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Fundamental analysis is examination of the underlying forces that affect the well being of examination of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements.
Most fundamental information focuses on economic, industry, and company statistics. The typical approach to analyzing a company involves three basic steps: 1. Determine the condition of the general economy. 2. Determine the condition of the industry. 3. Determine the condition of the company.
The economy is studied to determine if overall conditions are good for the stock market. Is inflation a concern? Are interest rates likely to rise or fall? Are consumers spending? Is the trade balance favorable? Is the money supply expanding or contracting? These are just some of the questions that the fundamental analyst would ask to determine if economic conditions are right for the stock market.
It is the study of industries which are on the upswing. The ideal investment is the investment in the growing industries. It is often said that a weak stock in a strong industry is preferable to a strong stock in a weak industry. In order to make productive investments the investor should know the industry classification used in the economy. It is also enviable to know the characteristics, problems and practices in different industries.
After determining the economic and industry conditions, the company itself is analyzed to determine its financial health. This is usually done by studying the company's financial statements. From these statements a number of useful ratios can be calculated. The ratios fall under five main categories: profitability, price, liquidity, leverage, and efficiency. While performing ratio analysis of a company, the ratios should be compared to other companies within the same or similar industry to get a feel for what is considered "normal." Phase Fundamental Analysis: Phase First Nature analysis Economic Analysis Industry Analysis of Purpose To assess the general economic situation both within the country and internationally To review prevailing conditions within a specific industry and its segments To analyze the financial & non-finance aspects of a company to determine whether to buy, sell, or hold onto the shares of a company Tools & Techniques Economic indicators – lead, lag and coincidental indicators Performance indicators – aggregate demand & supply position, internal & external competition, government policies Non-financial aspects analysis like promoters, management, vital product quality, corporate image, etc. financial aspects like EPS, sales, profitability, dividend record, asset growth
BENEFITS OF FUNDAMENTAL ANALYSIS
Long-term trends: Fundamental analysis is good for long-term investments based on long-term trends.
Value Spotting: Sound Fundamental Analysis will help identify companies that
represent good value. It can help discover companies with valuable assets, a strong balance sheet, stable earnings and staying power.
Business Expertise: Fundamental Analysis helps to develop a thorough
understanding of the business. The investor becomes familiar with the key revenue and profit drivers behind a company.
Categorization: Stocks move as a group, by understanding a company’s business,
investors can better position themselves to categorize stocks within their relevant industry groups. Knowing a company’s business and being able to place it in a group can make a huge difference in relative valuations. The stock market does not operate in a vacuum. Similarly no industry or company can exist in isolation. It is an integral part of the whole economy of a country, more so in a free economy like that of US and to some extent in a mixed economy like that of ours. The importance of Economic Analysis: • To gain an insight into the complexities of the stock market, one needs to develop a sound economic understanding and be able to interpret the important economic indicators on stock markets. • The economy is like the tide and the various industry groups and individual companies are like boats. When the economy expands, most industry groups and companies benefit and grow. When the economy declines, most sectors and companies usually suffer. • Investment decisions depend on the state of the economy existing at that particular point of time. E.g. if the economy is expanding then, an aggressive
growth-oriented strategy might be advisable. A growth strategy might involve the purchase of technology, biotech, semiconductor and cyclical stocks. If the economy is forecast to contract, an investor may opt for a more conservative strategy and seek out stable income-oriented companies.
The Economic Cycle:
Countries go through the business or economic cycle and the stage of the cycle at which a country is in has a direct impact both on industry and individual companies. It affects investment decisions, employment, demand and the profitability of companies. While some industries such as shipping or consumer durable goods are greatly affected by the business cycle, others such as the food or health industry are not affected to the same extent. This is because in regard to certain products consumers can postpone their purchase decisions, whereas in certain others they cannot. Fig.: Economic Cycle BOOM
DISINVEST RECOVERY INVEST RECESSION
THE INVESTMENT DECISION
Investors should attempt to determine the stage of the economic cycle the country is in. They should invest at the end of a depression when the economy begins to recover, and at the end of a recession. Investors should disinvest either just before or during the boom, or
at the worst, just after the boom. Investment and disinvestments made at these times will earn the investor the greatest benefits.
Key Economic Indicators:
There are certain economic indicators, which may be studied to assess the national economy as a whole.
Leading Indicators: These indicators predict what is likely to happen to the
economy. Perfect examples of leading indicators are the unemployment position, rainfall and agricultural production, fixed capital investment, corporate profits, money supply, credit position and index of equity share prices.
