not only find information about products
and services but also about almost all other things. Even
customer orientation, company values and corporate culture
can somewhat be sensed by browsing this material.
3) Newspapers, newsletters
Newspapers and vast amount of different www-sites offer
also valuable information for the analysts. This information
might discuss the company directly or about the products,
markets, technologies or competitors it operates closely
with. With newspaper supply a very good and real time
source for the analysts are the newsletters that are delivered
directly to e-mail and are normally free as they are financed
with advertisements. In Finland many financial newspapers
(like Taloussanomat, Talentum) have this kind of free
service.
4) From company directly (Investor Relations)
Company Investor Relation -services are dedicated to offer
investors information about the company. Of course they
can not reveal anything that might have instant effect
on stock price as that kind of information must be revealed
to all investors simulataneously with stock exchange releases.
So it is no use in asking investor relations about what
kind of growth they estimate in their sales or ebit but
you can ask them relevant background information about
the published figures, products, competitors etc. Below
is more about this under topic
where to get information about competition.
5) Company infos, CMD, other visits to company
Companies normally arrange at least some public events
per year where the management tells about published result
(fiscal year or interim info) or their outlook and strategy
in general (CMD = capital markets day). If you have informed
company Investor relations - department that you are following
the company and your analysis goes through customers through
Valuatum Platform and thus through brokers X, Y and Z,
then you will be invited to such events. Sometimes these
events are also publicly convened. Analysts can also often
meet management or CFO personally with meetings scheduled
on their own. Especially smaller companies are eager to
meet analysts as it is their way to increase their publicity
and thus also share liquidity.
6) Other sources like: company sales/cust service,
customers, competitors
The best sources of objective information are of course
the crucial operating activities: company sales/customer
service, customers, competitors... If you talk with the
big customers of the company and they reveal that they
are not satisfied and decreasing - or that they are very
satisfied and increasing - the sales from the company,
then that is of course the most powerful information that
you can have supporting your analysis.
What is important in analysis to try to estimate?
Profit development one year ahead is crucial for share
price
If you could estimate the results of companies one year
ahead with an accuracy of about +/- 10%, then you could
in many cases make a lot of money.
If you look at the shares that have appreciated 30-100%
or even more last year, you will most likely find one
common characteristic with them all: their sales and/or
especially EBIT or EPS growth has been much bigger than
investors had expected last year. In many cases, with
smaller companies there were clear signs of that kind
of potential to be seen but nobody brought these things
forward to wide audience. Perhaps because nobody really
followed those small companies carefully enough. This
kind of opportunities are the ones that the analyst should
try plot. And of course it is also important to find opposite
cases with unexpected bad performance.
Difference to consensus is
crucial - compare you estimates with consensus
The markets price each stock according to its own expectations.
The best estimate of "the market estimate" are
provided by the consensus estimates. Thus, if there are
consensus estimates available , you should always compare
your estimates to them and have clear reasons why your
estimates are higher or lower than consensus. These are
the most important things that you should also write to
your forum comments.
If you e.g. expect that the company profit (EBIT, PTP,
EPS) for next quarter is clearly bigger than the consensus
seems to believe - and that is not a non-recurring phenomenon
but more permanent rise of performance level - then this
should also mean a share price increase directly after
the result announcement. Thus: you should tell this in
your forum-comments and also give good reasons why you
expect better performance than research providers in consensus.
In Valuatum Platform there usually are consensus estimates
available for analysts, so finding consensus should not
be a problem. Of course we can not have consensus for
every small company as there probably isn't consensus
available from them and partly also because we do not
have access to figures of every consensus provider. However,
the consensus that we have in Valuatum Platform available
for analysts is going to significantly increase already
in the near future so majority of the companies followed
should also include some consensus estimates (in 2006
and thereafter).
Company performance after one or two years is not too
important
Even though profit development next year is very important
to try to estimate roughly in the right range, it does
not make much sense to try to put much energy to estimates
that are more than 2 years in the future. They should
of course be rational, consistent and at certain generally
defined resonable level as explained
later on in own chapter, but to be honest they have
very little intrinsic value. Of course they affect the
DCF-based fair value, but it is not a parameter that really
determines the share price as
explained better below. The real pricing of the stock
is normally done at the markets by the pricing multiples
of current year and next year. So profit development about
2 years from this moment is most crucial, often even more
shorter periods. Other future years are the less meaningful
the more far away from the current they are. Estimating
about distant future is very difficult and market does
not even try to do it honestly in determing the right
share price level. The market does of course discount
also the distant future and thus the market value of profitable
growth companies often includes assumptions of good performance
in many future years as well as the the market value of
unprofitable companies often includes assumptions of continuing
bad performance in future years. This is however different
thing as it is done in a very general way. What really
determines current share price is the performance here
and now and the performance in near future where markets
have clear visibility.
Company performance in this quarter
As stated above the share price of a company is determined
with performance in near future where markets have clear
visibility. With industries in dynamic or cyclical environment
the markets normally have good visibility only for current
quarter results that is published in few weeks time as
from that "future" they have both management
guidance and lots of news flow from what has happened.
It means that, in most cases there is no tremendous share
price effect with the next result announcement, and thus
there is also no tremendous value available even though
you could estimate the next quarter result with two-digit-accuracy
two weeks before it is published. This can be best seen
from share price graphs: a good result announcement might
increase the share price by a couple of percentage points
within the announcement day but in this kind of cases
the share price has normally appreciated during
the past quarter normally by more than 10%-points.
