UNIT 3 FUNDAMENTAL

ANALYSIS
 FUNDAMENTAL ANALYSIS

• Economic analysis
• Industry analysis
• Company analysis
 ECONOMIC ANALYSIS
• The level of the economic activity has an impact
on investment in many ways.
• If the economy grows rapidly the industry can also
be expected to show rapid growth.
• In general
– Level of economic activity is low – stock prices are
low
– Level of economic activity is high- stock prices are
high(prosperous outlook for sales and profits of the
firm)
 MACRO ECONOMIC ENVIRONMENT
(MACRO ECONOMIC FACTORS)

SAVINGS AND
X STRUCTURE INFLATION GDP
INVESTMENT

ONSOON AND
BOP INTEREST RATES BUDGET
GRICULTURE

DEMOGRAPHIC INFRASTRUCTURE
FACTORS FACILITIES
 ECONOMIC FORECASTING
• To estimate the stock price changes an analyst has
to analyze the macro economic environment and
their factors.
• For the purpose of economic analysis the analyst
should be familiar with forecasting technique.
• The common techniques used are
– Analysis of key economic indicators
– Diffusion index
– Surveys
– Econometric model building
 ECONOMIC INDICATORS
• The economic indicators are factors that indicate
the present status, progress or slow down of
economy.
• They are
– Capital investment
– Business profits
– Money supply
– GNP
– Interest rate
– Unemployment rate
 …contd
• The indicators are selected on following
criteria
– Economic significance
– Statistical adequacy
– Timing
– Conformity
• The economic indicators are grouped into
leading, coincidental and lagging indicators.
 LEADING INDICATORS
• Leading indicators indicate what is going to
happen in the economy.
• It helps investor to predict the path of
economy.
– Leading indicators are
• Fiscal policy(tax, budget)
• Monetary policy(rates)
• Productivity
• Rainfall
• Capital investment and stock indices
 COINCIDENTAL INDICATORS
• It indicate what economy is.
• The coincidental indicators are
– GNP
– Industrial production
– Interest rates
– Reserves funds
 LAGGING INDICATORS
• The changes that are occurring in the leading
and coincidental indicators are reflected in the
lagging indicators.
• Lagging indicators are
– Unemployment rate
– Consumer price index
– Flow of foreign funds
 DIFFUSION INDEX
• It is a composite or consensus index.
• It consists of leading, coincidental and lagging
indicators.
• This index has been constructed by
NATIONAL BUREAU OF ECONOMIC
RESEARCH (USA)
• It is complex in nature to calculate.
ECONOMETRIC MODEL BUILDING
• For model building several economic variables
are taken into consideration.
• Assumption were specified.
• Relation between dependent and
independent variables given mathematically.
• Models use mostly simultaneous equations
 INDUSTRY ANALYSIS
• An industry is a group of firms that have similar
technological structure of production and produce
similar products.
• Industry examples
– Automobile
– Textile
– Beverages
– Consumer goods(FMCG)
– Capital goods
– Chemical
– Pharmaceutical
– Engineering(EPC)
– Food
 CLASSIFICATION OF INDUSTRY
• Growth industry.
– High rate of earnings and growth in expansion
– Independent of business cycle
• Cyclical industry.
– Growth and profit move along with business cycle.
• Defensive industry.
– Independent of business cycle.
• Cyclical growth industry.
 INDUSTRY LIFE CYCLE

• 4 STAGES

MATURITY
AND
STABILIZATION
RAPID AND STAGE
GROWTH
STAGE

PIONEERING DECLIN
G
STAGE
STAGE
FACTORS TO BE CONSIDERED IN
INDUSTRY ANALYSIS
•Government
policy
SWOT
Cost e •Labor
tur •Research and
struc d
an ity development
f i t abil
pro

Growth of the industry

Nature of the product
Nature of the competition

Pollution
standards
 COMPANY ANALYSIS
• By using the several information related to
company the investor has to evaluate the
present and future value of stock.
• Risk and return also to be analyzed.
• The valuation process is depends upon the
investor how they used the information and
analyze the company performance.
FACTORS AFFECT THE PRESENT AND
FUTURE VALUES

