UNIT III: FUNDAMENTAL ANALYSIS

• EIC framework, Forecasting techniques,

Valuation of Equity Stocks: Approaches of
Equity Stock Valuation, Index features,
concept, applications and valuation
 Unit-III
• EIC framework
• Forecasting techniques
• Valuation of Equity Stocks: Approaches of
Equity Stock Valuation
• Index features, concept, applications and
valuation
 FUNDAMENTAL ANALYSIS
• TOP-DOWN V. BOTTOM UP
– TOP-DOWN APPROACH
• attempts to forecast in the following order
1. economic activity
2. industry performance
3. firm’s performance

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 FUNDAMENTAL ANALYSIS
• TOP-DOWN V. BOTTOM UP
– BOTTOM-UP APPROACH:
• attempts to estimate prospects in the following order:

1. The firm
2. The Industry
3. The economy

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 EIC Framework / Fundamental Analysis
Economic Analysis Industry Analysis Company Analysis
GDP Growth rate of Industry Competitive advantage
Savings and Investments Type of Industry Financial Stability and
Inflation Rate Nature of Competition performance
Interest Rate Nature of Product Growth rate sales and
Growth in Primary, Subsidies, incentive, market share
Secondary and Territory concessions Financial leverage
sectors Tax framework Borrowing Capacity
Tax Structure Export/import policies Previous track record
Economic Forecasts Financing norms Profit of the company
Infrastructure Development State of Technology Corporate image
Demographic factors Industrial Policies SWOT analysis profits
Climatic conditions Socio-demographic trends Management
State of Economy Govt. programs and projects Operating efficiency
Balance of Payments Industry life cycle Future projections
conditions SWOT analysis Financial Statement Analysis
Govt. Budget linkage to    
world economy

