TECHNICAL &

FUNDAMENTAL ANALYSIS
Focusing on DCF Analysis with Practical example of HUL

JULY 15, 2016

MODEX INTERNATIONAL SECURITIES LTD.
Made by- AKSHIT KHANIJO

INDEX
Introduction

...

Efficient Market Hypothesis

Technical Analysis
Introduction

....

Tools of Technical Analysis

Charts

........

........

2
3-10
3
4
5-6

Support & Resistance Levels

Volumes

Moving Averages

Limitations of Technical Analysis

Fundamental Analysis
Introduction

8-9
10

..

11-29

11-12

Qualitative Factors
Quantitative Factors

..
...........................................................................

13-15
16

Comparable Company Analysis

......................................................

17-18

Discounted Cash Flow Analysis

19-24

Practical Application of DCF Analysis

............................................

25-29

INTRODUCTION
All over the world, Financial Markets have become an
extremely critical component of the economy.
Basically, Financial Markets are an aggregation of
buyers and sellers of Financial Instruments. These
instruments can be Equity(Stocks), Debt Instruments,
Derivatives as well as commodities.
Throughout the world, many people use the services of
Financial Markets. However only a small portion of
traders and investors manage to beat the market
returns. In the long run, this only possible with
exhaustive research and analysis. Though even that
does not guarantee better profits but only enhances
the chances.

EFFICIENT MARKET
HYPOTHESISEfficient Market Hypothesis is an Investment Theory which suggests that it is
impossible to beat the market rate of return in the long run. This is because it
assumes that stock market efficiency always causes the stocks to trade at their
fair value. As a result, it is impossible to buy undervalued and sell overvalued
stocks, and thus beat the market.
Many investors try to time the market or to pick individual stocks which in
their opinion would outperform the market in the long run. But as per this
theory, these do not result in greater profits in the long run. Thus the only way
markets returns can be exceeded is by buying riskier investments.
While there is a large body of evidence in favour of EMH, there is also lots of
evidences which contradict the theory. Investors such as Warren Buffet have
consistently beaten market returns over a long period of time. Also there have
been events where stock prices have fallen by a large percentage in a single
day or in a very short period of time. Such events indicate that the stock prices
can be considerably overvalued or undervalued.
Thus most traders and investors do undertake some type of analysis.

It is often said that there are as many models for analysis as Analysts.
However, broadly speaking there are two schools of thought for the purpose of
financial statements analysis- Technical Analysis and Fundamental Analysis.
Technical Analysis is concerned about price movements of stocks. On the other
hand, Fundamental Analysis focuses on studying the characteristics of a
company, its business model, cash flows etc. for the purpose of its valuations.

TECHNICAL ANALYSIS
Long before accounting numbers became popular with financial
market participants, technical analysis was in vogue.
Technical Analysis deals with price movements of stock. It studies the
supply and demand in the market to understand the trend, i.e., in
which direction the market will continue in the future.
Technical Analysis is based on the following 3 assumptions1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.
The first assumption needs more explanation. Technical Analysis
considers that at any given time, all the factors that affect the prices
of stocks are already priced in. Thus, factors affecting the company,
the industry as well as the broader economy are all already priced in
and there is no need to consider them separately. As a result, it
focusses only on price movements, which it assumes as dependant
on demand and supply of stocks in the market.

TOOLS OF
TECHNICAL ANALYSIS
Plenty of Charting tools and methods are available for technical
analysis. There are no set patterns by which people use these charts.
Every analyst/trader has his own preferences. The underlying
thought in every case, however, is to earn profits. This is done
through buying when prices are low and selling when prices are high.
The problem is in which direction will the prices move. And it is to
predict this that technical analysis is used.

There are 3 types of charts that are used by Technical Traders : LINE CHARTS
BAR CHARTS
CANDLESTICK CHARTS

Line ChartsThese are the most basic types of charts. They generally represent
the value of closing price of stocks over a period of time.

Bar ChartsBar charts add more pieces of information to a line chart. It

represents information in the form of vertical bars. The opening and
closing prices are represented by a horizontal dash on the vertical
lines. In the below diagram, red bars represent fall in value during
that period while blue bars represent increase in value of shares.

Source- [Link]

Candlestick Charts
Like Bar Charts, these show opening and closing prices along with
days highs and lows. However unlike bar charts, the difference
between opening and closing prices is shown by the way of wide bars
and days highs and lows are shown as spikes. They also rely on
colour patterns for showing increase or decrease in prices.

Source- [Link]

Here we will understand few more terms with the help of charts.
Lets first take a look at support and resistance levels.

