A

Seminar Report
On

“FUNDAMENTAL ANALYSIS”

Chouksey Engineering College

Bilaspur (C.G)
MBA
(MASTER OF BUSINESS ADMINISTRATION)

Session 2010-2011

Submitted To: Submitted By:

Miss P. Vakula Priya Modi
(HOD, MBA Dept.) MBA, 3rd Sem

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 INDEX

1. INTRODUCTION.

2. FUNDAMENTAL ANALYSIS

A. Fundamental analysis

i. Concept of intrinsic value.

ii. Economic analysis

1. Introduction.

2. Economic factors to be analysed.

3. Economic forecasting.

iii. Industry analysis

1. Introduction.

2. Industry life cycle.

3. Industrial factors to be analysed.

iv. Company analysis

1. Introduction.

2. Company factors to be analysed.

v. Benefits and Drawbacks of Fundamental Analysis.

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3. CONCLUSION.

4. BIBLIOGRAPHY.

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 FUNDAMENTAL ANALYSIS

Fundamental analysis is a logical and systematic approach in estimating the share prices and
future dividends. The price of a share or security is determined by number of factors, relating to
economy, industry and company. Thus the fundamental analysis is the detailed analysis of the
fundamental factors affecting the company’s performance.

Each share is assumed to have an economic value, based on the present value and the future
earning capacity. This is termed as INTRINSIC VALUE or FUNDAMENTAL VALUE. The
intrinsic value of an equity share depends on a multitude of factors. The earnings of the
company, the growth rate and the risk exposure of the company have a direct bearing on the
price of the share. These factors in turn rely on the host of the other factors like economic
environment in which they function, the industry they belong to, and finally companies own
performance.

The fundamental analysis helps to evaluate the intrinsic value of the shares, which is analysed by
the investors, in order to compare the same with the prevailing price in the market. If there is a

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chance to the decrease of the value of shares than its intrinsic value, the investor would make a
decision to buy the shares.

On the other side, if the shares are over-priced, then such a market would come down in future,
hence the investors would decide to sell out.

The fundamental school of thought appraised the intrinsic value of shares through

 Economic analysis: - It is a systematic approach to determining the optimum use of

scarce resources, involving comparison of two or more alternatives in achieving a
specific objective under the
given assumptions and constraints.It takes into account the opportunitycosts ofresources e
mployed and attemptsto measure in monetary terms the private and
social costs and benefits of a project tothe community or economy. The level of
economic activity has an impact on investment in many ways. If the economy grows
rapidly, the industry can also be expected to show rapid growth and vice-versa. The
analysis of economic environment is essential to understand the behavior of the stock
prices.

 Industry analysis: - An industry analysis helps inform business managers about the
viability of their current strategy and on where to focus a business among its competitors

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 in an industry. The analysis examines factors such as competition and the external
business environment, substitute products, management preferences, buyers and
suppliers.

 Company analysis: - In the company analysis the investor assimilates several bits of
information related to the company and evaluates the present and future values of stocks.
The risk and return associated with the purchase of the stock is analysed to take better
investments decisions. The valuation process depends on the investor’s ability to elicit
information from the relationship and inter-relationship among the company related
variables.

ECONOMY
ANALYSIS

INDUSTRY
ANALYSIS

COMPANY
ANALYSIS

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Fundamental analysis is performed on historical and present data, but with the goal of making
financial forecasts. There are several possible OBJECTIVES:

1. To conduct a company stock valuation and predict its probable price evolution.
2. To make a projection on its business performance.
3. To evaluate its management and make internal business decisions.
4. To calculate its credit risk.

KEY POINTS OF FUNDAMENTAL ANALYSIS

1. Based on detailed analysis.

2. Selling and purchase is not done on the basis of tips and rumors.

3. Historical data is taken into view.

4. Intrinsic value of the share is considered as benchmark.

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 A. FUNDAMENTAL ANALYSIS

Fundamental analysis of a business involves analyzing its financial statements and health, its
management and competitive advantages, and its competitors and markets. When applied to
future, it focuses on the overall state of the economy, interest rates, production, earnings, and

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management. When analyzing a stock, futures contract, or currency using fundamental analysis
there are two basic approaches one can use; bottom up analysis and top down analysis. The term
is used to distinguish such analysis from other types of investment analysis, such as quantitative
analysis and technical analysis.
Fundamental analysis is performed on historical and present data, but with the goal of making
financial forecasts. There are several possible objectives:

1. To conduct a company stock valuation and predict its probable price evolution.
2. To make a projection on its business performance.
3. To evaluate its management and make internal business decisions.
4. To calculate its credit risk.

The biggest part of fundamental analysis involves delving into the financial statements. Also
known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and
all the other financial aspects of a company. Fundamental analysts look at this information to
gain insight on a company's future performance. A good part of this tutorial will be spent
learning about the balance sheet, income statement, cash flow statement and how they all fit
together.

When talking about stocks, fundamental analysis is a technique that attempts to determine a
security’s value by focusing on underlying factors that affect a company's actual business and its
future prospects. On a broader scope, you 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 a
financial entity as opposed to only its price movements.

Fundamental analysis serves to answer questions, such as:

 Is the company’s 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"?
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When the objective of the analysis is to determine what stock to buy and at what price, there are
two basic methodologies:-

1. Fundamental analysis maintains that markets may misprice a security in the short
run but that the "correct" price will eventually be reached. Profits can be made by trading
the mispriced security and then waiting for the market to recognize its "mistake" and re-
price the security.
2. Technical analysis maintains that all information is reflected already in the stock
price. Trends 'are your friend' and sentiment changes predate and predict trend changes.
Investors' emotional responses to price movements lead to recognizable price chart
patterns. Technical analysis does not care what the 'value' of a stock is. Their price
predictions are only extrapolations from historical price patterns.

Investors can use any or all of these different but somewhat complementary methods for stock
picking. For example many fundamental investors use technical’s for deciding entry and exit
points. Many technical investors use fundamentals to limit their universe of possible stock to
'good' companies.

Fundamental analysis includes:

1. Economic analysis.
2. Industry analysis.
3. Company analysis.

On the basis of these three analyses the intrinsic value of the shares are determined. This is
considered as the true value of the share. If the intrinsic value is higher than the market price it is
recommended to buy the share. If it is equal to market price then hold the share and if it is less
than the market price then sell the shares.

Aim of fundamental analysis

Followers of fundamental analysis - fundamentalists - believe that the market price of a stock
tends to move toward its instinct value. The objective of the fundamentalist is to use superior
information or information-processing techniques to identify these mispriced securities. Superior
returns may then be earned by either purchasing underpriced securities or short-selling
overpriced securities.

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The fundamentalist usually has time horizon of at least six months and often longer. This type of
analysis does not attempt to forecast stock price moves on a daily basis. That task is more often
reserved for technical analysts.

Fundamental Analysis and efficient markets

The fundamentalist hopes to earn a superior return as a result of having better access to relevant
information, or a better ability to process it. A market in which all relevant information is
currently reflected in present share prices is called an efficient market. In a perfectly efficient
market there would be no need for the output of fundamentalists, since current share price would
be the best estimate of intrinsic value. On the other hand, the only way for a market to become
efficient is through the efforts of a number of reasonably capable fundamentalists who constantly
make intrinsic value estimates.