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India - GDP Growth Rate

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 Financial Summary Components
• Annual Budget
• Annual Cost Reports
• Annual Tax Returns (Income Tax, Companies Act)
• Annual Financial Statements and Audit
• Statutory Requirements - Ind.AS, Intl. AS, Companies Act, SEBI, RBI, MCA
• Reporting Standards
- Generally Accepted Accounting Standards (GAAP)
- Financial Accounting Standards Board (FASB)
- Securities Exchange Commission (SEC)
- Internal Revenue System (IRS)
- Labor laws and Code of Conduct
 COMPANY ANALYSIS
– Review of Accounting Statements
– Ratio Analysis
– Comparative Financial Statements
– Common size Financial Statements
– Trend Analysis
– Company Track Record Analysis
– Financial Leverage
– Analysis of Audit observations and report
– Image Building and so on…
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Forecasting techniques
 Market Experiment Method
• Another one of the methods of demand forecasting
is the market experiment method. Under this
method, the demand is forecasted by conducting
market studies and experiments on consumer
behavior under actual but controlled, market
conditions.
• Certain determinants of demand that can be varied
are changed and the experiments are done keeping
other factors constant. However, this method is very
expensive and time-consuming.
 Collective Opinion Method
• Under this method, the salesperson of a firm predicts the estimated future
sales in their region. The individual estimates are aggregated to calculate
the total estimated future sales. These estimates are reviewed in the light
of factors like future changes in the selling price, product designs, changes
in competition, advertisement campaigns, the purchasing power of the
consumers, employment opportunities, population, etc.
• The principle underlying this method is that as the salesmen are closest to
the consumers they are more likely to understand the changes in their
needs and demands. They can also easily find out the reasons behind the
change in their tastes.
• Therefore, a firm having good sales personnel can utilize their experience
to predict the demands. Hence, this method is also known as Sales force
opinion or Grassroots approach method. However, this method depends
on the personal opinions of the sales personnel and is not purely scientific.
Time series Models
 Valuation of Equity Stocks: Approaches of
Equity Stock Valuation
• Valuation of Equity:
The main purpose of equity valuation is to
estimate a value for a firm or its security. A key
assumption of any fundamental value technique
is that the value of the security (in this case an
equity or a stock) is driven by the fundamentals
of the firm's underlying business at the end of
the day.
 Equity Valuation
Definition
• In finance, valuation is a process of determining the fair market value of an asset. Equity valuation
therefore refers to the process of determining the fair market value of equity securities.
Importance of Equity Valuation: Systemic
• The whole system of stock markets is based upon the idea of equity valuation. The stock markets
have a wide variety of stocks on offer, whose perceived market value changed every minute
because of the change in information that the market receives on a real time basis.
• Equity valuation therefore is the backbone of the modern financial system. It enables companies
with sound business models to command a premium in the market. On the other hand, it ensures
that companies whose fundamentals are weak witness a drop in their valuation. The art and
science of equity valuation therefore enables the modern economic system to efficiently allocate
scare capital resources amongst various market participants.
Importance of Equity Valuation: Individual
• As discussed, on a micro level, equity valuation is beneficial for the entire stock market ecosystem.
However, how does it benefit an individual to study and apply the principles of equity valuation?
• Well, markets receive information every moment and make an attempt to factor the financial effect
of this information in the stock price. Individual estimates of the effect vary and as such different
people may come up with different stock prices. Therefore, there can be a difference between the
market value of a company and what investors call its true or “intrinsic value”
• Investors, stand to gain a lot of money if they are able to correctly identify this difference. The
second richest person in the world, Warren Buffett has made his fortune correcting and applying
the art of equity valuation. In fact, the theory of equity valuation has been heavily influenced by
the work of Warren Buffett and his mentor.
 Process of Conducting Equity Valuation
• Equity valuation is followed differently by different individuals. As such, there is no set pre-defined standard
process. Instead, equity valuation consists of 4 or 5 broad categories of steps that need to be followed. The
procedures maybe different but the objectives are always the same. Every person conducting equity valuation,
must in one way or another account for these parameters:
• Understand the macroeconomic factors and the industry: No company operates in vacuum. As such, the
performance of every business is influenced by the performance of the economy in general as well as the industry
in which it operates. As such, before making an attempt to value a business, the macro-economic factors must be
accounted for. A reasonably accurate prediction regarding these parameters creates the base for an accurate
valuation.
• Make a reasonable forecast of the company’s performance: Mere extrapolation of the company’s current
financial statements does not constitute a good forecast. A good forecast takes into account how the company
may change its scale of production of the forthcoming future. Then, it also takes into account how changes in this
scale will affect the costs. Costs and sales do not move in linear fashion. To come up with an accurate forecast, an
analyst would require intricate knowledge of the company’s business.
• Select the appropriate valuation model: Valuation is less of a science and more of an art. There are multiple
valuation models available. Also, all these valuation models do not necessarily lead to the same conclusion.
Hence, it is the job of the analyst to understand which model would be most appropriate given the type and
quality of data available.
• Arrive at a valuation figure based on the forecast: The next step is to apply the valuation model and come up
with an exact numerical value which according to the analyst defines the worth of the business. It may be a single
estimated amount or it could be a range. Investors prefer a range so that they clearly know what their lower and
upper bounds for bidding should be.
• Take action based on the arrived valuation: Finally, the analyst has to give a buy, sell or hold recommendation
based on the current market price and what analysis shows is the intrinsic worth of the company.
 Market Value, Intrinsic Value and Investment Value
Market Value: Market value is the easiest valuation concept to understand. It simply means the value of the company or an
asset as denoted by its ongoing market price. As market prices vary wildly, so does the market value of any company or any asset
which is listed on it. Students tend to get confused trying to find out the difference between market valuation and market price.
The truth is that there is no difference at all! The fundamental idea is that markets are efficient and at any point of time the prices
reflected by the markets are an informed decision made by the market. The market price therefore is the same thing as market
valuation and is based on the idea of efficient market hypothesis.
Intrinsic Value: The concept of intrinsic value has been made famous by famous investors from value investing school like Warren
Buffet, Benjamin Graham etc. In simple words, intrinsic value is that value which is imbibed in the asset. For instance, a machine
may provide certain incremental benefits to its user over and above what manual labor could have. As such the machine provides
incremental cash flows to the firm and has some amount of intrinsic value.
• The value of a firm is nothing but the sum total of the value that will be provided by its assets over some selected time
horizon. As such, just like the intrinsic value of an asset can be estimated, similarly the intrinsic value of an entire firm can
also be estimated.
• It is important to understand that the intrinsic value can only be accurately understood and calculated by someone who has
an in-depth knowledge of the nature of the firm and the industry. Intrinsic value, calculated by analysts who are armchair
experts is often way off the mark and grossly miscalculates what the correct value of the firm should be. Hence, while
considering intrinsic value, one must compare and contrast the opinions of multiple analysts.
Investment Value: Intrinsic value looks at the value of a firm in isolation. It only considers that value which can be derived from
incremental cash flows that will be produced by a firm. However, consider the case of an oligarch who faces only one competitor.
This competitor is driving down the prices that the oligarch could otherwise charge from the customers. Hence, in such a case, if
the oligarch can buy out the competitor, he will be able to eliminate the competition and become a monopolist. The benefits that
will arise obviously cannot be computed using a simple discounted cash flow application. This may not be an ethical scenario.
However, business has in the past witnessed these situations and in all likelihood will witness them in the future as well.
• The point being made here is that sometimes corporations experience synergy when they combine their business. Hence,
some competitors may be able and willing to pay more for an asset or a company if its fits well with their existing business.
This valuation is called investment value. The recent acquisition of Whatsapp by Facebook is one such example of the use of
investment value in real life scenarios.
 When valuation is required ?
Equity Valuation becomes easy when the script is listed, Company is active in
business & shares are regularly trading. Since market price is ready available in stock
exchange website. Further we can average out the daily closing market price of last
one year to make it full proof, however it becomes challenge to value unlisted
companies equity shares or Companies whose shares are not regularly trade.
1. Compliance under section 56 (2) (viib) read with rule 11UA allotment of Shares at
premium.
2. Transfer of shares at fair market value under section 52(2) (viia) read with rule
11UA (Note- Rule 11UA prescribed two method of valuation – NAV & DCF)
3. Allotment of shares to Non Resident & Filing form FC GPR.
4. When Two or More Company Merge or Amalgamate in one & share exchange
ratio to find based on fair value
5. Share pledge as security for raising loan & security value to determine.
6. Purchase & Sales of Business.
7. Transfer Pricing – Share transfer between Associates.
8. Determining Business Value at the time of Family Separation.
9. Other statutory compliances including FEMA Rules.
 Valuation Methods
1. Net Asset Value (NAV) Method
2. Discounted Cash Flow Method
3. Profit or Dividend Yield Method
4. PE Ratio Method
 1. NAV
• Net Asset Value (NAV) Method Net Asset represent Net worth of the Company. After reduction of
preference share Capital value from net worth of the Company we get value of company to the Equity
share holders. Figures of net assets from last audited balance sheet can be taken.
Calculation under NAV Method
a. Total Asset excluding Misc Expenditure & P&L Dr Balance Say 5,00,00,000
b. Less- Total Liability excluding contingent liability Say 3,00,00,000
c. Net Assets Value (a-b) 2,00,00,000
d. Less- Preference shares value –
e. Value of net assets attributable to Equity Share Holders (c-d) 2,00,00,000
f. Number of Equity Shares Say 5,00,000
g. Value of Share (e/f) 40.00

