Investment Trm Paper

8/6/2019 Investment Trm Paper

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Term PaperOn

Chapter- 4 and 5Fundamental Analysis:Economy, Industry and Company

Analysis

Submitted to:

Dr. Md. Rafiqul Islam

Professor

Department of Banking

University of Dhaka

Submitted by:

Khodeza Kashem (50815003)

Shakera Afroz (50815057)

Rushmila Andalib (50916013)

Course code: CB-605

Course name: Bank Investment Analysis
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Submission date: 6th April, 2010

Table of Contents

Index Page No

Chapter Four1. Fundamental Analysis: Introduction 032. Fundamental Analysis: What Is It? 043. EIC Frame Work- The Economy Analysis 05

Chapter Five4. EIC Frame Work- The Industry Analysis 085. EIC Frame Work- The Company Analysis 11

6. Financial Statement- The Ratio Analysis 137. Strengths and Weaknesses of Fundamental Analysis 20

Conclusion 21

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Chapter Four

Fundamental Analysis: Introduction

Fundamental Analysis is the process of determining the value of a company by analyzing and

interpreting such key factors as economy, industry, and company.

Fundamental analysis is the examination of the underlying forces that affect the well being of the

economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast

and profit from future price movements. At the company level, fundamental analysis mayinvolve examination of financial data, management, business concept and competition. At the

industry level, there might be an examination of supply and demand forces for the productsoffered. For the national economy, fundamental analysis might focus on economic data to assessthe present and future growth of the economy. To forecast future stock prices, fundamental

analysis combines economic, industry, and company analysis to derive a stock's current fair

value and forecast future value. If fair value is not equal to the current stock price, fundamentalanalysts believe that the stock is either over or under valued and the market price will ultimately

gravitate towards fair value. Fundamentalists do not heed the advice of the random walkers and

believe that markets are weak-form efficient. By believing that prices do not accurately reflect all

available information, fundamental analysts look to capitalize on perceived price discrepancies.

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The EIC valuation process, it is necessary to being with Economic Analysis. If we can envision a

concentric circle with three sections; the first circle holds economic variables used to measure

the health of the economy. The circle in the middle holds industry variables. The center circle ofthe diagram holds valuation variables of the individual firm.

Fundamental analysis thus involves three steps:

Economic Analysis: Business Cycles, Monetary & Fiscal Policy, Economic Indicators, World

Events & Foreign Trade, Inflation, Public Sentiment, GDP Growth, Unemployment,Productivity, Capacity Utilization, etc.

Industry Analysis: Industry Structure, Competition, Supply-Demand Relationships, Product

Quality, Cost Elements, Government Regulation, Business Cycle Exposure, etc.

Analysis of the Individual Firm: Forecasts of Earnings, Dividends and discount rates, BalanceSheet/Income Statement Analysis, Management, Research, Return, Risk, etc

Fundamental Analysis: What Is It?

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The Very Basics

When talking about stocks, fundamental analysis is a technique that attempts to determine asecuritys value by focusing on underlying factors that affect a company's actualbusiness and its

future prospects. On a broader scope, we can perform fundamental analysis on industries or the

economy as a whole. The term simply refers to the analysis of the economic well-being of afinancial entity as opposed to only its price movements.

Fundamental analysis serves to answer questions, such as:

Is the companys revenue growing?

Is it actually making a profit?

Is it in a strong-enough position to beat out its competitors in the future?

Is it able to repay its debts?

Is management trying to "cook the books"?

Fundamentals: Quantitative and Qualitative

The various fundamental factors can be grouped into two categories: quantitative and qualitative.The financial meaning of these terms isnt all that different from their regular definitions. Here is

how the MSN Encarta dictionary defines the terms:

Quantitative capable of being measured or expressed in numerical terms.

Qualitative related to or based on the quality or character of something, often as

opposed to its size or quantity.

In our context, quantitative fundamentals are numeric, measurable characteristics about a

business. Its easy to see how the biggest source of quantitative data is the financial statements.You can measure revenue, profit, assets and more with great precision.

Turning to qualitative fundamentals, these are the less tangible factors surrounding a business -things such as the quality of a companys board members and key executives, its brand-name

recognition,patents orproprietary technology.

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EIC Frame Work- The Economy Analysis

Economy analysis is one of most important art of fundamental analysis. Companies are a part of

the industrial and business sector, which in turn is a part of the overall economy. Thus theperformance of a company depends on the performance of the economy in the first place.

If the economy is in recession or stagnation, the performance of companies will be bad in

general, with some exceptions however. On the other hand, if the economy is booming, incomes

are rising and the demand is good, then the industries and the companies in general may be

prosperous, with some exception however.