So, only a fraction of the upside potential is realised
with the result announcement and most of it is already
in the share price. It also means that you should concentrate
not on "the decimals of this quarter result"
but preferably on "the trend and expected
rough level of profits in current quarter and couple
of quarters thereafter". In other words the investors
are not so interested if you can say a week before the
result that the result will be in rage 234.9 - 235.1,
as they would be if you can credibly explain why
the result of the company will be on average increasing
about 20% e.g. in the next three quarters.
The first one is most likely already in the share price
but the latter is hardly there.
Some people might hereby protest and see it particularly
important that the analyst is able to accurately forecast
the result a week before the result announcement. And
I admit that thereby investors might be able to earn some
percentage points as I already stated above. And I also
admit that this kind of short-term predictions are much
more valuable and interesting than comments right after
the result about what did happen and why the result
was like it was - without any new information to markets
about what will happen next quarters.
To sum up: market expectations are conservative and
wait status quo to remain
At this point you perhaps feel a bit confused about what
is important in the analysis: Is current quarter important
or not? And what is it that markets expects currently
and what does it not expect?
This is how we believe the market normally behaves
and what it expects:
- Well performing companies - Markets
are conservative: if the sales and profits of a company
have been increased by e.g. 30% a year for already some
time then market expects that the situation will stabilize
and the growth will slow down soon. If you are sure
that the growth will continue or even accelerate during
the next year, then it is most likely a buy-case: the
share price will probably appreciate during that year
much more than the normal cost of equity i.e. more than
about 10%. On the other hand, if positive development
breaks very rapidly (as markets normally expect gradual
slowdown) then the share price might come down also
very quickly.
- Ordinary and stable companies - Markets
expect the status quo to continue. If you have reasons
to believe that this kind of company suddenly improves
(or declines) a lot then there is big upside (downside).
- Poor companies - Markets normally expect
the companies to get out of trouble but very slowly.
And markets normally do not believe until they see clear
facts about the improvement (first positive quarter).
So promises of improvement are normally not fully discounted
into the share price. These cases offer always upside
if you have reasons to believe to the improvement. If
there is no improvement, then this kind of companies
are of course always overpriced: loss-making companies
are options where investors bet on improvement. If the
improvement does not come then anything is too much
to pay for these companies.
Att: each standard cases above must be used and
viewed in the light of current valuation: if the
pricing ratios like P/E are very high then of course
market expects very good profit development in the
future years. If P/E ratio or P/BV ratio is extraordinary
low then the markets expect already quite bad performance
to continue for some time. This means e.g. that
"ordinary and stable" company might for
some reason (very optimistic management guidance,
rumours etc.) have great expectations (high pricing
ratios) inside its current valuation and thereby
of course continuing stable performance is a disappointment
for markets and decreases share price. You can use
e.g. valuation
scatter to compare valuation ratios vs growth
/profitability estimates of different companies.
And what period is then important for the analyst
to forecast?
Above is discussed what markets normally expect from
different companies. You should focus on the periods which
are as close as possible (to be interesting) but so far
away that the markets do not (yet) see there. So if you
feel that markets do not know about next quarter, then
you should focus on that. If the question is about a big
company and the next quarter result announcement is quite
close, then it is often the case that markets do already
know a lot and there is very little room for surprices.
Thus "what markets do not see" depends slightly
on situation and thus varies case by case. And of course
you do not have to try to dig something "surprising"
for every company as there is perhaps no unexpected things
going to happen during the next year - at least things
that could be foreseen. That kind of cases should normally
be in "Hold" => if there is nothing that
the markets would already know by now, then everything
is already discounted in the current share price. Then
there is no reason for you to say that the share should
be "BUY" or "SELL"... Of course there
is one exeption: if a company is very profitable and perhaps
even grows fast, then it is of course a BUY if it "only"
can maintain its status quo as markets can never price
this kind of companies with their intrinsic value but
rather wait - very rationally - that the performance will
deteriorate sooner or later.
And remember also that forecasting in itself means nothing,
only your arguments within
these forecasts mean something.
How far should I estimate in quarter level (net sales
and EBIT)?
Current year
Current year has to be estimated in quarter level. In
fact, there is even no full-year estimate cells available.
Second estimate years
In normal case it is enough to have full-year estimates
for the second year. But when year end is getting closer,
you might consider making quarterly estimates also for
the second year.
Quarter estimates for the following year should be made
at the latest before running YearChange macro. In technical
aspect you can still ignore those estimates but then the
year change would cause a significant change to fair value
as (new) current year growth and EBIT-% would become 0.
Third and fourth estimate years
You can always stay in full-year level when you make
net sales and EBIT estimates for the third and fourth
estimate years. The reason why there even is a possibility
to estimate in quarter level, is mainly technical.
Quarter estimates dominate
Please, remember that if you enter both quarter
and full-year estimate, the latter is ignored.
Seasonal variation in estimates
Some companies have quite stable turnover and operating
profit between different quarters. However, other companies
tend to sell each year more in certain time or make the
most of the profit in certain quarters.
Consider for example a skiing center: the most of the
turnover is created in the winter, while the revenues
in the summer may be close to nothing. Again, some consumer
goods are sold mainly at the end of the year, in christmas.
This phenomenom is called seasonal variation and you
should take it into account when you think about your
estimates.
How to take seasonal variation into account in Valuatum
Excel model?
There are three things that help you in this:
Division
graphs in I-divQ sheet
Info
fields in I-divQ sheet and
Quarter
graphs in O-quarter sheet.