•FUTURE PRICE
•COMPETETIVE EDGE
•EARNINGS
•CAPITAL STRUCTURE
•MANAGEMENT
•OPERATING EFFICIENCY
•FINANCIAL PERFORMANCE
•PRESENT PRICE
•HISTORIC PRICE OF STOCK
•P/E RATIO
•ECONOMIC CONDITION
•STOCK MARKET CONDITION
COMPETITIVE EDGE OF COMPANY
• The competitiveness of the company can be
studied with the help of
– Market share
– Growth of annual sales
– Stability of the annual sales
– Sales forecast
 EARNINGS OF THE COMPANY
• Sales alone do not increase the earnings.
• The cost and expenses of the company also
influence the earnings of the company.
• The rate of change in earnings differ from the
rate of change of sales.
• The companies in addition to the revenue from
sales may get revenue from other sources too.
– Interest from bond
– Rentals from lease
– Dividend from securities
– Sale of assets etc
 FACTORS INFLUENCING THE INCOME
OF THE COMPANY
• Change in sales
• Change in costs
• Depreciation method adopted
• Inventory accounting method
• Replacement costs of inventories
• Wages, salaries and fringe benefits.
• Income tax and other taxes.
CAPITAL STRUCTURE

DEBT EQUITY SHARES

PREFERENCE
SHARES

CAPITAL STRUCTURE
 DEBT
• Long term debt is an important source of finance
• Leverage effect of debt is highly advantageous to
the equity share holder.
• The interest for debt is tax deductible.
• Important to limit the debt component of capital
at reasonable level.
• The limit depends upon earnings capacity and
fixed assets
– Earnings limit of debt.(interest coverage ratio)
– Asset limit to debt.(fixed assets to debt ratio)
 OPERATING EFFICIENCY
• Operating efficiency of the company directly
affects the earnings of the company
• Efficient use of fixed assets with raw
materials, labor and management would lead
to more income from sales.
OPERATING LEVERAGE
• If the firm’s fixed cost is high in the total cost
the firm is said to have a high degree of
operating leverage.
 FINANCIAL ANALYSIS
• Financial statement analysis is the study of a
company’s financial statement from various
view points.
• The statement gives the historical and current
information about the company’s operation.
• The main financial statements are
– Balance sheet
– P/L ACCOUNT (profit and loss account)
 WHY FINANCIAL ANALYSIS
• Lenders’ need it for carrying out the following
– Technical Appraisal
– Commercial Appraisal
– Financial Appraisal
– Economic Appraisal
– Management Appraisal
BALANCE SHEET - FORMAT
PROFIT AND LOSS ACCOUNT FORMAT
FINANCIAL STATEMENT- ANALYSIS
• Comparative financial statement.
• Trend analysis.
• Common size statement.
• Fund flow analysis.
• Cash flow analysis.
• Ratio analysis.
RATIO ANALYSIS
 RATIO ANALYSIS
• It’s a tool which enables the banker or lender
to arrive at the following factors :
– Liquidity position
– Profitability
– Solvency
– Financial Stability
– Quality of the Management
– Safety & Security of the loans & advances to be
or already been provided
 HOW A RATIO IS EXPRESSED?
• As Percentage - such as 25% or 50% . For
example if net profit is Rs.25,000/- and the sales is
Rs.1,00,000/- then the net profit can be said to be
25% of the sales.
• As Proportion - The above figures may be
expressed in terms of the relationship between
net profit to sales as 1 : 4.
• As Pure Number /Times - The same can also be
expressed in an alternatively way such as the sale
is 4 times of the net profit or profit is 1/4th of the
sales.
 CLASSIFICATION OF RATIOS
Balance Sheet P&L Ratio or Balance Sheet and
Ratio Income/Revenue Profit & Loss Ratio
Statement Ratio

