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Analysis of Stock Performance Based on Fundamental Indicators

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Analysis of Stock Performance Based on Fundamental Indicators FACULTY OF F I N A N C E & ACCOUNTING C o p e n h a g e n Business School Master’s thesis Analysis of stock performance based on fundamental indicators Authors: Anders Heegaard & Peter Brøndum Riis Sørensen CPR nr.: Anders Heegaard CPR nr.: Peter Brøndum Riis Sørensen Academic advisor: Hans Kjær Submitted : 23/09/13 Pages: 122 Characters (with spaces): 312,862 Copenhagen Business School 2013 Anders Heegaard Peter Brøndum Riis Sørensen Executive summary The objective of this thesis is to examine the validity of enterprise value/earnings before interest and tax (EV/EBIT) and return on invested capital (RoIC) as a screening tool to select stocks. The various ways of im- proving the selection process is an integral part of investing, and therefore this subject is deemed highly current and relevant. The thesis is divided into four parts. The first part is an analysis of the approach chosen to select stocks. The second part is the theoretical foundation behind the measures and the risk incurred. Subsequently, a test of the approach and an analysis of the results are presented. Finally, the findings are evaluated and dis- cussed, resulting in the fourth part, which determines the framework for the screening tool. In the first part the thesis, the approach was examined as well as the underlying investment philosophy. It was found that the strategy rests on the belief that if investors can invest in quality companies at “cheap” prices, su- perior results should be achieved. To determine the quality of a company, Return on Tangible Capital (ROC) was used, and to determine the price, EV/EBIT was used in the original approach developed by American inves- tor Joel Greenblatt. The second part finds that EV/EBIT is the best price measure as the measure eliminates the effect of leverage, has a solid focus on the cash flows to the enterprise created from core operations, and is theoretically equivalent to other valuation techniques such as the discounted cash flow mode and the price to earnings ratio. Furthermore, RoIC was found to be the preferred quality measure as the measure captures the value that is created by core operations, and was overwhelmingly supported by academic research as an indicator for the quality of a busi- ness. Moreover, it is considered a good measure for economic value as it is related to Economic Value Added (EVA). This outweighed accounting issues related to the measure and the fact that it was not the measure used in the original test. Based on the chosen measures, the testing and analysis were carried out. Based on the test, the third part of this thesis found that ranking stocks solely on both RoIC and EV/EBIT is a valid approach to identify portfolios of stock that provide great and abysmal returns, respectively, as the best ranked stocks had a performance that vast- ly outperformed the market, whereas the lowest ranked portfolios of stocks significantly underperformed. Fur- thermore, the analysis finds that ranking stocks based on a combination of EV/EBIT and RoIC provides a better overall result as significantly more can be concluded across the different portfolios. However, the analysis proved that the strategy does not provide as great absolute performances for the best portfolios as is the case when using EV/EBIT and RoIC. Based on these findings, part four presents a discussion of the results and con- cludes that based on the overall findings, it is believed that a model based on EV/EBIT and RoIC can provide some valuable insights and can be considered a good starting point in terms of which stocks should be singled out. Nonetheless, the analysis also showed that a strategy based purely on this approach is not feasible as the performance of the various decentiles has been found to be significantly affected by a few stocks. Page 1 of 122 Table of Contents 1. Introduction ......................................................................................................................................................4 1.1 Motivation ......................................................................................................................................................5 1.2 Problem Statement ..........................................................................................................................................6 1.3 Methodology...................................................................................................................................................7 1.4 Structure of the Thesis ................................................................................................................................. 11 1.5 Demarcation ................................................................................................................................................ 11 1.6 Critique of Sources ...................................................................................................................................... 14 1.7 The Magic Formula ..................................................................................................................................... 15 2 Theoretical Framework ...................................................................................................................................... 16 2.1 Price Measures ............................................................................................................................................. 16 2.2 Price Earnings as a Measure .................................................................................................................... 18 2.3 Drivers of the Price to Earnings Ratio ..................................................................................................... 18 2.4 Ability to Create Cash Flows ................................................................................................................... 19 2.5 Growth Rate ............................................................................................................................................. 20 2.6 Uncertainty of Future Cash Flows (Risk) ................................................................................................ 21 2.7 What Earnings to Use? ............................................................................................................................ 22 2.8 P/E Across Different Sectors ................................................................................................................... 23 2.9 Is Price to Earnings A Valid Measure?.................................................................................................... 23 2.10 EV/EBIT as a Measure .............................................................................................................................. 24 2.11 Fundamental Drivers of EV/EBIT ......................................................................................................... 25 2.12 Advantages of EV/EBIT ........................................................................................................................ 27 2.2 Return on Invested Capital .......................................................................................................................... 29 2.21 NOPAT .................................................................................................................................................. 29 2.22 Invested Capital ..................................................................................................................................... 30 2.23 The Decomposition of RoIC .................................................................................................................. 31 2.3 Accounting Issues ........................................................................................................................................ 35 2.31 Accounting Issues Related to EBIT ....................................................................................................... 35 2.32 Accounting Issues Related to Invested Capital ..................................................................................... 41 2.33 Accounting Issues Related to Enterprise Value ..................................................................................... 46 2.4 Risk .............................................................................................................................................................. 47 3. Analysis ............................................................................................................................................................. 55 3.1 Analysis of Return on Invested Capital ....................................................................................................... 55 3.11 Returns ................................................................................................................................................... 55 3.12 Risk Measures ....................................................................................................................................... 57 3.13 Risk ........................................................................................................................................................ 57 3.14 Risk-Adjusted Returns ........................................................................................................................... 59 3.15 Top & Bottom Performers ....................................................................................................................
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