You are on page 1of 45

Fundamental Analysis




Learning Objectives

Elements of Top-Down Fundamental Analysis Macroeconomic Factors Classification of Industries Techniques for industry analysis Techniques for company analysis

Three Steps of Top-Down Fundamental Analysis

Macroeconomic analysis: evaluates current economic environment and its effect on industry and company fundamentals Industry analysis: evaluates outlook for particular industries Company analysis: evaluates companys strengths and weaknesses within industry

Micro Eco Analysis

The performance of a company depends much on the performance of the economy if the economy is BOOM, the industries and companies in general said to be prosperous. On the other hand, if the economy is in RECESSION, the performance of companies will be generally poor. Investors are interested in studying those economic varieties, which affect the performance of the company in which they proposed to invest. An analyzed of those economic variable would give an idea about future corporate earnings and the payment of dividends and interest to investors.

Classes of Macro economic policies

Fiscal policy Government spending , stimulates the demand for goods. Monetary policy Manipulation of money supply in an economy.

Indian Approach
Lagging Indicators
Duration of unemployment. Ratio of mfg. Commercial loans.

Leading Indicators Money supply. Consumer expectations. Orders for plant & machinery

GNP/ Geometric Model

GNP represents the aggregate value of goods and services produced in the economy. It reflects the over all performance of the economy. The growth rate of GNP indicates the growth rate of the economy the higher the rate of growth of GNP, the more favorable is it for the stock market and vice versa

Saving & investment

Savings and investment denote that position of GNP, which is saved and invested savings increases in India since eighties now the rate of savings is 25% from 21% in 80s, which indicates the growth of capital market. The higher the level of savings interest, the more favorable is it for the stock marketed vice versa

Inflation has considerate impact on the performance of companies. Higher rates of inflation upset business plans and erode purchasing power in the hands of consumers. This will result in lower demand for products. Thus high rates of inflation in an economy are likely to affect the performance of companies adversely. However industries and companies prosper during periods of low inflation. Hence an investor has to evaluate the inflation rates prevailing in the economy currently as well as the trend of inflation likely to prevail in the future.


Agriculture forms a major part of the Indian economy. Some companies are using agricultural raw material as inputs and some others are supplying inputs to agriculture. Such companies are directly affected by changes in agricultural production. Hence, the increase/decrease in agricultural production has a significant bearing on the industrial production and corporate performance

Rate of interest
The cost and availability of credit for companies are determined by the rates of interest prevalent in an economy. A low interest rate stimulates investment by making credit available easily and cheaply. As a result cost of finance for companies decreases which assures higher profitability. On the other hand, higher interest rates result in higher cost of production, which may lead to lower profitability and lower demand. Hence an investor has to consider the interest rates prevailing in the economy and evaluate their impact on the performance and profitability of the companies.


Government is the largest investor and spender of money. So the trends in government revenue expenditure deficits have a significant impact on the performance of industries and companies. So the investor has to evaluate these carefully to assess their impact on his investments.


The development of an economy very much on the availability of infrastructure. It includes electricity, roads and railways, communication channels etc. The availability of infrastructural facilities affects the performance of companies. Bas infrastructure leads to inefficiencies, lower productivity, wastage and delays and vice versa. Thus an investor should assess the status of infrastructural facilities available in the economy before finalizing his investment avenues.


The Indian economy is essentially an agrarian economy and agriculture forms a very important sector of the Indian economy. But the performance of agriculture to a very great extent depends upon the monsoon. The adequacy of the monsoon ensures the success of the agricultural activities in India and vice versa. Hence the progress and adequacy of the monsoon becomes a matter of great concern for an investor in India.

Political Stability

A stable political environment is necessary for steady and balanced growth. No industry or company can grow and prosper in the midst of political turmoil. Such long term economic policies are needed for industrial growth. Such stable policies can be framed only by stable political systems.

Industry Analysis
Industry analysis indicates to an investor whether the industry is a growth industry or not. It gives an investor a choice of the industry in which the investments should be made. Industry analysis refers to an evaluation of the relative strength and weakness of particular industries which can be divided in to three parts, viz., 1. Life cycle of an industry 2. Characteristics of an industry 3. Profit potential of an industry

Life Cycle
(a) Pioneering Stage: Technology and product are newly introduced. (b) Expansion stage: Those companies which reached first stage grow further and becomes stronger. (c) Stagnation Stage: In this stage the growth of the industries Stabilizes. Sales increases at slower rate.