Financial Ratio Operating Ratio Composite Ratio

•Current Ratio •Gross Profit Ratio •Fixed Asset Turnover
•Quick Asset Ratio •Operating Ratio Ratio
•Proprietary Ratio •Expense Ratio •Return on Total
•Debt Equity Ratio •Net profit Ratio Resources Ratio
•Stock Turnover Ratio •Return on Own Funds
Ratio
•Earning per Share
Ratio
•Debtors’ Turnover
Ratio,
 FORMAT OF BALANCE SHEET
LIABILITIES
NET WORTH/EQUITY/OWNED FUNDS
Share Capital/Partner’s Capital/Paid up Capital/ MACHINERIES
Owners Funds
Reserves ( General, Capital, Revaluation & Other Net Value or Book Value or Written down value
Reserves)
Credit Balance in P&L A/c
LONG TERM LIABILITIES/BORROWED FUNDS :
Term Loans (Banks & Institutions)
Debentures/Bonds, Unsecured Loans, Fixed
Deposits, Other Long Term Liabilities
CURRENT LIABILTIES
Bank Working Capital Limits such as
CC/OD/Bills/Export Credit
Sundry /Trade Creditors/Creditors/Bills Payable,
Short duration loans or deposits
Expenses payable & provisions against various
items
ASSETS
FIXED ASSETS : LAND & BUILDING, PLANT &
Original Value Less Depreciation
NON CURRENT ASSETS
Investments in quoted shares & securities
Old stocks or old/disputed book debts
Long Term Security Deposits
Other Misc. assets which are not current or fixed
in nature
CURRENT ASSETS : Cash & Bank Balance,
Marketable/quoted Govt. or other securities,
Book Debts/Sundry Debtors, Bills Receivables,
Stocks & inventory (RM,SIP,FG) Stores & Spares,
Advance Payment of Taxes, Prepaid expenses,
Loans and Advances recoverable within 12 months
INTANGIBLE ASSETS
Patent, Goodwill, Debit balance in P&L A/c,
Preliminary or Preoperative expenses
 SOME IMPORTANT NOTES
• Liabilities have Credit balance and Assets have Debit
balance
• Current Liabilities are those which have either become due
for payment or shall fall due for payment within 12 months
from the date of Balance Sheet
• Current Assets are those which undergo change in their
shape/form within 12 months. These are also called
Working Capital or Gross Working Capital
• Net Worth & Long Term Liabilities are also called Long Term
Sources of Funds
• Current Liabilities are known as Short Term Sources of
Funds
• Long Term Liabilities & Short Term Liabilities are also called
Outside Liabilities
• Current Assets are Short Term Use of Funds
 SOME IMPORTANT NOTES
• Assets other than Current Assets are Long Term Use of
Funds
• Installments of Term Loan Payable in 12 months are to be
taken as Current Liability only for Calculation of Current
Ratio & Quick Ratio.
• If there is profit it shall become part of Net Worth under the
head Reserves and if there is loss it will become part of
Intangible Assets
• Investments in Govt. Securities to be treated current only if
these are marketable and due. Investments in other
securities are to be treated Current if they are quoted.
Investments in allied/associate/sister units or firms to be
treated as Non-current.
• Bonus Shares as issued by capitalization of General reserves
and as such do not affect the Net Worth. With Rights Issue,
change takes place in Net Worth and Current Ratio.
• Current Ratio : It is the relationship between the
current assets and current liabilities of a concern.
Current Ratio = Current Assets/Current Liabilities
• If the Current Assets and Current Liabilities of a
concern are Rs.4,00,000 and Rs.2,00,000 respectively,
then the Current Ratio will be :
Rs.4,00,000/Rs.2,00,000 = 2 : 1
• The ideal Current Ratio preferred by Banks is 1.33 : 1

• Net Working Capital : This is worked out as surplus of

Long Term Sources over Long Term Uses, alternatively
it is the difference of Current Assets and Current
Liabilities.
NWC = Current Assets – Current Liabilities
• ACID TEST or QUICK RATIO : It is the ratio between Quick Current
Assets and Current Liabilities.

Quick Current Assets : Cash/Bank Balances + Receivables up to 6

months + Quickly realizable securities such as Govt. Securities or
quickly marketable/quoted shares and Bank Fixed Deposits

Acid Test or Quick Ratio = Quick Current Assets/Current

Liabilities
Example :
Cash 50,000
Debtors 1,00,000
Inventories 1,50,000 Current Liabilities 1,00,000
Total Current Assets 3,00,000

Current Ratio = > 3,00,000/1,00,000 = 3:1

Quick Ratio => 1,50,000/1,00,000 = 1.5 : 1
• DEBT EQUITY RATIO : It is the relationship between
borrower’s fund (Debt) and Owner’s Capital (Equity).