Most Important Economic indicators are:

National Output:

GDP

Output, the most important concept of macroeconomics, refers to the total amount of goods andservices a country produces, commonly known as the gross domestic product. The figure is like a

snapshot of the economy at a certain point in time. When referring to GDP, macroeconomists

tend to use real GDP, which takes inflation into account, as opposed to nominal GDP, which

reflects only changes in prices. The nominal GDP figure will be higher if inflation goes up fromyear to year, so it is not necessarily indicative of higher output levels, only of higher prices.

UnemploymentThe unemployment rate tells macroeconomists how many people from the available pool of

labor (the labor force) are unable to find work. (For more about employment, Macroeconomists

have come to agree that when the economy has witnessed growth from period to period, which is

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indicated in the GDP growth rate, unemployment levels tend to be low. This is because with

rising (real) GDP levels, we know that output is higher, and, hence, more laborers are needed to

keep up with the greater levels of production

.

Inflation

The third main factor that macroeconomists look at is the inflation rate, or the rate at which

prices rise. Inflation is primarily measured in two ways: through the Consumer Price Index (CPI)

and the GDP deflator. The CPI gives the current price of a selected basket of goods and servicesthat is updated periodically. The GDP deflator is the ratio of nominal GDP to real GDP. If

nominal GDP is higher than real GDP, we can assume that the prices of goods and services has

been rising. Both the CPI and GDP deflator tend to move in the same direction and differ by less

than 1%.

Greasing the Engine of the Economy - What the Government Can Do

Monetary Policy

A simple example ofmonetary policy is the central bank's open-market operations. When thereis a need to increase cash in the economy, the central bank will buy government bonds (monetary

expansion). These securities allow the central bank to inject the economy with an immediate

supply of cash. On the other hand, when the central bank needs to absorb extra money in theeconomy, and push inflation levels down, it will sell its T-bills. This will result in higher interest

rates (less borrowing, less spending and investment) and less demand, which will ultimately push

down price level (inflation) but will also result in less real output.

Fiscal Policy

The government can also increase taxes or lower government spending in order to conduct

a fiscal contraction. What this will do is lower real output because less government spending

means less disposable income for consumers. And, because more of consumers' wages will go totaxes, demand as well as output will decrease. A fiscal expansion by the government would

mean that taxes are decreased or government spending is increased. Ether way, the result will be

growth in real output because the government will stir demand with increased spending. In the

meantime, a consumer with more disposable income will be willing to buy more.

Forecasting Techniques

Anticipatory Surveys

Statistical surveys are used to collect quantitative information about items in a population.

Surveys of human populations and institutions are common in political polling and government,

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health, social science and marketing research. A survey may focus on opinions or factual

information depending on its purpose, and many surveys involve administering questions to

individuals. When the questions are administered by a researcher, the survey is called astructured interview or a researcher-administered survey. When the questions are administered

by the respondent, the survey is referred to as a questionnaire or a self-administered survey.

Barometric Forecasting Techniques

Barometric techniques examine the relationships between causal or coincident events to predictfuture events. This approach is based on the logic that key current developments can serve as a

barometer of the future. This approach assumes the key developments can be identified,

measured and recorded as a statistical time series.

Leading indicators

An economic indicator that changes before the economy has changed. Examples of leading

indicators include production workweek, building permits, unemployment insurance claims,money supply, inventory changes, andstockprices. TheFed watches many of these indicators as

it decides what to do about interest rates. There are also coincident indicators, which change

about the same time as the overall economy, and lagging indicators, which change after theoverall economy, but these are of minimal use as predictive tools.

Chapter Five

EIC Frame Work- The Industry Analysis

Each industry has differences in terms of its customer base, market share among firms, industry-

wide growth, competition, regulation and business cycles. Learning about how the industryworks will give an investor a deeper understanding of a company's financial health.

This section is divided into four parts:

The Business Cycle

Industry Life Cycle Analysis

Study of the Structure and Characteristics of an Industry

Profit Potential of Industries: Porter Model

The Business Cycle

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The economy recurrently experiences periods of expansion and contraction, although the length

and depth of those cycles can be irregular. This recurring pattern of recession and recovery iscalled the Business Cycle.

Stages in Business Cycle:

Expansion

Peak

Contraction

Trough

Industry Life Cycle

Where is the industry in its life cycle? The best returns and most risk tend to occur early in thecycle.

The possible phases are:

Introduction Phase/Birth Phase / Pioneering Stage / Start-up

Growth Phase / Expansion Stage / ConsolidationMature Growth Phase / MaturityDecline Phase / Relative Decline

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Study of the Structure and characteristics of an Industry

Customers

Some companies serve only a handful of customers, while others serve millions. In general, it's ared flag (a negative) if a business relies on a small number of customers for a large portion of its

sales because the loss of each customer could dramatically affect revenues.

Market Share

Understanding a company's present market share can tell volumes about the company's business.