The divison
graphs are most helpful things with estimating the
seasonal variation and therefore there is even an own
tutorial page for them. You really should learn how to
use them (it is so easy that you do not even need instructions
for them as long as you only know where to find them).
Info fields in I-divQ sheet and Quarter graphs in
O-quarter sheet
When you look at the Info
fields in I-divQ, you can see the periodic historical
values and also your estimates in the same rows. If there
are considerable variation between quarters, take it into
account in your estimates.
Perhaps an easier way to notice a possible variation
is to look at the graphs in the O-quarter sheet. You can
just change the sheet or change view: click the button
in the left upper corner of I-divQ and you get two sheets
to the view at the same time. When you click the button
again, you will get back to the original view.
Estimating long-term growth and profitability
Short-term vs. long-term estimates
The basis for the short-term estimates is the current
situation in the company: the management guidance, cyclical
situation, analyst's own assessment of the competitive
situation and market. However, the basis for the long-term
estimates should be more the long-term growth of the sector
in general.
Leveling off long-term growth
All rational company estimates are based on the fact
that sales growth levels off near to the long-term GDP
growth (about 3%), no matter what the business is. This
means that also growth companies become "ordinary"
in the long-run — even some software or mobile phones
cannot grow more than 5% a year forever... Att:
there is even a mathematical problem with high growth
rates (higher than WACC), which makes fair value negative
with high growth rates.
Profitability
Even more important for the estimates is that profitability
should be leveled off to normal levels. Profitability
is estimated/changed in the model with EBIT-%, but you
should follow profitability with ROI-%or EVA which are
much more relevant measures. In our competitive world
we have to assume that sooner or later competitors will
catch any company in the long run and "abnormal"
profits (large positive EVA, greater ROI than 15%) will
melt down.
Star companies
Of course there are companies that will not follow this
rule during their next 5 years, but it is no sense that
we try to "see" it in our 5+ years estimates.
Those companies that have grown very rapidly and have
been very profitable are for example Nokia and Microsoft.
Their share prices have appreciated about 10 000% and
300 000%
correspondingly. There is no sense in trying to catch
that kind of stars: it is enough if we find that those
companies are more than 50% undervalued because they will
grow more that 30% for the next 3 years and remain very
profitable.
How to set value for Tangible assets / net sales %?
How to choose percentage value?
Normally companies need certain amount of tangible assets
relative to their turnover. In many industries this proportion
is quite constant in the long-run. For example a pulp
& paper company might have had fixed assets about
85% of its sales and the proportion has alternated between
81% and 89% for the past ten years.
Simplyfied this means that the company needs to have
a paper machine worth 850 mEUR in oder to generate 1000
mEUR sales in one year. Thereby it is very unlikely that
the proportion of fixed (tangible) assets would change
much relative to sales either in the future. Therefore
it is quite logical basis for the estimates that the relation
between tangible assets and net sales would remain roughly
at the same level also in the future.
Estimates in Valuatum Excel model
In Valuatum Excel model this would mean that you can
first copy the value of Tangible asset / Net sales from
the last history year (I-main, J14) and paste it (as values)
to estimate years (I-main, K14:T14). If you have not estimated
investments with tangible assets (I-main, K13;L14;...)
in absolute terms, the Tangible assets / Net sales parameter
will adjust the investments automatically.
Differences inside of industry
Often the Tangible assets / Net sales ratio is rather
constant even inside a certain industry, so competitors
would have pretty similar relation between tangible assets
and sales. Of course it is normal to have some differences
between different companies inside the same industry.
Some other pulp & paper company might have e.g. proportianally
bigger share of certain product types (like: fine papers,
tissue papers etc.) and the different products tie capital
differently in production assets.
Furthermore different companies might have different
philosophy in these issues and therefore two companies
with exactly same businesses might have different "asset
turnover". Others tend to use their old machinery
as long as possible and others tend to keep their production
facility very modern. Thus the latter group might have
more efficient production capacity and also smaller variable
costs but higher depreciation percentage.
Fine tuning
As you have set the parameter (Tangible asset / Net sales)
roughly at the right level, you can (and often also should)
do some alteration to either this parameter or directly
to investments (I-main, K13;L14;...). It is often so that
at least current year values are easier to estimate directly
with absolute investments as we often know what kind of
investment plans the company has for the current year.
If you estimate only with the Tangible asset / Net sales
parameter, you should also take into account cyclical
factors (capasity utilisation is different over the cycle
and it affects Tangible asset / Net sales) and possible
changes in group structure (relative share of certain
business in the group might be changing).
Estimating Working capital
Formula for Working capital
Working capital consists of three parameters (see
more info in ValuModels tutorials):
Working capital
= Inventories + Receivables - Non interest bearing current
liabilities
It is estimated with the corresponding percentage figures:
Inventories / Net sales %, Receivables / Net sales %,
etc.
How to choose percentage values?
As with Tangible assets above, it is reasonable to assume
that company remains the same level of working capital
related to net sales as in history. For example usually
when net sales grows, inventories grow too. And since
receivables consist mainly of sales receivables, most
probably also receivables increase.
So when you consider values for these three parameters,
start with the last history year values or some average
value from the latest history years.
Estimates in Valuatum Excel model
If you use the latest history year values, copy the cells
J22:J25 and paste as values to the estimate columns (K22:T25).
Fine tuning
Since it is important for companies that working capital
would tie as little capital as possible, they have a tendency
to lower for example inventories level. You may see this
in historical Inventories %, as the value may have come
down year-by-year, and thus assume that this trend would
continue also in the future.
