ztu FUNDAMENTAL

ul
ANAIYSIS-:
a E.I.C AI'PROACH
224 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Investors purchase equity shares with two basic objectives. First, to make a capital profit
by selling at higher prices at a later stage and second. to earn dividend income. Dividend
income and price changes are the two basic ingredients that make the return from equity
investment. Unlike interest from fixed income securities, which is fixed in absolut" .-oo.ri
the return from equity investment is not fixed.lthe reasons being that neither the dividend
income is frxed nor the price changes are equal for all time periods. Reirrrn on equrty
investment is uncertain and affected by a host of factors, some of which
politicalandgoeialfactors.Aninvestora-astocareful|v "r" ".o11o-i.
understand and analyse all these factors and other An inuestor has to carefully
understanit a.nd. analyse ail
determinants of equity shares. There are basically two
approaches to study security prices and valuation. Ttrese are
these factors and other
determinants of equity shares.
Fundamental Analysis and Technical Analysis. The former
determines the worth of a share on the basis of future expected earnings while the latter is
the study of past price movements of the share' market and individual share to forecast the
future course of prices. Present chapter and the next one deal with an introduction to
fundamental analysis and technical analysis. The different approaches to valuation of equity
shares have been discussed in Chapter 9. Discussion in the present chapter has been dividei
in 4 parts each dealing with Fundamental Analysis, Economic Analysis, Industry Analysis
and CompanyAnalysis.

FUNDAMENTAT ANATYSIS
In Chapter 1, investmAnt process has been defined to refer to decision making process
employed by an investor to decide as to what assets to invest in and when to investin. The
investment process must be cnitically organised analysing the basic nature of the investment
decisions and different activities required for that. In Chapter 1, it has also been noted that
the Investment process is consisting of two stages:
(o) Asset Allocation. In the frrst step, the investor has to allocate total investible funds to
various assets classes such as shares, bonds, gold, real investments, etc. For exarnple, an
investor may decide to go for 4OVo real investments, SOVo equities and 21Vobonds. There is no
siandard pattern for asset allocation and it depends upott th" risk-return preferences ofthe
investor.
(6) Security Selection. Secondly, within each asset class, the investor has to select specific
securities. The process- of security selection involves (i) the valuation, and (ii) analysis of
different securities. The process of security analysis is a professional and technical job and
is usually undertaken by specialists called security analysts. Different aspects of security
analysis with special reference to equity shares have been
discussed in the present chapter. The other aspect of The process of security analysis
security selection, i.e., the valuation of equity shares has is a professional and technical
been taken up in the next chapter. Valuation of securit5r job and is usually undertaken
refers to frnding out fair value of a security and it is a by specialists, called security
factor of expected return and risk attached to the security. analysts.
Approaches to Equity Analysis. The equity analysis involves a lot of technical and
indepth analysis of the expected behaviour of security risk and returns. An individual
FUNDAMENTAL ANALYSIS : E.I.C APPROAOH 225

investor may undertake the security analysis himself or may depend upon the professional
analysis of others. Approaches to equity analysis can be classified into two groups :
(i) Active or Primary Approach. Aciive approach involves studying the individual
securities and then selecting the specific securities for investment. An investor,may attempt
to improve upon the performance and to earn a higher return than the market- Active
approach assumes that the investor has more inforrnation than the other participants and
he catt earn more than others. On the basis of security specifrc analysis, an inv'estor likeS to
identify and picking (buying) up qndervalued equity investment and attempts to "beat the
marketo. He may identifi high growth shares which are expected to show higher growth than
other shares. Fundamental analysis and technical analysis, as discussed later, provide the
basis for active or primary approach to equity analysis.
(ii) Passive or Secondar5r Approach. A passive approach to equity analysis attempts to go
with the market and to'buy the market'. The investor would like to invest in such a way to
earn as mtrch as the market as a whole is earning. He may not devote time for equity
analysis. ?assive approach to equity analysis may be employed in two ways :
(o) Buy and, Eold Approoch. An investor may make investment in some selected shares
and hold the investments for some time. By holding the investment, the investor would be
able to save on account of transaction costs (brokerage on sales/purchases of sharels), e/c.
Such a passive approach may or may not bring as much net return to the investor as
available from active approach (which involves a lot of costs regarding research, etc.).
Sometimes, adjustments may be made in the tuy and hold'approach to suit the change in
risk preference ofthe investor.
.(b) Ind.er Fund Approach An index firnd is a mutual fund that invests its corpus in those
:equity shares which are comprising in the benchmark index. For example, Sensex is the
benchmark for index fund scheme of Tata Mutual Fund. An investor buying the units of Tata
Mutual Fund, is actually investing in 30 shares of Sensex in the same proportion as they are
included in the Sensex. Ttre return from his investment will be as much as from Sensex.
However, there are different index funds available and a investor has to carefully select a
particular benchmark. Mutual funds have been discussed in Chapter 4.
Investors buy shares in expectation of dividend income and a capital gain. For any
investor, the primary questions in share investment are: (o) what will determine the
dividends to be paid on a share?. (b) What will be the share price in future? To answer these
questions, an indepth analysis in respect of expected performance of a share is required.
There are two basic approaches to the indepth analysis. These two approaches are :
Fundamental Analysis and Technical Analysis. Former of the two is being discussed in this
chapter and latter is taken up in the next chapter.
Equif shares have an economic worth which is based on The analysis of the determinants
existing and expected earnings capacity. Fundn'nental of the
fair ualue of a security is
analysis attempts to find out the true value of securities called the
so that the investors can decide to buyor notto buythe fundamental analysis-
securities at the curtent market prices. It encompa$ses a logical and systematic approach to
estimate the returns from shares and their true values. In order to find out the true value,
what is required is the forecast and analysis of the dividends and earnings that can be
expected from the ftm. The analysis of the determinants of the fair ualue of a security is
called the fundamental analysis. The basic philosophy underlying the fundamental analyiis
is that if an inuestor invests one rupee in buying a share of a cotnpany, hout much expected
 226 INVEsTMENT ANALysrs AND poRTFoLto MANAGEMENT

returns from this inuestment he has. These future expeeted returns when d.iscounted, at the
required rate ofreturn ofthc inuestor, giue thn fair ualue ofthc shares
A fundamental analyst oompares the fair value of the share
with its market price. rn case forrner is higher than the latter, The basic prerni.se is that in
it denotes the under valuation of share in the market and prine the long run, the ntarket
signals the buying of share. on the other hand, if fair value is tends to moue towards
less than market price,.he share is considerGd to be overpriced its fair or intrinsic ualue.
and signals the selling of share. The basic premise is that in the long run, the market price
tend.s to move towards its fair or intrinsic value.

Dividends, earnitr€s and the market price of a share are determined by the performance
of the company. The performance and success, in turn, depend upon broadier industry
economic, political and social factors. In fact, the overall business in which a
firm operates, determines and affects the performance of a company."Irrri"oo-"nt
In order to be rational
and scientifrc, an investor has to evaluate a whole lot of inforuiation about the past
perf,ormance as well as the future prospecis of earnings of the eompany, industrial
and
economic environment in the economy and other relevant factors.

Figure 7.1 : E-l-C Analysis

I{owever, a broader framework for fundamental analysis is known as .top-down
appnoach'. This approach attempts to study the economic scenario, industry posiltion and
flggom_pany expectations, and is also known e s Economic-Industqr-Company Approach
(EIC). In EIC approach, the investor starts with the economy and overall market
and then
ositive signals given bf economic analysis and
he industry analysis, the investor moves to
el, fundamental analysis involves examination
ere would be an examination of demand and
e national level, fundamental analvsis
FUNDAMENTAL ANALYSIS : E.I.C APPROACH 227

focuses affection on the econbmic data to assess

the present and future gowth of the economy.
The EIC approach has been presented in Business Clcles, Monetary Policy, Fiscal Policy,
Inflation, Inlerest Rate Structure,
Figure 7.1. The rationale of the three tier EIC GDP growth, Unemployment,
Analysis is that the share worth depends on the
company performance which is affected by the
general economic and industry factdrs. The
elements of top-down approach to fundamental Demand-supply Relationship,
analysis have been presented in Figure 7,2. re,
s,
Figure 7.2 shows the Top-Down Approach as Responsiveness lo
an inverted triangle. It starts with the analysis of Income, etc.
basic macro economic variables and then moves
to identify the industry variables. Thereafter,
Expected Eamings,
each company can be studied and screened in Dividends, Funds
terms of the risk-return perspective. If the Posilion, Accounting
Policies, Risk-
company passes the screening, it may be added to Returns, Quality
the existing portfolio. Ttre next section deals with of Management, etc.
the economic analysis with 'which the
fundamental analysis begins. In other wordg in
order to analyse a firm's prospects, one should Figure 7.2 zToyDown Approach to
start with the broad macroeQononlc env.ironment Fundamental Analysis
examining even international economy, and then
,considering the implications of the outside environment on the industry and frnally
examining the frrm's positiori within that industry.
Thus, fundamental analysis attempts to examine the underlying forces that affect the
well being of the'economy, the industry group and the company. The goal is to derive a
forecast of profit from future piice'movements. To forecast future share prices, fundamental
analysis combines Economy, Industry and Company analysis to derive current fair values. If
fair value is nof equal to the current market price, it signals that the share is either
overvalued or uhdervalued and how the market price would deviate in future.
In fundamental analysis, it is important to remember that all information is relative.
Industry groups are compared against other industry groups and companies are compared
against other companies.

Pqrt ll
ECONOMIC ANAIYSIS
First and foremost in the top-down approach is the Economic analysis has an
overaU evaluation of the general economy. Economic analysis
important role to play in the
deals with the analysis of forces operating in the overall inuestment decisions.
economy. In the security analysis, the expected course of the
economy mustae enquired into because overall economic conditions and economic activities
affect corporate profrts and investors'expectations and thereby affect the security prices in
the capital market. Economic analysis has an important role to play in the investmerrt
decisions. If the economic analysis shows a strong and vibrant economic conditions, iravestdfs
228 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

will buy the shares in expectation of earning capital prgfits at a later stage- An expectation of
saggtn; economic conclitions can lead.to lower corporate profrts and the security price will
fall resulting from the selling pressure.
,.A the current scenarlo of gl-obalisation, it makes sense to examine the state of
international economic conditions as wdl I]te international economy might affect the frrm's
expotcornm-itments, t[=e pricscompetition it faces internationally and the profrts its makes
onits foreign investments. In the wake of international division of labourand specialisation,
the global should also be looked into- For example, a number of Indian software
crrmpa'ries ".orro^y
are prJcuring orders from overseas market- In view of the expected economic
go up or down.
conditions overseas, the f,rofitability of Indian companies may be expected to
An important factor that affects the internatior: onomy is the
exchante rate between two currencies. -Whef the exc rupee value of
Indian Lxports and the doll-ar value of Indian impo reby it affects
the profitability of Indian companies-
T?re economic analysis helps to identiff whether the economic climate is conducive
or not
that when economy grows'
for the growth of the business in general. It is imperative to note
all ind,ustries are expected, to benefrted. In c rse of weak economies, industries struggle (i)
to
survive. With reference to national economy, important variables to be looked into are :
(u) Monetary
Gross Domestic Product, (jj) Inflation, (iii) Interesit Rates, (iu) Fiscal Policy
poti.y, tr;) Business Cycles, etc., Fore'casting and analysing these variables is a diffrcult
exercise and a lot of data and expertise is required.

