Shri Guru Ram Rai University

Lecture- 1
Unit- 3
Principles of Investment
POIN: 603

Fundamental analysis

The primary motive of buying a share is to sell it subsequently at a higher price. In many cases,
dividends are also expected. Thus, dividends and prices changes constitute the return from
investing in shares. Consequently an investor would be interested to know the dividend to be
paid on the share in the future as also future price of the share. These values can only be
estimated and not predicted with certainty. These values are primarily determined by the
performance of the company which in turn is influenced by the performance of the industry to
which the company belongs and the general economic and socio-political scenario of the
country. An investor who would like to be rational and scientific in his investment activity has to
evaluate a lot of information about the past performance and expected future performance of
companies, industries and the economy as a whole before taking the investment decision. Such
evaluation or analysis is called fundamental analysis

MEANING OF 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
number of fundamental factors relating to the economy, industry and company fundamentals
have to be considered while analyzing a security for investment purpose. Fundamental analysis
is, in other words 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. 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 and thereby assess the intrinsic value of the
share. The investor can then compare the intrinsic value of the share with prevailing market price
to arrive at an investment decision. If the market price of the share price is lower than its intrinsic
value, the investor would decide to buy the share as it is under-priced. On the contrary when the
market price of a share is higher than its intrinsic value, it is perceived to be overpriced. The
market price of such a share is expected to come down in future and hence, the investor would
decide to sell such a share. Fundamental analysis thus provides an analytical framework for
rational investment decision. Fundamental analysis involves three steps.

1. Economy Analysis

2. Industry Analysis

3.Company Analysis.

ECONOMY ANALYSIS:

The performance of the company depends on the performance of the economy. If the economy is
booming, incomes rise, demand for goods increases and hence the industries and companies in
general tend to be prosperous. On the other hand, if the economy is in recession, the performance
of the company will be generally bad. Investors are concerned with those variables in the
economy which affect the performance of the company in which they tend to invest. Study of
these economic variables would give an idea about future corporate earnings and payment of
dividends and interest to investors. Some of the key economic variables that an investor must
monitor as a part of his/her fundamental analysis.
Inflation:
Inflation prevailing in the economy has considered impact on the performance of companies.
Higher rates of inflation upset business planes, lead to cost escalation and result in a squeeze on
profit margins. On the other hand inflation leads to erosion of purchasing power in the hands of
consumers. This will result lower demand for products. Thus higher inflation in an economy are
likely to affect the performance of companies adversely. Industries and companies prosper
during times of low inflation.

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. Moreover it implies lower cost of finance for companies and thereby assures higher
profitability. On the contrary, higher interest rates result in higher cost of production which may
lead to lower profitability and lower demand. The interest rates in the organized financial sector
of the economy are determined by the monetary policy of the government and the trends in
the money supply. These rates are thus controlled and vary within certain ranges. But the interest
rates in the unorganized financial sector are controlled and may fluctuate widely depending upon
the demand and supply of funds in the market.
Government revenues, expenditure and deficits:
As the government is the largest investor and spender of money, the trends in government
revenue, expenditure and deficits have a signifying impact on the performance of industries and
companies. Expenditure by govt. stimulates the economy by creating jobs and generating
demand. Since a major portion of demand in the economy is generated by govt.
 Exchange rates

The performance and profitability of industries and companies that are major importers and
exporters are considerably affected by the exchange rates of the rupee against major currencies
of the world. A depreciation of rupee improves the competitive position of Indian products in
foreign markets, thereby stimulating exports. But it would also make imports more expensive.
The exchange rates of the rupee are influenced by the balance of trade deficit, the balance of
payments deficit and also the foreign exchange reserves of the country. The excess of imports
over exports is called balance of trade deficit. A country needs foreign exchange reserves to meet
several commitments such as payment for imports and servicing of foreign debts. Balance of
payment deficit typically leads to decline in foreign exchange reserves as the deficit has to be
met from reserve.

Economic and political stability

A stable political environment is necessary for steady and balanced growth. No industry or

Company analysis is the first stage of fundamental analysis. The economy analysis provides the
investor a broad outline of the prospects of growth in the economy. The industry analysis helps
the investor to select the industry in which investment would be rewarding.

 Company analysis deals with the estimation of return and risk of individual shares. In company
analysis he may evaluate short and long term financial position by applying various ratios. The
prosperity of a company would depend upon its profitability and financial health. For knowing
profitability of the company the investor may calculate profitable ratios, operating ratios etc.