Fundamental Analysis

▪ Fundamental Analysis is an approach to determine

“What ought to be the price of security.”
▪ Fundamental Analysis believe that due to temporary
market disequilibrium the current price may be at
variance with the intrinsic value.
▪ Objective of Fundamental Analysis is not to make
speculative profit but to avoid buying overpriced stock or
sell under priced stock.
▪ Dividend capitalization, PE approach and CAPM will only
provide Value anchors.
▪ The framework of Fundamental Analysis hinges on
understanding Economic factors, Industrial factors, and
company factors to determine the intrinsic value.
Researchers the world over have found that stock price
changes can be attributed to following factors:

• Economy wide factors 30%--35%

• Industry factors 15%--20%

• Company factors 30%--35%

• Other factors 15%--25%

Fundamental Analysis involves the following steps:

• Understanding macro economic factors.

• Prospect of the industry to which the firm belong.

• Assessing the projected performance of the company.

 Economic factors
▪ Gross national product
▪ Savings and Investments
▪ Price level and inflation
▪ Agriculture and monsoon
▪ Fiscal and monetary framework
▪ Budget and its composition
▪ Magnitude of budget surplus/deficit
▪ Level of internal and external debt
▪ Balance of payment position
▪ Tax structure
▪ Money supply
▪ Interest rate structure and credit policy
▪ Change in CRR and SLR
▪ Natural calamity
▪ Future projection of the economy.
▪ World economic trend and its impact on Indian economy
 Industry analysis

▪ Why should a security analyst do industry

analysis?

▪ The mediocre stock in a growth industry

usually out performs the best stock in a
stagnant industry.
Importance of industry analysis
Classical economic theory suggests that firms
which manufacture homogeneous products
should maximize their profit by adopting similar
policies w.r.t.
▪ Labour capital ratio
▪ Mark up, profit margin and selling price.
▪ Advertising & promotional programme.
▪ R&D expenses.
▪ Approaches to different legislation.

Empirical evidence have shown different

investment result in different levels of risk.
The theoretical framework suggest that in general the risk
analysis of a given firm will closely follow the risk analysis of
the industry.

The Beta of the various firms in the industry will be close to

the beta of the industry. Hence it is imperative to analyst the
industry to have a fair projection of the intrinsic value of the
firm.

The analysis of industry can be divided into the following

section:

• Industry life cycle analysis

• Study of structure and characteristic of an Industry

• Profit potential of Industry.

Industry life cycle analysis

▪ Introduction stage

▪ Rapid expansion / growth stage

▪ Mature growth & stabilization stage

▪ Decline stage
 Structure and characteristic of
industry
▪ Structure of industry and nature of
competition
▪ No of firms and market share
▪ Licensing policy of the govt.
▪ Pricing policy
▪ Homogeneity / product differentiation
▪ Foreign firms
▪ Comparison of substitute product.
Structure and characteristic of
industry

▪ Nature and prospect of demand

▪ Major customers and their requirements
▪ Key determinants of demand
▪ Degree of cyclicality
▪ CAGR
 Compounded Annual
Growth Rate CAGR
▪ The year-over-year growth rate of an
investment over a specified period of time.

The compound annual growth rate is

calculated by taking the nth root of the total
percentage growth rate, where n is the number
of years in the period being considered.
Illustration
▪ CAGR is not the actual return in reality. It's an imaginary number that
describes the rate at which an investment would have grown if it grew
at a steady rate. You can think of CAGR as a way to smooth out the
returns.
Don't worry if this concept is still fuzzy to you - CAGR is one of those
terms best defined by example.
▪ Suppose you invested Rs.10,000 in a portfolio on Jan 1, 2005. Let's say
by Jan 1, 2006, your portfolio had grown to Rs.13,000, then Rs.14,000
by 2007, and finally ended up at Rs.19,500 by 2008.
Your CAGR would be the ratio of your ending value to beginning value
(Rs. 19,500 / Rs. 10,000 = 1.95) raised to the power of 1/3 (since 1/# of
years = 1/3), then subtracting 1 from the resulting number:
1.95 raised to 1/3 power = 1.2493. (This could be written as
1.95^0.3333).
1.2493 - 1 = 0.2493
Another way of writing 0.2493 is 24.93%.
Thus, your CAGR for your three-year investment is equal to 24.93%,
representing the smoothed annualized gain you earned over your
investment time horizon.
Example
▪ The overall automobile exports grew by
2.03 per cent during April-August 2013.
Furthermore, the production of
passenger vehicles in India was recorded
at 3.23 million in 2012-13 and is
expected to grow at a compound annual
growth rate (CAGR) of 13 per cent during
2012-2021, as per data published by
Automotive Component Manufacturers'
Association of India (ACMA).
Structure and characteristic of
industry
▪ Cost efficiency and profitability
▪ Proportions of key cost elements
▪ Turnover ratios
▪ Control over prices of output and input
▪ Behavior of prices of inputs and outputs in response
to inflationary pressures.
▪ Gross profit, operating profit, net profit margin
▪ Return on assets, earning power, and return on
equity
Structure and characteristic of
industry