VAR.IABTES AND TECHNIGIUES FOR ECOINOMIC ANATYSIS

Companies operate in the overall economic en'rironment in the country. The economic
environment is shaped and iffected by various social, economic and political changes taking
place in the These changes are generally n,ot controllable by a firm. Nevertheless, it
".ooo*].
must try to adjust to these forces, some of which are :
(a) Increasing consumerism-
(b) Increasing free-market corhpetition,
(c) Increasing trend towards privatisation,
(d) Increasing migration of population toward urban areas'
(e) Increasing globalisation and international trade,
a Increasing women employment and presence in other ateas, etc.
state of economy- An
there are several indicators which can be used to identity thee..conomy is' expected to
understanding of these variables will help to make an idea as to how
perform which in turn will affect the future earnings and frnancial position of the companies'
Some of the variables are discussed hereunder-
Gross Domestic product (GDP) : GDP is-defined as the market value of goods and
services produced in an economy during a period (gernerally one year)- It may be calculated
by
adding the market values of all the frnal goods and services produced over the period. GDP is
an important measure of economic activity. GDP is considered as arr appropriate measure
of
economic4rowth in a country. Changein GDP resullts on account of :
(i) Change in availability of resources.
(ii) Change in usage ofthese resources, and
(iii) change in effrciency with which factors of production are used.
 FUNDAMENTAL ANALYSIS : E.I-C APPROAOH

' GDP indicates the performance of the economy duning the period. An increasing
trend in
GDP tells about an expanding economy which prlvides tot oi opportunities to the
firms to
" There are turo other measures,
increase the level of activities and to increase the earrrings.
Gross National Product and Net National Product rvhich are also indicators of Economic
activity.
Business Cycles : Business cycles refer to cyclical movement in the economic activity in a
country as a-whole' An economy marching towaills prosperity passes throuJh diflierent
phases, each known as a component of a business cycle- These phases are generally
designated as depression, recovery, boom and recession.Depression is the lowest level o-f
economic activities. The demand level in the economy is very low. Interest rates and Inllation
rates'are high. These affect the profitability of the corporate sector in general. Individual
companies face ilifferent degrees of economic crises. There is a heav! pr."ot" on their
profitability resulting in lesser and lesser dividend pay out and reinvestment activities.
companies even might be forced to shut down some of trhe plants.
During later stages of d.epression, the economy' starts. showing signs ,of revival.
Demand level starts picking up. There is an all round improvem"ttt i" the economy.
Increasing demadd results in growth in production which is r&ected in the improvement lf
bottom li:ee of the incorr,,re statement of business firms. Fresh investment by cofoorate firms
shows increasing trend, Ttris stage is known as recouer!.
After a consistent recovery for a number of years, the economy starts showing signs of
bootn which is charact_erised by high level of economic a.ctivities such as demand, prodriction,
profits. The business firms tt" in fresh investrnents and uti.ontra grb;ii'i's seen in
the economy. "ttg.gd
;The boom period is gener not able to sustain for a long period. It slows down and
results in the recession.
Almost all economies face peripds of contraction an<l expansion , i.e., thedifferent phases
of business cycles. However, the length and depth otay differ and these cycles riay be
irregular. Different phases of a business cycle are shownL in Figure z.B.

Level
of
Economic
Activity

Figure 7.3 : Business Cycle and its Components

The transition points across cycles are classed.peaks, (p) and rrough,(T). These have.
been labelled as 'P' and 'T' in Figure 7 .3. 'P' refers to tranrsition from gto*irg phase
to start
of
 230 INVESTMENT .ANALYSIS AND PORTFOLIO MANAGEMENT

recession and'T' refers to the bottom of depression and there is a sign of recovery towards
growth. It may be noted that various industries show different patterns of response. Some
industries may show above-average response and rvould tend to outperform the economy.
These include capital goods industries such as conrsumer durables. The demand for these
goods is generally deferred during recession period. But during the recovery, the dem'and
pattern outperforms the general demand level. However, during the same period, industries
dealing with essential commodities such as food, are less responsive. On the other hand,
these industries would tend to outperform the genelaLl level during the recession'period.
An understanding of business cycles will be of great help to an An understanding of
investor. Ifthe indications for recession are there, one should go for business cycles will
investment in the essential goods industries w'hile in case of be ofgreat help to an
indications for recovery, the investment in capital goods industry inuestor.
may by preferred.
Inf,lation : Inflation refers to general increasing trerrd in prices. Inflationary pressure in the
economy.affects (decreases) the purchasing pow€r olthe consumers and thus has a
considerable impact on the performance and profitability of companies. High inflation rate
can be considered as an indication for slower growth rate and low inflation rate can be
taken as a positive sign for an expansionary phase. .[nflation has a relationship with capital
market as well. During inflation, the nominal required rate of return of investors goes up
resulting in the decrease in bond and equity prices- Inflation can be measured in terms of
wholesale priee indr* or consumer price index. An analysis of these indices will indicate the
economic conditions expected to prevail.
Interest rates : Interest rates directly affect the cost of funds to the Irrespectiue of the
,industry. Higher interest rates increase the cost otf funds and thus reason
I squeezes the income of the companies. On the other hand, lower
for change
in interest rates, the
interest rates reduce the cost of funds resulting in higher profrt. There inuestment pattern
are several reasons for change in interest rates such as monetary in the econom.y is
policy, fiscal policy, inflation rate, etc. Irrespective of the reasons for affected.
change in interest rates, the investment pattern in the economy is
affected by the change in.interest rates. The interest rates affect the opportunity cost of the
investors also, thus affecting the bond and equity prices. So, the changes in interest rates
have repercussion on the profit of the companies as u'ell as on the market prices of securities.
-
There are several indicators of interest rates. These are interest ratqs in the call money
market or the Bank Rate or the Prime lending rate of the lending institutions.
Monetary Policy, Money Supply and"Liquidity : The liquidity in the economy depends
upon the money supply which is regulated by the monetary policy of the government.
Reserve Bank of India has been adopting several nreasures to regulate the money supply
and liquidity in the economy. Business frrms require funds for expansion projects. The
capacity to raise funds from the market is affected by the liquidity position in the econorny.
The monetary policy is designed with an objective to maintain a balance in liquidity position.
Neither the excess liquidity nor the shortage are des.irable. The
shortage of.liquidity will tend to increase the interest rates A shift in money supply
rnay be a leading indicator
while the excess will result in inflation.
of tlrc beginning of a new
Monetary supply and monetary environment affect share
phase in the economic and
prices through affecting the discount rate. An easy monetary
business enuironment.
policy is expected to result in decreasing discount rarte. Money
 FUNDAMENTAL ANALYSIS : E.I.C APPROAOH
231

suPPlY also ) change i

change in and (jj)
shift ln leading
indicator of rlconomic
rin
rthe
[3 is

Other Factors : Besides the factors mentioaed abo've, there are

certain other factors which-
should also be incorporated in the broad economic
analysis. some of these factors are :
(o) Industrial Growth Rate-Sectoral and Total.
(b) furicultural output and Rainfall pattern.
(c) Fiscal Policy of the Governmdnt
(d) Foreign Exchange Reserves.
(e) Growth of Infrasbnictural Facilities.
A Global Industriflinkages. I
G) Global Economic Scenario and confidence.
(h) General Economic senti'ents and confidence in
the Economy.
(t) Economic and Political Stability.
ECONOMIC FORECASNNG

In the above discussion, several factors

been noted. The outlook for the industries

r of the components of GDp and how these

stries and companies is also required.
^uources ;ting :_It is generally not possible to collect
economic national level information about
the econo
;:::lT
e.

iffbrent Issues.

Vlonthly Reviews and Annual Reports.

ifferent Issues.
nliing in India, Different fssues.
Public Enterprise Survey, GOI.
 232 INVESTMENT ANALYSIS' AND PoRTFoLIo MANAGEMENT

Forecasting Techniques : Future profit of firms alre related to the key macro-economic
factors- The reason being that the future prospects otf industries and companies
are tied to
the future prospects of specific economic indicators noted profits of
money, leasing and frnance companies are tied to the liquidity "*ti".--foitu*p1",
position and interest rates
structu-re. However, in case of labour-intensive industry, the future prospects are linked
to
the labour cost and labour position. Similarly, in case of entertainnent industry, more
relevant indicators are the available leisure timer and the disposable income of the
conEuners. Besides identifying the rel-evant economic vaTiable, the analyst shiruld also
decide about time span for which lhe forecasting is to be made. In case, he is interested
in
making forecast for period upto threb years, he is interested in short-term forecast. period
covered from three to five years is known as interrrrediate forecast. fn case of long-term
forecast, the period covered is more than five years.
rnvestment decision requires a long-term as well :ls near future
forecasts. The market price of eqtii$tr shares is defined as the sum Inuestment decision
present values of all expected future requires a long-term
\efits company, in tthe
for the cornpany,
form of dividends, right shares, bonujshares, etc. The long-period as uell es near future
growth and stability of dividends, expectation of bonus shares, e/c. forecasts.
can not be effectively evaluated
'in term of one or two or three years perspeitive- Several
economic forecasting models have been developed to r:stimate the trend of prices of equity
shares. Some of the models are:
(o) fime'series Models : Tire time-serie"
-oa!rc attempt to forecast a particular variable
on the basis of the past trend and behaviour of the variable. The trend ii,'" i, extended
to
estimate the expected value in future.
(b,) Structural Models : These models attempt rbo establish a relationship
between
ariables. Ttre relationship is defined as a causal relationship
nt variable is forecasted on the basis of the given values o1
:

Leading and Lagging fndicators : Different indical;ors of level of economic activities and
chan-gesthe-r as leading and lagging indicators. T?re leadingindicators
are thosewh st level (peak) o.lo*,"rt level (troughs) in advance of the
total econom ther hand, the lagging indicatot, those which show
turning after the economy has already taken the turn. Some of the"." leading and l"ggg
indicators are as follows :
Leading Indicators -
(i) Money Supply,
(li)' Industrial Production,
(iii) Averuge weakly hours of production,
(lu) New order-s with the manufacturers.
(u) Order for capital goods.
Lagging Indicators
(t) Industrial loans outstanding,
(ll) 4rr"r.ge duration of employnient (unemployment), '
(lli) Average prime lending rates,
(lu ) 4rr"t"ge ratio of inventories (stock levels)
to sales,
(u) Ratio of consumer credit outstanding to personal income.
FUNDAMENTAL ANALYSIS : E-I-C APPROACH 233

Analysis of leading and lagging indicators suggests the direction of change in aggregate
economi; activity. In oiher words, Lhe turning points in the level of economic activities can be
identifred. However, it may be noted that this anarlysis does not tell any thing about the
duration and magnitude of the change.
Economic forecasting may be undertaken on threlfollowing patlern :
(r) A trend analysis of the basic economic indi'cators (GDP' etc-,) should be made to
identify the basic. economic environment.
(ii) Leading indicators of the economic environment be aniysed to forecast the change in
phase of the business cycles.
(iii) Analysis of lagging indicators be made to study the impact of change in business cycle.
Once a scenario for the overall €conomy has been developed, an investor should more to
breakdown the economy into various industry grroups. The national and international
conditions affect various industries differently. The economic analysis must precede the
industry analysis which is tbe next element of EIQ approach.

Pnrt lll
INDUSTRY ANATYSIS
In the economic analysis, as 3bove, the direr:tion for the The analyst must realise
change in capital market may be identifred-. Howeve:r, the analyst that different industries
must realise that different industries respond differently in the respond dffirently in th.e
capital market. For 6xample, in case of good econonric prospects, capital rnarket.
lconsumer goods industries may show relatively hLigher growth
than the heavy industries. Every investment ernalyst intends to isolate investment
opportunities that have favourable risk-return features. He rnay have several querries to
answer: ,

(l) Are the risk level of various industries differernt ?