General instructions for providing comments in company
specific forums
What should be written in company forums?
1) Comments on estimates
The most important thing in company forums is to
provide arguments about your estimates. Your estimates
are reliable only if you tell what they are based on -
especially if you do not have a very long track record
and thus people can not see that your estimates have been
very accurate in the past. With good estimate comments
users can not only see what facts support the current
estimate but also the risks, possible range of outcomes
etc. We have dedicated
instructions for estimate comments, please look at them.
Historical figures: comparability
Sometimes you have to describe also the past so that
people could understand the estimates: Some companies
have also had some restructuring or other major changes
in the past meaning that past financial performance
is not very good indication for future financial performance
and these things should be described.
Adjustments
If you have adjusted the company figures somehow
e.g. by transferring some capital gains or other non-recurring
items from EBIT to Extra Ordinary Items, then this should
of course be explained very clearly (with own company
forum message which header could be like: "Adjustments
made to 2004/Q3 income statement..."). You should
not only tell clearly what you have done but also the
arguments for doing it.
2) Market position, competitors, competitive advantages...
Besides estimate comments you can also describe any
other essential things within the valuation of your target
company. Those things include e.g. competitors, market
position of the company, competitive advantages, historical
track record and credibility of current management etc.
3.) Something new...
If you want to be pro then you can try to satisfy the
needs of institutional investors and their fund managers.
They always require analysts to "Tell me something
new!". Fund managers and sell-side analysts typically
know their domestic target companies rather well and they
get masses of sell-side equity research from big companies.
Therefore they have normally heard all the normal stuff.
They call attention only to something that has not been
told them already. This kind of things might be e.g. things
about the business itself:
1) down-to-earth comments of the competitive edge of
a complex and not-so-well-known product (like Basware)
=> why is it competitive, how close are the competitors,
how big market will they have ahead..?
2) effects of new technology in certain industry (up
to revenue and margin level) like VOIP, wlan or push-to-talk
in operator business => will almost all voice get
into data networks and when, what does it mean to operator
revenues and margins?
3) what are the real consequences in sales and ebit
-level of certain transactions like when Tietoenator
gets lots of IT-outsourcing contracts => how profitable
contracts are they in the long run, how much of them
will we see in the future...
4.) What kind of growth opportunities certain companies
will have in the foreign markets and why would their
product offering be competitive there (like: Ponsse
in Russia, Kesko in Baltics etc.)
...or things related also to the valuation:
5.) company X will reveal such figures that have not
been expected as current EPS consensus estimate for
yyy is ... and EPS has to be at least... because...
6.) next year P/E would be below ... which is lower
than it has ever been ... lower than any other company
within the same industry and this company has always
been valued more than .... since...
7.) this reconstruction would mean that company ebit
... ...meaning that ROI would.... ...and as the P/BV
is currently ... => the company will double its share
price if and when the P/BV will rise to the same level
as all the other companies producing that kind return.
E.g....
Like you and me, institutional investors also like concrete
things: they are perhaps not excited about your story
how some technology will change the world. But they would
like to hear it if you can also tell how it changes the
figures of a certain company, at what level the valuation
figures (like P/E, EV/EBIT, P/BV) will be after these
changes have happened, how and when this change will happen
and what are the proofs of it. So if you can tell with
solid and understandable arguments why the share price
of a certain company will rise more than 30% then you
will be heard.
Do not put news on the forum
The company forums are not a news channel. So
do not copy-paste many company press releases on the forum
(or even big clips from them). There are different organizations
and companies inside the media sector which are much better
in these operations - so leave it to them. Besides: if
we all would put many press releases on the company forum,
it would be 90% full of them and important things would
not stand out. Of course you can and perhaps even sometimes
should quote some important things from those press releases
- at least if you also tell your own comments on them:
how this is going to change the company figures or affect
valuation/share price in the long-run.
Commenting company news or rumours
Of course you can inform investors about some major news
in the forum, but only in those cases where you have something
to comment on the news: if your company has made a major
acquisition you can tell whether you see it affecting
positively or negatively on the share price and especially
why it does so and how big the effect would be (with quantitative
comments). If the news do not affect share price, then
why bother commenting them. Only in those cases where
media tells some negative news about the company with
big headlines and you think that those news do not affect
the company´s financials, should you comment on
it on the forum. Thereby you have important message: "do
not believe in the media, this event is not important
for the share price" (or: "this persistent rumour
is not likely to be true or happen"). To sum up:
If there is news from the company but you do not believe
it is important or you have nothing to say about it, you
would only echo the news from the media, then do not write
anything. For company releases we have the the company
website address on background page. And remember that
investors follow media themselves, analysts should not
try to repeat news but to point out and analyse the most
important things - whether they have been in media or
not...
How should the comments be formulated?
Try to be brief with your comments. Use headlines
also inside forum messages to make the text more readable
and to enable reader to choose/skip parts that are interesting/non-interesting
for him/her at the moment. Also providing summaries
at the top is a very good habit. Remember that many investors
browse ranking lists and multi-criteria rankings and as
they find plenty of interesting companies they quickly
browse their figures and comments on their figures. Thereby
they are not very happy if the essential things like solid
grounds for current year result or information from competition
and competitive weeknesses and strengths are hard to find
from the text. Already forum message headings should include
the most essential things. And plenty of unrelevent forum
messages hinder that the investor does not even find the
right message...
Of course you can also write long comments and thoroughful
information about some things. That kind of information
is of course valuable in some cases and for some users,
just ensure with the above means (headings, sub headings,
summaries etc.) that you serve also busy investors.