Support & Resistance LevelsSupport is the price level below which price seldom falls. On the
other hand, Resistance is the level above which price level rarely
rises.
In simple terms, at Support levels, a large no. of market participants
are willing to buy the stocks, thus pushing up the price of stocks. The
opposite happens in case of Resistance levels.
Once a support or resistance level is breached, the trader psychology
changes and as a result, the market moves over to a new support or
resistance level.

Source- [Link]
7

VOLUMEVolume, in this context, refers to the number of shares that are

traded during a period of time. It can be calculated in terms of no. of
shares traded as well as in terms of total value of shares traded. It is
also an important aspect of Technical Analysis.
If price movement is accompanied by a large volume, then it is seen
as a more definite indicator of the trend than if the volume had been
low.
Traders often view volumes as preceding the Price. For instance, if
price of a stock is going upwards but the volume being traded is
decreasing then it is viewed as a sign that the uptrend is going to
reverse soon.

MOVING AVERAGESAnother popular tool used by the traders is the Moving Averages
charts. Moving Averages can be simple moving averages or
exponential moving averages. In exponential moving averages, the
recent prices are given greater weights while in simple moving
averages all prices have equal weights.
Moving averages can be used to quickly identify whether a security is
moving in an uptrend or a downtrend depending on the direction of
the moving average. When a moving average is heading upward and
the price is above it, the security is in an uptrend. Conversely, a
downward sloping moving average with the price below can be used
to signal a downtrend.

Source- [Link]

Another method of determining momentum is to look at the order of

a pair of moving averages. When a short-term average is above a
longer-term average, the trend is up. On the other hand, a long-term
average above a shorter-term average signals a downward
movement in the trend.

LIMITATIONS OF TECHNICAL ANALYSIS Technical Analysis tools have no academic basis. They just predict what
is likely to happen. By the Law of Chance, 50% of the time a trader will
be right. Technical analysis only improves the chances that correct
decision but that improvement is not a great degree.
A fundamental assumption of technical analysis is that the market
discounts everything. All factors are already priced into the stock but
this is certainly not true. A certain news item about a stock takes some
time to reflect in its prices. Also future uncertainties cannot be
automatically priced into the stock since every analyst has a different
take on uncertainties. Hence, this fundamental assumption is flawed.

It ignores accounting numbers and statistics. As a result, we never get

to know whether a stock is undervalued or overvalued. Thus Technical
analysis has very little long term relevance.
With the advent of Computer-based Algorithmic trading, we have to
consider if classical technical analysis tools are really relevant for small
investors. Obviously, Computer-based programmes are able to recognize
the trends much earlier than a person can and hence can time the
market better. Earlier, Algo-Trading was popular only in developed
economies but now even in developing economies like India, it has
gained prominence. This puts small traders at a big disadvantage.

10

FUNDAMENTAL ANALYSISFundamental analysis aims at determining the value of a security

taking into account its financial statements, health, competitors
and the wider market.

Fundamental analysis includes:

1. Economic analysis
2. Industry analysis
3. Company analysis

Based on these, the intrinsic value of securities is determined.

Fundamental Analysis considers that in the short run a security may
be under/overvalued, however in the long run, the correct price of
the security will be reached. Thus by buying mispriced securities and
selling them at the correct price, profits can be earned.

11

According to fundamental analysis, the price of a security always

tends to move towards its intrinsic value, which is its true value
calculated as per its fundamentals.
In case the current market price is lower than its intrinsic value, then
the investor should buy the stock and wait for the prices to rise in
the long run. Similarly, an investor can sell the stock whose current
price is lower than intrinsic value, expecting it to decline in the
future.

A classic example is the Junk bond bust-up takeover that was often
seen in late 20th century in developed economies.
Simply stated, companies issued Junk Bonds (bonds with higher yield
and lower credit ratings) and used the proceeds to takeover shares
of companies with market value significantly less than its
replacement value.
Then they disposed off these companies by selling their assets at
replacement levels, repaid the bonds and kept the difference. The
complication, however, is that it is very difficult to obtain accurate
values for assets of the company.

12

There are two dimensions of fundamental analysis- Quantitative and

Qualitative Analysis. Quantitative Analysis looks at the numerical
aspects and includes all sorts of number crunching. On the other
hand, factors such as management of a company, customer base and
loyalty, public image etc. are included in Qualitative analysis.

QUALITATIVE ANALYSISQualitative factors play a very significant role in fundamental

analysis. While they are difficult to analyse, successful analysis of
these factors can mean the difference between a successful investor
and an unsuccessful one.