(li) Does the risk level of a particular industry vary or remains constant ?
(ili) Does the return from various industries differr over a specifrc period ?
(lu) Would an industry contihue to perform well in future ?
(u) Would the performance of a frrm in an industry be constant over time ?
Industry analysis is relevant and important for the same
reasons that the economic analysis is. As it is dif1fi.cult. for an
As it is difficult for an
industry to perfonn well if
industry to perform well if the economy is ailinlg, it is also the economy is ailing, it is
diffrcult for a frrm to do well if the'industry is in troubled also diffi.cult for a firm to.
position. So, after an economic analysis, what is recluired is the do well i.flhe industry is
industry analysis. The industry analysis requires an insight in troubled position.
into (i) the key sectors, and (ii) the relative strength and
weakness of a particular sector about the economic activities.
An industry mBy be defrned as a homogenous group of frrms which compete with one
another with a similar type of product, goods and services. Industries may be classified into
different classes on the basis of:
(l) Product line : Automobiles, Steel, Cement, Textiles, e/c.
(ll) Sector wise : Agriculture, Mining, Conr;truction, Manufacturing, IT, Services,
Transportation, etc.
 234 INVESTM\NT ANALYSIS AND PORTFOLIO MANAGEMENT

(iii) Business cycle wise , Gto*?h, Cyclical, "ttf ?:FTive. Growth industries are-tho-se
which show high growth rate iiespeciive_ of the business cycle. S-oftware industry
U" a growth industry. Clyclical industries are those which move
-.v
with the n11"n""" cyclJs. These are blneirted as well as have to suffer with the
"t.5in1a?s
;[;;g;i" phase of"the business cy9le inthe.economy. Defensive industries are
cycles. For-ex-ample, industries
those which are virtually.rrorr-""oritit'e to business
a..firg *itft essential c6mmodities such as food, are defensive industries.
Some industries are
uirtually independent and
sorle are hiahly sensitiue to
the business cycles.
industries are virtually independent and some are highly
groY, there are certain
sensitive to the business cycles. Even if the econonoy is expected to
vestor can narrow down the analysis to those
e current or expected economic environment'
ndependent of the business cycle' On the
,latile. Sensitivity of a particular industry
to a business cycle is determined by three factors :
(a) sensitiuity of sales. some industries such asi food, drugs, med'ical services and other
to business cycles.
necessities have low sensitivity whereas luxury goodls have high sensitivity
Profits in those industries
which haue high fixed costs
will swing more widelY with
sales because costs do not
moue to offset sales changes-

appears, output
;"J";;#;;;;;;';ii;*i'g
sales changes. Example
profit's of the firms-
*ifi f.U, reducing the total variablle costs. Profits in those industries which
r --- ---- L^ ^tC-^L
i'or" widely with sales because cssts do not move to offset
Z,l explains the relations)hip of fixed costs, operating leverage and

and have same

T\vo frr-ms A and B are operating in the same competitive environment
.oilditiot.r. The costltructure and other details of these
level of sales under all
frrms are as follows : ".ono-i"
ALtd B Ltd.
t 5,oo,ooo T g,oo,0oo
Fixed Cost
Variable cost (Per unit) t1 ? 0.50
Selling Price (Per unit) 72 <2
6,00,000 5,00,000
No. of Units sold Normal
Good 7,00,000 7,00,000
Poor 5,00,000 5,00,000

The profrt position of these firms under dilferent economic conditions are given in
Table 7.5.

:. 'l:i . ;;P6i_:
-- ,a. ..!. --, - '-_ r'-... .g
:i- ."r:.. :
 FUNDAMENTAL ANALYSIS : E-I-C APPROACH 235

Toble 7.5 Profiit Position under diifferenr Economic Condition

Normal Cottdition Good. Cond.itinn Poor Cond.ition
Firtn A FinnB FtinnA Firtn B Firm A Finn B
l
T ( ( ? ?
Sales 12,oo,oo0 12,00,000 14,00,000 14,00,000 10,00;000 10,00,000
-Variable Cost 6,oo,0oo 3,00,000 1/,oo,ooo 3,50,000 5,00,000 2,50,000
Contributio! | 6,00,000 9,00,000 7,00,000 10,50,000 5,00,000 7,50,000
-Fixetl Cost 5,00,000 8,00,000 ]i,00,000 8,00,000 5,00,000 8,O0,000
Income 1,00,000 1,00,000 :2,00,000 2,50,000 NIL -50,000

Table ?.5 shows that under the normal conrditions, both frrms have same amount of,
earnings. However, firm A is expected to perfornr better than firm B in poor conditions, but
not as well in good conditions. The reason being lbhat firm A has lower fixed cost resulting in
lower operating leverage. Its costs move in conjunction with the movement in sales resulting
in relaiively bltter plrfo.ttr.rrce in economic down trends. On the other hand, frrm B
perforrns better in good condition. The reason being that it has higher fixed cost but lower
variable cost. Once the fixed cost is covered, I gher contribution per unit results in higher
earnings for the firm. The operating leverage for two firms (under normal conditions) can be
calculated as follows :
Operating Leverage
Contribution
EBIT
Firm B has higher operat-ing leverage as it hzrs higher fixed cost and is exposed to higher
fluctuation in case ofvariation is sales-
(c) Financial Leverogr. Firratrcial leverage of a. firm depends upon the use of debt funds in
the capital structur". Higtt"t the proportion o1'borrowed funds, greater is the degtee of
financial leverage. Interes-t payment on borrowings have to be made irrespective of the sales
level. profits of lhose firms'which have high bon'owing are more sensitive to business cycles
than of those firms which have lesser borrowings. The effect of financial leverage on the
variability of profits can be arialysed in the same way as done for operating leverage.
In order to assess the potential of an indusitry group, an investor would consider the
overall growth rate, market size and its importances to the overall economy. The individual
is important, still however, it cannot brs denied that the industry gfoup is likely to
"o-p..yas much itrflo"rt." on the share price. When prices move, they usually move as a group.
"*"rt
Investors should prefer those industries which haVe lower sensitivity to business cycles-
Investments in higher sensitivity industries will'be riskier.
Key Factors in Industry Analysis. In an industry analysis, number of key factors and
characteristics should be considered to identif5r the industrieswhere investments can be
made. Some of these factors are :
1. The past performance of the industry. Past sales and past earnings for certain years m3y
be analysed to forecast future earnings. The cost structure of the industry may also be
analysed to look into the leverages of the industry-
2. The permarlence of the prod,uct and technology of the industry.If the analyst feels that the
demand for the product for a particular industry would soon vanish, no investment be
made in that intustry. In the age of rapicl technological obsolescence, the degree of
permanence has become an important consideration in the industry analysis.
 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

3- Role of Gouernrnent in the Industry. trnvestor s.hould try to assess the probable role of
government. Will it restrain the i:rdustr5/s gro'wth ? Will it provide financial or other
supports? For example, in India, till a few years ago, the import of several electronic
items was restricted but allowed at a later stage which has severally affected the Indian
manufacturers.
4. Labour conditions relating to the industry.
5. Competitiue cond,itions in the marhef. The corrrpetitive conditions in the industry be
analysed with following questions irrmind : -
(l) Whether there is a barrier to entry or threat of entry of new firms in the industry.
New entrants to an industry put presure on prices and profit of existing firms.
(ii) Extent of competition among existing players is another dimension. In case of cut-
throat competition, the margins are bound to decrease. Industries having slow
growth rate face this situation as firms seek expansion at the expense of rival's
market share.
(ili) Whether there is a substitute product rvhich can replace the given product.
Availability of a substitute product defrniterly affects the price chargeable from the
customer and hence affects profit margin-
6. Inter-linkages with other industries- In the indurstry analysis, the interdependence and
inter-linkages of one industry with other industries should be considered. For example,
the position of auto-ancillary industry depends on the position of the auto industry.
Similarly, the demand of cement industry depends on the infrastructure budget of the
government.
Figure ?-4 shows the effect of different factors affecting ProfiUGrowth potentiality of an
industry.

Figure 7.4: Factors affecting ProfiUGrowlh Potentiality of an Industry

INDUSTRY TIFE CYCTE

It is firmly believed that every product has a life cycle. A product comes into existence,
it grows in demand, it faces decline and ultimately vanishes. Similar is the case with
industries which also go through different stages narmely pioneering stage, expansion stage,
 237
FUNDAMENTAL ANALYSIS : E-I-G APPROACH

stagnation stage and the decline stage. The <levelopment and existence of any industry can
be analysed in terms of life cycle consisting of these four stages.
Pioneering Stage : In the i-nitiaUfrrst stage of any Inuestors are required to identity
industry, the product as well as rts technology is new and the stronger and broad based
yet to reach the stage of perfection- It is the bime when firms and to take risk of
entrepreneurs are required to enter these industries. The inuesting in these firms.
--itrilustty, seems to be promising, growth oriented and
offerinj a lot of opportunities to make profrt. Lured b,f th.ege !e.atur9s, many companies
compet-e to grab as- much market share as pres5ifle. The rule of 'suruiual of the fittest'
is
appl-icable u,'a tn" weaker firms disappear froim the scene. Investors are required to identity
the stronger and broad based firms and to take risk of investing in these firms. Early
detection of a new industry and more promising players in that industry brings a lot of
returns to the investors. Foi example, 10-15 years ago, the IT industry was'irr the pioneering
stage in India and those who had inlested in this industry at that time.have reaped higher
retums.
Expansioi Stage : After the intense competition inthe poiheering stage, only the stronger
coipanies survive and then these companies consolidate their position. Ttrese companies
i"pid grovrth at a manageable ."t" ". reflected in the increasing efficiency.position
These
"t "i
companils become even stronger and develop theii own strategies to maintain their
in the market. Investment in these. "o-prtti"s is less riEkier but offer higher return. The
position continues until profrt margin declines due to fierce competition. Computer hardware,
iashion, Colour Television, Paint Industry, Automobiles.industries, etc-, are in the expansion
stage in India.
Stagnation Stage : Slowly. and gradually, e'rery industry matures' The growth rate slows
down and the ability of the indusiry to sustdir itself vanishes. New companies rarely
entel
these industries and thp existing one faces d,ifficulties to maintain. During eighties and
fi t;il:*';:-*HlH*:l'Jin"ffi'1be
try. Rather, the existing holding should
disposed off.
Decay Stage : From stagnation stage, the inrd.ustry gradually enters into the decline stage'
Change in consum". p."i"."oces, introduction of new products, change in customs
or other
.o*pilrion$ may b€-iesponsible for the decline of an industry. Decay stage for an indrrstry
may be few yea5s,o; f"* decades. With the development of highly technical and digital
the-industry for the manually oper:rted real size negative frlm camera industry is
"ri"r"r,
decaying world-uride.
Life:cy-cle approach to industry analysis suggests that Life cycle approach to industrY
analysis suggests that euerY
industry posses through four
phases in sequence and Prouides
-an
in-sight into the Preuailing
state of affairs.
i

i a sudden but is a gradual one. Second, different industries have varying pattern of these
stages. There may be variation in terms of relative duration of these stages from
one
i
indirstry to another. It is not always possible to frnd out as to how long the current stage
would contirrue. Third, thoughthe .i"g". of life cycle shows generalpattern, sgtill there can be
238 INVESTMENT ANALYSIS AND PORTFOUO MANAGEMENT

exeptio4s. Different stages of life cycle have been shown in Figure' 7.5.