You can also add
images inside your forum-messages, look here how it can
be done.
Commenting and providing arguments for the estimates
of current year
Quantitative vs qualitative comments
Arguments for estimates should be both qualitative
and especially quantitative. Always justify qualitative
argument with quantitative facts (such as last year's
corresponding numbers, order book and their development).
They are a good way to add credibility to your arguments.
And remember that graphs e.g. from quarter development
illustrate the situation very clearly so please use
graphs to back up your text.
You should also try to estimate what kind of quantitative
impact a factor is going to have. Try to give a good insight
on what presumptions your estimates are based on and how
possible changes in these presumptions would affect your
estimates. Use arguments that people can easily comment
on and you can later get back to see what went wrong and
what you were right about.
Do not try to give too exact numbers like 356,7 MEUR
as your expectation - use rather acceptable range like
350-360 MEUR (range depending on uncertainty). Of course
your analysis (model) includes exact numbers but in your
comments you can use ranges to describe the uncertainty
of your assumptions.
What things should be commented?
Normally you should comment at least the following: Net
sales, EBIT, EBIT %, their development and management
guidance. The advice of "commenting EBIT" should
not mean that you expect EBIT of xxx mEUR but that your
current EBIT estimate is based on the facts like... ...and
these assumptions are backed by facts like... So please,
do not just tell WHAT your estimates are (everyone
can see it), but describe rather WHY your estimates
are at certain level.
Quite often we need to understand the past in order to
understand the future. Therefore it is also good to briefly
go through what has happend in the past and from there
draw conslusions what will perhaps happen in the future.
Normally e.g. total turnarounds or profitability crashes
do not happen over night but there are some signs about
changing company performance during at least some quarters
before any such change really occurs. And thereby you
should comment also past performance and tell how you
have interpreted it and how it has affected your estimates.
A very good and recommended way to do this is to attach
a couple of graphs from company views pages to back up
your story. Instructions
for adding graphs can be found from here.
Depending on company one should think about commenting
order book, seasonal variation, balance sheet structure,
investments and naturally all factors that have a significant
impact on the profitability of your company.
Tell also what others think and comment possible differences.
This is important so that people can see why your estimates
differ from others and later one can easily see whose
presumptions were correct. If consensus estimates are
available, it is good to reflect your estimates on them.
Do not use irrelevant remarks, which often result on question
why. Don't leave readers wondering: "why?".
What kind of comments are possible?
Sometimes the analyst generates her estimates like this:
she looks that the company has been growing for about
5% a year within the past 3 years and it has produced
EBIT-margin about 10% each year. As there are really not
any other relevant information available (company is not
eager to give any information, and the business represent
such a niche that there really is nothing publicly available
about it), then the analyst makes a cautios estimate -
based on these tiny pieces of information - that the company
will grow 4% this year and the EBIT-% will be 9% (both
slightly less that the realised figures) and that the
capital tied up to business will be at the same relative
level than with previous years (fixed assets/net sales%,
inventories/sales-%, receivables/sales % etc. will remain
stable).
If this is the process how the estimates have been generated,
then the analyst should tell it openly to customers/users
in the company forum. I know that it sometimes embarasses
analysts to tell how simply the estimates have been formed
- they would prefer to describe that the process of generating
estimates have been much more complicated and the analyst
has taken into account dozens of sophisticated factors.
However, describing the simple way of processing the
estimates is actually very valuable for customers. With
that information the customers are able to form their
own scenarios much easier: if they happen to know some
factors affecting next year sales/EBIT positively or negatively,
then they can also estimate easier how the EPS, P/E etc.
will differ from the estimate of the analyst. So, please
tell the users exactly how the estimates have been formed
no matter how simple the process has been and how little
information there has been used.
Customers can also better make comments that might help
you with your estimates. And they can give these helpful
comments often only if you have been open enough to reveal
how you have generated your estimates. The customers might
give you hints about things that should be taken into
account: the effects of new competitors or competitive
products, new demand from certain geographical areas or
towards certain products or any other interesting information.
The more open you are, the more open and helpful the customers
are likely to be with you.
Furthermore if the analyst makes the estimates in a simple
way described above and takes thereby, in cases necessary,
into account also some relevant minor things like seasonal
variation, then the estimates might turn out to be
very accurate. The simple way of processing the estimates
is often a very good method - also from the point of view
of estimate accuracy.
Estimates produced originally with a simple method can
also be adjusted slightly upwards or downwards according
to intuitive feeling about the management, tightening
competitive situation, future trends or things like that.
And these intuitive ways in adjusting the estimates might
turn out to be very successful especially what comes to
estimates beyond next quarter as there are often no accurate
information or any guidance available after that. However,
any intuitive adjustments made to the base scenario must
always be commented transparently. So, even if some of
your figures are based on feeling about vague things "tightening
competition" and not to accurate calcuations, you
still must tell those grounds to users.
Management guidance
Include management guidance to your comments. Tell what
the management is expecting and compare your estimates
with them. Always justify any arguments that are not in-line
with management guidance.
Make obvious difference between your own thoughts and
those of management or any other person. You could also
check out and tell how accurate the management guidance
has been in the past and how reliable you consider this
information to be.
Uncertainty in estimates
If you are unsure about some things in your estimates
(like you probably are), don't try to hide it behind fragile
explanations. Not only tell what you know but also what
(relevant) facts you don't know. It is better to tell
that you are uncertain about these things and about their
impact on estimates than to ignore them.