Long Term Outside Liabilities / Tangible Net Worth

Liabilities of Long Term Nature

Total of Capital and Reserves & Surplus Less Intangible

Assets

For instance, if the Firm is having the following :

Capital = Rs. 200 Lacs

Free Reserves & Surplus = Rs. 300 Lacs
Long Term Loans/Liabilities = Rs. 800 Lacs

Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1

• PROPRIETARY RATIO : This ratio indicates the extent to which
Tangible Assets are financed by Owner’s Fund.
Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x
100
The ratio will be 100% when there is no Borrowing for purchasing of
Assets.

• GROSS PROFIT RATIO : By comparing Gross Profit percentage to Net

Sales we can arrive at the Gross Profit Ratio which indicates the
manufacturing efficiency as well as the pricing policy of the concern.

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100

Alternatively , since Gross Profit is equal to Sales minus Cost of Goods

Sold, it can also be interpreted as below :

Gross Profit Ratio = [ (Sales – Cost of goods sold)/ Net Sales] x 100
A higher Gross Profit Ratio indicates efficiency in production of the unit.
• OPERATING PROFIT RATIO :

It is expressed as => (Operating Profit / Net Sales ) x 100

Higher the ratio indicates operational efficiency

• NET PROFIT RATIO :

It is expressed as => ( Net Profit / Net Sales ) x 100

It measures overall profitability.

• STOCK/INVENTORY TURNOVER RATIO :

(Average Inventory/Sales) x 365 for days

(Average Inventory/Sales) x 52 for weeks
(Average Inventory/Sales) x 12 for months

Average Inventory or Stocks = (Opening Stock + Closing Stock)

-----------------------------------------
2
. This ratio indicates the number of times the inventory is rotated
during the relevant accounting period
 DEBTORS TURNOVER RATIO : This is also called Debtors Velocity or
Average Collection Period or Period of Credit given .

(Average Debtors/Sales ) x 365 for days

(52 for weeks & 12 for months)

ASSET TRUNOVER RATIO : Net Sales/Tangible Assets

FIXED ASSET TURNOVER RATIO : Net Sales /Fixed Assets

CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets

CREDITORS TURNOVER RATIO : This is also called Creditors Velocity

Ratio, which determines the creditor payment period.

(Average Creditors/Purchases)x365 for days

(52 for weeks & 12 for months)
• RETRUN ON ASSETS : Net Profit after Taxes/Total Assets

• RETRUN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share

capital and long term funds provided by the owners and the
creditors of the firm at the beginning and end of the accounting
period.
 COMPOSITE RATIO

RETRUN ON EQUITY CAPITAL (ROE) :

Net Profit after Taxes / Tangible Net Worth

EARNING PER SHARE : EPS indicates the quantum of net profit of

the year that would be ranking for dividend for each share of
the company being held by the equity share holders.

Net profit after Taxes and Preference Dividend/ No. of Equity

Shares

PRICE EARNING RATIO : PE Ratio indicates the number of times the

Earning Per Share is covered by its market price.

Market Price Per Equity Share/Earning Per Share

DEBT SERVICE COVERAGE RATIO : This ratio is one of the most
important one which indicates the ability of an enterprise to
meet its liabilities by way of payment of installments of Term
Loans and Interest thereon from out of the cash accruals and
forms the basis for fixation of the repayment schedule in
respect of the Term Loans raised for a project. (The Ideal DSCR
Ratio is considered to be 2 )

PAT + Depr. + Annual Interest on Long Term Loans &

Liabilities
---------------------------------------------------------------------------------
Annual interest on Long Term Loans & Liabilities + Annual
Installments payable on Long Term Loans & Liabilities

( Where PAT is Profit after Tax and Depr. is Depreciation)