(d) Decay stage: gradually ceases to exist.






Characterstics of an industry
Relationship between Demand & supply: Excess supply reduces the profitability of the industry and insufficient supply tends to improve the profitability. Thus an investor should estimate the demand and supply gap in an industry. (b) Period of life: Life of the industry depends on the products and the technology used by the industry. Technological changes leads to product obsolete. No investment should be made in such industries.

(c) State of labour: When there is labour revolution, industries cannot become bright.
(d) Governments attitude: The Government may encourage the growth and development of certain industries by giving much assistance to such industries. (e) Availability of Raw Material: An industry may depend on internal / external country for raw material. Sometimes they depend on import of raw material. (f) Cost structure: It refers to the proportion of fixed costs to variable costs. (Discuss about Marginal Cost)

Profit potential of industry

(i) Threat new entrants: New entrants inflate cost, push down the prices and reduce profitability. An industry which is well protected from the entry of new firms would be ideal for investment. (ii) Competitions among existing firms: The firm competes with each other on the basis of price, quality, promotion, service, warranties and so on. If the rivalry between the firms in an industry is strong average profitability of the industry may be discouraged. The rivalry in an industry is high when the following conditions prevail in the market: (a) There is a sustained competitive battle (b) The industry growth is dull (c) The level of fixed cost is high (d) There is over capacity in the industry continuing for a long time. (e) The industry product is considered as a commodity, which stimulates strong competition. (f) The industry struggles much to withstand.

Macroeconomic Analysis

Business Cycles

Expansion, Peak, Contraction, Trough Impact of Inventory and Final Sales

Leading (10): new orders, building permits, first time unemployment claims, stock prices, rate spreads Coincident (4): Non-ag payroll, industrial production Lagging (7): Inventory-to-sales, labor cost

Economic Indicators (see Table 7-2 on page 7.7)

Fiscal & Monetary Policy

Fiscal Policy (Keynesians)

Government expenditures (demand) Tax & Debt policies

Interest rates (discount, fed funds) Money supply (Open market ops): M1, M2 Reserve requirements (commercial banks) Margin requirements (brokerage accounts)

Monetary Policy (Monetarists M. Friedman)

Goals of Policy

Full Employment

Interest Rates Money Supply

Interest Rates Money Supply Interest Rates Money Supply

Price Stability (control inflation)

Economic Growth

Impediments to Effective Policy

Time lags between [stimulus] and [desired effect] Unintended consequences

irrational expectations on part of policy makers Adverse influence of speculators Adverse global responses

Consumer behavior (rational expectations) Incorrect analysis, actions, or timing by policy makers

Industry Analysis

Classifying industries

Cyclical industry - performance is positively related to economic activity Defensive industry - performance is insensitive to economic activity Growth industry - characterized by rapid growth in sales, independent of the business cycle

Industry Analysis

Industry Life Cycle Theory:

Birth (heavy R&D, large losses - low revenues) Growth (building market share and economies of scale) Mature growth (maximum profitability) Stabilization (increase in unit sales may be achieved by decreasing prices) Decline (demand shifts lead to declining sales and profitability - losses)

Industry Analysis

Life Cycle of an Industry (Marketing view)

Start-up stage: many new firms; grows rapidly (example: genetic engineering) Consolidation stage: shakeout period; growth slows (example: video games) Maturity stage: grows with economy (example: automobile industry) Decline stage: grows slower than economy (example: railroads)

Industry Analysis

Qualitative Issues

Competitive Structure Permanence (probability of product obsolescence) Vulnerability to external shocks (foreign competition) Regulatory and tax conditions (adverse changes) Labor conditions (unionization)

Industry Analysis

End use analysis

identify demand for industrys products estimates of future demand identification of substitutes
examining data over time identifying favorable/unfavorable trends determining the relationship between variables

Ratio analysis

Regression analysis

Company Analysis: Qualitative Issues

Sales Revenue (growth) Profitability (trend) Product line (turnover, age)

Output rate of new products Product innovation strategies R&D budgets

Pricing Strategy Patents and technology

Company Analysis: Qualitative Issues

Organizational performance

Effective application of company resources Efficient accomplishment of company goals

Planning - setting goals/resources Organizing - assigning tasks/resources Leading - motivating achievement Controlling - monitoring performance

Management functions

Company Analysis: Qualitative Issues

Evaluating Management Quality

Age and experience of management Strategic planning

Understanding of the global environment Adaptability to external changes Track record of the competitive position Sustainable growth Public image

Marketing strategy

Finance Strategy - adequate and appropriate Employee/union relations Effectiveness of board of directors

Company Analysis: Quantitative Issues

Operating efficiency

Productivity Production function

Understanding a companys risks

Importance of Q.A.