This creates a paradox; while stock markets appear to be efficient, they can only continue to be
efficient through the efforts of a large number of fundamentalists who believe the market is not
efficient. Furthermore, the purchase of stocks that are deemed to be priced below their intrinsic
value only makes senses if prices ultimately tend to adjust toward intrinsic values.

 Use by different portfolio styles:

Investors may use fundamental analysis within different portfolio management styles.

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 Buy and hold investors believe that latching onto good businesses allows the investor's
asset to grow with the business. Fundamental analysis lets them find 'good' companies, so
they lower their risk and probability of wipe-out.
 Managers may use fundamental analysis to correctly value 'good' and 'bad' companies.
Eventually 'bad' companies' stock goes up and down, creating opportunities for profits.
 Managers may also consider the economic cycle in determining whether conditions are
'right' to buy fundamentally suitable companies.
 Contrarian investors distinguish "in the short run, the market is a voting machine, not a
weighing machine". Fundamental analysis allows you to make your own decision on
value, and ignore the market.
 Value investors restrict their attention to under-valued companies, believing that 'it's
hard to fall out of a ditch'. The value comes from fundamental analysis.
 Managers may use fundamental analysis to determine future growth rates for buying high
priced growth stocks.
 Managers may also include fundamental factors along with technical factors into
computer models (quantitative analysis).

 Top Down & Bottom-Up:

Investors can use either a top-down or bottom-up approach.

 The top-down investor starts his analysis with global economics, including both
international and national economic indicators, such as GDP growth
rates, inflation, interest rates, exchange rates, productivity, and energy prices. He narrows
his search down to regional/industry analysis of total sales, price levels, the effects of
competing products, foreign competition, and entry or exit from the industry. Only then
he narrows his search to the best business in that area.
 The bottom-up investor starts with specific businesses, regardless of their industry/region.

 General strategy in Fundamental Analysis:

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 According to the ‘fundamentalists’, the market price of stocks tends to move towards its
“real value” or “intrinsic value”. If the “intrinsic” or “real” value of a stock is above the
current market price, the investor would purchase the stock because of the fact that the
stock price would probably rise and move towards its intrinsic or real value.
For example, if the intrinsic value of a stock is below the market price, smart move for an
investor would be to sell the stock because the stock price will probably fall and come
closer to its intrinsic value.

But question is how to find out what the intrinsic value of stocks of certain company is?
Once that value is revealed, investor would be able to compare this price to the market
price of the company and decide whether to buy it or sell it (if investor already owns that
stock).

1. First important step in finding out the intrinsic value of the stock through the
fundamental analysis is an examination of the current and future overall health of the
economy as a whole.

2. After analyzing the overall economy state, analysts should analyze the company they
are interested in, where the special attention should be given to the analyzing factors that
give the company a competitive advantage in its branch, also to the management,
experience, history, growth potential, costs, brand name, etc.

3. These are several questions that anyone who performs fundamental analysis,
particularly examination of the company in question:

• Does the company have any competency?

• What advantage the company has over their competitors?
• Does the company have a strong market presence and market share?
• Does the company have to deploy often a large part of their profits and resources in
marketing and finding new customers and fighting for market share?

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4. After the analysis of the company and their production, efficiency, market and
customer relations, investor will be in a far better position to decide whether the price of
the company’s stocks will go up or fall down.

5. Next step would be analysis of the stocks. There are few tips what shouldn’t be
overlooked. When investing in the stocks, the main goal is to find stocks which price will
rise. Moreover, stocks which prices will raise fast.
Important thing to know is that the price of the stock is not important. Some stocks are
cheap and some cost more. But, the price of the stock does not make a good stock to buy.
What is important is how much the price of the stock is likely to rise.

What is often overlooked in stock prices is the percentage of their rise.

To simplify this: If the one $500 stock becomes worth $540, then that is 8% rise. This 8%
rise only makes $40 to the investor. On the other hand when the same amount is invested
in the 50 cent stock and the stock price goes up to $1, which means basically a 100% rise
as the stock price has doubled. This 100% rise gives $500 to investor.
But, which is the good way to compare the value of stocks?

The price-to-sales ratio (Price/Sales or P/S) provides a simple approach: taking the
company's market capitalization (the number of shares multiplied by the share price) and
dividing it by the company's total sales over the past 12 months. The lower the ratio, the
more attractive is the investment. As easy as it sounds, price-to-sales provides a useful
measure for sizing up stocks. But investors need to be careful of the ratio's potential
pitfalls and possible unreliability.

Thus the steps involved in fundamental analysis can be summarized as:

1.Macroeconomic analysis, which involves considering currencies, commodities and

indices.
2. Industry sector analysis, which involves the analysis of companies that are a part of the
sector.

3. Situational analysis of a company.

4. Financial analysis of the company.

5. Valuation.

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The valuation of any security is done through the discounted cash flow (DCF) model, which
takes into consideration:

1. Dividends received by investors.

2. Earnings or cash flows of a company.
3. Debt, which is calculated by using the debt to equity ratio and the current ratio (current
assets/current liabilities).

 Fundamental analysis and Technical analysis:

Technical analysis and fundamental analysis are the two main attentions in the financial
markets. Mainly, technical analysis looks at the price movement of a security and uses this
data to predict its future price movements. Fundamental analysis, on the other hand, looks at
economic factors, known as fundamentals. Let’s see how it works to determine the correct
value of stock and how technical and fundamental analysis can be used together to analyze
securities.

1. Charts vs. Financial Statements

At the most basic level, a technical analyst approaches a security from the charts, while a
fundamental analyst starts with the financial statements. By looking at the balance sheet, cash
flow statement and income statement, a fundamental analyst tries to determine a company’s
value. In financial terms, an analyst attempts to measure a company’s fundamental value. In
this approach, investment decisions are fairly easy to make - if the price of a stock trades
below its intrinsic value, it’s a good investment.

Technical traders, on the other hand, believe there is no reason to analyze a company’s
fundamentals because these are all accounted for in the stock’s price. Technicians believe that
all the information they need about a stock can be found in its charts.

2. Time approach for both the technique

Fundamental analysis takes a relatively long-term approach to analyzing the market compared
to technical analysis. While technical analysis can be used on a timeframe of weeks, days or
even minutes, fundamental analysis often looks at data over a number of years.

The different timeframes that these two approaches use is a result of the nature of the
investing style to which they each adhere. It can take a long time for a company’s value to be
reflected in the market, so when a fundamental analyst estimates intrinsic value, a gain is not
realized until the stock’s market price rises to its “correct” value. This type of investing is

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called value investing and assumes that the short-term market is wrong, but that the price of a
particular stock will correct itself over the long run. This “long run” can represent a timeframe
of as long as several years, in some cases.

