Fundamental analysis

Dr Rishi manrai
ABS Amity University Gurugram
 Objectives
Tasks involved in security analysis
• Forecasting future conditions
• The prospective benefits from holding a security given
these forecasted conditions
• ‘What ought to be price of security’ given these
benefits after adjusting for risk

Fundamental analysis seeks to find the

intrinsic value of these securities to identify
overpriced or underpriced security
 Beliefs
The current market price of a may vary due to temporary
market disequilibrium from its intrinsic value but in the
long run it will be equal to the intrinsic value

Intrinsic value changes from year to year according to

the factors determining change

Beating the market – Buying an underpriced security &

getting abnormal return

Fundamentalists – Buy a security for long term and get

normal return & believe that stock market could be
beaten
 Framework
Discrepancies in intrinsic value & current market
value can be realized by fundamentalists who will
get profit
• EIC framework
• CIE framework

Estimates are made of stream of benefits & required

rate of return

Use of dividend discount model to find intrinsic

value
Preferred order of Analysis
The Economy & the Market

The Industry

The Company
 EIC framework
Economic Analysis
• Study of economic trends, study of govt. policies, analysis of
the relationship between economic trends & economic
policies, study of world economic trend & impact on India

Industry Analysis
• Implication of projected growth in GNP, plan priorities,
govt. regulation, industrial & fiscal policies, effect of
business cycle, life cycle position, competitive conditions

Company Analysis
• Market share, cost structure, ratio analysis, funds flow
analysis, growth in dividend per share, dividend yield, P/E,
quality of management
 Intrinsic Value
The actual value of a security as opposed to its market price or
book value

John Burr Williams – Present value of all future cash flows

Graham & Dodd – “That value which is justified by the facts e.g.
assets, earnings, prospects, mgt. of the company etc”

Fundamental analysts seek to establish quantitative relationship

between economic, industrial, & company indicators to forecast
earnings & dividends & calculates a range of intrinsic values.
Implication of Intrinsic Value
Intrinsic value > Market price =
Underpriced

Problem with intrinsic value

• Uncertain future benefits
• Varying discounting rates by different investors

Market price is consensus intrinsic value

 Market Analysis
To understand
economic factors • Knowing the status of market through
that affect security security market indicators
market

• Expected stream of benefits (cash flows)

Two determinants • Required rate of return
of stock prices • There is an impact of change in corporate
earnings on prices of stock

• Economic policies
Corporate earnings • Fiscal policies
are influenced by • Monsoons
 Economic Analysis
Basic objectives are 1) To find out the relevant
economic factors 2) How can we forecast any
possible changes in them.

Key Economic variables

• Growth in National income which helps in finding the current
phase of business cycle.
• Industrial production is a measures of the productive capacity
and economic independence of an economy. Higher production
leads t0 higher investment and higher level of capital formation
and higher level of economic activity.
• Monsoon and Agricultural production which directly affects
the rural as well urban income and also boosts the consumption
and investment component in the economy.
 Economic Analysis – Key Economic Variables

Infrastructure Facilities and proposed investment which will

lead to increased investment and economic efficiency.
Political stability and Govt. attitude leading to clear – cut
long term policies conducive for economic growth.
Inflation as measured in terms of difference between the WPI
or CPI at two given points of time, which if high results into less
savings and lower capital formation.
Interest Rates determining the cost and availability of credit
with lower interest rates stimulating investment due to lower
cost of finance and vice – versa. It also stimulates foreign debt
investment.
Exchange rate stability indicates the competitive position of a
country, encouraging more investment in the country and a
comfortable BoP position
 Economic Analysis – Key Economic Variables
Changes in major Economic Indices
Demographic Factors provides data useful for
demand forecasting and labour forecasting purposes
indicating growth in various sectors.
Central Bank’s policies relating to money supply to
curb or promote inflation and also to affect the liquidity
in country, which in turn have substantial effect on
other variables as well.
Government Policies like
Industrial policies promoting investment
Budgetary Policies and deficit financing mechanisms
Tax policies promoting investment
 Economic Forecasting
Need of forecasting – Investment is future oriented
activity.
Main objective – To forecast the level of national
income
Anticipatory Surveys
Survey about the intentions of people in Govt.,
business, trade & industry regarding their intended
investments.
Future plans of consumers regarding their expenditure
pattern
Purely dependent on materialization of intentions –
reliable only to a limited extent
 Economic Forecasting
Barometric or
Indicator
approach

Leading Coincidental Lagging

Indicators Indicators Indicators
Economic Forecasting Methods
Lead Indicator Approach
• Identifying the economic indicator which turn ahead
of the change in level of economic activity (business
cycle)
• Leading indicators provide advance signals of turning
point in economic activity
• Should move smoothly from one period to another
• Should always lead turning point
• Should not be too short or too long
• Should fit logically with business cycle theory
• Does not convey about magnitude & duration of
change
• Different lead indicators convey mixed signals
Economic Forecasting Methods
• Diffusion index for leading indicator =
Diffusion The number of indicators that rise during
a particular period X 100/ total number of
Indices lead indicators

• The quality of forecast is dependent on

Econometric quality of input, validity of assumptions &
model builder’s understanding of
Model economic theory
Building • Can be meaningful if estimated co –
efficient are found to be stable over time
Economic Forecasting Methods

