Fundamental Analysis

Fundamental analysis is really a logical and systematic approach to estimating the future dividends and share price.

It is based on the basic premise that share price is determined by a number of fundamental factors relating to the economy, industry and company.

It is a detailed analysis of the fundamental factors affecting the performance of companies.

Each share is assumed to have an economic worth based on its present and future earning capacity. This is called its intrinsic value or fundamental value.

Fundamental Analysis

The purpose of fundamental analysis is to evaluate the present and future earning capacity of a share based on the economy, industry and company fundamentals.

The investor can compare the intrinsic value of the share with the prevailing market price to arrive at an investment decision.

If the market price of the share is lower than the its intrinsic value, the investor would decide to buy the share as it is underpriced.

The price of such a share is expected to move up in future to match with its intrinsic value.

Fundamental Analysis

When the market price of a share is

higher than its intrinsic value, it is

perceived to be overpriced.

The market price of such share is

expected to comedown in future.

The investor would decide to sell such a

share.

Economy-Industry-Company

Analysis Framework The analysis of economy, industry and

company fundamentals constitute the main activity in the fundamental approach to security analysis.

The logic of this three tier analysis is that the company performance depends not only on its own efforts, but also on the general industry and economy factors.

The multitude of factors affecting the performance of a company can be classified as

Economy-Industry-Company

Analysis Framework Economy-wide factors such as growth rate

of the economy, inflation rate, foreign exchange rates, etc. which affect all companies.

Industry-wide factors such as demand-supply gap in the industry, the emergence of substitute products, changes in government policy relating to the industry.

Company-specific factors such as the age of its plant, the quality of management, brand image of its products, its labour-management relations, etc.

Steps in Fundamental Analysis

Economic Analysis

Industry Analysis

Company Analysis

Economic Analysis

The performance of a company depends on the performance of the economy.

If the economy grows rapidly, the industry can also be expected to show rapid growth and vice versa.

When the level of economic activity is low, stock prices are low, and when the level of economic activity is high, stock prices are high reflecting the prosperous outlook for sales and profits of the firms.

Economic variables

A study of these economic variables would give an idea about future corporate earnings and the payment of dividends and interest to investors.

The following are the some of the key economic variables that an investor must monitor as part of his fundamental analysis.

1. Growth Rates of National Income

2. Inflation

3. Interest Rates

4. Budget

5. The balance of payment

6. Infrastructure

7. Monsoon

8. Economic and Political Stability

Growth Rates of National

Income GNP (Gross national product), NNP (Net

national product) and GDP (Gross domestic product) are the different measures of the total income or total economic output of the country as a whole.

The growth rates of these measures indicate the growth rate of the economy.

The estimate of GNP, NNP and GDP and their growth rates are made available by the government from time to time.

An economy typically passes through different phases of prosperity known as the different stages of the economic or business cycle.

Growth Rates of National

Income

The stage of the economic cycle through which a country passes has a direct impact on the performance of industries and companies.

While analysing the growth rate of the economy, an investor would do well to determine the stage of the economic cycle through which the economy is passing and evaluate its impact on his investment decision.

Inflation

Inflation prevailing in the economy has considerable impact on the performance of companies.

High rates of inflation in an economy are likely to affect the performance of companies adversely.

Industries and companies prosper during times of low inflation.

Inflation is measured both in terms of wholesale prices through the wholesale price index (WPI) and in terms of retail prices through the consumer price index (CPI).

Interest Rates

Interest rates determine the cost and availability of credit for companies operating in an economy.

A low interest rate stimulates investment by making credit available easily and cheaply.

It implies lower cost of finance for companies and thereby assures higher profitability.

Higher interest rates result in higher cost of production which may lead to lower profitability and lower demand.

Interest Rates

The interest rate in the organised sector

of the economy are determined by the

monetary policy of the government and

the trends in the money supply.

An investor has to consider the interest

rates prevailing in the different segments

of the economy and evaluate their

impact on the and profitability of

companies.

Budget

The budget draft provides an elaborate

account of the government revenues

and expenditures.

A deficit budget may lead to high rate of

inflation and adversely affect the cost of

production.

Surplus budget may result in deflation.

Hence, balanced budget is highly

favorable to the stock market.

The balance of payment

The balance of payment is the record of a country’s money receipt from and payments abroad.