Furthermore, the numbers that a fundamentalist analyzes are only released over long periods
of time. Financial statements are filed quarterly and changes in earnings per share don’t
emerge on a daily basis like price and volume information. Also remember that fundamentals
are the actual characteristics of a business. New management can’t implement sweeping
changes overnight and it takes time to create new products, marketing campaigns, supply
chains, etc. Part of the reason that fundamental analysts use a long-term timeframe, therefore,
is because the data they use to analyze a stock is generated much more slowly than the price
and volume data used by technical analysts.

3. Trading Versus Investing

Not only is technical analysis more short term in nature that fundamental analysis, but the
goals of a purchase (or sale) of a stock are usually different for each approach. In general,
technical analysis is used for a trade, whereas fundamental analysis is used to make
an investment. Investors buy assets they believe can increase in value, while traders buy assets
they believe they can sell to somebody else at a greater price. The line between a trade and an
investment can be blurry, but it does characterize a difference between the two schools. Some
analysts see technical analysis as a form of black magic. Don’t be surprised to see them
question the validity of the discipline to the point where they mock its supporters. In fact,
technical analysis has only recently begun to enjoy some mainstream credibility. While most
analysts on Wall Street focus on the fundamental side, just about any major brokerage now
employs technical analysts as well.

Much of the criticism of technical analysis has its roots in academic theory - specifically
the efficient market hypothesis (EMH). This theory says that the market’s price is always the
correct one - any past trading information is already reflected in the price of the stock and,
therefore, any analysis to find undervalued securities is useless.

There are three versions of EMH. In the first, called weak form efficiency, all past price
information is already included in the current price. According to weak form efficiency,
technical analysis can’t predict future movements because all past information has already
been accounted for and, therefore, analyzing the stocks past price movements will provide no
insight into its future movements. In the second, semi-strong form efficiency, fundamental
analysis is also claimed to be of little use in finding investment opportunities. The third is

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strong form efficiency, which states that all information in the market is accounted for in a
stock’s price and neither technical nor fundamental analysis can provide investors with an
edge. The vast majority of academics believe in at least the weak version of EMH, therefore,
from their point of view, if technical analysis works, market efficiency will be called into
question. There is no right answer as to who is correct. There are arguments to be made on
both sides and, therefore, it’s up to you to do the homework and determine your own
philosophy.

4. Combo Pack

Although technical analysis and fundamental analysis are seen by many as polar opposites -
the oil and water of investing - many market participants have experienced great success by
combining the two. For example, some fundamental analysts use technical analysis techniques
to figure out the best time to enter into an undervalued security. Oftentimes, this situation
occurs when the security is severely oversold. By timing entry into a security, the gains on the
investment can be greatly improved.
Alternatively, some technical traders might look at fundamentals to add strength to a technical
signal. For example, if a sell signal is given through technical patterns and indicators, a
technical trader might look to reaffirm his or her decision by looking at some key fundamental
data. Oftentimes, having both the fundamentals and technical’s on your side can provide the
best-case scenario for a trade.

While mixing some of the components of technical and fundamental analysis is not well
received by the most devoted groups in each school, there are certainly benefits to at least
understanding both schools of thought.

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 ii. CONCEPT OF INTRINSIC VALUE OF SHARE

The actual value of a security, as opposed to its market or book value, is the intrinsic
value of the security. Intrinsic value may differ from market value because of brand
names, patents and other intangibles that are difficult for investors to quantify. There are
various approaches but no standard formula for calculating the intrinsic value of an asset.
The concept of intrinsic value is also used in options trading where intrinsic value
measures the amount by which the option is in the money. A call option's intrinsic value
is calculated by subtracting the strike price of the call option from the market price of
the underlying security. A put option's intrinsic value is measured by subtracting the
market price of the underlying security from the strike price of the put option. For call
options, this is the difference between the underlying stock's price and the strike price.
For put options, it is the difference between the strike price and the underlying stock's
price. In the case of both puts and calls, if the respective difference value is negative, the
intrinsic value is given as zero.

For example, value investors that follow fundamental analysis look at both qualitative
(business model, governance, target market factors etc.) and quantitative (ratios, financial
statement analysis, etc.) aspects of a business to see if the business is currently out of
favor with the market and is really worth much more than its current valuation.

To determine the intrinsic value of the stock, one should:

1. Eliminate poorly run businesses from intrinsic value calculations by starting with a cash
flow analysis. Experienced investors will project annual revenues and expenses for the
next decade before taking the trouble to calculate intrinsic value. These calculations
should be adjusted based on a reasonable interest rate to account for changes in lending
and inflation.

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2. Utilize the current interest rate on government bonds as a way to differentiate market
value from intrinsic value. These bonds are designed as stable investments for people
who want low but steady growth.

3. Divide the government bond rate by last year's earnings estimate on a particular stock to
find intrinsic value. An investor calculating an earnings estimate of $6 divided by a bond
rate of 2.5 percent will get an intrinsic value of $240.

4. Write down the potential return percentage of a stock based on its intrinsic value by
dividing last year's earnings estimate by the stock's current market value. An investor
who divides an earnings estimate of $6 by a market value of $75 will get a return
percentage of 8 percent. Most investors choose stocks with intrinsic values that earn at
least twice the return rate on government bonds.

5. Stay committed to a margin of safety that fits your investment philosophy. The margin of
safety is a figure that measures the difference between market and intrinsic values. A
stock holder with a 50 percent margin of safety looking at a stock with a $30 market
value will need to find an intrinsic value of at least $45 before investing.

6. Adhere to the intrinsic value you calculated for each stock in order to realize larger
dividends down the road. Novice investors may dump their stocks during a brief upward
swing in the market without looking ahead to bigger improvements in subsequent weeks
and months.

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 iii. ECONOMIC ANALYSIS

Economic analysis is a process whereby strengths and weaknesses of an economy are analyzed.
Economic analysis is important in order to understand exact condition of an economy. It can
cover a number of important economic issues that keep cropping up within a particular economy,
which is being analyzed. The level of economic activity has an impact on investment in many
ways. If the economy grows rapidly, the industry can also be expected to show rapid growth and
vice-versa. The analysis of economic environment is essential to understand the behavior of the
stock prices.

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Macroeconomic issues are important aspects of economic analysis process. However, economic
analysis can also be done at a microeconomic level. Macroeconomic analysis helps in
understanding fundamentals of an economy. Since such a form of analysis operates on a wide
scale, it helps one to analyze strengths and weaknesses of particular economies.

Macroeconomic analysis takes into account growth achieved by a particular economy or rather a
particular sector of that economy. It tries to find out reasons behind a particular economic
phenomenon like growth or reversal of economy.

MEASURES OF ECONOMIC ACTIVITY

Gross Domestic Product: The most commonly used statistic is the average "Gross
Domestic Product (GDP)". GDP is the total money value of all the final goods and
services produced in an economy in a given year, which is clear from the name. However,
there are difficulties associated with using GDP, such as inflation - the money value of an
economy's products will increase even if there is no real growth, as inflation reduces the
value of money. So, GDP is often adjusted for inflation, the result being called real GDP.
The gross domestic product (GDP) or gross domestic income (GDI) is a measure of a
country's overall economic output. It is the market value of all final goods and services
made within the borders of a country in a year. It is often positively correlated with
the standard of living, alternative measures to GDP for that purpose. Gross domestic
product comes under the heading of national accounts, which is a subject in
macroeconomics.
For example, if the GDP of an economy in 2004 is 1 trillion, and the next year is 1.1
trillion, the change in GDP is 10%. However, if money inflation is 5% then the change
in real GDP is somewhat less than that.