The fact that a company possesses an 85% market share tells you that it is the largest player in its

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market by far. Furthermore, this could also suggest that the company possesses some sort of

"economic moat," in other words, a competitive barrier serving to protect its current and future

earnings, along with its market share.

Industry Growth

One way of examining a company's growth potential is to first examine whether the amount ofcustomers in the overall market will grow. This is crucial because without new customers, a

company has to steal market share in order to grow

Competition

Simply looking at the number of competitors goes a long way in understanding the competitivelandscape for a company. Industries that have limited barriers to entry and a large number of

competing firms create a difficult operating environment for firms.

Regulation

Certain industries are heavily regulated due to the importance or severity of the industry'sproducts and/or services. As important as some of these regulations are to the public, they can

drastically affect the attractiveness of a company for investment purposes.

Profit Potential of Industries: Porter Model

The profit potential of an industry depends on the combined strength of the following 5 basic

competitive forces:

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Five factors are:

1. Threat of new entrants

2. Rivalry among the existing firms

3. Pressure from substitute products

4. Bargaining power of buyers5. Bargaining power of sellers
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.

EIC Frame Work- The Company Analysis

Fundamental analysis seeks to determine the intrinsic value of a company's stock. But since

qualitative factors, by definition, represent aspects of a company's business that are difficult or

impossible to quantify, incorporating that kind of information into a pricing evaluation can bequite difficult. On the flip side, as we've demonstrated, you can't ignore the less tangible

characteristics of a company.

The massive amount of numbers in a company's financial statements can be bewildering andintimidating to many investors. On the other hand, if you know how to analyze them, the

financial statements are a gold mine of information.

Financial statements are the medium by which a company discloses information concerning its

financial performance. Followers offundamental analysis use the quantitative information

gleaned from financial statements to make investment decisions. Before we jump into thespecifics of the three most important financial statements - income statements, balance sheets

and cash flow statements - we will briefly introduce each financial statement's specific function,

along with where they can be found.

The Major Statements

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The Balance Sheet

The balance sheet represents a record of a company's assets, liabilities and equity at a particular

point in time. The balance sheet is named by the fact that a business's financial structure balances

in the following manner:

Assets = Liabilities + Shareholders' Equity

Assets represent the resources that the business owns or controls at a given point in time. This

includes items such as cash, inventory, machinery and buildings. The other side of the equation

represents the total value of the financing the company has used to acquire those assets.Financing comes as a result of liabilities orequity. Liabilities represent debt (which of course

must be paid back), while equity represents the total value of money that the owners have

contributed to the business - including retained earnings, which is the profit made in previousyears.

The Income Statement

While the balance sheet takes a snapshot approach in examining a business, the income

statement measures a company's performance over a specific time frame. Technically, you could

have a balance sheet for a month or even a day, but you'll only see public companies reportquarterly and annually.

The income statement presents information about revenues, expenses and profit that was

generated as a result of the business' operations for that period.Statement of Cash Flows

The statement of cash flows represents a record of a business' cash inflows and outflows over a

period of time. Typically, a statement of cash flows focuses on the following cash-related

activities:

Operating Cash Flow (OCF): Cash generated from day-to-day business operations

Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from

the sale of other businesses, equipment or long-term assets

Cash from financing (CFF): Cash paid or received from the issuing and borrowing offunds.

Financial Statement- The Ratio Analysis

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Financial ratio (or accounting ratio) is a relative magnitude of two selected numerical valuestaken from an enterprise's financial statements. Often used in accounting, there are many

standard ratios used to try to evaluate the overall financial condition of a corporation or other

organization. Financial ratios may be used by managers within a firm, by current and potentialshareholders (owners) of a firm, and by a firm's creditors. Security analysts use financial ratios to

compare the strengths and weaknesses in various companies. If shares in a company are traded in

a financial market, the market price of the shares is used in certain financial ratios.

Ratios may be expressed as a decimal value, such as 0.10, or given as an equivalent percent

value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are

usually or always less than 1, such as earnings yield, while others are usually quoted as decimalnumbers, especially ratios that are usually more than 1, such as P/E ratio; these latter are also

called multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1, the

reciprocal will be below 1, and conversely. The reciprocal expresses the same information, butmay be more understandable: for instance, the earnings yield can be compared with bond yields,

while the P/E ratio cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of5%.

Purpose and types of ratios

Financial ratios quantify many aspects of a business and are an integral part of financial

statement analysis. Financial ratios are categorized according to the financial aspect of the

business which the ratio measures. Liquidity ratios measure the availability of cash to pay debt.

Activity ratios measure how quickly a firm converts non-cash assets to cash assets. Debt ratiosmeasure the firm's ability to repay long-term debt. Profitability ratios measure the firm's use of

its assets and control of its expenses to generate an acceptable rate of return. Market ratios

measure investor response to owning a company's stock and also the cost of issuing stock.

