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Investment Analysis and
Management - BU
Module 6: Fundamental Analysis
Agenda
• Pointer.
• Economic Analysis.
• Steps in Fundamental Analysis.
• Key Macroeconomic factors analysed.
• Industry Analysis.
• Company Analysis.
• Estimation of Intrinsic value
• Obstacles in the way of Analyst.
• Empirical evidence of P/E.
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Pointer
• Key determinants of intrinsic value:
• Earnings per share
• Payout ratio
• Discount rate
• Growth rate
• Explain the impact of above factors on the intrinsic value.
• Explain the impact of growth and discount rates on P/E
multiple.
Economic Analysis
• The IV of a equity share is a function of earnings level,
growth rate and risk exposure of the company.
• The above factors to a great extent depend upon the
prospects of the industry to which the company belongs.
• The prospects of various industries, in turn are largely
influenced by the developments in macro-economic env.
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Economic Analysis
• Empirically, researchers have found the stock price
changes can be attributed to the following factors:
• Economic wide factors: 30 – 35 percent.
• Industry factors: 15 – 20 percent.
• Company factors: 30 – 35 percent.
• Other factors: 15 – 25 percent.
• Based on the above evidence a three pronged procedure
is adopted for fundamental analysis.
Steps in Fundamental Analysis
• Understanding of the macro-economic environment and
developments.
• Analyzing the prospects of the industry to which the firm
belongs; and
• Assessing the projected performance of the company.
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Key Macroeconomic Factors – Analyzed.
• Gross National Product.
• Savings and Investment.
• Price level and inflation.
• Agriculture and monsoons.
• Fiscal and monetary framework.
• Infrastructural facilities and agreements.
Fiscal and Monetary Policy
• Favourable Budget:
• A reasonably balanced budget (no high surplus / deficit).
• A level of internal and external debt that can be serviced
comfortably.
• A satisfactory balance of payment situation.
• A tax structure which provides incentive for savings and
investment.
• A rate of increase in money supply which ensures that inflation is
within permissible limit.
• A credit policy which accommodates reasonable business
demands.
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Industry Analysis
• Objective of this analysis is to assess the prospects of
various industrial groupings.
• It is almost impossible to forecast exactly which industrial
groups will appreciate the most.
• Most careful analysis can suggest which industries have a
brighter future than others.
• Industry analysis can be performed:
• Industry life cycle analysis.
• Study of the structure and characteristics of an industry.
Industry Life Cycle Analysis
• Industrial economists believe that the development of
almost every industry may be analyzed in terms of LCA.
• The four well-defined stages are
• Pioneering stage.
• Rapid growth stage.
• Maturity and stabilisation stage.
• Decline stage.
• Explain the investment implications for each stage.
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Industry Structure and Characteristics
• Since each industry is unique,
• A systematic study of its specific features and characteristics is
an integral part of the decision process.
• The following points are focus on the following:
• a. Structure of the industry and nature of competition.
• b. Nature and prospect of demand.
• c. Cost, efficiency, and profitability.
• d. Technology and Research
Company Analysis
• This is the last leg in the economy – industry – company
analysis sequence.
• Company analysis is organised by three parts:
• Study of financial information.
• Sizing up of present situation and prospects.
• Evaluation of management.
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Study of Financial Information
• Study of GAIL (appended in Excel sheet)
Sizing up – Present Situation & Prospects
• The analyst should question along the following lines:
• Availability and cost inputs.
• Order position.
• Regulatory framework.
• Technological and production capabilities.
• Marketing and distribution.
• Finance and accounting.
• Product Portfolio.
• Human resource and personnel.
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Evaluation of Management
• The analyst should ask the following questions:
• What is the grand design of the management? (Conglomerate or
close knit).
• What is the caliber, motivation, integrity, dynamism and
commitment of the top management personnel?
• Does the management have specific objectives, plans and time-
bound programmes?
• What emphasis is accorded to research and development?
Evaluation of Management
• The analyst should ask the following questions:
• How effective is the organisational structure?
• How sound are the management systems of the company?
• What is the importance assigned to management development?
• How investor friendly is the management?
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Estimation of Intrinsic Value
• Commonly adopted procedure by investment analysts:
• Estimate the earnings per share for the current year.
• Forecast the growth rate in earnings per share.
• Assess the risk.
• Establish a P/E ratio.
• Develop a value anchor and value range.
Estimate EPS – Current year
• Estimate the EPS based on the current published annual
reports and based on interview with management.
• Apart from EPS, establish the CFPS.
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Forecast the g in EPS
• If there is a stable cost and profit structure is expected in
the foreseeable future:
• The g in EPS may be equated with the projected growth
rate in sales?
• g in sales can be expressed in monetary terms as =
growth rate in physical terms + inflation rate.
Assess the Risk Exposure
• Investment analyst look commonly for the following
aspects of risk:
• Business Risk.
• Financial Risk.
• Market Risk (with respect to stock market).
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Establish a P/E Multiple
• Growth prospects and risk exposure are the key
determinants of P/E multiple.
• Following factors will also have a bearing:
• Dividend and bonus policy of the firm (liberal to niggardly).
• The size of the firm (very large to very small).
• The general image of the firm (very favourable to unfavourable).
Determine – Value Anchor & Range
• The value anchor is obtained as follows:
• Projected EPS * Appropriate P/E multiple.
• Practical wisdom calls for defining an intrinsic value range
around the single point estimate.
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Obstacles – Way of Analyst
• Inadequacies or incorrectness of data.
• Future uncertainties.
• Irrational market behaviour.
• Fallibility of experts.
Empirical Estimation of P/E
• Whitbek and Kisor in one of the earlier studies conducted
in the U.S found the following relationship:
• 8.2 + 1.5 * Growth rate in earnings + 6.7 Payout ratio – 0.2 *
Variability in earnings.
• Obaidullah and Kalyani Ramachandran estimated the
following relationship for Indian stock market in 1992:
• 0.0003 + 1.153 * Growth rate in earnings – 0.392 * Required rate
of return + 0.2 Growth rate in funds flowing into the securities
market.
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Reasons of Lack in Success – B/S
• Almost most of the variables discussed are fairly
successful in explaining P/E multiples.
• The models discussed are not so successful in selecting
the appropriate stocks to buy or sell.
• The following are the three reasons why they are not so
successful:
• Shift in market taste.
• Change in input values
• Firm effects.
Word of Caution
• Update the model periodically to reflect the most current
valuation mode.
• Define input variables taking into account the changing
corporate fortunes.
• Adjust the value estimate provided by the model in the
light of firm effects which the model does not capture.
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