1. Savings and Investment: It is obvious that growth requires investment which in

urn requires substantial amount of domestic savings. Stock market is a channel through
which the savings of the investors are made available to corporate bodies. Savings are
distributed over various assets like equity shares, deposits, mutual funds units, real estate
and bullion. The saving and investment patterns of the public affect the stock to a great
extent.

2. Inflation: Along with the growth of GDP, the inflation rate also increases, and
then the real rate of the growth would be very little. The demand in the consumer product

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industry is significantly affected. The industries which come under the government price
control policy may lose the market, for example Sugar. The government control over this
industry, affects the price of the sugar and thereby the profitability of the industry itself. If
there is a mild level of inflation, it is good to the stock market but high rate of inflation is
harmful to the stock market.

3. Interest Rates: It affects the cost of financing to the firms. A decrease in interest
rate implies lower cost of finance for firms and more profitability. More money is
available at a lower interest rate for the brokers who are doing business with borrowed
money. Availability of cheap fund encourages speculation and rise in the price of shares.

Bank Rate % p.a.

Feb 2001 7.5

March 2001 7.0

22 Oct 2001 6.5

29 Oct 2001 6.25

April 2003 6.0

4. The Balance of Payment: It is the record of a country’s’ money receipts from

and payment abroad. The difference between receipts and payments may be surplus or
deficit. BOP 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 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
investments of the foreign institutional investors in the Indian stock market. A favourable
BOP renders a positive effect on the stock market.

5. Monsoon and Agriculture: Agriculture is directly or indirectly linked with the

industries. For example, sugar, cotton, textile industries depend upon agriculture for raw-
material. Fertilizer and insecticide industries are supplying inputs to the agriculture. A
good monsoon leads to higher demand for inputs and results in bumper crop. This would

22
 lead to buoyancy in the stock market. When the monsoon is bad, agriculture and hydel
power production would suffer. They cast a shadow on the share market.

6. Infrastructural facilities: These are essential for the growth of industrial and
agricultural sector. A wide network of communication system is must for the growth of
the economy. Regular supply of power without any power cut would boost the production.
Banking and financial sectors also should be sound enough to provide adequate support to
the industry and agriculture. Good infrastructure facilities affect the stock market
favourably. In India even though facilities have been developed, still they are not
adequate. The government has liberalized its policy regarding the communication,
transport and power sector. Fro example, power sector has been opened up to the foreign
investors with assured rates of returns.

7. Demographic Factors: The demographic data provides details about the

population by age, occupation, literacy and geographic location. This is needed to forecast
the demand for the consumer goods. The population by age indicates the availability of the
able workforce. The cheap labor force in India has encouraged many multinationals to
start their ventures. Indian labor is cheaper compared to the Western labor force.
Population, by providing labor and demand for products, affects the industry and the stock
market.

ECONOMIC FORECASTING

The process of attempting to predict the future condition of the economy is economic
forecasting. This involves the use of statistical models utilizing variables sometimes called
indicators. Some of the most well-known economic indicators include inflation and interest
rates, GDP growth/decline, retail sales and unemployment rates. While economic forecasting
is not an exact science, it remains an important decision-making tool for businesses and
governments as they formulate financial policy and strategy.
Economic forecasting is the prediction of any of the elements of economic activity. Such
forecasts may be made in great detail or may be very general. In any case, they describe the
expected future behavior of all or part of the economy and help form the basis of planning.

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Formal economic forecasting is usually based on a specific theory as to how the economy
works. Some theories are complicated, and their application requires an elaborate tracing
of cause and effect. Others are relatively simple, ascribing most developments in the economy
to one or two basic factors.

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Many economists, for example, believe that changes in the supply of money determine the
rate of growth of general business activity. Others assign a central role to investment in new
facilities—housing, industrial plants, highways, and so forth. In the United States, where
consumers account for such a large share of economic activity, some economists believe that
consumer decisions to invest or save provide the principal clues to the future course of the
entire economy. Obviously the theory that a forecaster applies is of critical importance to the
forecasting process; it dictates his line of investigation, the statistics he will regard as most
important, and many of the techniques he will apply.

Although economic theory may determine the general outline of a forecast, judgment also
often plays an important role. A forecaster may decide that the circumstances of the moment
are unique and that a forecast produced by the usual statistical methods should be modified to
take account of special current circumstances. This is particularly necessary when some event
outside the usual run of economic activity inevitably has an economic effect.

Economic forecasting is probably as old as organized economic activity, but modern

forecasting got its impetus from the Great Depression of the 1930s. The effort to understand
and correct the worldwide economic disaster led to the development of a vastly greater supply
of statistics and also of the techniques needed to analyze them. After World War II, many
governments committed themselves to maintaining a high level of employment. Most
governments of the industrialized Western countries were prepared to intervene more often
and more directly in economic affairs than previously. Business organizations manifested
more concern with anticipating the future. Many trade associations now provide forecasts of
future trends for their members, and a number of highly successful consulting firms have been
formed to provide additional forecasting help for governments and businesses.

“These techniques help him to decide the right time to invest and the type of security he has to
purchase i.e. stocks or bonds or some combination of stocks and bonds.”

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 The common techniques used in economic forecasting are:

1. Analysis of key economic indicators: A piece of economic data, usually of

macroeconomic scale, that is used by investors to interpret current or future investment
possibilities and judge the overall health of an economy. Economic indicators can
potentially be anything the investor chooses, but specific pieces of data released by
government and non-profit organizations have become widely followed - these include:

- The Consumer Price Index (CPI)

- Gross Domestic Product (GDP)
- Unemployment figures
- The price of crude oil

An economic indicator is only useful if one interprets it correctly. History has shown
strong correlations between economic growth (as measured by GDP) and corporate profit
growth. However, determining whether a specific company will grow its earnings based
on one indicator is nearly impossible. Indicators give us signs along the road, but the best
investors will utilize many economic indicators, looking for patterns and verifications
within different sets of data.

Most economic indicators have a specific schedule for release, allowing investors to
prepare for and plan on seeing certain information at certain times of the month and year.

They are of 3 types as follows:

 Leading Indicators: A measurable economic factor that changes before the economy
starts to follow a particular pattern or trend. Leading indicators are used to predict
changes in the economy, but are not always accurate. Bond yields are typically a good
leading indicator of the market because traders anticipate and speculate trends in the
economy.

EX:-

Fiscal policy

Monetary policy

26
 Capital investment

Stock indices, etc.

 Coincidental Indicators: An economic factor that varies directly and simultaneously

with the business cycle, thus indicating the current state of the economy.

EX:-

Gross national product

Industrial production

Interest rates, etc.

 Lagging Indicators: Lagging indicators confirm long-term trends, but they do not
predict them. Some examples are unemployment, corporate profits and labor cost per
unit of output. Interest rates are another good lagging indicator; rates change after
severe market changes.