Financial ratios allow for comparisons

between companies

between industries

between different time periods for one company

between a single company and its industry average

Ratios generally hold no meaning unless they are benchmarked against something else, like past

performance or another company. Thus, the ratios of firms in different industries, which face

different risks, capital requirements, and competition.

Profitability ratios

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Profitability ratios measure the firm's use of its assets and control of its expenses to generate an

acceptable rate of return.

Gross margin, Gross profit margin or Gross Profit Rate

Operating margin, Operating Income Margin, Operating profit margin or Return on sales

Note: Operating income is the difference between operating revenues and operating expenses,

but it is also sometimes used as a synonym for EBIT and operating profit. This is true if the firmhas no non-operating income. (Earnings before interest and taxes / Sales)

Profit margin, net margin or net profit margin

Return on equity (ROE)

Return on investment (ROI ratio or Du Pont Ratio)

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Return on assets (ROA)

Return on Equity Du Pont (ROE Du Pont)

Risk adjusted return on capital (RAROC)

Efficiency ratio

Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt.

Current ratio

Acid-test ratio (Quick ratio)

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Operation cash flow ratio

Activity ratios (Efficiency Ratios)

Activity ratios measure the effectiveness of the firms use of resources.

Average collection period

Degree of Operating Leverage (DOL)

Asset turnover

Stock turnover ratio

Receivables Turnover Ratio

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Inventory conversion ratio

Inventory conversion period

Receivables conversion period

Debt ratios (leveraging ratios)

Debt ratios measure the firm's ability to repay long-term debt. Debt ratios measure financialleverage.

Debt ratio

Debt to equity ratio

Long-term Debt to equity (LT Debt to Equity)

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Times interest-earned ratio / Interest Coverage Ratio

Debt service coverage ratio

Market ratios

Market ratios measure investor response to owning a company's stock and also the cost ofissuing stock.

Earnings per share (EPS)

Payout ratio

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Dividend cover (the inverse of Payout Ratio)

P/E ratio

Dividend yield

Price/sales ratio

PEG ratio

Strengths and Weakness of Fundamental Analysis

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Strengths

Long-term Trends

Fundamental analysis is good for long-term investments based on long-term trends, very long-

term. The ability to identify and predict long-term economic, demographic, technological or

consumer trends can benefit patient investors who pick the right industry groups or companies.

Value Spotting

Sound fundamental analysis will help identify companies that represent a good value. Some of

the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett andJohn Neff are seen as the champions of value investing. Fundamental analysis can help uncover

companies with valuable assets, a strong balance sheet, stable earnings, and staying power.

Business Acumen

One of the most obvious, but less tangible, rewards of fundamental analysis is the development

of a thorough understanding of the business. After such painstaking research and analysis, an

investor will be familiar with the key revenue and profit drivers behind a company. Earnings and

earnings expectations can be potent drivers of equity prices. Even some technicians will agree tothat. A good understanding can help investors avoid companies that are prone to shortfalls and

identify those that continue to deliver. In addition to understanding the business, fundamental

analysis allows investors to develop an understanding of the key value drivers and companieswithin an industry.

Weaknesses

Time Constraints

Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming.

Time-consuming models often produce valuations that are contradictory to the current price

prevailing on Wall Street. When this happens, the analyst basically claims that the whole street

has got it wrong. This is not to say that there are not misunderstood companies out there, but it isquite brash to imply that the market price, and hence Wall Street, is wrong.

Industry/Company Specific

Valuation techniques vary depending on the industry group and specifics of each company. For

this reason, a different technique and model is required for different industries and different

companies. This can get quite time-consuming, which can limit the amount of research that can

be performed.

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Subjectivity

Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly

alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity

analysis to present a base-case valuation, an average-case valuation and a worst-case valuation.

However, even on a worst-case valuation, most models are almost always bullish, the onlyquestion is how much so.

Analyst Bias

The majority of the information that goes into the analysis comes from the company itself.

Companies employ investor relations managers specifically to handle the analyst community and

release information. As Mark Twain said, "there are lies, damn lies, and statistics."

Conclusions

Fundamental analysis can be valuable, but it should be approached with caution. If you are

reading research written by a sell-side analyst, it is important to be familiar with the analystbehind the report. We all have personal biases, and every analyst has some sort of bias. There is

nothing wrong with this, and the research can still be of great value. Learn what the ratings mean

and the track record of an analyst before jumping off the deep end. Corporate statements andpress releases offer good information, but they should be read with a healthy degree of

skepticism to separate the facts from the spin. Press releases don't happen by accident; they are

an important PR tool for companies. Investors should become skilled readers to weed out theimportant information and ignore the hype.

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