Financial, operating, and business risks

Financial Ratio Analysis

Past financial ratios With industry, competitors, and Forecast Revenues, Expenses, Net Income Forecast Assets, Liabilities, External Capital Requirements

Regression analysis

An Adage
Financial statements are like fine perfume;

To be sniffed but not swallowed.

Dr. Abraham J Briloff, Ph.D. CPA
Emmanuel Saxe Distinguished Professor of Accountancy Emeritus, Baruch College, CCNY

Company Analysis: Quantitative Issues

Balance Sheet

Snapshot of companys Assets, Liabilities and Equity.

Sales, expenses, and taxes incurred to operate Earnings per share Sources and Uses of funds G.A.A.P. vs Cleverly Rigged Accounting Ploys

Income statement

Cash flow statement

Are financial statements reliable?

Company Analysis: Quantitative Issues

Financial Ratio Analysis

Liquidity (ability to pay bills) Debt (financial leverage) Profitability (cost controls) Efficiency (asset management)
Top-down analysis of company operations Objective: increase ROE

DuPont Analysis

Liquidity Ratios

Measure ability to pay maturing obligations Current ratio

Current assets / current liabilities (Current assets less inventories) / current liabilities

Quick ratio

Debt Ratios

Measure extent to which firm uses debt to finance asset investment (risk attribute) Debt-equity ratio

Total long-term debt / total equity (Current liabilities + long-term debt) / total assets EBIT / interest charges (EBIT + Lease Exp.) / (Int. Exp. + Lease Exp.)

Total debt - total assets ratio

Times interest earned

Fixed charge coverage ratio

Profitability Ratios

Measure profits relative to sales Gross profit margin ( % ) = Gross profit / sales Operating Profit Margin = Operating profits / sales Net profit margin = Net profit after taxes / sales ROA = Net Profit / Total Assets ROE = Net Profit / Stockholder Equity*
* Excludes preferred stock balances

Efficiency Ratios

Measure effectiveness of asset management Average collection period (in days)

Average receivables / Sales per day

Inventory turnover (times per year)

Cost of Goods Sold / average inventory

Sales / average total assets Sales / average net fixed assets

Total asset turnover

Fixed asset turnover

Other Ratios

Earnings per share (EPS): (Net income after taxes preferred dividends)/ number of shares Price-earnings (P/E): Price per share/expected EPS Dividend yield: Indicated annual dividend/price per share Dividend payout: Dividends per share/EPS Cash flow per share: (After-tax profits + depreciation and other noncash expenses)/number of shares Book value per share: Net worth attributable to common shareholders/number of shares

DuPont Analysis of ROE

Net profits after taxe s Net profits ROE Common stockholders' equity Common equity
Net Profits Net Profits Sales Total Assets ROE Equity Sales Total Assets Equity Ratio 1
Ratio 1 = NPM

Ratio 2

Ratio 3
Ratio 3 = Equity Kicker

Ratio 2 = TATO

The DuPont System suggests that ROE (which drives stock price) is a function of cost control, asset management, and debt management.

Estimating Earnings and Fair Market Value for Equity

Five Steps
1. 2. 3. 4. Estimate next years sales revenues Estimate next years expenses Earnings = Revenue - Expenses Estimate next years dividend per share

= Earnings Per Share * dividend payout ratio

5. Estimate the fair market value of stock given next years earnings, dividend, ROE, and growth rate for dividends.

Using Gordon Growth model or P/E Model

Woerheides Conclusions

Fundamental Analysis vs. Market Efficiency

Fundamental analysis critical when dealing with private companies Necessary condition for market efficiency of publicly traded companies (although worthless at the margin) Earnings surprises major component of performance

How much is real? How much is C. R. A. P.?