EX:-

Unemployment rate

Consumer price index

Flow of foreign funds, etc.

27
2. Diffusion index: Some economists also use sets of statistics called diffusion indexes to
calculate economic turning points. A diffusion index is a method of summarizing the
common tendency of a group of statistical series. If a greater number of the series are
rising than are declining, the index will be above 50; if fewer are rising than declining, it
will be below 50. In effect, a diffusion index measures the degree to which either strength
or weakness pervades the economy. If, for example, most of a group of industries are
increasing their production rates, the economy as a whole is probably expanding; if the
proportion of industries that are growing begins to decline and falls significantly below
50 percent for a period of time, the economy is probably in a recession, or at least moving
in that direction.

3. Econometric model building: Economists frequently use mathematical equations to

express the normal relations between various economic factors. As a simple example, a
given increase in consumer income will ordinarily produce a certain increase in sales,
saving, and tax revenue, and these developments can be expressed mathematically. With
a sufficient number of equations, all the important interactions within the economy can be
simulated in a mathematical model.

With the advent of computers able to make millions of calculations in a few moments,
economists began to construct more and more complex sets of equations,
called econometric models. These models, some of which include hundreds of equations,
can be used to forecast overall economic activity (macroeconomic forecasting) or
developments in particular parts of the economy (microeconomic forecasting). The
success of econometric forecasting has so far been limited because the exact nature of
economic relations is not fully known, and also because of the inadequacies of existing

28
 statistics. Nevertheless, the improvement of these techniques represents the greatest hope
for more accurate economic forecasting in the future.

4. Anticipatory surveys: Periodic surveys conducted both by government and by private

organizations measure business plans to invest in new plants and equipment.
Increasingly, attempts are made to probe the mood and intentions of consumers
concerning the possible purchase of automobiles, houses, appliances, and other durable
goods. Regular surveys are also made to determine the general mood of the public—
whether people are optimistic or pessimistic about their own economic future and thus
whether their spending is apt to be relatively strong or relatively weak.

In general, such information obtained from the various surveys of investment plans,
spending plans, and attitudes has been highly useful to economic forecasters. Such
information helps to limit the range of possibility. But plans and attitudes change,
sometimes quite abruptly, and although the surveys are useful tools they are not clear and
reliable guides to the future.

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 iv. Industry Analysis

An industry is a group of firms that have similar technological structure of production and
produce similar products. Industries can be classified under:

 Food products,
 Beverages,
 Textiles,
 Wood & wood products,
 Leather & leather products,
 Machinery & machine tool, etc.

It is important for companies to understand the use of the industry lifecycle because it is a
survival tool for businesses to compete in the industry effectively and successfully. Industry
lifecycle comprises four stages including fragmentation, growth, maturity and decline. An
understanding of the industry lifecycle can help competing companies survive during periods of
transition. Information on the industry lifecycle can be found in most business management
books. Several variations of the lifecycle model have been developed to address the development
and transition of products, market and industry. The models are similar but the number of stages
and names of each may differ. Major models include those developed by Fox (1973), Wasson
(1974), Anderson & Zeithaml (1984), and Hill & Jones (1998).

These industries are classified on the basis of the business cycle as following:

Growth industry: If companies across an industry exhibit solid earnings and revenue figures,
that industry may be showing signs that it is in its growth stage. Growth industries tend to be
composed of relatively volatile and risky stocks. Often investors must be willing to accept
increased risk in order to take part in the potentially large gains offered by stocks within a
particular growth industry.

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Cyclical industry: A type of an industry that is sensitive to the business cycle, such that
revenues are generally higher in periods of economic prosperity and expansion and lower in
periods of economic downturn and contraction. Companies in cyclical industries can deal with
this type of volatility by implementing cuts to compensations and layoffs during bad times,
and paying bonuses and hiring en masse in good times. Cyclical industries include those that
produce durable goods such as raw materials and heavy equipment.

Defensive industry: It defies the movement of the business cycles. Fro example, food and
shelter are the basic requirement of the humanity. The food industry withstands recession and
depression. The stocks of these industries can be held by the investor for incoming purpose.
They expand and earn income in the depression period too, under the government’s umbrella of
protection and are counter cyclical in nature.

Cyclical growth industry: This is a new type of industry that is cyclical and at the same time
growing. For example, the 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.

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The stages of industry lifecycle include introduction, growth, maturity and decline.

1. Introduction: In the introduction stage of the life cycle, an industry is in

its infancy. Perhaps a new, unique product offering has been developed
and patented, thus beginning a new industry. Some analysts even add an
embryonic stage before introduction. At the introduction stage, the firm
may be alone in the industry. It may be a small entrepreneurial company
or a proven company which used research and development funds and
expertise to develop something new.

A firm will use a focus strategy at this stage to stress the uniqueness of the new product
or service to a small group of customers. These customers are typically referred to in the
marketing literature as the "innovators" and "early adopters." Marketing tactics during
this stage are intended to explain the product and its uses to consumers and thus create
awareness for the product and the industry.

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Because it costs money to create a new product offering, develop and test prototypes, and
market the product from its embryonic stage to introduction, the firm's and the industry's
profits are usually negative at this stage.

2. Growth: Like the introduction stage, the growth stage also requires a
significant amount of capital for the firm. The goal of marketing efforts at
this stage is to differentiate a firm's offerings from other competitors
within the industry. Thus the growth stage requires funds to launch a
newly focused marketing campaign as well as funds for continued
investment in property, plant, and equipment to facilitate the growth
required by the market demands.

Research and development funds will be needed to make changes to the product or
services to better reflect customer's needs and suggestions. In this stage, if the firm is
successful in the market, growing demand will create sales growth. Earnings and
accompanying assets will also grow and profits will be positive for the firms.

During the growth stage, the life cycle curve is very steep, indicating fast growth. Firms
tend to spread out geographically during this stage of the life cycle and continue to
disperse during the maturity and decline stages. As an example, the automobile industry
in the United States was initially concentrated in the Detroit area and surrounding cities.
Today, as the industry has matured, automobile manufacturers are spread throughout the
country and internationally.

3. Maturity: Maturity is the third stage in the industry lifecycle. Maturity is

a stage at which the efficiencies of the dominant business model give these
organizations competitive advantage over competition. The competition in
the industry is rather aggressive because there are many competitors and
product substitutes. Price, competition, and cooperation take on a complex
form. Some companies may shift some of the production overseas in order
to gain competitive advantage.

For example, Toyota is one of the world's leading multinational companies, selling
automobiles to customers worldwide. The export and import taxes mean that its cars lose
competitiveness to the local competitors, especially in the European automobile industry.

33
 As a result, Toyota decided to open a factory in the UK in order to produce cars and sell
them to customers in the European market (Toyota, 2007).

4. Decline: Decline is the final stage of the industry lifecycle. Decline is a

stage during which a war of slow destruction between businesses may
develop and those with heavy bureaucracies may fail.