Earnings

Figure 7.5 : Differe-nt Stages in life cycle of an lndustry

The life cycle analysis can help an investor to take wise and rational investment
decision. By identiffini tn" stage of an inclustry, an investor can decide what to
"orr"rr[
invest in and what tL invest out. Following prepositions can be noted inthis respect :
(a) Industry analysis be given sufficient emphasis in the investment decision process'
(b) If an industry is found. operating in the pioneering stage, extra care be applied to
identify the stronger comPanies.
(c)tergroupshouldbeenquiredinto.Aprompt-res-ponseis
, d"rriif."d"r operating:in fhe expansion stage. Delay here will
good returns from investment.
(d) There is no purpose of waiting for the end of the stagnation slag-e:.Alryays try to offload
an investment before or immeiiately after identilying the onset of the d'ecay
stage'

SWOT ANALYSIS FOR THE INDUSTRY

Industry analysis need not be static and based on historical facts only. Ttre coverage of
the analysis should be broadened to include the expected risk of the industry. Risk is
measured in terms of expected variability in return' The ri.sk pattern differs from
Business risk of an industry, as reflected in the total profit of one industry to arcotlter. This
the industry as well as the profit of individual firm, risk pattern is reflected in the
emanates from several factors. The risk pattern diff'ers from difference in price behauiour
one industry to another. This risk pattern is reflecteld in the at stock exchange.
difference in price behaviour at stock exchanges. | ,t '
The movement in market price of equity shares belonging to different industries may
d,iffer in direction as well as in degree. in order to assess and predict the behaviour and
performance of an industry and toldentify the rele,vant factors, SWOT Analysis should be
made for the given indusiry. This analysis consis.bs of the assessment and evaluation of
Strength, Weakness, Opportunities and Threats to an industry. Out of these four facets of
SWOi, frrst two ;.e., Strength and Weakness are internal to an industry and the other two
i.e., Opportunities and Threats are external to an industry. For example, low elasticity of
demand for the product is strength, but price control imposed. by the government is a
weakness.
FUNDAMENTAL ANALYSIS : E.I.C APPROACH

Strength : Strength of an industry refers to its capacity and comparativb advantage in the
economy. For example, the existing research and development facilities ?nd the greater
dependLnce on allopathic drugs are two elements contributing to the strength of
pharmaceutical industry in India. Other elements that may add to the strength of an
industry are : High quality products, good c,ustomer service, restriction on entry of
competitive product. In India, at one time, the innport of colour pjcture tube was restrictive,
and-it was the strength-of this industry (represented by JCT Electronic I:td. and- S4l4tel
Colour Ltd.). It may b1 noted that the stren th c,f an industry cannot be guaianteed, r-ather
.the industry has to rnaintain it b-y innovative pro<lucts-
Weakness : Weakness refers to the restrictions and inherent limitations in the industry,
which keep the industry away from meeting its target. For example, lack of infrastructure
facility, rail-road links, etc., are weakness of t}
hand, the strength of the industry is that the g
development of infrastructure. One of the weakn
is thai majority of population in India is poor and not able to buy costlier allopathic
medicines.
Opportunities : Opportunities refer to the expectation of favourable situation for an
in-clirstry. It may be identified by a trend ant rsis or by a patte3 o_f changing_ consum-er
rchasing power with the people, demand' for
; preference from gold to diamond jewellary
rd industry. It may be noted that change in
preference and taste is gradually becoming strength of the diamond industry.
Threats : Threat refers to an unfavourable sihration that has a potential to endanger the
existenee of a an industry. For example, after t;he liberalization of import policy in India,
import of Chinese goods has threatened many int
Threat may also come in the shape of new produ<
terms of the outgoing block based printing sys
system. Indian white goods industry (i.e., consur
the imported white goods. ;

COMPANY ANATYSIS
The third element of the EIC ipproach to fundamental Effect of a business cycle
analydisis the company analysis. In the preceding discussion, on an indiuidual corLpany
the economy analysis and industry analysis have attempted to may be different that
from
show their impact on the earnings of a companyr S1le9 of some on, the industry in general.
industries (aut6mobiles, etc.) move in line withthebusiness
cycles while of others (food, e/c.) do not.
may be different from that on the indus
such that the sales revenue and the earnings
than proportionately to the microeconomic an
focal point is the relationship between reven
anC iridustry changes.
'companies before proceeding for a detailed
out the leaders and innovators in the group.
dentity better performing companies in an
re competitively placed as compared to other
 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

companies, are identifred for investrnent. Multi-step process may be taken up'to attain the
objective. Various steps involved are as follows :
1. Analysis of the Management of the company to evaluate its trust-worthiness and its
capacity and efficiency to counter any untoward situation in the industry.
2. Analysis of the Financial Performance of the company to forecast the future expected
earnings capacity.
3. Evaluation of long-term-vision and strategies of the company in terms of the-
organizational strength and resources of the company, and
4. Analysis of key success factor for a particular industry and the strength of the particular
firm in respect of that factor-
The company analysis presupposes that the economic and industry analysis have already
been made and now the objectives of company analysis are :
(i) To analyse the e4pected earnings of the company, and
(il) To find out the fair value (intrinsic value) of the share.
The'earnings capacity of a frrm depends upon several variables Finding out the fair
such as sales, profit margin, tax rate, debt proportion, asset ualue of the shane, in
utilisation, etc. Th.e earnings, together with other factors such as the ultimnte objectiue
future growth rate, etc., affect and determine the fair value of the of company analysis
share. Finding out the fair value of the share is the ultimate objective
of company analysis and has been taken up in detail in Chapter 9. However, discussion in
the present chapter is restricted to the analysis of expected earnings of the firm.
Sources of Information : Informatioir and data required for analysis of earnings of a firm
are primarily available in the annual frnancial statements of the frrm. The financial
statements include :
(i) Balance Sheet, or the Position Statement,
(ij) Income Statement, or the Profrt & Loss Account,
(ili) Cash Flow Statement, the statement of sources and uses of cash.

BATANCE SHEET (BSl

The BS is regarded as the most signilicant and basic The BS is prepared by a finn to
financial statement of any firm. The BS is prepared by a present a surnrnary of financial
ftrm to present d summary of financial position at a given position at a giuen point of time,
point of time, usually at the end of a financial year. It usually at the end of a financinl
shows the state of affairs of the firm at a point of time..It year. It shows the state of affairs
presents the assets of the frrm (i.e. the resources of the of the firrn at a point of time.
firm), the liabilities of the firm (i.e. obligations of the firm I ' ' '
towards outsiders) and the contribution of the owners of the firm. The BS, in fact, balances
the assets of the frrm against its financing (which can be debt and owners funds) i.e. the
total value of the assets must be equal to the total claims against the firm and this can be
stated as :

Total Assets = Total Claim (Debt + Shareholders)

= Liabilities + Shareholders Equity
ft may be noted thatJhe BS is relevant at a particular point of time. It is like a financial
snapshot at a point of time, before and after which the position may be different. So, the BS
is a status report. Table 7.6 presents the BS oI'a company as per proforma contained in
Schedule VI annexed to the Companies Act, 1956.
 FUNDAMENTAL ANALYSIS : E.I-C APPRCACH 241

: Protormo Balonce Sheet os per the Componies Act, 1956

Tcrbfe 7.6
Bqlqnce Shegt of ............ qs oll .......r.
Capital and Liabilities Amount Assets Amount
Share Capital ***** Fixed Assets *,k***
Reserves & Surplus ***** Less Dep. ***** *****
Secured Loans ***+* Investments *****
Unsecured Loans :***** C. Assets, Loans & Advances *****
Current Liabilities ***** Miscellaneous Exlpendituteq ****x
Provisions *****
***{<** ******
The BS presented in the above form is known as the Horizontal BS, The BS cen be
presented in another form also known as Vertical BS given in Table 7.? :
Tqble 7.7 z Proformq Bolcrnce Sheet (Verficol presentotion)
Bolonce Sheer of ............ Glg on .........
Amount Ambunt
1. Sources offunds
(i) Shareholders firnds '
(o) Share Capital x<****
(b) Reserves & Surplus ***t* *rF**:l€
(ii) Loan funds
(a) Secured Loans *****
(b) Unsecured Loans ***** *t**+
Total {c****

2. Application of funds ,
(j) Fixed Assets . *****
Less Dep. ****:k t<****
(il) Investments *:1.***
(iii) C. Assets, Loan & Advances *****
Le'ss Current Liabilities ***** t<***{<
(lu) Miscellaneous Expenditures *****
(u) Profit & Loss Account *****
'l-otal *t*:**
The different items contained in the in the BS can be grouped into (i) Assets,
(ii) Liabilitiesand ( iii) Shareholder's funds.
1. Assets : An asset is a resource that has the potential either to generate future cash
inllows or reduce cash outflows. For a resource to be an asset,'therefore, a firm has to have
acquired it in a prior transaction and be able to quantity future
benefits. The assets of the firm represent the investments made
The assets of the firn
by the firm in order to generate earnings.'So, the assets consist represent the inuestments
of all that is owned by the firm. Assets are generally bifurcated made by the firm in order
into Fixed Assefs and Current Assets. to generate earnings.
The Fixed assets are those which are intended to be held for a long period. These assets
are of permanent nature, relatively less liquid and are not usually converted into cash in the
short run- The assets included in the frxed assets are plant & machinery, firrniture and
fixtures, and building, work-in-progress, ship, etc. The BS shows these assets at historical

1
242 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

cost less d,epreciation date. Thus, these assets are shown at their written down values in
till i

the BS. ThL market value or the replacement cost of these assets is not shown in the BS. I

Ilowever, as per the Grridance Note issued by'the Institute of Chartered Accountants of {

India, can revalue their fixed assets so that these can be shown at their current
"o-prrri".
worth in the BS. The value of a fixed asset (historical cost or revalued frgure) is known as the
Book Value, which may be different from the market value or replacement cost of the assets.
As already said, the fixed assets are shown in the BS at an amount which is net of
depreciation. The depreciation is the process-of allocation of the cost of the assets toThe time
periodduringwhichtheassetshasbeLnusedfortheactiviti." The amount of depreciation
of the frrm. Tb,e amount of depreciation is a non-cash expense is a non-cash expense and
and does not involve a cash outflow. It is taken as an expense does not inuoloe a cash
item and is included in the cost of goods solS or indirect outflow.
expenses depending upon the nature of the frrm-
current assets are the liquid assets of the lirm and are Current ossefs are the
convertible into cash within a period of one year. Current assets Iiquid assets of the firm
includ.e items such as cash and bank balance, receivable (debtors arud are conuertible into
n-process and finished cash within a period of
expenses, loan and ofle year.
The total of all current
assets is also knovrn as gross working capital.
Besides, frxed assets and current assets, there may also be some intangible assets such as
goodwill, patents, trademarks, cop5rrights, etc- These are
BS. There may also be items like preliminary expenses'
and underwriting expenses ),. share/debenture discount,
20g of the Companies Act, 1956), efc. These asset are in the nature of accumulated losses
which are not written off so far. These are neither included in the fixed assets nor in the
current assets and are shown separately in the BS'
2. Debts or Liabilities : Debts or liabilities are the claims of the outsiders against the
assets of the firm. The liabilities refer to the amount payable by the frrm to the claim holders
i.e- the amount owed by the frrm to other parties. The liabilities may be classifred on the
basis of payment coinmitments, into long term liabilities and current liabilities.
The Long Term Liabilities (LTL) are the debts incurred by the frrm, which are not
payable during a period of next one year. So, the LTL are those obligations of the firm which
are not to be discharged during the next one year. The LTL thus, represent the long term
borrowings of the firm.
Ttre Current Liabilities, on the other hand, are those liabilities which the firm expects
to pay within a period of one year. The current liabilities are related to the current assets
of
tfre fiim in the sense that current liabilities are paid out of the realizations of current assets.
The current liabilities (and current assets also) are related to The current liabilitins (and
the operating cycle of the frrm. The current liabilities are current assets also) are
, expecled to be discharged within an operating
cycle of the firm. related to the operati
The current liabilities may include payable (creditors and bills), cycle of the firm.
outstanding expenses, bank overdraft, provision for tax, etc:
|-
3- Shareholders Equity (SE) : The SE represents the ownership interest in the frrm
and reflects the obligations of the firm towards its owners. The SE consists of the share
capital and the retaired earnings. The share capital is the direct contribution of the
 FUNDAMENTAL ANALYSIS : E-].C APPROACH 243

shareholders to the firm. The retained earnings on the

o sccumulated effect of the firms The share capital is the direct
e not been distributed)- So, the contribution of the sharehold'ers
r e amount earned, retained and to the firm. The retained
r hareholders in the firm itself' The earnings on the other hand,
profits retained ong reflect the accumulated effect of
----th" shareholder
the the firms earnings (which haue
shareholders in net not been distributed).
worth.
Taken together, the liabilities and the SE must be equal to the total assets of the firm- As
discussed lat-er, the BS supplies a lot of information for the critical analysis of the financial
position of the firm.

rNcoME STATEMENT (lS)