Coincidental Indicators: These indicators highlight the current position. Some
examples are Gross National Product, Index of Industrial Production, money market rates, interest rates and reserve funds with commercial banks.
Lagging Indicators: These explain what has already taken place. Some examples are
large-scale unemployment, piled up inventories, outstanding debt, interest rates of commercial loans, etc. Though useful, these indicators must be used with caution. These can only help in understanding economic trends and outlining your investment strategy intelligently.
A stable political environment is necessary for steady, balanced growth. A stable government is able to take decisions regarding long-term development of the country, which leads to prosperity of industries and companies. On the other hand, instability causes insecurity. India has been going through a fairly difficult period. There had been terrible political instability since the late eighties. Various elections with no majority power to any one party, religious and ethnic issues, the Pakistan issue etc. lead to instability in the Government.
An upswing in industrial production is good for the economy and a downswing rings an alarm. The decline in agricultural growth and the steep hike in petroleum prices would affect industrial growth.
Inflation has an enormous effect on the economy. Within the country it erodes purchasing power considerably. As a result, demand falls. A low rate of inflation indicates stability and healthy economic conditions and industries prosper at such times. The USA and Europe have fairly low inflation rates.
A low rate of interest rate is must for economic development. It stimulates investment and industry. On the contrary, high interest rates result in high cost of production, low consumption and decrease in company’s competitiveness.
The development of an economy is dependent on its infrastructure. Public infrastructure services like banking, telecom, coal and power etc play a crucial role in deciding the fate of an economy. Investments into these sectors have accounted for a major share of public spending for most of the last fifty years. A key constraint facing the Indian economy is the country's seriously inadequate infrastructure. Uncertainties over the policy, legal, and regulatory frameworks in key infrastructure sectors continue to act as a constraint to increasing private sector involvement.
Rainfall and Agricultural Production:
Foreign Exchange Reserves:
A country needs foreign exchange reserves to meet its commitments, pay for its imports and service foreign debts. Without foreign exchange, a country would not be able to import materials or goods for its development and there is also a loss of international confidence in such a country.
A budgetary deficit occurs when governmental expenditure exceeds its income. Expenditure stimulates the economy by creating jobs and stimulating demand. However, this can also lead to deficit financing and inflation. All developing economies including India suffer from budget deficits. The performance of India's economy in recent years has been overwhelmingly encouraging, but that doesn't reduce the magnitude of the problem posed by its fiscal deficits.
Domestic Savings and Capital Output Ratio:
High employment is required to achieve a good growth in national income. As the population growth is faster than the economic growth unemployment is increasing. This is not good for the economy.
International Developments US Factor
The second phase of fundamental analysis consists of a detailed analysis of a specific industry; its characteristics, past record, present state and future prospects. The purpose of industry analysis is to identify those industries with a potential for future growth, and to invest in equity shares of companies selected from such industries. Industry analysis has become very important after the opening of the economy, new entrants and intense competition. To assess an industry groups’ potential, an investor should consider the overall growth rate, market size, and importance to the economy. While the individual company is still important, its industry group is likely to exert just as much, or more, influence on the stock price. When stocks move, they usually move as groups; there are very few lone guns out there. Many times it is more important to be in the right industry than in the right stock! Every industry, and company with in a particular industry, undergoes a life cycle with four distinct phases as shown in the diagram below: Figure: Industry Life cycle 1 2 3 4
1. Entrepreneurial or nascent stage 2. Expansion or growth stage 3. Stagnation stage 4. Decay or sunset stage Entrepreneurial Stage: This is the first stage of the industrial life cycle of a new industry where the technology as well as the product are relatively new and have not reached a stage of perfection. The pioneering stage is characterized by rapid growth in demand for the output of the industry. As a result there is great opportunity for profit. As a large number of companies attempt to capture their share of the market, there arises a high business mortality rate. Weak firma are eliminated and a lesser number of firms survive the pioneering stage. It is difficult for the analyst to identify those companies that are in the likely to survive and come out strong later on. Therefore, investment in a company in an industry which is in the pioneering stage is highly risky. Industries in the entrepreneurial stage are also called as sunrise or nascent industries. Telecommunications, computer software, information technology are the examples of the sunrise industries in India.
Expansion or Growth Stage: The second stage of expansion includes only those companies that have survived the pioneering stage. These companies continue to become stronger. Each company finds a market for itself and develops its own strategies to sell and maintain its position in the market. The competition among the surviving companies brings about improved products at lower prices. Companies in the expansion stage of an industry are quite attractive for investment purposes. Investors can get high returns at lower risk because demand exceeds supply in this stage. Companies will earn increasing amounts of profits and pay attractive dividends.