Declines are almost inevitable in an industry. If product innovation has not kept pace
with other competitors, or if new innovations or technological changes have caused the
industry to become obsolete, sales suffer and the life cycle experiences a decline. In this
phase, sales are decreasing at an accelerating rate, causing the plotted curve to trend
downward. Profits may continue to rise, however. There is usually another, larger shake-
out in the industry as competitors who did not leave during the maturity stage now exit
the industry. Yet some firms will remain to compete in the smaller market. Mergers and
consolidations will also be the norm as firms try other strategies to continue to be
competitive or grow through acquisition and/or diversification.

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

 Growth of the industry,

 Cost structure and profitability,
 Nature of product,
 Nature of competition, government policy and
 Labor.

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  Growth of the Industry: The historical performance of the industry in terms of
growth and profitability should be analysed. Industry wise growth is published
periodically by the Centre for Monitoring Indian Economy. The past variability in
return and growth in reaction to macro economic factors provide an insight into
the future. Even though history may not repeat in the exact manner, looking into
the past growth of the industry, the analyst can predict the future. The information
technology industry has witnessed a tremendous growth in the past so also the
scrip prices of the IT industry.

 Cost Structure and Profitability: The cost structure, that is the fixed and
variable cost, affects the cost of production and profitability of the firm. In the
case of oil and natural gas industry and iron and steel industry the fixed cost
portion is high and the gestation period is also lengthy. Higher the fixed cost
component, greater sales volume is required to reach the firm’s break even point.
Once the break even point is reached and the production is on the track, the
profitability can be increased by utilizing the capacity to full. Once the maximum
capacity is reached, again capital has to be invested in the fixed equipment.
Hence, lower the fixed cost, adjustability to the changing demand and reaching
the break even points are comparatively easier.

 Nature of the Product: The products produced by the industries are demanded
by the consumers and other industries. If industrial goods like pig iron, iron sheet
and coils are produced, the demand for them depends on the construction
industry. Like wise, textile machine tools industry produces tools for the textile
industry and the entire demand depends upon the health of the textile industry.
Several such examples can be cited. The investor has to analyse the condition of
related goods producing industry and the end user industry to find out the demand
for industrial goods.

In the case of consumer goods industry, the change in the consumer’s preference,
technological innovations and substitute products affect the demand. A simple example is

35
that the demand for the ink pen is affected by the ball point pen with the change in the
consumer preference toward the easy usage of the pen.

 Nature of Competition: Nature of competition is an essential factor that

determines the demand for the particular product, its profitability and the price of
the concerned company scrips. The supply may arise from indigenous producers
and multinationals. In the case of detergents, it is produced by indigenous
manufacturers and distributed locally at a competitive price. This poses a threat to
the company made products. The multinationals are also entering into the field
with sophisticated product process and better quality product. Now the company’s
ability to withstand the local as well as the multinational competition counts
much. If too many firms are present in the organized sector, the competition
would be severe. The competition would lead to a decline in the price of the
product. The investor before investing in the scrip of a company should analyse
the market share of the particular company’s product and should compare it with
the top five companies.

 Government Policy: The government policy affects the very of the industry and
the effects differ from industry to industry. Tax subsidies and tax holidays are
provided for export oriented products. Government regulates the size of the
production and the pricing of certain products. The sugar, fertilizers and
pharmaceutical industries are often affected by the inconsistent government
policies. Control and decontrol of sugar price affect the profitability of the sugar
industry. In some cases entry barriers are placed by the government. In the

36
 airways, private corporate are permitted to operate the domestic flights only.
When selecting an industry, the government policy regarding the particular
industry should be carefully evaluated. Liberalization and delicensing have
brought immense threat to the existing domestic industries in several sectors.

 Labour: the analysis of the labour scenario in a particular industry is of great

importance. The numbers of trade unions and their operating mode have impact
on the labor productivity and modernization the industry. Textile industry is
known for its militant trade unions. If the trade unions are strong and strikes occur
frequently, it would lead to fall in the production. In an industry of high fixed
cost, the stoppage of production may lead to loss. When trade unions oppose the
introduction of automation, in the product market the company may stand to loose
with high cost of production. The unhealthy relationship leads to loss of
customer’s goodwill too. Skilled labour is needed for certain industries. In the
case of Indian labour market, even in computer technology or in any other
industry skilled and well-qualified labour is available at a cheaper rate. This is one
of the many reasons attracting the MNC’s to set up companies in India.

Pharmaceutical industry

Growth of the industry- The industry has witnessed healthy growth in the recent past and
investment in pharmaceutical industry is continuing. The product output is also increasing and
operational and business management efficiency also seems to have improved. This is shown by
the increase in the output of the industry as given in table:

Year Bulk Drugs Growth% Formulations Growth%

2003-04 1320 14.8 6900 15
2004-05 1518 15 7935 15
2005-06 1822 20 9125 15
37
2006-07 2186 19.9 10494 15
2007-08 2623 20 12068 15

Structure of the industry: Pharmaceutical industry adopts high technology and produces high
value added products. The process is very complex in nature. The processes are classified into
primary and secondary. The primary process requires uninterrupted power supply, maintaining
of conditions under which the molecules react and yield a new product, excellent manufacturing
conditions and well-trained personnel. A specific plant costs less but, they have the risk of
obsolescence. Multipurpose plants are expensive and have no risk of obsolescence but, they have
the risk of cross contamination. The secondary process is not much technology intensive and has
low capital cost. Hence, there are many players in the market.

Nature of the product: the products of the pharmaceutical industry are broadly classified into
bulk drugs, formulations and intravenous fluids. Bulk drugs are like Ciprofloxacin, Ibuprofen,
Ethan-butol, etc. the major manufacturers of the products are Ranbaxy, Cipla, Cadilla, Dr.
Reddy’s Lab and Lupin. Some companies manufacture formulations from bulk drugs and market
them under brands. Companies also manufacture formulations for other companies. Some of the
companies in the formulation segment are Ranbaxy, Cipla, Lupin, etc.

Intravenous fluids are preparations which aid in quick replenishment of body fluids. Bulk drugs
and formulation companies produce intravenous fluids also. The formulations are produced by
the firms from all over the country. Andhra Pradesh stands first in the production of bulk drugs.

Demand for the product: the Indian pharmaceutical market which was worth rs 90 billion in
2007, is growing at 13.5%. but only 3 out of 10 Indians have access to allopathic drug. Even in
this segment vast majority of them belong to urban area. Investments in medical and public
health declined from 2% of the total capital outlay in the sixth five year plan to 1.7% in the Eight
five year plan. 12006-07, the portion in the annual budget was 1.7%.

The less than 15 age segment of the population is expected to grow at 0.5% but the fastest
growth is expected in the 50-59 group. This has led to a shift in the demand from the life saving
drug to life enhancing drugs. It is referred to as a shift from age old diseases to old age diseases.

Competition: the industry is having 2400 players within the organized sector, and around
15,000 in small-scale sector. The low entry barriers, government’s encouragement given to small

38
sector units and low capital cost are the reason for the presence of large number of units in the
pharmaceutical sector. This has lead to price crash in the bulk drug.