Let us take a look at some industry specific factors COMPETITIONThe degree of competition in the industry has a profound
influence on the policies of a company. The entire marketing
and salesforce activities are dictated by the extent of
competition facing the company. Low barriers of entry, large
no. of competing firms or easy availability of alternatives can
create difficult environment for a business.
CUSTOMERSCompanies having sales relation with a large no. of customers
are in a better position than those relying on a small no. of
customers. Brands which have built customer loyalty like Apple
are at an obvious advantage.
13

 FUTURE OUTLOOK OF INDUSTRYIf an industry is expected to grow in future at a good pace, then
firms in that industry will enjoy higher valuations. Industries
having a negative outlook will severely affect the valuations of
firms operating in it.
LEGAL REQUIREMENTSIndustries having to comply with a large no. of regulations
often have hampered growth. Firms operating in energy,
pharmaceutical and mining sectors have to comply with a large
no. of regulations. However, this may also serve as a partial
barrier to entry thus reducing competition.

Now let us study some Company-specific factors BUSINESS MODELThe single most important factor for long term success of a
company is its business model- how it earns profits. High
revenues or large market share do not mean adequate profits
in the long run. A financially sound and sustainable business
model is very critical to the long term success of any
organisation.
Recently, many start-ups had achieved high valuations due to
large capital funding that they obtained. However, many of
them have withered away because their business models were
not sustainable. Thus currently a consolidation is taking place
with only large and efficient players surviving will others are
being acquired or being shut down.

14

 MANAGEMENTThe management team of any organisation also has a very

critical role to play. They are responsible for executing the
business model, i.e., to implement what is planned.
As an analyst, you can take an idea about the management
competency of a company by looking at information provided
on company website about top management team, letters of
management in the annual reports etc. However, these being
companys sources are unlikely to disclose negatives about
management.
So things like interviews to media by the top management,
compensation of top executives and past performances of the
executives in their previous companies are better indicators. If
a large part of remuneration of management comes in the
form of stocks options, then it is a good sign. If top executives
are found selling their shares, then it is an obvious negative
sign.
If you are a portfolio manager wanting to invest a very large
portion in the company, then if possible arrange for an
interview with some top executive to better understand their
outlook. This, however, will not be available to a retail investor.

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QUANTITATIVE ANALYSISQuantitative Analysis includes analysing the numerical information

contained in the financial statements of a company. Thus all the
number crunching is included in Quantitative analysis.
The set of financial statements of a company comprise of its Balance
Sheet, Profit and Loss Account, Cash Flow Statement and the Notes
to Accounts. They contain tonnes of information about the affairs of
a company. While every company has to annually file these
statements, publically traded companies have to do this quarterly
also.
Apart from these, Auditors Report and Directors Report are also
integral parts of financial statements. If the management gives the
details upfront and makes a candid disclosure of important
developments concerning the company, then it suggests that the
management has nothing to hide. If it however uses technical jargon
and big words to confuse the investors, then it serves as a red flag
that something is wrong.
Financial Statements are the mines from which critical information
required for examining the fundamentals of the business. These
contain the quantitative data that is the basis for analysis. It is also
important to take into account the Notes to Accounts. These should
ideally contain disclosures regarding the accounting principles and
methods being followed by the company as well as details regarding
other important aspects that affect the investors.

16

COMPARABLE COMPANY ANALYSISIt is a basic yet effective tool to find out the Valuation of a company.
It is a process of evaluating the value of a company using some
characteristics like ratios of other companies of the similar size and
industry. The underlying assumption is that similar companies have
similar valuation multiples, such as the P/E Ratio or the EV/EBITDA
Ratio.
The first step is to identify the Peer Group of companies similar in
terms of size, industry and region.
The next step is to identify the measures to be used for comparable
analysis. The measures are typically of either of the following typesEnterprise Value MultiplesThe look at the entire capital structure of the company- both debt
and equity. Some common EV multiples include:
EV / EBITDA
EV / EBIT
EV / Sales
Equity Value MultiplesThese look at only the Equity portion of the capital structure of a
firm. Some common Equity Value multiples include:
Price / Earnings Per Share
Price / Book Value Per Share
Industry Specific MultiplesThese multiples provide a better picture for the specific industries
where they are relevant. For e.g. Oil & Gas - Total Reserves / Annual Production
Retail - Sales
17

 Airline - Total Passenger Revenue

E-Commerce Gross Merchandise Value (GMV)
The choice of appropriate multiple depends upon the judgement of
analyst. Generally, P/E Ratio and EV/EBIT Ratios are commonly used
across industries.
The next stage is to collect data. The data can be historical, current
or forward looking. Generally, forward looking data is used since
valuations are concerned more with the future prospects.