Also if you cannot estimate how big quantitative impact
some factor is going to have, you should admit it. There
are always some things that cause uncertainty to estimates
and there is no reason to deny this. It is very essential
information to tell investors things like: "I have
not been able to gather information about the effects
of...." OR: "this figure is more like a sophisticated
guess than... " OR: "it is very hard to say
how and when this is..."
Feel free to look help from those analyses that have
high points. Still keep in mind that every company has
its unique situation and thus there are no "universally
good style" to formulate your comments.
Setting and arguing recommendation
Before reading this section you should have read the
section "What
is important in analysis to try to estimate?".
It discusses also the basis of recommendation and different
valuation cases thereby. We also recommend that you would
use valuation
scatter in estimating the valuation of your target
company.
The key factors when setting investment recommendation
is that an analyst
1) makes justified target price assumption of the company
based of future financial perfomance and current valuation
(with e.g. valuation
scatter)
2) compares the company (valuation multiples and financial
perfomance) to other companies (with e.g. valuation
scatter) and
3) above all gives transparent and realistic arguments
for all the factors he/she has pondered hereby, so that
an investor (a customer) can see which of those arguments
are reliable and which perhaps not.
The recommendation should never be based on your (unexplained)
"feeling" and the recommendation should always
be based on/ in line with a long-term target price set
by an analyst.
Setting target price
What should the target price then be? There is no exhaustive
answer on that question. There are several valuation methods,
and important is that you shouldn't blindly trust one.
Instead use many methods together and then set some kind
of consensus target price.
Different valuation methods
Relative valuation (comparison with other companies):
For example if some multiples (e.g. P/E, EV/EBIT) are
lower/higher than the ones for companies in the same
industry (or companies in general). Be careful using
this method, because the variable of your company may
well be at the "right" level when the industry
is over/undervalued. Furthermore the company itself
might have such characters that justify lower relative
valuation than its peers: weaker profitability etc.
Hereby you can use e.g. valuation
scatter.
Absolute valuation:
Some variables are very low/high. For example P/BV
(Price / Book value) is low (e.g. below 1) despite of
that company's profitability (e.g. ROE %) in the future
seems good (e.g. better than 20% in the same time as
P/BV is below 1). In this case you should recommend
buying this share, because when the markets notice that
profitability will improve, the P/BV (the share price)
rises. Hereby you can also use e.g. valuation
scatter.
DCF (discounted cash flow) value:
One thing that should also be in the line with the
recommendation is the DCF value of share price. The
DCF value should rather be supportive for the recommendation
than be the factor on what the recommendation is based
on. In other words, it is preferred that you adjust
the DCF value to support your recommendation, and not
vice versa, because DCF can be manipulated easily: by
manipulating profitability or growth estimates in distant
future you can always make DCF fair value look like
as the company is "cheap".
DCF parameters (mid-term growth and profitability)
should be set at the level, which makes your the DCF
fair value to be about the same level as your target
price (which in turn is defined by other means than
DCF). If that is not easily possible (requires too high
or too low estimate parameters), then it is of course
a sign that something is wrong and you should rethink
your target and the whole valuation. Thus the DCF acts
best as a kind of "reality check": it checks
whether your target price is approximately at the right
range.
Remember that good profitability and good earnings development
always reflect the share price. In the very long-term
share prices follow the return on equity (ROE%) of the
company. In the short term does not as the current market
value can be far from equity book value and as current
valuation (P/BV) reflects the whole future and not just
one or two years.
Do not forget to compare to other companies
Analysts sometimes tend to "fall in love with some
companies they analyse". This happens especially
if the companies are very good at what they do. This sometimes
ends to buy recommendations even in cases when the company
or the whole industry is overvalued. That's why it is
vital that you remember to compare your company to other
companies and use that information when setting the target
price and recommendation.
Great help for doing comparison gives Multi-criteria
rankings (MCR) page in ValuViews where companies are ranked
based on different variables. If your opinion differs
a lot from MCR lists, you should give very clear justification
why you have ended up on your decision. Another, perhaps
even more illustrative comparison tool is valuation
scatter which you should also use hereby.
For example, if the company you are analysing is located
on the top of the MCR or scatter list and your recommendation
is reduce, you should argue why you have decided this
way. However, the MCR-list is not pure truth, so don't
be afraid to disagree with it. For example a company may
well be at the bottom of the list because of current bad
financial performance, but the financial performance might
be improving in the next years (there are already signs
of that but profitability lags the other signs like improved
customer orientation or improved operative efficiency
which can not perhaps be seen in ebit because of overcapasity
or something like that) and the market may have not noticed
it yet.
Briefly, if the company is "bad" at the moment,
it doesn't mean that will always be "bad" and
cannot improve - but there must be reasons and proofs
of that improvement - otherwise it might be bad for next
ten years. So do not just expect that something must happen....
However, one common feature of really good investment
target is that market is not yet aware of something that
will happen.
Check list to see if the company really is cheap
The following list should be checked if you bump into
company that looks very cheap with relative valuation:
cheap P/E, EV/EBIT, P/BV etc. ratios:
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Does the drop in earnings seem obvious (bad competitive
position, cyclical fluctuations downwards inevitable
in the future for the whole industry, no superior
competitive strengths that would protect from future
competition etc.)?
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Are there some signs in the owner structure that
might weaken the position of company in the long-term
(main owners might want to take all the cash out
of the company etc. with transfer pricing - in situation
where unlisted parent company owns listed daughter
company is always a very big risk - especially if
they have common business and therefore room for
overpriced transfer pricing in transactions)?
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Are there any other features that may weaken the
position of a company in the future?