▪ Technology and research

▪ Stability of technology
▪ Technology change in the horizon
▪ R & D as percent of sales
▪ Sales growth attributable to new sales
Profit potential of industry
▪ Profit potential of an industry
depends on the combined strengths
of the following basic competitive
forces:
▪ Threat to new entrants
▪ Rivalry among existing firms
▪ Bargaining power of buyers
▪ Bargaining power of sellers
 Forces driving industry competition

Potential
entrants

Threat of new entrants

Bargaining
Power of Industry
suppliers Rivalry
Suppliers Among Buyers
Existing Bargaining
firms Power of
buyers

Threat of substitute products

Substitutes
Threat of new entrants
▪ New entrants will
▪ Add capacity
▪ Inflate costs
▪ Push prices down
▪ Reduce profitability
▪ Threat of new entrant is low if there is advertisement for
existing firm and deterrent for new entrant high if
▪ Substantial investment
▪ Economies of scale enjoyed by existing firm
▪ Control on channels
▪ Benefit from product differentiation and brand
image
▪ High switching cost
▪ Government policy limits new entrants
 Rivalry between existing firms
▪ Firms compete on the basis of price, quality,
promotion, services, warranties.
▪ Improvement in competitive position provoke
retaliatory position
▪ Strong competitive moves and counter moves
dampen average profitability
▪ Only few firms emerge from competitive battle
▪ Industry growth is sluggish
▪ High fixed costs and strong pressures to
achieve high capacity
▪ Chronic over capacity
▪ Product is regarded as commodity or near
commodity.
▪ High exit barrier.
Pressures from substitute products

▪ High threat from substitute if

▪ Price-performance trade-off
offered by substitute product high
▪ Switching costs for prospective
buyer minimal
▪ Substitute products are produced
by industries earning superior
profit
Bargaining power of buyers

▪ Buyers are a competitive force

▪ Bargain for price cuts, superior quality and
service
▪ Powerful buyers can depress profitability
▪ Bargaining power of buyer high if its purchase
is high relative to the sales of the sellers.
▪ Switching costs are low
▪ Posses strong threat of backward integration.
Bargaining power of suppliers

▪ Powerful suppliers can lower prices,

lower quality, curtail free services and
hurt profitability.
▪ Suppliers have strong bargaining power if
▪ There are few suppliers
▪ No viable substitute
▪ High switching cost
▪ Threat of forward integration.
 Company analysis
Involves
▪ Study of financials
▪ Comparative study of financials / ratios –
Inter firm and Intra firm.
▪ Analyze key factors
▪ Analyze manipulation of financials
▪ Study of factors
▪ Sizing up the present situation
 Company analysis
▪ Comparative study of financials.
▪ Liquidity financials
▪ Current ratios
▪ Acid test
▪ Turnover ratio
▪ Inventory turnover ratio
▪ Average Collection Period
▪ Receivables turnover ratio
▪ Fixed asset turnover
▪ Total asset turnover
▪ Leverage ratios
▪ Debt equity ratio
▪ Debt asset ratio
▪ Interest coverage ratio
 Company analysis

• Comparative study of financials-

• Profitability ratios
▪ GPM
▪ NPM
▪ ROI
▪ ROE
▪ Net income to total assets
▪ EPS
▪ PE ratio
 Company analysis

▪ Earning level
▪ EPS & PE ratio
▪ BV per share
▪ ROE
▪ Growth rate
▪ Risk exposure
▪ Risk associated with nature of industry
▪ Financial risks on account of volatility of
returns
 Company analysis

▪ Analysis of manipulation of financials

▪ Inflate sales
▪ Alter other income
▪ Fiddle with rate of depreciation
▪ Change method of stock valuation
▪ Capitalize certain expenses
▪ Defer discretionary expenses Ex: R & D
▪ Inadequate provision for certain known liabilities
▪ Unacceptable accounting practices
▪ Revalue assets
▪ Lengthen the accounting year
 Company analysis

▪ Identification of manipulation
▪ Knowledge of financial reporting pratices
▪ Discover change in accounting policies
▪ Understand nature & magnitude of
contingent liabilities
▪ Read auditors report
▪ Understand the implications of auditors
qualifications
▪ Study the financials over a period of time
 Company analysis

▪ Study of factors which effect the performance

▪ Availability & cost of inputs
▪ Order position
▪ Regulatory framework
▪ Technology and production capabilities
▪ Marketing and distribution
▪ Finance & accounting
▪ Product portfolios
▪ Human resources and personnel
▪ Evaluation of management
For Valuation of Equity or
Stock Valuation Refer
class notes