The IS, also known as the Profit and Lorss A./c or the The IS shows the results
statement or n^trrirtgs, summarizes the revenues iand expense of of the operations of the
the.firm for an period. It gives a deta.il of sorirces of firm during a period.
"""orioting
innnrno qnd ornerr*o" ttd thus it provides the summary of the
r a specific period. It;r.ratches the
revenues, and shows the differenc
profit made or net loss incurred during the period. The IS shows
of tn" firm during p"ri"a. The IS thJrefor^e, is a fllow report ag-ainst lhe !S which is a stock
"
report or a statuJ reiort. The IS depicts the earning capacity.of
-the th9 f}rm inr,-terms'of the net
---l^-
ffiA: It-h;lpr;i"rri""Ji"g-hie f".tormanc(]"of r proforma firm du'ing
i----
the-period-under
:-
---:-l
m^Ll^^
^consideration.
The IS of a firm iray ne'prepared asi per the ^ given in Tables 7'8O and
ry ^-,1
7.9.
Tobfe 7.8 z Proformq lncome Stofement (Horizonrnl Form!
Income stqtement for the yeoir ending .""'
Particulars Amount Amount
***{<* By Sales
*****
To Cost of Goods Sold {<***x
To General Expenses
***** By Other Incomes
To Depreciation
*****
To Financial Charges
***+*
t<****
To Non operating expenses
****{<
To Provision for tax
To Net Profit (Balancing figure)
***{<*

***** *{<**{.

Toble 7.9 z Proformo lnrgome St<rtemenr (Verticol Form)

lncome Stqlement for
Amount Amount
**{'**
Sales ****:F
Less Cost of Goods Sold *****
Gross Profrt
Less Indirect expenses
* * ,r-lc *
General Expenses *****
Depreciation ***** ***+*
Financial Charges

_:*t ;

- *-.,'i '..';. --
244 INVESTMENT ANALYSIS ANP PORTFOLIO MANAGEMENT

****+
Operating Profit
*****
+ Non Operating Incomes/ExP€nses
+{<***
Profit before Tax
*****
Less Provision for Tax
*****
Net Profit
The contenT! oT an IS can be gtouped frFo threr: classes i.e. (i) revenues,
(il)-expenses,
and (iil) net profit or loss'
l. Revenues : Revenue is the inflow of resources/cersh that It may be noted that reuenues
arises because of the operation of the firm. The revenue are recorded on the basis of
arise from the sale of goods and services to the customer accruals and the actual receipt
and other non-operating incomes. when goods and services of tIrc reuenue rnay be delayed.
are sold by the firm, then either the cash is r:ealized
immediatelf or receivable are cr'eated (to be realized later). Both are a part of the revenues-
Similarly, the profits earngd on the sale of some assets or investment is also a revenue. It
may be noted that revenues are recorded. on the basiis of accruals and the actual receipt of the
t".rlrro" may be delayed. The frrm may also get' revenue from the use of its economic
resources elsewherer For exa-ple, some of the funds might have been invested in some
other
investment is also a revenue of the
frrm. The income by'way of interest or dividend on this
firm.
Revenue have linear relation with owners'funds. Revenues arise when there
is Fn
increase in owners'nriras represented by increase in assets or decrease in liabilities.
Inflow of
;;;;;gether with an io.."r"" in tiabilities doers not result in increase in owners'funds,
: and hence is not a revenue, For example, cash rer:eived by the issue of debenture is not a
revenue as there is a simultaneous inciease in liabilities also and the owrrers'funds
remain
intact.
the
2. Expenses : The cost incurred in earning the revenues is called the expense. Against
sales ievenue, the most important expense is the Cost of goods sold. There are other expenses
also such as salaries, gen-eial repairs, etc. An expense occurs when there is a
"*p"or"a,
decrease in assets t".g. puy*ent o? wages irrcash) or increase in liabilities
(e.g. outstanding
io it rePresents the de
d, be cash PaYment for
o - I as these are relate
the frrm. The provision for the tax is also treated as an erpense though it is not directly
related to operations. Similarly, amortization of go,odwill, preliminary expenses, e/e are also
taken as expense

STATEMENT OF APPROPRIATION OF PIROFIT

A/c. Though it is not necessary as per the
It is also called the Profit & Loss Appropriationr
provision of the Companies Act, 1956, to prepare t
iplit the IS into two parts i-e- ttre IS and the P & L
Part II. The net profit figure shown by the IS is tr
wherein it is bifurcated into two main parts i'e' t
profits retained in the frrm. The Stalement of Appropriation of Profit or the P & L
Appropriation A/c may be prepared as per proforma given in Table 7.10.
 FUNDAMENTAL ANALYSIS : E:I.C APPROACH
245
l

Amount
To General Reserve ***** By Balance b/d *****
To Interim Dividend ***** By Net Profrt ***:F*
To Proposed Dividend *iF***
By Tle4sfer from General
To Corporate Dividend Tax :k**>1.+
Reserve
To Balance cld(Balancing figure) :f*+:F:k
***** :F+**+

STATEN,IENT OF CHANGE IN CASH POSITI(

The BS and the IS are two common fin.ancial
statements and are also known as traditional fi.anciar For a better understandinp of
statements. The BS depicts the financial position at a the financial posi-tions, tt t"
point of time and the IS shows the net results of of essential to know the mouement
cash **'"'"6 thn
operations of the firrn during a particurar periorl. Bu1,t -' ---'- during "'* period.
Yo' ou-'
f?il b provide infor:mation regarding the change in financial
*l1,tl'::-3.y':]:l1te3ent1
pos-ition over the period. For a better understanding of the fiiancial"positions,
to know the movement of cash during the peririd. For this porpior", it is essential
statement may be prepared and it is known ur th. cash
another frnancial
Flow Siatiment which shows how
how the cash was utilized. It reports the flow
is a historical record of where the cash came
have procured and there can be different
""'";:,;;:';f"::;f,:i*i1ifiT"l1"r:':f#Jil-
It maybe noted that the BS and IS are prepared an accrual basis whereas the
statement is prepared on cash basis. For examfle, rlepreciation cash flow
is an expense for IS but it is
not shown in cFS as depreciation does not involve any cash
flow.

ANATYSIS OF FINANCIAM
Researches and investment analysts have an inclination
on the information contained in the annual financial sta any analysis
primary reason for this being that the annual financial state mpany. The
to the set of
---- and conform
as provided in var ards issued by the
Institute of . oi Irdi, (ICAI) \ d *hii;;;il;;;
the financia on to annual finar
'a summary of financial highlights for anies also provide
say 5 years or' l0 years, as a part of Annual Reporrlo
the shareholders' The information contained in annual financial
statements can be used by
an investment analyst to focus on :
(l) Profitabillty of the company,
(lr) Liquidity of the company,
(ill) Solvency of the company, and
(ju) A.1intty level of the company.
246 INVESTMEIIT ANALYSIS AND PORTFOLIO MANAGEMENT

Tables 7.11 to 7.14 contain the Annual Financial Statements of Voltas Ltd. for the year
2008-09.
Toble 7-ll . Bolqnce Sheet of Vohos Ltd-
qs ot 3lst Mor,ch,2OO9 ({ in Lo,khs)
As ai As at
31-03-2009 31-03-2008

Sources ofFunds
Shareholders Funds
1. Share Capital 33'07.34 3306.95
2. Reserves and Surplus 69592.05 80525-07
3. Total 72899.39 53832.02

LoanFunds
4. Secured Loans L2W.26 4766.60
8574:t.65 58598.62

Application of Funds
5. Fixed Assets
26302.39
Gross Block 29392.54
treris.: Depreciation 13058.12 t2227.74
NCtBlock : 16339.46 t4074.65
Capliat Work-in-Progress 965.14 1875.21
1?304.60 15949.86
23580.03 26792.63
6. Imrestinents
7. Deferred Tax Asset (Net) 2158.58 2043.t2
8. CurrentAssets, LoansasdAdvances
60958.5?
1. Inventories r05141.05
. 2. SundryDebtors 916a4.47 53169.16
3. Cash and BankBalances 400'24.4 27520.78
4- Interest accrued on Investments : Nil 3.70
5. Loans and advrnces 22/1t93.34 14319.99
2493'45.5O 755972.20
9. Less : Current Liabilities and Provisions
(o) CurrentLiabilities 182169.06 121739.31
(b)'Provisions 24475.4O 20419.88
20661(4.86 t42L5Ll9
13813.01
10. Net Current Assets
58598.62

Tcrbfe7-12: Cosh Flow Storlement of Voltos [td.

for the yeor ended 3lst Morch,2OO9 (? in lakhs)
2007-08
Rupees in
Lakhs

A Cash Flow From OperatingActivities

36742.9r 30753.95
Net Profrt before taxation
Add-Adjustments for:
Depreciation /Amortisaf,ion r659.48 1356.49
232.94 (100.00)
Provision for Contingencies
l40.43 4.55
Provision for Diminution in value of Investments
 FUNDAMENTAL ANALYSIS : E-I-C APPROACH 247

Profrt on Sale/Retirement of Fixed Assets (Net) (24156.85) (2752.L7)

Profrt on Redemption of Mutual FundVSale
or Non Trade Current Investments (Net) (7005.2) (47.99\
Interest Paid 485.69 595.94
Interest Received (L272.41) (330.45)
Income from Investments $5a2.54) (1134.49)
Impairment of Fixed Assets 70.06 Nil
Provision for Emplole Benefits 738.91 360.43
Profrt on Sale of Chemicals Tlading Business (87322) Nit
Provision for trade Guarantees 66222 1409.80
(2895.81) (637.89)
Operating Profit before Working Capital changes 338:|7.10 30116.06
Less-Adjustments for :
(Increase/Decrease in Inventories @4La448t (L2707.77)
(Increase)/Decrease in Trade and Other Receivables (28515.31) (9791.14)
(Increase)/Decrease in Loans and Advances (5Ut2.20) 445.54
' (Decrease)/Increase in Advances from Customers r5815.06 2L497.60
(Decrease)/lncrease in Trade Payables 44588.69 10933.09
(18r8824) to37L-32
Cash generated from Operatioos 15698.86 40487"38
Less:
Taxes paid 9991.31 5904.81
Net Cash From Operating Activities 5707.55 34582.57
B. Cash Flow From InvestingActivities
Purchase of Fixed Assets (3370.U2' (4468.64)
Sale of Fixed Assets 700.74 1930.95
Proceeds from Assignment of Balance Leasehold Rights/ 2042.25 97O:78
Surrender of Tenancy Rigtrts
Purchase of Investments : (9L.O46.47) (Lt4s62.76)
Increase in Share Application Money (783.r4) (298.10)
Refund of Share Application Money 432.50 7.76
Investment in Subsidiaries (6645.73) (0.10)
Sale of Investments 10r464.91 101954.73
Interest Received L276.tt 373.82
Income from Investments 1582.54 t3L2.24
Advances to-Subsidiary Companies (r25L.42) 0.31
Net Cash From/(Used in) Investing Activities 440L.87 (13179.61)

C. Cash Flow From Financing Activities

Proceeds from Share Capital (Calls in Arrears) 0.39 0.L2
Securities Premium (Calls in Arrears) 1.98 0.57
Increase/(Decrease) in other Borrowings 9077.84 (24{1.59)
Repayment of Long Term Borrowings (1000.0o) (1000.00)
Interest Paid (488.88) (607.71)
Decrease in unpaid Deposits (2.11) (8.14)
Dividend paid including dividend tax (51e4.80) (3846.44\
Net Cash from/(Used in) Financing Activities 2394.24 (7907.19)
Net Increase./(Decrease) in Cash and Cash Equivalent;s 12503.66 L3495.77
Cash and Cash Equivalents as at 1.4.2008 27520.78 14025.01
Cash and Cash Equivalents as at 31.3.2009 40024.4 27520.78

sE**, J

I
248 I NVESTM ENT ANALYSIS AN D PORTFOLIO -"=*'
"O*-OU
Ttrbfe 7.13: Profit ond loss l\/c of Voltqs Ltd.
for the yeor en<ied 3lst rMarch,2OO9
((in Inkhs)
Year ending
31-03-2008
1. Sales and Services 308617.33
Zess : Excise Duty 1163-67
Net Sales and Services 30445366
2. Other Income 4631.94
3. Cost ofSales, Services and Expenses- 279366.71
4. Profit before Interest, Depreciation
And Exceptional Items 29718.89
5. Interest 595.94
6. Depreciation/Amortisation on Fixed Assets 1356.49
7. Profrt before Exceptional Items 27766.46
8. Exceptional Items 2987.49
9. Provision for Taxation 30753.95
10. Profrt before Taxation
Provision for Current Tax 8710.45
[(Including Foreign Income Tax a ?07.28 Lakhs t
(2007-08 :? 240.20 Lakhs)l ir

Provision for Taxation of Earlier Years Written Back Nil

Provision for Deferred Fax 850.00
Provision for Wealth Tax 32.00
Provision for Fringe Benefit Tax 325.00
99L7.45
11. Profit After Taxation 20836.50
12. B alance brou ght forw a-r&fr o-m?fevious Year 4000.00
13. Amount Transferred from Foreign Projects Reserve 250.00
14. Profit available for Appropriatiops 25086.50
15. Appropriations:
(a) General Reserve 14000.00
(b) Proposed Dividend 4466.94
(c) Tax on Dividend 759.16
L9226.LO
16. Balance Carried Forward 5860.40

Basic and Diluted Earnings per Share ofT 1 each 6.30

Tobfe 7.14. Five-yesr Highlights (of Volros [td.]