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Summary
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Use long-term investment horizon when setting the
target price and recommendation.
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Use complete yet understandable arguments to explain
why you have ended up to your recommendation.
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Don't set recommendation separately from the other
companies (MCR and scatter
lists).
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Don't use only one method to value the target price.
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Check that the DCF-value is in the line with your
recommendation (adjust fair value if possible, if
not possible (requires unrealistic future estimates)
then rethink and adjust target price and recomm.).
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There is not one right way to value the price of
a company, thus use many methods. Use relative and
absolute valuation and try to find hidden strengths
and weaknesses that market may not know yet. Based
on these decide (long-term) target price.
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Description of competitive situation and position in
markets
Description of the biggest competitors
You might want to write a brief description of the worst
competitors of your company. It should be able to answer
at least to the following questions:
- What is the current competitive situation,
how has it been developing and how do you believe it
will develop in the future?
- How are market shares divided among companies?
How have they been developing and how do you see the
future?
- How big and profitable are the competitors?
- What are the major differences between the competitors?
- What are the strengths and the weaknesses of
each competitor?
- Has the competition any special features (such
as government regulation or major changes)?
Comparing to others
Always compare features of companies to the ones of your
company. This way readers can get better vision of the
market situation than just plain numbers without context.
Remember that companies also have different kinds of valuations.
If some company is in superb situation, growing fast or
has exceptional profitability, it is natural that this
company should have higher valuation. Valuation can be
seen for example in P/E-, EV/EBITDA- and P/B - ratios.
Compare these figures in your company's peer group. Still
the acceptable level of these figures should be determined
case by case.
Competition methods and advances
Tell about the competition methods of the business. Are
companies competing with price, quality, image, brand
or something else? What are the competitive advances of
your company? Tell about their nature for example whether
they are long-lasting or easy to copy and therefore temporary.
Is the importance of your company's competitive advance
diminishing or growing? Think also about the future and
possible changes.
Try to express the situation in a way that everyone can
assess how competition will develop in the future and
how each company is going to succeed in it. You may also
try to compare things like brand and image among peers
group. Although it's difficult to estimate the importance
of brand, it is clear that a strong and well-known brand
has a significant effect on competitive situation and
on consumer choices.
Where to get this kind of information?
First you should ask the company (investor relations
contact). The company has surely information about its
competitors and their market shares etc. and normally
they also give investors at least some of this information.
Even just a list of competitors is a good start and thereafter
you can put the names on Google and... Also customers
of the company are a very good source of information and
they can tell you also much more interesting things than
just the name of potential suppliers. The customers can
reveal also why they prefer some suppliers over the others
i.e. what are the relevant competitive advantages that
the companies may have.
The track-record and creditability of current management
Importance of management guidance
Management guidance (or management outlook etc.) probably
has a lot weight when considering estimates - Normally
it can be said that the management has the best view about
how their company is really doing and what the future
holds for them. This, however, does not mean that you
should believe everything management says without checking
the facts.
Track-record and creditability
What you should do is find out and tell how accurate
the management guidance has been in the past. Best way
to do this is to use the track-record of management: basically
you just tell what the management has been expecting and
what has been the actual result. Compare estimate vs.
actual, simple but effective. With this information you,
and every one else, can measure the creditability of current
management. If you for some reason doubt the credibility
of management, always justify your arguments with facts.
Management probably doesn't appreciate if their trustworthiness
is questioned without solid arguments that are backed
up with facts. For example you can support your thoughts
with developments of net sales, profitability, order book
or market situation.
Good management vs. bad management
Even the best of us make mistakes and management is no
exception. What separates good management from bad management
is the amount of mistakes and the quality of communication.
Bad management makes perhaps more mistakes, more serious/stupid
mistakes and/or it does not reassess and communicate the
situation so quickly to investors than the good one. Good
management tells relevant information openly, honestly
and without delays. Bad management normally communicates
poorly with the market and maybe even, in some extreme
cases, delays, hides or twists relevant information (this
naturally is against law and very extraordinary).
Management guidance and expectations - Different styles
It is good to recognize the style of your company's management.
In many cases management gives cautious and modest estimates,
so they can be outperformed and disappointments are avoided.
In the other end there are some companies that are constantly
over-optimistic. These companies are due to disappoint
the market with less than expected results. Some companies
don't really offer much management guidance - they just
settle for stating some obvious facts. This is quite common
among smaller companies as they typically have less resources
for this kind of things. Fortunately there are also companies
that can normally offer both realistic and useful management
guidance.
Summary
All in all, good management can normally be trusted and
it's accurate enough on its estimates. On the contradictory,
bad management can rarely be trusted and its expectations
can be more based on a feeling than actual facts. Still,
if you don't trust management and you're estimates differ
from theirs; always justify your thoughts and estimates
with good, fact-based arguments. There are also different
kinds of styles giving management guidance - try to recognize
the style of your company.
WACC - Parameter guidance
The Importance of WACC
WACC (Weighted Average Cost of Capital) is a key component
when DCF fair value is calculated. Even small changes
in WACC may cause significant change in DCF. WACC alone
is not that important - nobody makes investment decisions
based purely on WACC. To some extent you can even modify
WACC-parameters to justify your own fair value with DCF.
Still remember that this can be done only after you have
done reality check with DCF that has not been modified.
WACC - Parameters
How should you set WACC-parameters? Here are some tips
how it should be done:
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Tax rate. Simply fill out your company's
tax rate. Basically this is your company's home
country's tax rate for companies. In Finland the
tax rate is due to decrease to 26 % (from 29 %).