• GNP = C + I + G + X – M
• Based on budget estimates of central
& state governments, socio –
GNP or economic surveys & field data
Opportunistic • Testing the forecast for internal
consistency because of
Model interrelatedness of the GNP accounts
Building • Testing for external consistency by
comparing the forecast with forecast
obtained from other approaches
 Industry Analysis

Consider those industries

• Which promise most opportunities
• Considering performance of other industries
• Continuous analysis to surface the inconsistencies in the
performance

Life cycle analysis

Industry position in relation to business cycle

Key Characteristics in Industry Analysis

Past sales & • Examining the contribution of various factors to

earning evaluate their relevance individually & relatively
• Finding out stability in sales & earnings
performance

• Products & technology not becoming obsolete in

Permanence a short span of time

• Considering various government regulations &

Govt. attitude their implications on industries, especially the
change in regulations
Key Characteristics in Industry Analysis

• Important for labor intensive industries

Labor • Examining the various labor loss & impact
Conditions of possible labor problems on productivity

• Product differentiation
Competitive • Cost advantages
conditions • Economies of scale

Industry share • Share prices should not be inflated for a new

prices relative industry
to its earnings
 Key Characteristics in Industry Analysis

Demand and supply Gap

• The level of sustainable demand as against the supply will lead to
growth in the earnings

Supply of Raw Material

• Shortage of raw material can cause immense losses to manufacturers in
form of higher input costs

Gestation Period
• Delay in projects with longer gestation period leads to escalation in
costs and losses

Industrial Growth
• Picking up industries with higher growth forecast will lead to higher
returns in the form of capital appreciation and profits.
 Industry Life Cycle

Pioneering Expansion Stabilizatio Declining

n
 Stages – Investopedia
Early stage phase
• Alternative product designing and positioning

Innovation stage
• A dominant design would appear with focus shifting to process innovation

Cost or Shakeout phase

• Economies of scale are achieved with “dominant design” forcing the
competitors to exit or get acquired, large scale consolidation and barriers to
entry becoming high

Maturity
• Focus shifting from growth to cash flows & market share

Decline
• Revenues declining, need for major restructuring or replacement
 Business Cycle Analysis
• Earnings are much above the average &
Growth industries may occur still after setback in economy

Defensive • Least affected by economic adversities.

industries

• Do unusually well when the economy is

Cyclical Industries going good & do more badly when
economy is down

Interest – sensitive • Financial services, banking etc.

industries
 Structural Analysis
If rate of return are higher than adjusted free
market return then it will stimulate capital
flow in industry

Michael Porter’s five forces model

• Threat of Entry
• Threat of substitution
• Bargaining power of buyers
• Bargaining power of suppliers
• Rivalry among current competitors
 Threats of Entry
• Economies of scale
• Product differentiation
Barriers of • Capital requirements
• Switching costs
entry • Access to distribution channels
• Government policy

• Proprietary product technology

Cost • Favorable access to raw materials
Disadvantages • Favorable locations
• Government subsidies
for Entrants • Learning curve
 Rivalry among current competitors

Equally • Slow industry growth

balanced • High fixed costs
• Lack of differentiation & switching costs
competitors

• High strategic stakes

• Shifting rivalry
Diverse • Exit barriers (Specialized assets, exit
Competitors costs, strategic relationships, emotional
barriers)
 Other Forces
• If buyer groups are concentrated or make bulk
Bargaining purchases
• If products are standardized
power of • Threat of backward integration
• The buyer has full information
Buyers • Switching costs are low

Bargaining •
•
Concentrated suppliers or differentiated product
Industry is not important for suppliers
power of • Suppliers product is important input
•
Suppliers Threat of forward integration
 Company Analysis
Project Analysis

Product analysis

Financial health

Management Analysis
 Project analysis
Project potential in terms of current demand and
supply gap and unutilized capacity in industry
Success stories to ensure the reliability of promoters
Background check of Promoters – specially those
included in various blacklists
Quality of project appraisal and reliability of
appraising institution
Situation of environmental and legal clearances
 Product Analysis
Types and number of products – availability of a flagship or
generic product and product mix.
Technology – current technology and its longevity,
technological collaborations and performance guarantees
for newly acquired technologies
Market in terms of sales growth, stability of sales and sales
forecast
Level of competition and availability of comparative and
competitive advantage along with the size and share of
market
Quality management policy and certifications received
Cost and profit structure
R & D Initiatives and innovative practices.
 Financial Health
Financial Analysis
Ratio Analysis
Financial Statement Analysis
Economic Condition Analysis
Internal Condition Analysis
External Condition Analysis
Financial Environment Analysis
Stock Market Conditions
Historic Price Movements
Current Price
 Financial Analysis

• Turnover ratios
• Profitability ratios
Ratio • Leverage Ratios
Analysis • Liquidity Ratios
• Valuation ratios
 Financial Analysis
Financial •
•
Balance Sheet Analysis
Income and Expenditure Analysis
Statement • Earning Power or DuPont Analysis
Analysis • Cash Flow/ Funds Flow analysis

• Internal Conditions – economies of

scale, consistent growth and better
Economic financial governance
Conditions • External Conditions – Covered in
economic analysis
 Management Analysis
Management team members – Their qualifications
and background, their interrelationships, their
knowledge, the culture and employee management
relationship.
Key Personnel & their Background – The chairman or
CEO, key technicians, policies relating to preservation
of know – how.
 Capital Structure and promoter’s contribution – the
condition of capital gearing and the stake of
promoter’s in the capital.
Litigation and legal issues pending