Stagnation Stage: This is the third stage in the industry life cycle. In this stage, the growth of the industry stabilizes. The ability of the industry to grow appears to be lost. Sales may be increasing but at a lower rate than that experienced by the competitive industries or the overall economy. The industry begins to stagnate. The transition of the industry from expansion to stagnation stage is often very slow. Two important reasons for this transition are change in social habits and development of new technology. Sometimes an industry may stagnate only for a short period. By the introduction of a technological innovation or a new product, it may resume a process of growth, thereby starting a new cycle. Therefore an investor or analyst has to monitor the industry developments constantly and with diligence. Decay Stage: From the stagnation stage the industry passes to the decay stage. This occurs when the products of the industry are no longer in demand. New products and technologies have come to the market. Customers have changed their habits style and liking. As a result the industry becomes obsolete and gradually ceases to exist. Thus, changes in social habits, technology and declining demand are the causes of decay of any industry. An investor should get out of the industry before the decay stage.. The profits associated with the different stages in the life of an industry can be illustrated in the form of an inverted ‘S’ curve as shown in the figure. It is not always easy to detect which stage of development an industry is in at any point in time. The transition form one stage to the next is slow and unclear. It can be detected only by careful analysis. Further, the classification of industries under this approach is the general pattern. There can be exceptions to the general pattern. The life of industry may, for instance, be extended after the stagnation and decay stage through appropriate adaptation to changes in the environment. Careful analysis is needed to detect such exceptions.
In an industry analysis, there are a number of key characteristics that are to be considered by the analyst. These features broadly relate to the operational and structural aspects of the industry. They have a bearing on the prospects of the industry. Some of these are discussed below:
Demand Supply Gap:
The demand for a product usually tends to change at a steady rate, whereas the capacity to produce the product tends to change at irregular intervals, depending on the installation of additional production capacity. As a result an industry is likely to experience under-supply and over-supply of capacity at different times. Excess supply educes the profitability of the industry through a decrease in the unit price realization. On the contrary, insufficient supply tends to improve the profitability through higher unit price realization. Therefore, the gap between the demand and supply in an industry is a fairly good indicator of its short term or medium-term prospects. As part of industry analysis, an investor should estimate the demand supply gap in the industry.
Competitive Conditions in the Industry:
Another significant factor to be considered in industry analysis is the competitive conditions in the industry. The level of competition among various companies in an industry is determined by certain competitive forces. These competitive prices are: barriers to entry, threat of substitution, bargaining power of the buyers, bargaining power of the suppliers and the rivalry among competitors. New entrants to an industry increase the capacity in the industry. But these new entrants may face certain barriers to their entry. The barriers to their entry may arise because of product differentiation, absolute cost advantage or economy of scale. Product differentiation refers to the preference the buyers have to the products of the already established players. Their products enjoy a premium in the market. Absolute cost
advantage refers to the ability of established firms to produce their products at a lower cost than any new entrant. Economy of scale refers to a situation in which it is necessary to attain a fairly high level of production in order to obtain economically feasible levels of cost. In some industries it may not be economical to set up small capacities. An industry that is well protected from the inroads of new firms would be ideal for investment.
In this age of rapid technological change, the degree of permanence of an industry is an important consideration in industry analysis. Permanence is a phenomenon related to the products and technology used by the industry. If an analyst feels that the need for a particular industry will vanish in a short period, it would be foolish to invest in such an industry.
The state of labor conditions in the industry under analysis is an important consideration in an economy such as ours where the unions are very powerful. If the labor in a particular industry is rebellious and is inclined to strikes frequently, the prospects of that industry cannot become bright.
Attitude of Government:
The attitude of the government towards an industry has a significant impact on its prospects. The government may encourage the growth of certain industries and can assist such industries through favorable legislations. On the contrary, the government will look with disfavor on certain other industries. In India, this has been the experience of alcoholic drinks and cigarette industries. The government may place different kinds of legal restrictions on its development. A prospective investor must therefore consider the role the government is likely to play.
Supply of Raw Materials: The availability of raw materials is an important factor determining the profitability of an industry. Some industries may have no difficulty in obtaining the raw materials while the others have to depend on limited resources. Industry analysis must take into consideration the availability of raw materials and its impact on the industry prospects.