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Target debt ratio (D/D+E). In many cases
company has stated their target debt ratio. If your
company hasn't, you can think what it could be.
Try to stay away from extremes. Depending on company,
the debt ratio is normally around 5-60 %. Do not
confuse actual debt ratio for the target debt ratio.
They are usually two completely different things,
but we prefer to calculate WACC with long-term target
insted of volatile actual values.
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Cost of debt. Try to estimate what is the
cost of debt of your company. Cost of debt varies
according to company and economical situation. Try
to estimate your company's cost of debt, if company
doesn't tell it or it can not be reliably calculated
from financial statements (sometimes the company
includes such items in interest expences etc. that
the calculated values do not tell the whole truth).
This such as size, financial situation, profitability
and possible credit rating affect the value. Normally
cost of debt is about 0.25% - 1.5%-points more than
risk free interest rate (for small/unprofitable
companies somewhat more than with blue chips). If
you have not better way to estimate the value, then
you can e.g. assume that it is 0.75%-points more
than long-term risk-free interest rate - and it
probably is not very far away from truth. So if
risk-free rate is 5%, then let cost of debt be 5.75%.
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Equity beta. Describes what is the relative
equity risk concerning your company (normally the
risk of its business sector). The average beta is
1 and thus the companies that have about average
risk have beta of 1. If the business is more risky
(very cyclical, high fixed costs/operational leverage)
then the beta is more than 1 (normally 1.1 - 1.5).
This kind of businesses are e.g. internet business
(high fixed costs, high operational risk), pulp
and paper (cyclical and high fixed costs). If the
business is less risky (very smooth: not cyclical
and not very high operational risk) then the beta
is below 1 (normally 0.6 - 0.9). This kind of businesses
are real estate and food and beverage retail and
production. We
have made a table that has different betas for different
businesses. That page tells also other information
on beta and its estimation. Normally you get
biased betas if you estimate them from market data
from illiquid companies or illiquid /not-so-diversified
markets. Therefore it is normally better to estimate
the beta yourself than to get it from market data.
You can estimate them by assessing whether the company
is more or less risky than some other industries
whose beta you know.
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Market risk premium. It describes the premium
that equity investors tend to expect to get when
investing to equity markets compared to return they
would get from risk-free investments - long-term
government bonds. Normally equity research producers
use hereby values between 3.5% - 5%, even though
some academic research has suggested also that the
premium might be as big as 6%. The problem is that
there is no method to get/estimate the value in
reality, so we just have to take some reasonable
value here. It would also be important that the
value would be about the same with every analyst
and currently we recommend that this value would
be 4.75; So use it until you hear otherwise.
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Risk free interest rate. Input the interest
rate of government 10 year bond. For example Finland's
government bond it is currently about 4,3 %. You
should use the one of your country/your own currency
area. The risk free interest rates varies a bit
in different currency areas as the long-term interest
rate holds inside the expectation about the future
inflation. As the real interest rate (interest what
people expect to get from risk free investments
after inflation has been deducted) is about 3%,
then the long-term risk free interest rate is currently:
real interest rate + current long-term inflation
expectation = 3% + 1.3% = 4.3%
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Setting fair value and the meaning of DCF
How to determine fair value of company?
Fair value of company should be determined using different
kinds of multiples such as P/E, P/BV and EV/EBITDA, development
of sales and profitable and for some part DCF model. Multi-criteria
Rankings is an excellent tool for determining fair value
of company. Value of company should always be compared
among its peers and competitors and also the current level
of valuation in overall markets.
Read more about this (if you haven't done it already)
on Setting and arguing
recommendation
Reality check using DCF fair value
DCF is at its best when it is used as a reality check
as it should be. With DCF you can see what would actually
be demanded in certain price - expectations considering
growth, profitability and their development. Had this
been used in the end of the roaring nineties the outcome
could have been different. Still DCF is not an absolute
truth and should never be used without other methods.
Anyway the reality check with DCF is strongly recommended.
If the difference between DCF fair value and the fair
value you determined earlier is acceptable, you can continue
to next step. If there is a significant difference between
these levels, you should recheck your expectations.
Adjusting DCF to support your target price
After the reality check DCF can be modified to support
and justify your fair value. Do not modify DCF before
you have really thought about realistic fair value of
the company and determined your target price - it would
be useless and misleading. Adjusting DCF can be done best
e.g. by changing parameters such as mid-term growth and
profitability: Net Sales growth and Ebit-% estimates.
By mid-term we mean e.g years 3-7 from current year (e.g.
2007-2011 if 2004 would be current year). If you slow
down the current perhaps rapid growth towards the terminal
value or decrease profitability faster than the previous
estimates you also decrease fair value. If you increase
growth and profitability (or preferably make them decrease
in a slower pace towards the terminal value) then you
increase terminal value. The terminal values themselves
should not be manipulated much (See how
long-term growth and profitability should be estimated.)
Most recommended way is to use net sales and ebit parameters,
as all the other estimate parameters should be rather
constant: there is not much sense in changing the average
depreciation-% or changing the working capital or investments
as there are normally only one reasonable level (look
more info on tangible
assets and working
capital). Also WACC parameters are rather constant
so they should ne be manipulated much. if you have big
problems on adjusting DCF fair value to your fair value,
check your estimates once again. Investors (customers)
are able to see (as they should be) on what are your estimates
based on. They can see your growth and profitability estimates
easily. Remember this when you are justifying your target
price / fair value - and never try to justify something
that just is not there.
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