The difference between receipts and payments may be surplus or deficit.

Balance of payment is a measure of the strength of rupee on external account.

If the deficit increases, the rupee may depreciate against other currencies, thereby, affecting the cost of imports.

The balance of payment

The industries involved in the export

and import are considerably affected by

the changes in foreign exchange rate.

The volatility of the foreign exchange

rate affects the investment of the FII in

the Indian stock market.

Infrastructure

The development of an economy depends very much on the infrastructure available.

The availability of infrastructural facilities such as power, transportation and communication systems affects the performance of companies.

An investor should assess the status of the infrastructural facilities available in the economy before finalising his investment plans.

Monsoon

The performance of agriculture to a very great extent depends on the monsoon.

The adequacy of the monsoon determines the success or failure of the agricultural activities in India.

The progress and adequacy of the monsoon becomes a matter of a great concern for an investor in the Indian context.

Economic and political stability

A stable political environment is

necessary for steady and balanced

growth.

Stable long-term economic policies are

needed for industrial growth.

A stable government with clear cut long-

term economic policies will be conducive

to good performance of the economy.

Economic Forecasting

Economy analysis is the first stage of fundamental analysis and starts with an analysis of historical performance of the economy.

Investment is a future-oriented activity, the investor is more interested in the expected future performance of the overall economy and its various segments.

For this, forecasting the future direction of the economy becomes necessary.

Economic forecasting becomes a key activity in economy analysis.

Economic Forecasting

The central theme in economic forecasting is to forecast the national income with its various components.

GNP is a measure of the national income.

It is the total value of the final output of goods and services produced in the economy.

It is a measure of the total economic activities over a specified period of time and is an indicator of the level and rate of growth of economic activities.

Economic Indicators

The economic indicators are factors that

indicate the present status, progress or

slowdown of the economy.

They are capital investment, business

profits, money supply, GNP, interest

rate, unemployment rate, etc.

The economic indicators are grouped

into leading, coincidental and lagging

indicators.

Leading Indicators

The leading indicators indicate what is

going to happen in the economy.

It helps the investor to predict the path

of the economy.

The popular leading indicators are the

fiscal policy, monetary policy,

productivity, rainfall, capital investment

and the stock indices.

Coincidental Indicators

The coincidental indicators indicate what the economy is.

The coincidental indicators are gross national product, industrial production, interest rates and reserve funds.

GDP is the aggregate amount of goods and services produced in the national economy.

The gap between the budgeted GDP and the actual GDP attained indicates the present situation.

Lagging Indicators

The changes that are occurring in the

leading and coincidental indicators are

reflected in the lagging indicators.

Lagging indicators are identified as

unemployment rate, consumer price

index and flow of foreign funds.

Forecasting Techniques

Economic forecasting may be carried out for short-term periods (up to three months), intermediate terms periods (three to five years) and long-term periods (more than five years).

An investor is more concerned about short-term economic forecasts.

Some of the techniques of short-term economic forecasting are discussed below:

1. Anticipatory Surveys

2. Barometric or Economic Indicator Approach

3. Econometric Model Building

4. Opportunistic Model Building

Anticipatory Surveys

Anticipatory surveys are the surveys of intentions of people in government, business, trade and industry regarding their construction activities, plant and machinery expenditures, level of inventory, etc.

Such surveys may also include the future plans of consumers with regards to their spending on durables and non-durables.

Based on the results of these surveys, the analyst can form his own forecast of the future state of the economy.

Econometric Model Building

This is the most precise and scientific of the different forecasting techniques.

This technique makes use of Econometrics.

Econometrics is a discipline that applies mathematical and statistical techniques to economic theory.

In the economic field we find complex interrelationship between the different economic variables.

The precise relationship between the dependent and independent variables are specified in a formal mathematical manner in the form of equations.

Econometric Model Building

In applying this technique, the analyst is forced to define clearly and precisely the interrelationship between the economic variables.

Econometric models used for economic forecasting are generally complex.

Vast amounts of data are required to be collected and processed for the solution of the model.

This may cause delay in making the results available.

Opportunistic Model

Building This is one of the most widely used forecasting

techniques.

It is also known as GNP model building or sectoral analysis.

Initially, an analyst estimates the total demand in the economy, and based on this he estimates the total income or GNP for the forecast period.