(7in La.khs ercept for per share d,a.ta)
2008-09 2007-08 2006-o7 2(X)5"O6 20{}445
1. Sales and Services 407025 308617 245078 190418 L44L43
2. Other Income t 924L 4632 3071 243L 1953
3. CostofSales and Services (incl. Excise 299802 22767L 186100 r45L62 108570
Duty)
4. Operating, Administration and Other t 82931 57811 46537 35899 32264
ExpenSes
5. StaffExpenses ? (4286) (27685) (24008) (17623) (1,1435)
Number of Employees Nos. 10657 7378 5848 5390 5747
6. Operating Profrt - 33533 27767 L55t2 11788 5262

' .-,.,-:.:.".-.' : . .. . .."^:"..;- 5 15-..:.'ii

 249
FUNDAMENTAL ANALYSIS : E-I-C APPROACH

2987 (2619) 504

7. Exceptional Incomey'(Expenses) 3200 -6771
8. ProfiV(Loss) Before Taxation 36733 30754 22283 9169 5766

Percentage to Sales
4.0
L9.2
Percentage to Total Assets
9. Taxation
5041
10. ProfiU(Loss) Aftertaxation
3-5
Percentoge to Sales
26.1
to Shorehold.ers' Fund,s
3155
11. Retained Profrt
1654
12. Dividend on EquitY CaPital
50
24858
13- Fixed Assets (At Cost) 30358
13053 16615
14. Depreciation
23580 4622
15. Investments
42700 L4974
16. Net Current Assets
2158 2153
17. Deferred Tax Asset
18. Deferred Revenue ExPenditure
19. Total Assets 85743
20. Share Capital t 3305
T 16046
21. Reserves and SurPlus 19351
22. Shareholders' Funds (
t+ t5.2
Earnings per Sh,are
lVos. 53674
Nurnber of Shorehnld,ers
Share Prices on Stock Exchange-High tt 248
-Low tt 88
10641
23. Borrowings ?
cc
Debtl Vo

Note : All amounts are Rupees in laktrs except those marhet t

* Face Value of ? 1 each

ANAIYSING COMPANY'S EARNINGS

rthe earnings of the company in order to
Some of the variables used in the analysis
e Interest and Taxes (EBIT), Profit Before
Per Share (EPS), Dividend Per Share (DPS)'
s
Return on Equity (ROE), efc. These variables (ratios) can be calculated as follows
:

0) EBIT = Sales - Variables Cost - Fixed Cost

' (ii) PBT = EBIT - Interest Cost
(iii) PAT=PBT-Tax
(iu) Retum examines profitability from the perspective of the
equity invest e for the eqTty shareholders with the book vafue
of the equity the point of .'i"* of equity shareholders may be
calculated by comparing the net profit less preference dividend vrith their
total contribution
in the firm.
Return on EquitY x 100

Return on EquitY 100

,:S*t.
250 INVESTMENT AhIALYSIS AND PORTFOLIO MANAGEMENT

The ROE indicates as to how well the funds of the owner have been used by the firrn. It
also examines whether the firm has been able to eanr satisfactory return for the owners or
not. Therefore, the investors would probably be most interested in the ROE analysis.
In order to forecast the expected ROE for future years, a series of ROE for several last
years may be anaiysed, as it is reasonable to assume that the future ROE will approximate
its past value. It may be noted, however, that high RC)E in past does not necessarily imply a
high ROE for future. Increasing or decreasing trend in ROE may indicate future ROE. If
ROE is decfiiling over years, it shows that new investments of the firm are offeiing lower
ROE than of the past investment an4 in this case, the future forecast of ROE would be lesser
than the most recent ROE. TogQther with ROE analysis, the profitability can also be
assessed with the help of other measures as follows :
(u) Earnings Per Share (EPS). The ROE measurer; the profrtability in terms of the total
ftrnds and explains the return as a percentage of the funds. The profitabiliW of a firm can
also be measured in terms of number of equity shares. This is known as EPS which is derived
by dividing the PAT by the number of equity shares. [io,
PAT - Preference Dividend
Earnings Per Share =
Number of Equity Shares

The EPS calculations in a time series analysis indicate whether the firm's E_PS is
increasing or decreasing.
(ui) Dividend Per Sha.re (DPS). Sometimes, the eqtrity shareholders may not be interested
in the EPS but in the return which they are actually receiving from the firm in the form of
difidends. The amount of profrts distributed to sharehrolders per share is known as DPS and
may be calculated as follows :
Total Profits Distributed
Dividend Per Share = Number of' Equity Shares

Generally, companies declare dividends in terms of percentage of paid-up capital. For

example, if a company declares a dividend of 25Vo on equity shares of face vdlue of { 100 each,
then lhe DpS is 7 25, i.e., 25Vo of T 100. In this case, if the paid-up value of the share is t 80
only, then the DPS is T 20, i.e., 25Vo of { 80. In the time series analysis of DPS, the analyst
should make adjustments for'bonus share, e/c.
(uii) Dividend Payout Ratio (DP Ratio). The DP lRatio.is the ratio between the DPS and
the EPS of the frrm, i.e., it refers to the proportion of the EPS which has been distributed by
the company as dividends. For example, if the frrnr has an EPS and DPS of T 5 and T 3
respectively, then the DP Ratio is
Dividend F'er Share
DP Ratio = x 100
Earnings ller Share
u3
a x 1.O0
U-
== 60Vo

So, the frrm has distributed 6OVo of its PAT as dividend among its shareholders. It may
be noted, that the DPS and the DP Ratio both are subject to the statutory provisions r'dlating
to compulsory appropriation of profits, efc.

r-- i!. .^
 251
FUNDAMENTAL ANALYSIS : E-I.C APPROACH

(uiii') pric-e Earnings Ratio (PE Ratio). This is the ratio which establishes the
relationship between tfr" npS and the market ptrice of a share and is calculated as follows :

Market Price Per Share

PE Ratio =
Earnings Per Share

The pE Ratio indicates the expectations of the equity investors about the earnings of the
frrm. The investor's expecJations are reflected in the market price of thlslare and therefo-re
the pE Ratio gives an icfea of investors' percepti.on of the EPS. The PE Ratio is one of the
most widely used measure of financial analysis in practice. Companies having high-end
growth prospects have higher PE Ratio as compared to no-growth or slow-growth firms'
In the calculation of PE Ratio, the EPS is basrid on earnings for last years, nevertheless,
pE Ratio is more than a rleasure of company'si past performance. It also considers the
market expectations for the growth of the company. As the stock price reflects what the
the growth of the corlpaLrr/, reflection of market's
company,s growth prospects. o does not necessarily
undervalued.. Rather, it could comp.any is headed for
some problem in future-
In order to take a.view on the reasonable PE ratio for a particular company, one can look
at the pE ratio of other firms in the same industry. In addition to the cross-section analysis,
-for
the historical pE ratio of the firm should also be analysed to forecast the trend in PE ratio
the firm.
A high pE Ratio may ind.icate (i) that the: share has a low risk and therefore the
investors are content with low prospective rehtrrrt, or (ii) the investors expect high dividend
growth and are ready to pay a higher price for the share at present.
(ir) Market to Book Value Ratio (PB Ratio) : This ratio expresses the relationship
betrveen the market price and book value of a share. It is calculated as follows :
Market Price Per Share
PB Ratio = gooWatue
Per Share

The book value of a share provides a floor belovr which the market price of a share is not
expected to fall. Shares wtrictr have lower PB Ratio may be considered'G a'safet'investment-
It can be argued that if other attributes of two firms are same, then the share having lower
pB Ratio should be preferred. Higher PB Ratio irnplies higher market price which results in
lower yield for the share.
The concept of pB Ratio in conjunction with the ROE can help to identity overValued and
undervalued shares. Figure 7.6 presents the PB-ILOE combinations in a box diagram.
Low PB Ratio High PB Ratio Investment Profile
High ROE Ratio High ROE Ratio (1) Low risk, low-return Investment
€ (3) (4) (2) Overvalued stock
Low PB Ratio High PB Ratio (3) Undervalued stock
Low ROE Ratio Low ROE Ratio (4) High-risk, High-return Investment
&
(1) (2)
PB Ratio
Figure 7.6 : PB Ratio - ROE Pnofile and Investment Profile
 252 INVESTMENT /\NALYSIS AND PORTFOLIO MANAGEMENT

(t'r) Yield. The yield is defined as the rate of return on the amount invested.
With reference
to the equity shares, the yield may be defined as th.e rate of return on the market price
of
equity shares. In order to find out the yield of an equity share, the market price may be
cornpared with the EPS or the DPS to frn I out the Earnings Yield or Dividend yield
respectively as follows :

EarningsYield=#ffi#ffi
DividendsYierd =
,ffi*Hffi
It may be observed that the Earnings Yield is the, inverse of the PE Ratio. The Earnings
Yield is also known as Earnings Price Ratio. The Elarnings-Yield and the Dividend yield
evaluate the profitability of the firm in terms of the nrarket pice of the share and are
usefirl
measures from the point of view of a prospective invelstor wlo is evaluating a share,s
worth
to take a buy or not to buy decision.
Examlle 7'2 explains the calculation of different ratios from the point of view of a
prospective investor-

Example 7.2
- The following are the Income Statement and the ]Salance Sheet (Partial) of ABC Ltd. for
the accounting year 2OI2 :
INCOME STATEMEI{T
For the year ending De:c- 57,2072
Operating profit (EBIT) T g,36,000
I Zess : Interest charges 1,76,000
' Profit before Tax (PBT)
6,60,000
Less : Provisions for Tax (BAVo)
1,98,000
Net Profit (PAT) I

4,62,OO0
Less : Preference Dividend 20,000
Earnings for Equity Shareholders 4,42,O00
Less : Dividend Paid 1,96,000
Retained Earnings 2,46,OOO
BAII\NCE SIMET (PARTITL) OF ABC LTD.
ds on Dec. 37,2012
|Vo Preference Share Capital (of { 100 each) T 4,00,000
Equity Share Capital (98,200 Shares of { 10 each) 3,92,000
Total Share Capital 7,g2,OOO
Add: .Share Premium A/c 9,56,000
Profit and Loss A./c 22,70,OOO
Shareholders' Fund
39,09,000
Add: Long-term Loans 20,46,000
Capital Employed 59,54,000
Additional Information :
G) Market price of the share on 81.12.11was {g0
(ii) No final dividend has been proposed.
FUNDAMENTAL ANALYSIS : E-l-C APPROACH

You are requrred to a4alyse the profitabiltity from the point of view of a prospective
investor.
Solution :
Different ratios for the year 2Ol2 have been calculated as follows :