Company analysis is the final stage of fundamental analysis. The economy analysis provides the investor a broad outline of the prospects of growth in the economy. The industry analysis helps the investor to select the industry in which investment would be rewarding. Now he has to decide in which company he has to invest. Company analysis provides the answer to this question. In company analysis the investor tries to predict the future earnings of the company because there is strong evidence that the earnings have a strong effect on the share prices. The level, trend and safety of earnings of a company, however depend upon a number of factors concerning the operations of the company.
The prosperity of a company will depend upon its profitability and financial health. The financial statement published by a company periodically helps us to access the profitability and financial health of the company. The two basic financial statements provided by the companies are the balance sheet and the P&L A/C. The first gives us a picture of the company’s assets and liabilities while the second gives us a picture of its earnings. The balance sheet gives us the list of assets and liabilities of a company on a specific date. The major categories of assets are fixed and current. The P&L A/C, also
called as the income statement, reveals the revenue earned, the cost incurred and the resulting profit or loss of the company for one accounting year. The profit after tax (PAT) divided by the number of shares gives the Earnings per Share (EPS), which is a figure which most investors are interested. The P&L A/C summarizes the activities of a company during an accounting year.
ANALYSIS OF FINANCIAL STATEMENTS
The financial statement of a company can be used to evaluate the financial position f the company. Financial ratios are most extensively used for this purpose. Ratio analysis helps an investor to determine the strengths and weakness of the company. It also helps him to analyze whether the financial performance and financial strengths are improving or deteriorating. Ratios can be used for comparative analysis either with other firms in the industry through a cross sectional analysis or with past data through a time series analysis. Different ratios measure different aspects of a company’s performance or health. Four groups of ratios may be used for analyzing the performance of a company. Liquidity Ratios: These measure the company’s ability to fulfill its short-term obligations and reflect its short-term financial strength or liquidity. The commonly used ratios are Current Ratio = Current Assets / Current Liabilities. Quick Ratio = Current Assets- Inventory – Prepaid Expenses Current Liabilities A higher current ratio would enable a company to meet its short-term obligations even if the value of current assets decline. The quick ratio represents the ratio between quick assets and current liabilities. It is a more rigorous measure of liquidity. However, both these ratios are to be used together to analyze the liquidity of the company.
Leverage Ratios: These ratios are also known as capital structure ratios. They measure the ability of the company to meet its long-term debt obligations. They throw light on the long-term solvency of a company. The commonly used leverage ratios are: Long-term Debt Shareholder’s Equity Total Debt Total Assets Shareholders Equity Total Assets EBIT Interest
Debt-Equity Ratio = Debt to Total Asset Ratio =
Proprietary Ratio =
Interest Coverage Ratio =
The first three ratios indicate the relative contribution of owners and creditors in financing the assets of the company. These ratios reflect the safety margin available to the long-term creditors. The coverage ratios measures the ability if the company to meet its interest payments arising from the debt. Profitability Ratios: The profitability of a company can be the profitability ratios. These ratios are calculated be relating the profits either to sales, or to investment, or t the equity shares. Thus we have three groups of profitability ratios. These are listed below. A. Profitability related to Sales Gross Profit Ratio = Gross Profit (Sales – Cost of Goods Sold) Sales Operating Profit Ratio Net Profit Ratio = = EBIT / Sales EAT Sales
Administrative Expenses Ratio =
Administrative Expenses Sales
Selling Expenses Ratio
Selling Expenses Sales
Operating Expenses Ratio
Administrative Expenses + Selling Expenses Sales
COGS + Operating Expenses Sales
B. Profitability related to Investment. Return on Assets = EAT Total Assets Return on Capital Employed = EBIT Total Capital Employed Return on Equity = EAT Shareholders Equity
C. Profitability related to Equity Shares. Earnings Per Share = Net Profit available to Eq.Sh.Holders Number of Equity Shares Earnings Yield = EPS Market Price per Share
DPS (Dividend per Share) Market Price per Share
Dividend Payout Ratio
Price Earning Ratio (P/E Ratio)
Market Price per Share EPS
D. Overall Profitability (Earning Power) Return on Investment (ROI) = EAT Total Assets The overall profitability is measured by the ROI, which is the product of the net profit ratio and the investment turnover. It is a central measure of the earning power or operating efficiency of a company. Activity or Efficiency Ratios: These are also known as turnover ratios. These ratios measure the efficiency in asset management. They express the relation between the sales and the different types of assets, showing the speed with which these assets generate sales. Important activity ratios are enumerated below. Current Asset Turnover Fixed Assets Turnover Total Assets Turnover = = = Sales / Current Assets Sales / Fixed Assets Sales / Total Assets