One major criticism of this technique is that it assumes that the

other company or companies relative to which Valuation is done
are correctly valued. Thus if the other company is over/under
valued, then the valuation of the company under analysis will also be
affected. Thus the results will be unreliable in case the entire
Industry is over/undervalued, as in the case of e-Commerce Industry
where the valuations are often based on Gross Merchandise Value
which may tend to considerably overprice the company.

18

DISCOUNTED CASH FLOW TECHNIQUEThis is the most popular way of analysis is DCF Valuation. As per DCF
Analysis, present value of all future cash flows is calculated by
discounting them at an appropriate rate.

As mentioned above, Comparable Analysis will not give a

satisfactory answer in case entire industry is incorrectly valued. DCF
Analysis helps to overcome this limitation because in this case, the
valuation of a company is not dependant on the valuation of other
companies.

Although the results of this method heavily depend on assumptions

made, but it still is one of the best methods of analysis.

Here, we will briefly mention the steps involved in this technique.

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STEP 1- Calculate Historical Free Cash Flows

While DCF deals with future cash flows but determining Historical
Cash Flows is important as it is on these cash flows that predicted
trends will be applied to calculate future cash flows.
1. Unlevered Free Cash Flows - These are the cash flows available
to investors in the whole capital structure of the business
UFCF = EBIT(1-T) Capital Expdn + D&A - Net Change Non-Cash WC
+ One Time Cash Expenses

2. Levered Free Cash Flows - These are the cash flows available to
only investors in the equity portion of the capital structure
LFCF = EBIT(1-T) Capital Expdn + D&A - Net Change Non-Cash WC
+ One Time Cash Expenses - Interest Exp

The additions and subtractions to capital expenditure are made to

represent the true amount of cash available with the company.
Generally, unlevered cash flows are used because it allows for
comparison with companies with different capital structures.

20

STEP 2- Projecting Cash Flows

For this step, we will need to project all of the components required
for calculation of free cash flows as stated above. Thus, to forecast
EBIT, we will need to forecast the Income Statement.

Start by projecting revenue for next few years. Generally, this is

done for 5 or 10 years. This can be done by applying projected
growth rates for different business lines. The sources for growth
rate/projection can be Equity Research Reports as well as
Managements outlook for the industry.

Projecting EBIT- For this, we can prepare a Projected Income

Statement or also taken operating profit as a percentage of sales
after making necessary adjustments.

Similarly, project other components of Free Cash Flows. This again

can be as a percentage of sales or through a pro-forma Income
Statement, Balance Sheet, Cash Flows etc.

21

STEP 3- Calculating Discount Rate

Discount rate is the rate that the investors in a firm require for their
funding. This rate can be used for discounting because in case the
return is lower, investors can move on to other investment
opportunities.

Weighted Average Cost of Capital (WACC) can be used as Discount

Rate.
WACC = (Equity/Value)*Cost of equity + (Debt/Value)*Cost of
debt*(1-Tax rate)

Basically we are multiplying the weight of equity in the capital

structure (E/V) by the Cost of Equity. The weight of debt in the
capital structure (D/V) multiplied by the Cost of Debt (net of tax) is
the debt portion of the discount rate.

Cost of Equity can be calculated by using Capital Assets Pricing

Model (CAPM) Cost of Equity = rf + (b * mrp)
The CAPM is a function of the risk free rate (rf) plus the beta (b) of
the company's stock multiplied by market risk premium (mrp).

In case the DCF Analysis is being carried out on the basis of Levered
Cash Flows, then Cost of Capital will be the same as Cost of equity
calculated using CAPM.

22

STEP 4- Calculating Terminal Value

Terminal value is the value of Free Cash Flows for all years after the
end of the period for which projection for cash flows is made. It can
be calculated using 2 methods, both having separate sets of
assumptions-

Gordon Growth ModelIt assumes that the last years cash flows will grow at the same rate
till perpetuity. The formula for calculating Terminal Value is as
follows:Terminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate)
(Discount Rate Long-Term Cash Flow Growth Rate)

Exit Multiple ModelAnother way to determine a terminal value of cash flows is to use a
multiplier of some income or cash flow measure, such as net income,
net operating profit, EBITDA, operating cash flow or free cash flow.
The multiple is generally determined by looking at how comparable
companies are valued by the market.