PAT - Pref. lDividend 4,42,000

Earnings-Per Share Number of Eqrdty Shares
=T B8,2oo : { 11.57
Profits Distribruted T 1,g6,000
Dividend Per Share = Number of Sh,rres = B8,2oo
= { 5.14
Dividend Per fihare ( 5.14
Dividend Payout Ratio = Earnings Per lshare = ? 11sz = 44Vo

E"Tltg="
Earnings Yield = l= lihare x
Market Price
1oo = 100 = L4.467o

Dividends Yield
Dividend Per Sihare
x 100. =
-
T=5'14
Tg0
=#x
x 1oo
rvv = 6.42Vo
Market Price
Market PriLce T80
Price Earnings Ratio = { 11. bz = 6'91
Earnings Per Share
PAT - Pref. Dividend < 4,42,OOO
x 100
Return on Equity Equity Shareholders Fund = {39,08,000-4,oo,ooo
= L2.6Vo
Profit Aftelr Tax T 4,62,00n
Returnon Shareholders'tund = T"t"iffiffix 100 =ffi =LL'82vo

pRoFltE oF PROFITABILITY OF A FIlt tl (DU PONT ANALYSIS)

The overall profrtabiliff of a firm is comprisring of two eleinents' Ttrese are :
(o)
' ' The profit margin on sales i.e- how much tLLe frrm is earning on every rupee of sale made.
Thi" profit mar-gin is also shown by the NP Ratio.
(b) The turnover of the firmi.e., the total a lviLties undertaken by the firm'
These two factors interaci and collectively determine the profitability of the firq- Jn
other words, these two factors when combined together determine the earning power of the
frrm. Moreover, the profrt margin is determrned Def,ween dhs
relationship between
determined by the relaf,ronsmp 5slling price,
f,rle seIrIrrB Prrstr,
cost structure and tire expensJs. pach of these elements has an effect on the pt€t margrn o{
the firm. On the other hand, the turnover of the firm (as measured in terms of turnover of
total assets) depends upon ih" of total issets and their relationship with the
sales of the firm. This can be "o-position
Profitability or Earnings Power = Profit margin x Assets Turnover
PAT Sales
x'Total
= S;; Assets
PAT
= Totrl Assets

This Ratio is also known as the Return on Investment. The profile of profitabihty i.e.,
the elements contributing to the return on insestment in respect of the Example 7.2 can be
analysed as follows :
 I NVESTN/IENT A,NALYSIS AN D PORTFOLIO MANAG EM ENT

Say, the Sales of the compzrny are (61,48,000. The Cost of Goods Sold (COGS) and
Operating Expenses are T 4I,76,000 and T11,36,000 respectively- The total Capital
Employed ({ 59,54,000) is represented as follows :
Fixed Assets {47,4g,000
Current Assets < 24,46,000
Less Current Liabilities 72,40,O00
Net working Capital 12,06,000
Total Assets 59,54,000
Ttre elements contributing to the profit of the firm have been shown in figure 7.2.

Return on Investment (ROl = 6-42%)

Profit After Tax

T 4,62,000

Sales - COGS - OP. Expenses - Interest - Tax Cunent Assets

(a 61 ,48,000 - 41 ,76,000 - 11 ,36,000 - 1 ,76,000 - 1 ,98,OOO t 24,46,000

Fig.7.7 : DU PONT Analysis-Return on Investment

The left hand side of the frgure deals with the profit margin. The cqst of goods sold,
erpenses and tax liabilities are deducted from the salles revenue to find out the profit after
tax. This profit after tax divided by the sales figure gives the NP Ratio. Ttre right hand side
of the frgure deals with the total assets/investments 'burnover. The sum of fixed assets and
current assets is equal to the total investments in the firm. The sales divided by.this total
investment gives the assets/investments turnover.
Wtren the investment turnover (on the right hand side of the Figure Z.Z) is multiplied by
the NP Ratio (as developed on the left hand side of thLe figure), the product is known as the
Return on Investment (ROI). The analysis of profitability on the above pattern is also known
as DU PONT ANALYSIS, as it was developed by the DU PONT Corporation of the US. This
analysis brings together the profit margin with the assets turnover and shows that the
profitability depends not only on the profrt margin but also on how efficiently the firm has
used its assets to generate sales.
The above anafysis can be further extended to identify the Return on Shareholders,
Funds. The Return on Shareholders' Funds depends upon the use of debt in the financing of
total assets or the leverage effect. In the Example 7.2, o:ut of total assets of T 71,g4,000, the
shareholders have financed {39,08,000 i.e.,54.3Vo. But the total ROI i.e.,6.42Vo (T 4,62,000
on T 71,94,000) will be available only to the shareholders (as the debt investors have alreadv
 FUNDAMENTAL ANALYSIS : E-I-C APPROACH

been paid interest of { 1,76,000), therefore, the return to shareholders will be more'than
6.42Vo. The exact rate of return to shareholders is :

Return on shareholders Funds = x 100

7o Assets lrnanced by Shareholcters-
-P
6.4i1
= S+.il x 100 = LI-82Vo

This is the same as calculated earlier in Example 7.2 as the rate of return on
shareholders funds. This has been presented in Iligure 7-8.

Return to Shareholderrs (11.82%)

7" of Assets Financed by

Shareholders (54.3"/"1

Figure 7.8 : DU PONT Analysis: Return to Shareholders

In the ratio analyqis, it has been discussed that the difference between ROA and ROE is
a reflection of the'use of debt financing. This can be further substantiated as follows :

Retirin on SH funds =
PAT PAT Total Assets
sH Frrrrds =SH Fuod" " Tot"r Assets
PAT Total Assets
= Totul A"."t=
" SH F -r:rd"
= ROA x Equity Multiplier
= ROA x (1+ Debt Equity Ratio)

In case of Example'i.2, ROA is 6-42Vo, Total Assets are{ 71,94,000 and SH Funds are
{ 39,08,000. The Equity multiplier is 1.841. Now,
Return on SH Funds = ROA x Equity Multiplier
=6.42Vo x 1.841
= II.82Vo
It is the same as obtained earlier.
ROE can also be explained as :

RoE=#"#**"ffi#
= Profrt Margin x Total Assets Turnover x Equity Multiplier
= 7.5L4 x .855 x 1.841
= LL.82Vo
Debt Financing and Growth of the Finn: The target growth rate and the debt financing
(external financing) are obviously related. Other things remaining same, the higher the
growth rate, the greater would be the need for external financing. The financial planning i.e.,
the Debt-Equif composition and its relationship with growth may be studied as follows :

" il '*
 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Internal Groutth Rate.' It is f,hs matirnum growth rate that can be achieved with no
external financing. Internal growth rate is the rate that the firm can maintain with internal
financing only. Ttris rate can be defined as :
ROAx b
Internal Growth Rate =1-RoAxb
where, ROA = Return on Assets
b = Retention rate i-e., L - DP Ratio
For example, Cifizen Ltd. has total assets of { 5,00,000 and Net Profit of ? 66,000. Ttre ROA
is 66,000/5,00,000 = I3.2Vo. Say, the company has a Payout Ratio of 33-33Vo. ft means that it
has retained T 44,000 i.e., 66.67Vo- The Intenaal Grov,rth Rate for Citizen Ltd. is :

Internal Growth Rate =

t'ffiffi = e.Gtvo
so, the company would expand at9.65vo p.a. wittLout external financing.
Sustainoble Growth Rote.' It is the growth rate that a firm can achieve with no extbrnal
equif financing while maintaining the debt equity ratio. Sustainable Growth Rate (SGR) is
the rate that a firm can maintain without increasingJits financial leverage. Suppose, Citizen
Ltd. has Equity of T 2,50,000 and Debt of {2,50,000 (i.e., the Debt Equity Ratio is 1 : 1). The
Net Profit is T 66,000, grving BOE (Return on Equity) as 2G.4Io. The retention ratio is the
same at 66.67Vo. The sustainable growth rate is :

sustainabre Growth Rate =

J$3#* = ##% = 2L.B6vo

The growth rate of 21-36Vo canbe verified as follows :

After l year
Net Income ({66,000 + 2L.36Vo) T 80,099
Retained Earnings (.6667)' T 53,400
Equrty 2,5O,000
Total Equity 3,03,400
Debt EquW Ratio 1:1
Total Debt - 3,03,400
New External Debt required (3,03,400 - 2,50,000)- 53,400
Total Assets at presbnt (Debt + Equity) {5,00,000
Growth Rate 27.36Vo
Total Assets after l year (Debt + Equiff) 6,06,900
The balance sheet after one year would appear as follows :

Liabilities Amount Assetts Amount

Capital 4 2,50,000 Assets T 6,06,900
Retained Earnings 53,400
Debt (2,50,000 + 53,400) 3,03,400
6,06,800 6,06,900
The DU PONT ANALYSIS shows that ROE can written as
bre

ROE = Profit Margin x Assets T\r.rnover;< Equity Multiplier

FUNDAMENTAL ANALYSIS : E-I-C APPROACH 2s7

Ir[ow, taking ROE and Sustainable Growth Rate together, it may be noticed that ROE
will increase the SGR by making numerator bigger or denominator smaller. Firms abilitv to
sustain growth depends on:
1. Profit Margin : It will generate the funds internally and thereby increase the SGR.
2. Dividend Policy : An increase in retention ratio will increase the internally generated
equity.
3. Financial Policy: Increase in debt frnancirig increases the equity multiplier
4. Total Assets Turnover : It increases the s:rles generated by assets. This decreases the
need for new assets as the sales grow.
The concept of SGR is based on the following assumptions:
(i) The firm's asgets vary at a constant orib of sales 1.e., the frxed assets expand and
contract with level of sales.
(ii) The frrms liabilities also vary directly with sales l.e. borrowings expand in direct
proportion to sales.
(iii) The frrm maintains a constant DP Ratio irrespective of sales.level.

Fast Growth Ltd. has a debt equity ratio of .5, a profrt margin of 3Vo, a DP tatio of 40Vo
and capital intensity ratio of 1. Find out its SGR,. In case, it wants to achieve a SGR of 70Vo
by improving profit margin (PM), how much profit margin should it attain ?
Solution.
In the gtven situation, the Capital Intensity Ratio is 1. It means that Assets T\rrnover
Ratio is 1. Debt-Equity Ratio of 0.5 means that debt is 50Vo of Equity or Equity Multiplier is
L.5 i.e., (1 + .5). Now,
ROExb
SGR =
1-ROExb
and, ROE = PM x Asset Turnover x Equity Multiplier
= .03 x 1x 1.5
= 4.5Vo
.045 x .6 .027
SGR
1- (0.045 x .06) .g7B= 2.77Vo
=
In order to have a SGR of LOVo, the PM requir,ed is.:
ROExb
SGR =
1-ROExb
n= (PM x 1 x 1.5) (.6) .9 PM
'ru
a
rLPMx 1 x 1 b) (^6)= 1- p4r^n
PM = I0.LVo
DU PONT Analysis yields same results as given by the ratio analysis. Yet, the former
has some advantages. It helps examining that Rreturn on Shareholders Funds or Return on
Equity is affected by 3 factors :
(i) Operating elfrciency (as measured by Profrt Margin).
(li) Assets use effrciency (as measured by Assets turnover).
(lil) Financial leverage (as measured by the Erluity multiplier).
258 INVESTMENT,ANALYSIS AND PORTFOLIO MANAGEMENT

ECONOMIC VATUE ADDED

EVA is based upon the concept of economic return lvhich refers EVA is defined in terms of
to excess of after tax return on capital employed over: the cost returns earned by the
capital employed- The concept of EVA, as developerd by Stern company in excess of the
Stewart & Co. of the U.S., compares the return on capital minimum expected return
employed with the cost of capital of the Srm. It takes into ofthe shareholdets-
account the minimumexpectations of the shareholders. EVA is
defined in terms of returns earned by the company in excess of the minimum expected return
of the investors. EVA is calculated as the net operal;ing profit (Earnings before Interest but
after Taxes) minus the capital charges (capital enrployed x cost of capital). This.can be
presented as follows : -
EVA = EBIT - Taxes - Cost of funds enrployed'
= Net Operating Profit after Taxes - Cost of Capital Employed.