Important Notes
1. Value of Assets can be modify from audited figures by taking market value of Properties, Listed
Investments etc.
2. Rules 11UA of Income tax Rules allows only audited balance sheet figures for valuation of equity
shares by net assets value method, however value of Liability will not include provisions made for
meeting liabilities, other than ascertained liabilities like provision for gratuity & others and net provision
for taxation.
3. Partly paid up shares should be made equivalent to fully paid up shares by reducing in numbers in
proportion to their lesser paid up amount.
 2. Discounted Cash Flow Method (DCF)

• Discounted Cash Flow Method (DCF) is a complex calculation however it

considers not just Companies present situation but also take in to figure,
future of the Company.
• DCF also works for start-up Companies Valuations which do not have track
records but has valuation based on business idea & current resources. Value
of firm derived by discounting future cash flows to the company by expected
rate of return of Equity & Debt holders.
• Valuation through DCF imbibe expectation of owners & lenders by
considering expected rate of return of both Equity & Debt holders.
• DCF becomes more relevant since any decision related to investment is
taken considering future return on it & DCF figures out valuation based on
future cash flows of the Company.
 Process of valuation - DCF
Step 1: Arrive at Projected Profit after Tax
Step 2: Add back non-cash costs i.e. depreciation etc
Step 3: Subtract capital expenditures.
Step 4: Subtract Increases in working capital.
Step 5: Take into account the effect of changes in Debts.
Step 6: Discount the FCFF (free cash flow to the firm) for each
year at the cost of capital.
Step 7: Add the terminal value accruing in the final year.
Step 8: Arrive value of Equity by subtracting debt value.
Step 9: Arrive Value of Equity Share by dividing number of
shares to value of Equity
 Cost of Capital can be derived as under
- Equity Share Holders expected rate of return vary from
industry to industry which can be calculated by adding
extra return for taking industry specific risk to market
expected rate of return.
- Technically its equals to Beta*(Expected Return- Risk free
return) + Risk free Return
- Debt Holder expected rate of return would be after tax
interest rate on debt.
- and cost of capital is derived by weighted averaging the
above rates of return as per total value of Capital & Debt.
 3. Profit OR Divided Yield Method
• Profit after tax or dividend is divided by Normal rate of
return to derive Capitalized Value & the same is
divided by number of shares to get value per share.
• Capitalize Value = ( Profit / Dividend ) / Normal Rate of
Return
• Value per Share = Capitalize Value / Number of shares
• Generally We take Average profit of 5 years to rule out
higher or lower side valuation.
• Preference Share Dividend to be subtracted from
profit to find profit attributable to equity share
holders.
 Div. Yield Menthod
The yield is calculated as: ​
Dividend Yield=Price per Share /
Annual Dividends per Share​​
 4. Price-Earnings Ratio Method

• This method is generally used to calculate listed Company

Share Value. It uses Earning Per Share (EPS) & Market Price
of Share (MPS) to calculate value of share.
• PE Ratio is determined as follow- MPS/ EPS
• Investor can average out PE Ratio Companies in same sector
to rule out higher or lower side valuation based on one
company data.
• Value per share – EPS x P/E Ratio
• Whenever Company declare its Qrtly results & EPS, Investor
by using particular sector PE Ratio can find Value of Share to
take investment decision.
 Selection of Method Decision

• Discounted Cash Flow Method & Net Assets Value

Method are the most used methods to value Shares
since both method uses wide range of data & capture lot
of figures to derive Value of Share.
• It is always advisable to Value Share by Earning OR
Market Based Method i.e. Discounted Cash Flow Method
for Companies in to Manufacturing & Service. Net Asset
Value Method is used by Investment Companies.
• Valuation by Earning & Market based method can be
cross check by other method.