This initial estimate takes into consideration the prevailing economic environment such as the existing tax rates, interests rates, rate of inflation, fiscal policies, etc.

Opportunistic Model

Building After initial forecast is arrived at, the analyst

now begins building up a forecast of the GNP figure by estimating the levels of various components of GNP such as consumption expenditure, gross private domestic investment, government purchase of goods and services and net exports.

The two GNP forecasts arrived at by two different methods will be compared and necessary adjustments will be made.

This model building approach makes use of other forecasting techniques to build up the various components.

Industry Analysis

Industry analysis refers to an evaluation

of the relative strengths and

weaknesses of particular industries.

An industry is generally described as a

homogenous group of companies.

An industry is a group of firms that have

similar technological structure of

production and produce similar

products.

Industry Classification

Industries can be classified on the basis

of the business cycle.

They are classified into growth, cyclical,

defensive and cyclical growth industry

Growth Industry

The growth industries have special features of high rate of earnings and growth in expansion, independent of the business cycle.

The expansion of the industry mainly depends on the technological change.

In every phase of the history certain industries like colour televisions, pharmaceutical and telecommunication industries have shown remarkable growth.

Cyclical Industry

The growth and profitability of the industry move along with the business cycle.

During the boom period they enjoy growth and during depression they suffer a set back.

For example Refridgerator, washing machine and kitchen range products command a good market in the boom period and the demand for them slackens during the recession.

Defensive Industry

Defensive industry defies the movement

of the business cycle.

Food and shelter are the basic

requirements of humanity.

The food industry withstands recession

and depression.

The stocks of the defensive industries

can be held by the investors for income

earning purpose.

Cyclical growth Industry

This is a new type of industry that is

cyclical and at the same time growing.

Automobile industry experiences

periods of stagnation, decline but they

grow tremendously.

The changes in technology and

introduction of new models help the

automobile industry to resume their

growth path.

Industry Life Cycle

The industry life cycle theory is generally attributed to Julius Grodensky.

The life cycle of the industry is separated into four well defined stages such as

1. Pioneering stage

2. Rapid growth stage

3. Maturity and stabilisation stage

4. Declining stage

Pioneering stage

The prospective demand for the product

is promising in this stage and the

technology of the product is low.

The demand for the product attracts

many producers to produce the

particular product.

There would be severe competition and

only fittest companies survive this stage.

The producer try to develop brand

name, differentiate the product and

create a product image.

Rapid growth stage

This stage starts with the appearance of surviving firms from the pioneering stage.

The companies that have withstood the competition grow strongly in market share and financial performance.

The technology of the production would have improved resulting in low cost of production and good quality products.

The companies have stable growth rate in this stage and they declare dividend to the shareholders.

Rapid growth stage

It is advisable to invest the shares of

these companies.

In this stage the growth rate is more

than the industry’s average growth rate.

Maturity and stabilisation stage

In the stabilisation stage, the growth

rate tends to moderate and the rate of

growth would be more or less equal to

the industrial growth rate or GDP growth

rate.

To keep going, technological

innovations in the production process

and product should be introduced.

The investors have to closely monitor

the events that take place in the maturity

stage of the industry.

Declining stage

In this stage, demand for the particular

product and the earnings of the companies

in the industry decline.

Innovation of new products and changes

in consumer preferences lead to this stage.

The specific feature of the declining stage

is that even in the boom period, the growth

of the industry would be low and decline at

higher rate during the recession.

It is better to avoid investing in the shares

of the low growth industry even in the

boom period.

Factors to be considered

Apart from industry life cycle analysis, the investor has to analyse some other factors too. They are as follows

1. Growth of the industry

2. Cost structure and profitability

3. Nature of the product

4. Nature of the competition

5. Government policy

6. Labour

7. Research and development

Company Analysis

Company analysis deals with the estimation of return and risk of individual shares.

This calls for information.

Information regarding companies can be broadly classified into two broad group: internal and external.

Internal information consists of data and events made public by companies concerning their operations.

The internal information sources include annual reports to shareholders, public and private statements of officers of the company, the company’s financial statements, etc.

Company Analysis

External sources of information are

those generated independently outside

the company.

In company analysis, the analyst tries to

forecast the future earning of the

company.