Apart from the internal competition, the industry is facing international competition too. There is
a large import of bulk drugs from China. The Chinese products are a significant competitor for
the Indian pharmaceutical industry. Multinational corporations like Pfizer, Abbot labs also pose
threat to the local producers.

Government policy: the drug companies operate in a highly politicized environment. The
product development, prices, safety are regulated to make the available to the masses at
affordable prices. The DPCO is issued from time to time to keep the policy in tune with the
changing demands.

The Patent law in India, provides patent only for process and there is no product patent. But, with
signing of GATT, India is required to amend the Patent Law. Once the product patent comes into
force, the reverse engineering route to introduce new molecules will not be available to Indian
companies.

Research and development: The average sum spent by the 15 largest Indian pharmaceutical
companies for R&D is around 2% of turnover. This is drastically low and research is mainly
concentrated towards the area of process development rather than on new molecular searching.

SWOT Analysis:-

39
STRENGTH WEAKNESS

Despite economic slowdown, the industry Decline in plan investment in medical and
registered double digit growth rate. public health.

Indian pharmaceutical market is growing at Only three out of ten Indians have access to
13.7%. allopathic drugs.

Next exporter of bulk drugs and formulations. Various price controls.

Low cost in process development and R & D.

Third largest scientific pool in the world.

OPPORTUNITY THREAT

With increase in purchasing power, health Fall in the price of bulk drugs and imports
care expenditures would increase. from China.

60 major products may lose patent protection.

Non Japan Asia’s share of world health care
spends will double. Ambiguity regarding the timing and content
of the Indian patent act amendment.
Patent law will lead to consolidation of
industry.

40
 v. Company Analysis

In the company analysis the investor assimilates several bits of information related to the
company and evaluates the present and future values of stocks. The risk and return associated
with the purchase of the stock is analysed to take better investments decisions. The valuation
process depends on the investor’s ability to elicit information from the relationship and inter-
relationship among the company related variables.

The present and the future values are affected by a number of factors and they are,

41
1. Competitive edge of the company: major industries in India are composed of hundreds of
individual companies. In the information technology industry even though the number of
companies is large, few companies like Tata InfoTech, Infosys, NIIT, etc., control the major
market share. Like-wise in all industries, some companies rise to the position of eminence
and dominance. The large companies are successful in meeting the competition. Once the
company obtains the leadership position in the market, they seldom loose it. Over the time
they would have proved their ability to withstand competition and to have a sizeable market
share in the market.

The competitiveness of the company can be studied with the help of,

• Market share.
• Growth of Sales.
• Stability of Sales.

Market Share: The market share of the annual sales helps to determine a company’s
relative competitive position within the industry. If the market share is high, the company
would be able to meet the competition successfully. Companies with significant market
share create a problem for competitors because these competitors will have to rely on
"stealing" market share away from the competition; they can't just create business out of thin
air. After all, would you want to create a cola product if you knew you'd be going head-to-
head with such goliaths as Pepsi and Coke? It's also great for the company because it
means its products are well-known and well-received in the marketplace. Market share can
be imposing but if the industry has significant profit potential for new entrants, market share
can be eroded.

Growth of Sales: The Company may be leading company, but if the growth in the sales is
comparatively lower than other company, it indicates the possibility of the company losing
the leadership. The rapid growth in sales would keep the shareholder in a better position
than one with the stagnant growth rate. The company of large size with inadequate growth
in sales will not be preferred by the investors. Growth in sales is usually followed by the
growth in profits. Investor generally prefers size and growth in sales because the larger size

42
companies may be able to withstand the business cycle rather than the company of the
smaller size.

The growth in the sales of the company is analysed both in rupee terms and in physical
terms. Physical term is very essential because it shows the growth in the real terms. The
rupee term is affected by the inflation. Companies with diversified sales are compared in
rupee terms and percentage of growth over time.

Stability of Sales: If a firm has stable sales revenue, other things being remaining constant,
will have more stable earnings. Wide variations in sales lead to variations in capacity
utilisation, financial planning and dividend. The fall in the market shares indicates the
declining trend of the company, even if the sales are stable in absolute terms. Hence, the
stability of sales also should be compared with its market share and the competitors’ market
shares.

2. Earnings of the company: Sales alone do not increase the earnings but the costs and
expenses of the company also influence the earnings of the company. Further, earnings do
not always increase with the sales. The company’s sales might have increased but its
earnings per share may decline due to the rise in costs. The rate of change in earnings differs
from the rate of change of sales. Sales may increase by 10% in a company but earnings per
share may increase only by 5%. Sometimes, the volume of sales may decline but the earnings
may improve due to the rise in the unit price of the article. Hence, the investor should not
depend only on sales, but should analyse the earnings of the company.

Sometimes earning per share may seem to be attractive in a particular year but in actual case
the revenue generated through sales may be comparatively lower than in the previous year.

43
The earnings might have been generated through the sale of the assets. The investor should
be aware that income of the company may vary due to following reasons-

• Change in sales,
• Change in costs,
• Depreciation methods adopted,
• Wages, salaries and fringe benefits,
• Income taxes and other taxes,
• Inventory accounting method,
• Replacement cost of inventories, etc.

3. Capital Structure: Capital structure refers to the way a corporation finances

its assets through some combination of equity, debt, or hybrid securities. A firm's capital
structure is then the composition or 'structure' of its liabilities. For example, a firm that sells
$20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-
financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the
firm's leverage. In reality, capital structure may be highly complex and include dozens of
sources. Gearing Ratio is the proportion of the capital employed of the firm which come from
outside of the business finance, e.g. by taking a short term loan etc.

• Preference shares- This refers to money put up and owned by the shareholders (owners).
Typically, equity capital consists of two types: 1) contributed capital, which is the money
that was originally invested in the business in exchange for shares of stock or ownership
and 2) retained earnings, which represents profits from past years that have been kept by
the company and used to strengthen the balance sheet or fund growth, acquisitions, or
expansion. Many consider equity capital to be the most expensive type of capital a
company can utilize because it’s "cost" is the return the firm must earn to attract
investment.

• Debt- The debt capital in a company's capital structure refers to borrowed money
that is at work in the business. The safest type is generally considered long-term

44
 bonds because the company has years, if not decades, to come up with the principal,
while paying interest only in the meantime. Other types of debt capital can include short-
term commercial paper utilized by giants such as Wal-Mart and General Electric that
amount to billions of dollars in 24-hour loans from the capital markets to meet day-to-day
working capital requirements such as payroll and utility bills. The cost of debt capital in
the capital structure depends on the health of the company's balance sheet.

4. Management: Good and capable management generates profit to investors. The

management of the firm should efficiently plan, organise, actuate and control the activities of
the company. The basic objective of management is to attain the stated objectives of
company for the good of the equity holders, the public and the employees. If the objectives of
the company are achieved the investors will have a profit. A management that ignores profit
does more harm to the investors than one that over emphasizes it.

Koontz and O’Donnell suggest the following as special traits of an able manager:

• Ability to get along with people,

• Leadership,
• Analytical competence,
• Judgment,
• Ability to get things done,
• Industry.

