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Fundamental analysis is the study of economic, industry, and company conditions in an effort to determine the value of a company's stock. Involves analyzing the company’s financial statements and health, its management and competitive advantages and its competitors and markets. There are several possible objectives: to conduct a company stock valuation and predict its probable price evolution, to make projection on its business performance, to evaluate its management and make internal business decisions, to calculate its credit risk.
STEPS IN FUNDAMENTAL ANALYSIS
Company Analysis APPROACHES USED: Top-down Approach Bottom-up Approach
1. GEOGRAPHICAL ANALYSIS
Based on: Topography Size Location Climate Natural resources Cost effectiveness
LAC NAR EMEA APAC
2. ECONOMY ANALYSIS
The stock market does not operate in a vacuum. To get an insight into the complexities of the stock market , one needs to develop a sound economic understanding and be able to interpret the impact of important economic indicators on stock markets.
Economic analysis is a process whereby strengths and weaknesses of an economy are analyzed.
ECONOMIC ANALYSIS FACTORS
Gross Domestic Product (GDP) Industrial Production Inflation Exchange Rate Interest Rates Unemployment Rate Capital Account Deficit Government Policy (Monetary & Fiscal) Consumer Sentiment
Economists use three types of indicators that provide data on the movement of the economy as the business cycle enters different phases.
Yield curve slope Stock Prices Money Supply
Employees on Non Agricultural Payrolls Industrial Production Manufacturing and Trade Scales
Average Duration of Unemployment Ratio of Trade Inventories to Sales Change in Consumer Price Index for services
Economic forecasting is the process of making predictions about the economy. It may be: Short term forecast – upto 3 years Intermediate forecast – 3-5 years Long term forecast – more than 5 years Forecasting Techniques: Anticipatory surveys Barometric or Indicator Approach Economic Model Building Approach
1. 2. 3.
1. 2. 3.
1. Anticipatory Surveys
It is a survey of expert opinions of those prominent in the government, business, trade and industry. Generally it incorporates expert opinion with construction activities, plant and machinery expenditure, level of inventory, etc. It may also include the opinion or future plans of consumers regarding their spending
2. Barometric Or Indicator Approach
In this approach, various economic indicators are studied to find out how the economy is likely to behave in the future. These indicators are classified as:
1. 2. 3.
Leading indicators Coincident indicators Lagging indicators
3. Economic Model Building Approach
In this approach the forecaster makes use of various independent and dependent variables. He must specify the relationship between these variables. Assumptions should be clearly stated. It yields a definite forecast figure based on precisely stated factors. Gives the direction and also the magnitude.
3. INDUSTRY ANALYSIS
OBJECTIVES: To understand how industry structure drives competition, which determines the level of industry profitability To assess industry attractiveness To forecast future profitability To identify key success factors
PORTER’S FIVE FORCE MODEL
The five forces are environmental forces that impact on a company’s ability to compete in a given market. They determine the attractiveness of a market i.e., the overall industry profitability. The purpose of five-forces analysis is to diagnose the principal competitive pressures in a market and assess how strong and important each one is.
The Five Forces:
1. THREAT OF NEW ENTRANTS
Economies of Scale Product Differentiation Entry Barriers Capital Requirements Switching Costs Access to Distribution Channels Customer loyalty to established Eg. – Power Industry brands Government Policy
2. BARGAINING POWER OF SUPPLIERS
Threatening to raise prices or reduce quality
Bargaining Power of Suppliers
Eg. Auto ancillary industry
Suppliers are likely to be profitable if: Supplier industry is dominated by few firms Supplier products have few substitutes Supplier products are differentiated Supplier products have high switching costs
3. BARGAINING POWER OF BUYERS
Compete with supplier industry by: Bargaining Power of Buyers Bargaining down prices Forcing higher quality
Eg. FMCG Industry
4. THREAT OF SUBSTITUTE PRODUCTS
Buyer propensity to substitute Relative price performance of substitutes Buyer switching costs Perceived level of product differentiation Products with improving performance relative to present industry products
Threat of Substitutes
Eg. Electronic products
5. RIVALRY AMONG COMPETITORS
o Occurs when a firm is pressured or
sees an opportunity Rivalry among competitors
competition often leaves the
entire industry worse off
Eg. Telecom Industry
battles may increase
total industry demand, but may be costly to smaller competitors
Cutthroat competition is more likely to occur when:
Numerous or equally balanced competitors Slow growth industry High fixed cost High storage cost Lack of differentiation Diverse competitors High exit barriers
The economy recurrently experiences periods of expansion and contraction, although the length and depth of those cycles can be irregular. This recurring pattern of recession and recovery is called the Business Cycle. Stages in Business Cycle: Expansion Peak Contraction Trough
STAGES IN BUSINESS CYCLE
Expansion • Production up • Employment up Peak • Production highest • Employment highest • Inflationary pressures (demand more than supply) Contraction • Production down • Employment down Recession • Trough • Production lowest • Employment lowest
The direction in which an economy is heading has a significant impact on companies’ performance and ability to deliver earnings.
SENSITIVITY OF INDUSTRIES TO BUSINESS CYCLE
Cyclical Industries Have above average sensitivity to the state of the economy Outperform other industries Defensive Industries Have little sensitivity to the business cycle. Outperform others when economy enters recession.
Eg. Durable goods industries like: Automobile industry Capital goods industry
Eg. Food producers and processors Pharmaceutical firms
INDUSTRY LIFE CYCLE
Industry Life Cycle consists of the stages of evolution through which an industry progresses as it moves from conception to stabilization and stagnation. The stage in which a particular industry (and thus, a firm within the industry) currently exists plays a major role in the way investors view its future.
Stages in Industry Life Cycle:
Introduction Growth Maturity Decline
The industry life cycle helps investors to assess the growth potential of different companies in an industry.
4. COMPANY ANALYSIS
Balance sheet analysis Technical analysis