where, Net Operating Profrt after Taxes represenLts the total pool of profrt available to
provide a return to the lenders and the sharehollers, and Cost of Capital Employed is
Weighted Average Cost of Capital x Average Capital employed.
So, EVA is the post-tax return on capital emplo.yed (adjusted for tax shield of debt) less
the cost of capital employed. It measures the profrtability of a company after having taken
into account the cost of all capital funds including equity. It may be noted that the arnount of
cost of debt (Interest) is deducted in the income statement. In the calculation of EVA, the cost
pf equity is also deducted. The resultant figure shows as to how much has been added in
valul of the frrm, after meriting all costs. It should be pointed out that there is more to
calculation of cost of equity than simple deduction o:[the dividends paid. So, EVA represents
the value added in excess of the cost of capital employed. EVA increases if :
(i) Operating profrts grow without employing additional capital, i.e-, through greater
effrciency.
(tt) Additional c'apital is invested in the projects ,bhat give higher returns than the cost of
procuring new capital, and
(lil) Unproductive capital is liquidat ed, i.e., curtailing the unproductive uses of capital-
EVA can be used as a tool in decision-rnaking within an enterprise.'It can help
integration of customer satisfaction, operating effrciencies, and management and financial
poliJies in a single measure. However, EVA is based on the performance of one year and does
not allow for increase in economic value that may:result from investing in new assets that
have not yet had time to show the results.
In India, EVA has emerged as a popular measure to In India, EVA has
understand and evaluate financial performance of a company- emerged as a popular
Several companies have started showing the EVA during a year as tLeasure to understand
a pait of the Annual Report. Hero Honda Lt;d., BPL Ltd., and eualuate financial
Hindustan Unilever Ltd-, Infosys Technologies Ltd- and Balrampur perforrnance of a
chini Mills Ltd. Rolta Ltd. are rr few of them. The Table 7.15 shows company.
the EVA information for Hindustan Unilever Ltd.
 I
FUNDAMENTAL ANALYSIS : E-I-C APPROACH 259

Tqble 7.15 z EVA of Hindrustcrn Unilever Ltd.

((in crores)
2000 2001 20f,2 2003 200,4 2005 2006 2007 2009,* 20lo
Cost of Capital Employed
(cocE)
1. Average Debt 93 50 45 881 1588 360 163 382 342 119
2- Average Equity 2296 2766 3351 2899 2Lr6 2200 25t5 2402 1928 2497
3. Average Capital
Employed: (1) + (2) 2389 2816 3396 3780 3704 2560 2677 2785 2270 2616
4. Coit of Debt, post-tax Vo 8.46 _ 7.72 6.45 4.88 5.19 3.38 5.90 6.24 3.91 3.95
5. Cost of Equity Vo 19.70 16.70 L4.40 12.95 L4.77 15.50 16.38 17.59 14.47 L2.5L
ge Cost of L9.27 t6.54 14.30 11.07 10.66' 13.80 15.74 16.03 L2.78 12.12

7. COCE: (3) x (6) 4rL8 395 353 42L 446 377

Economic Value added (EVA)
8. Profit after tax. before 1310 L547 r7t6 18Cr4 1199 1355 1540 1769 2501 2lO3
exceptional items
9. Add : Inberesf, dfter taxes 8564,3 82L2777175
10. Net Operating Profits After 1318 7546 t722 L84,7 L28L 1367 t547 1786 2518 2108
Taxes (NOPAT)
11. COCE, as per (7) above (460) (466) (.186) (418) (395) (353) (42r) (446) (365) (317)
12. EVA: (10) = (11) 858 1080 t236 L42:$ 887 1014 LL25 1340 2t54 1791
* Figures upto 200? are December ending and from 2009 are March ending.

Calculate Economic Value Added. (EVA) with the help of the following information of
Hlpothetical Limited :
Financial leverage 1.4 times
Capital structure Equrty Capital { 170lakhs
R,eserves and surplus t 130lakhs
10 7o Debentures T400 lakhs
Cost of Equity L7-iVo
. Income Tax Rate 30Vo

Solution:
EVA is defined as the excess of Net Operating Pr,ofrt After Tax (NOPAT) over the cost of
capital. Ttre NOPAT may be calculated as follows :
Interest = ?40 lakhs
Financial Leverage = 1.4
Now, 1.4 = EBIT / PBT
L.4 = EBIT / EBIT - 4t0
Therefore, EBIT = T 140laHN
NOPAT = EBIT (1- Tax rzrte)
= L4O (1- .30) = ( 98lakhs.
Cost of Equity, \ = L7.|Vo
Cost of Debt, kd = LO.OVo (L-.30) = 7Vo
WACC, ko = .L75 (300/700) + .07 (400 1700) = LL.\Vo
Now, EVA = NOPAT - (Cap. Employed x WACC)
= { 98 lakhs - t 700 lakhs x .115 = 7 L7 .S lakhs

': .! . - : "1.. ,1' ".; :; 3

260 INVESTMENT P.NALYSIS AND PORTFOLIO MANAGEMENT

The balance sheet and income statement of Better Performer are as follows :

Balance Sheet
Liabilities Amount
Share{apital { 25,00,00e Fixed Assets - 55,00,000
Reserves 15,00,000 Current Assets 15,00,000
t2voDebt r8,00,000
Current Liabilities 12,00,000
< 70,00,000 { 70.00.000
Income Staternent
Sales ,- 65,00,000

EBIT 14,oo,ooo
-Interest 2,16,000
Profit before Tax 11,84,000
-Tax @ 35Vo 4,14,400
Profit After Tax (PAT) 7,69,600

The WACC of the eompany is L1Vo. Find out the EVA of the company.
Solution,
Total Funds Employed (Cap. + Res. + Debt) < 58,00,000
WACC ISVo
Now, EVA = (EBIT - Tax - Cost of Funds)
= T 14,00,000 - 4,L4,O00 -- 8,70,000
= { 1,15,600
In the same case, if the cost of capital of the frrm is L87o,then the cost of funds would be
{ 10,44,00 O (i.e., LSVo of T 58,00,000). Now, the EVA of the firm would be - { 58,400.

Fundarnental Analysis : A few Pitfalls: Fundamerntal analysis can be valuable but there
is a word of caution for investors attempting a fundamental analysis. First, the fundamental
analysis is expegted to offer an insight into the profrtability and fair value of a share, but it is
time consuming. Second, these is no one valuation technique which can be applied to all
industry groups or companies. Technique required for a manufacturing company is different
from that applicable to a service provider company. 'fhird, as the valuation process is based
on assumptions, there is always a case for influence of subjectivity and biasness of the
analvst.
FUNDAMENTAL ANALYSIS : E.I-C APPROACH 261

CONCTUSION ON EIC APPROACH

The significance of the EIC approach as suggested by the above discussion is that in
order to arrive at valuation of shares, an investor should devote some time to investigate the
forces operating in the economy and that in the particular industry. The reason being that it
is important to predict the economic environment in the country which affects the industry
position as well as the corporate profit and in hrrn aLffects the security prices.
If the outl is bright and upbeat, this may The linkage insonomic
be considered growing profit of the frrm. The enuironrnent in the
general.optimissn is reflected in the security prices.. On the other econotly q,nd the security
hand, sagging economic environment lead to pelssimism and prices is obuious and
results in lower corporate profit and declining selcurity prices. critical.
The linkage in economic environment in the eccrnomy and the
security -prices is obvious and critical. EIC approach helps an investor to decide when to
invest and where to invest. A rational investor will like to decide if there is an appropriate
time to commit funds in the stock market.
One may contend that the industry selection is more important than the company
selection. When a particular industry is expanding or decaying , all the constituent firms are
affected. However, it may be noted that always some firms perform better than others. On
the other hand, another view could be that only the company selection is important and not
the industry. Nevertheless, the fact is that a lational investor should frrst identity a
promising industry and then pick up the undervalued shares in that industry.
-

a In the investment decision process, the sele,ction of specific securities is subject to hvo
steps, i.e., the securities arialysis and the veiluation.
Securities analysis aims at f;nding the trur: economic value and the future prospects
of specific secuiities while in the valuation process, an investor tries to f,r{il out the
true intrinsic value.
Approach to equity analysis may be active approach or passive approach. In Passive
approach, the investor in fact relies on the tmalysis mad.e by others.
In Active approach, the investor attempts to make an indepth analysis of different
facts and figures.
Security analysis is broadly classifred iniio Fundamental Analysis and Technical
Analysis. Though these two differ in therir approach and methodology, still both
have their relevance in the investment decision.
In fundamental analysis, the determinants of fair value of a security are
investigated. This analysis is also called E-I-C because the fundamental analysis is
consisting of the step-by-step analysis of ecgnomy, industry ald the company.
The earnings potential of a firm are related and depends on the prospects of the
industry to which the frrm belongs. In turn, the industry prospects are highly related
to the macroeconomic prospects
In economic analysis, various macroeconromic variables such as GDP, Inrlation,
Interest Rates, etc-, axe studied to forecast lbhe economic position in the country.
Analysis of industry is also required as it p.rovides the structure in which a particular
frrm operates.
 INVESTMENTANALYS|:ANDPoRTFoLIoMANAGEMENT
262

Inthecompanyanalysis,thefuturee,arningscapacityisinvestigatedthroughtheuse
of a""o,rrtting ratios and other related paramr:ters'
share, forecast of earnings is required'
To frnd out the intrinsic worth of an equity
eiqual to the required rate of return of
These earnings are then discounted'at " tate
equity investors-
prospects' important
To assess the valuation based on earnings and dividend -t
Earnings per share, Dividend Pay out
variabtes to be analysed are Retmn on Equiliy,
etc'
Ratio, Book Value per Share, Price Earnings Rat'io'
o Earningscapacityofu"o.p.,.ycanbeanaly,sedintheDUPoNTr}amework.
of funds employed by the frrm' It
a EVA refers to the excess of earnings over the cost
can be used to estimate the value of the frrm'

OSJECT|VE TYPE QIUESTIONS

of the following statements is Tbue
(T) or False (F) :
State whether each
regulations'
(t) Securities Analysis deals with analysis of'stock market exchange to deal with the
(iD .i\n Index Fundis a fund maintained by the stock
grievances of the investors'
of the company'
Gii) Fundamental analysis deals with the capital structure
out the intrinsic value of a security'
(iu) The purpose of fundamental analysis is i,r frnd
to fundamental analysis'
(u) Bottom-up and Top-down are two approaches
(ui) In'EIC'approach, E stands for earnings of the company'
future earnings capacity of the
(iirt) In the fundamental analysis, the focalp,rint is the
firm. is the stock market
(viii) For fundamental analysis, the basic source of information
quotations
';';dis o-
(ix) n"tio analysis important tool of fun'damenta I analysis'
an imnnrtqnt
(r)GDPisanimportantmacroeconomicvariabletoassessthehealthoftheeconomy.
(ri)Changeinpercapitaincomeinacountryaffectstheleveilofstockmarket
activities.
(xii)Growthsharewillhelpaninvestortoincreasetherateofreturn. price of a
(xiii) price Earmngs Ratio ieflects the ratio oI'retained earnings to the market
share-
analysis concentrated only on the
-(xid The ,bottom up' approach to the fundamental
analysisrcf earnings of the company'
(xu) GDP helps in estimation of earnings of ei
company
of the same coin'
(xui) Business cycle and industry life cycle are twobides
the earnings of a
(xuii) Analysis of leading and lagging fa"tort helps in estimating
charge of the
(xuiii) 8ilTlil- leverage depends on the amount of frxed financial
company-
to each other'
(xix) operating leverage and frnancial leverage are complementary existing firm in that
(xx) Open entry to an ind,ustry leads to iribrirase in earnings of the
industry.
of a firm'
(xxil Balance sheet helPs in analysis of earnings