 EXERCISE 1

LIABILITES ASSETS
Capital 180 Net Fixed Assets 400
Reserves 20 Inventories 150
Term Loan 300 Cash 50
Bank C/C 200 Receivables 150
Trade Creditors 50 Goodwill 50
Provisions 50
800 800

a. What is the Net Worth : Capital + Reserve = 200

b. Tangible Net Worth is : Net Worth - Goodwill = 150
c. Outside Liabilities : TL + CC + Creditors + Provisions = 600
d. Net Working Capital : C A - C L = 350 - 300 = 50
e. Current Ratio : C A / C L = 350 /300 = 1.17 : 1
f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1
 EXERCISE 2

LIABILITIES 2005-06 2006-07 2005-06 2006-07

Capital 300 350 Net Fixed Assets 730 750
Reserves 140 160 Security Electricity 30 30
Bank Term Loan 320 280 Investments 110 110
Bank CC (Hyp) 490 580 Raw Materials 150 170
Unsec. Long T L 150 170 S I P 20 30
Creditors (RM) 120 70 Finished Goods 140 170
Bills Payable 40 80 Cash 30 20
Expenses Payable 20 30 Receivables 310 240
Provisions 20 40 Loans/Advances 30 190
Goodwill 50 50
Total 1600 1760 1600 1760

1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 20 + 240 + 2+ 190 ) / (580+70+80+70)

820 /800 = 1.02
3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21
 Exercise 3.

LIABIITIES ASSETS
Equity Capital 200 Net Fixed Assets 800
Preference Capital 100 Inventory 300
Term Loan 600 Receivables 150
Bank CC (Hyp) 400 Investment In Govt. Secu. 50
Sundry Creditors 100 Preliminary Expenses 100
Total 1400 1400

1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 1

2. Tangible Net Worth : Only equity Capital i.e. = 200

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200

= 11 : 2

4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

 Exercise 4.
LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q. What is the Current Ratio ? Ans : (125 +128+1+30) / (38+26+9+15)

: 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW

= 100 / ( 362 – 30)
= 100 / 332 = 0.30 : 1
 Exercise 4. contd…
LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100

[ (362 - 30 ) / (550 – 30)] x 100
(332 / 520) x 100 = 64%
Q . What is the Net Working Capital ?
Ans : C. A - C L. = 255 - 88 = 167

Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover Ratio in
Times ? Ans : Net Sales / Average Inventories/Stock
1500 / 128 = 12 times approximately
 Exercise 4. contd…
LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.

Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12

= 1 month

Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ?

Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months
Exercise 5. : Profit to sales is 2% and amount of profit is say Rs.5 Lac.
Then What is the amount of Sales ?

Answer : Net Profit Ratio = (Net Profit / Sales ) x 100

2 = (5 x100) /Sales
Therefore Sales = 500/2 = Rs.250 Lac
Exercise 6. A Company has Net Worth of Rs.5 Lac, Term Liabilities of
Rs.10 Lac. Fixed Assets worth RS.16 Lac and Current Assets are Rs.25
Lac. There is no intangible Assets or other Non Current Assets.
Calculate its Net Working Capital.
Answer
Total Assets = 16 + 25 = Rs. 41 Lac
Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac
Current Liabilities = 41 – 15 = 26 Lac

Therefore Net Working Capital = C. A – C.L

= 25 – 26 = (- )1 Lac
Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net Working
Capital ?

Answer : It suggest that the Current Assets is equal to Current Liabilities hence the
NWC would be NIL

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What is the

amount of Current Assets ?

Answer : 4 x - 1 x = 30,000
Therefore x = 10,000 i.e. Current Liabilities is Rs.10,000
Hence Current Assets would be 4x = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per month,

monthly average interest on TL is Rs.5000/-. If the amount of Depreciation is
Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment

= (270000 + 30000 + 60000 ) / 60000 + 120000
= 360000 / 180000 = 2
• Exercise 10 : Total Liabilities of a firm is Rs.100 Lac
and Current Ratio is 1.5 : 1. If Fixed Assets and
Other Non Current Assets are to the tune of Rs. 70
Lac and Debt Equity Ratio being 3 : 1. What would
be the Long Term Liabilities?
• Ans : We can easily arrive at the amount of Current
Asset being Rs. 30 Lac i.e. ( Rs. 100 L - Rs. 70 L ). If
the Current Ratio is 1.5 : 1, then Current Liabilities
works out to be Rs. 20 Lac. That means the
aggregate of Net Worth and Long Term Liabilities
would be Rs. 80 Lacs. If the Debt Equity Ratio is 3 : 1
then Debt works out to be Rs. 60 Lacs and equity Rs.
20 Lacs. Therefore the Long Term Liabilities would
be Rs.60 Lac.
• Exercise 11 : Current Ratio is say 1.2 : 1 .
Total of balance sheet being Rs.22 Lac. The
amount of Fixed Assets + Non Current Assets
is Rs. 10 Lac. What would be the Current
Liabilities?

• Ans : When Total Assets is Rs.22 Lac then

Current Assets would be 22 – 10 i.e Rs. 12
Lac. Thus we can easily arrive at the Current
Liabilities figure which should be Rs. 10 Lac
 BASIC INVESTMENT STRATEGIES
• Top-down
• Bottom-up
• Value
• Growth
• GARP
• Market cap
• International
 TOP-DOWN STRATEGY
• Start with forecast of the economy: GDP growth,
interest rates, exchange rates, capital flows,
employment growth….etc.
• Then select industries that will prosper in the
forecasted economic environment
• Then select companies in the chosen industries,
based on financial analysis
• Asset allocation funds are examples of top-down
strategy
– Portfolio weights of two (or more) asset classes vary
over time, depending on market conditions
 BOTTOM-UP STRATEGY
• Focus on the financial characteristics of
individual companies
– Start with preliminary screening based on
financial analysis, e.g., dividend yield > 2.5%,
consistent sales growth ….etc.
– More in-depth company analysis of the stocks left
in the universe after screening
– Managers with a specific mandate, e.g., value,
growth, income…etc. tend to be bottom-up
managers
 VALUE STOCKS
• Value Investing: investment approach aimed
at identifying stock market bargains
• Bargains measured in terms of market prices
below estimated economic value of tangible
and intangible assets
 WHY COULD STOCK PRICES FALL
BELOW THE VALUE OF A FIRM’S
ASSETS?
Contrarian Investment • Entrenched
Philosophy ineffective
based on premise that management
investors can profit by
betting against overly • Near-term potential
emotional crowd for favorable change
– regulatory
– technological
 WHAT IS A VALUE STOCK?

• Value investors seek out-of-favor stocks selling at a

discount to the overall market, in which such
discounts are measured in terms of low P/E, or
dividend yield standards.
DEEP-VALUE INVESTORS FOCUS ON VERY CHEAP
STOCKS.
 VALUE INVESTING
• Choosing companies for which analysis reveals
unrecognized value
– Company experienced profits and stock price
decline
– Stock underpriced by the market relative to its
long-term fundamentals
– Value stocks tend to have high dividend yield, low
P/E, and P/cash flow
 VALUE INVESTING
Investment decision
Long-term
earnings potential?

Which?

Profits and stock

price decline

Did investors over-react to short-term negative events?

 VALUE INVESTING (CONT’D)
• Graham and Dodd’s 1934 classic, Security
Analysis, published during the Great Depression
– Warren Buffet was a student of Ben Graham at
Columbia University
• But old ratios no longer apply in today’s market
(e.g., P/B < 2/3x. Now, 2x is considered very low)
– New value rules have been proposed by various
authors
• Value trap: low price stock ≠ value stock
– Momentum factor is important here
VALUE STOCK SELECTION CRITERIA
• Liquidation Value: company worth measured
in scrap value
• Net Working Capital: current assets less all
liabilities, including long-term debt and
preferred stock
• Working Capital: current assets minus current
liabilities
– If P/NWC < 1, strong buy signal
 GRAHAM & DODD APPROACH
• Coauthors of Security Analysis—value
investor’s guide
– Graham lost fortune in 1929 crash.
– Learned that true measure of stock values come
from earnings, dividends, future prospects, and
asset values, NOT price movements
• Graham “Dean of Financial Analysis”
• Followers: Graham and Dodd investors