Step 5- Calculate Net Present Value

This is calculated by discounting the projected cash flows and the
terminal value to their present values and taking their sum. Discount
Rate can be calculated as mentioned in Step 3.

23

Step 6- Calculate the price

The Value so derived is the total value of the firm.
To find the Equity Value, subtract the Value of Debt from the Total
Value.
Divide the Equity Value by the fully diluted shares outstanding to get
the Target Price.
Alternatively, Net Shares Outstanding can also be used.

24

PRACTICAL APPLICATION OF DCF ANALYSIS

Now we will analyse a Company using DCF Analysis. For this purpose,
I have chosen Hindustan Unilever Ltd. It is a popular company in
FMCG Sector. It is listed on both BSE and NSE.

For the purpose of this analysis, we need to know the historical free
cash flows, project future cash flows, calculate WACC and Terminal
Value and finally discount the future cash flows and terminal value to
obtain the valuation.

First, we will calculate Free Cash Flows for the last 4 years for which
data is available.
All figures in crores

Particulars
NOPAT
(+)Depn &
Amortization
(-)Capital
Expdn
(-) Working
Cap. Changes
Free Cash
Flows

2011-12
2600
218.25

2012-13
3331
236.02

2013-14
3579
260.55

2014-15
3854
286.69

2015-16
4078
320.75

252.21

405.65

530.81

526.54

-101.6

183.52

472.66

476.55

-215.57

756.95

2382.52

2688.71

2832.19

3829.72

3743.4

Source- Annual Reports of HUL for 2012-13, 2014-15 & 2015-16

Here, NOPAT stands for Net Operating Profit after Tax.

We can plot this data on a graph to get a trend line for Free Cash
Flows. Here, we have assumed a linear trend for Cash flows.

25

Thus, we obtain a trend line (dotted line above) and can use it to
calculate the projected cash flows for the next 5 years.

Hence, we obtain following Free Cash Flows for next 5 yearsYear

Free Cash Flows

(in crores)

2016-17

4,254.14

2017-18

4,640.42

2018-19

5,026.69

2019-20

5,412.97

2020-21

5,799.25

26

Calculating Discount RateHUL is an unlevered company having no long term debt. As a result,
its Weighted Average Cost of Capital will be equal to the Cost of
Equity.
Currently, Risk-Free Return is 7.5%, Beta value of HUL is 0.4 and
Market Risk Premium is 3%.
Thus, using CAPM, Cost of Equity is7.5% + (0.4*3%) = 8.7%
Thus, the appropriate discount rate will be 8.7%.

Calculating Terminal ValueWe can use Gordon Growth model for the purpose. As mentioned
above, its formula isTerminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate)
(Discount Rate Long-Term Cash Flow Growth Rate)

Here, we take the long term growth rate to be 7%. Historically, if we

see the Profits before Taxation have grown at close to 7%. Though
that is expected to decline under normal circumstances but with a
large rural population that currently consumes only basic goods and
decline in poverty expected as a result of high growth rates, FMCG
sector will continue to get new consumers. As a result, a growth rate
of 7% is very much achievable.
Accordingly, terminal value comes out to be Rs. 3,65,011.43 crores.

27

Calculating Net Present ValueUsing the Discount Rate of 8.7%, we will now discount the projected
future cash flows.

Years

Projected Cash
Flows

Present Value of
Cash Flows

2016-17

4,254.14

3,913.65

2017-18

4,640.42

3,927.33

2018-19

5,026.69

3,913.76

2019-20

5,412.97

3,877.19

2020-21

5,799.25

3,821.41

Terminal Value

3,65,011.43

2,21,273.39

Total Enterprise Value

2,40,726.74

Currently, 2,16,39,36,971 shares of HUL are outstanding. As a result,

the price of a share comes out to Rs. 1,112.45.
The price as on July 14, 2016 is Rs. 927. So as per this model, the
shares are undervalued and investors should Buy the stock.
The price of HUL share was Rs. 872 at the end of the previous
financial year and it has already risen to Rs. 927. So the results of DCF
Analysis point in the right direction.

It is, however, important to note that the valuation made above is an

approximate value.
Also a lot of assumptions have to be made for calculating the value
using DCF Analysis. If any assumption is changed, the value will also
28

change considerably. For instance, if long term growth rate is taken

to be 6% instead of 7%, the value will fall to Rs. 727.
This is the biggest limitation of DCF Analysis. Every analyst may
make his own assumptions and as a result, the target prices
prescribed by them will vary.
But nevertheless, it is one of the most effective methods of
Fundamental Analysis. With the right set of assumptions, it will very
often give a reliable and unbiased valuation.

29