Since the traits are difficult to measure, managerial performance is evaluated against setting and
accomplishing verifiable objectives. If the investor needs greater proof of excellence of
management, he has to analyse management ability. The analysis can be carried out on the
following ways:

45
 Background of managerial personnel contributes much to the success of the management.
The manager’s age, educational background, advancement within the company, etc.

 The record of the management over the past years has to be reviewed. This gives an
insight into the ability of the top management.

 The management’s skill to have market share ahead of others is a proof of managerial
success. The investors can rely on this type management and choose the stock.

 Company’s strength to expand also plays a major role in management. The horizontal or
vertical expansion of the production is a healthy sign of an efficient management.

 The management’s ability to maintain efficient production by proper utilisation of plant

and machinery has to be analysed. Suitable inventory planning and scheduling have to be
drafted and worked out by the management.

 Management’s capacity to finance the company adequately has to be studied.

Accomplishing the financial requirement is a direct reflection of managerial ability. The
management should adopt a realistic dividend policy in relation to earnings. A realistic
dividend policy boosts the image of the company’s stock in the market.

46
  The functional ability of the management to work with employees and union is another
area of concern; unions’ poses a threat to the smooth functioning of the firm. The
management’s adaptability to scientific management and quality control techniques
should be analysed.

After analyzing the above mentioned factors, the investor should select companies that possess
excellent management and maintain the competitive position of the company in the market.

5. Operating Efficiency: The operating efficiency of a company directly affects the

earnings of a company. An expanding company that maintains high operating efficiencies
with a low break-even point earns more than the company with high break –even point. If a
firm has stable operating ratio, the revenues also would be stable. Efficient use of fixed assets
with raw materials, labour and management would lead to more income from sales. This
leads to internal fund generation for the expansion of the firm. A growing company should
have low operating ratio to meet the growing demand for its product.

6. Financial Analysis: “Financial analysis is a process of evaluating the relationship

between component parts of a financial statement to obtain a better understanding of a firm’s
position and performances”.

According to Matclf and Titard

It is performed by professionals who prepare reports using ratios that make use of
information taken from financial statements and other reports. These reports are usually
presented to top management as one of their bases in making business decisions. Based on
these reports, management may:

 Continue or discontinue its main operation or part of its business;

 Make or purchase certain materials in the manufacture of its product;
 Acquire or rent/lease certain machineries and equipment in the production of its goods;
 Issue stocks or negotiate for a bank loan to increase its working capital;

47
 Make decisions regarding investing or lending capital;
 Other decisions that allow management to make an informed selection on various
alternatives in the conduct of its business.

The best source of financial information about a company is its own financial statements.
The statement gives the historical and current information about the company’s operations.
The two main statements used in analysis are:

• Balance Sheet: A balance sheet or statement of financial position is a

summary of the financial balances of a sole proprietorship, a business
partnership or a company. Assets, liabilities and ownership equity are
listed as of a specific date, such as the end of its financial year. A balance
sheet is often described as a "snapshot of a company's financial condition".

• Profit & Loss Account: A profit and loss statement, shows the revenues
from business operations, expenses of operating the business, and the
resulting net profit or loss of a company over a specific period of time. In
assessing the overall financial condition of a company, you'll want to look
at the income statement and the balance sheet together, as the income
statement captures the company's operating performance and the balance
sheet shows its net worth.

The following methods of analysis are generally used:

48
a. Comparative Statement: Comparative balance sheet analysis is the study of the trend
of the same items, group of item and computed item in two or more balance sheets of the
same business enterprise on different data.

b. Trend analysis: This method determines the direction upwards and involves the
computation of the percentage relationship that each statement item bears to the same
item in base year.

c. Common size Statement: The common size statements balance sheet statements are
shown in analytical percentages. The figures are shown as percentages of total assets,
total liabilities and total sales. Total assets are taken as 100 and different assets are
expressed as a percentage of the total, similarly various liabilities are taken as a part of
total liabilities.

d. Cash flow Statement: Cash flow statement is a statement which describes the inflow
(sources) and outflow (uses) of cash and cash equivalent in an enterprise during a
specified period of time.

e. Ratio Analysis: Ratio is a simple arithmetical expression of the relationship of one

number to another. It may be defined as the indicated quotient of two mathematical
expressions.

Generally, financial ratios are calculated for the purpose of evaluating aspects of a company's
operations and fall into the following categories:

• Liquidity ratios measure a firm's ability to meet its current obligations. Following are
the ratios:

i. Current Ratio = Total Current Assets / Total Current Liabilities

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 ii. Quick Ratio = (Cash + Accounts Receivable + Other Easily Liquidated
Assets) / Current Liabilities

• Profitability ratios measure management's ability to control expenses and to earn

a return on the resources committed to the business. Following are the ratios:

i. Net Profit Margin = Net Profit / Total Sales

ii. Return on Assets = Net Profit Before Taxes / Total Assets
iii. Return on Equity= Net Profit Before Taxes / Net Worth

• Leverage ratios measure the degree of protection of suppliers of long-term funds

and can also aid in judging a firm's ability to raise additional debt and its capacity to pay
its liabilities on time. Following are the ratios:

i. Debt to Equity = Total Liabilities / Total Equity

ii. Debt to Asset = Total Debt/ Total Assets
iii. Long term debt to Equity = Long term debt/ Net worth

• Efficiency, activity or turnover ratios provide information about management's

ability to control expenses and to earn a return on the resources committed to the
business. Following are the ratios:

i. Inventory Turnover = Cost of Goods Sold / Inventory

ii. Accounts Receivable Turnover = Total Net Sales / Accounts Receivable
iii. Sales to Total Assets = Total Sales / Total Assets

• Book value per share (BV): Book value per share is a ratio that is calculated by
subtracting all liabilities from all assets, then dividing it by the total number of
outstanding shares (or equivalents). The idea behind book value per share is that if
a company's calculated book value per share is higher than the current stock price,
the company is undervalued. It can also be used in the reverse where if a stock
price is substantially higher than the book value per share that it is overvalued and
prone to
Stockholders Equity - Preferred Stock
corrections. =
Average Outstanding Shares
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 BV

• Earnings per Share: Earnings per share (EPS) are the amount of earnings per
each outstanding share of a company's stock.

The EPS formula does not include preferred dividends for categories outside of continued
operations and net income. Earnings per share for continuing operations and net income
are more complicated in that any preferred dividends are removed from net income
before calculating EPS.

Net Income - Dividends on Preferred Stock

EPS =
Average Outstanding Shares

• Price Earning Ratio: The P/E ratio (price-to-earnings ratio) of a stock (also
called its "P/E", or simply "multiple") is a measure of the price paid for a share
relative to the annual net income or profit earned by the firm per share. P/E is
a financial ratio used for valuation: a higher P/E ratio means that investors are
paying more for each unit of net income, so the stock is more expensive compared
to one with lower P/E ratio. In other words, P/E ratio shows current investor
demand for a company share. The reciprocal of the P/E ratio is known as
the earnings yield.[3] The earnings yield is an estimate of expected return to be
earned from holding the stock if we accept certain restrictive assumptions.

The price per share in the numerator is the market price of a single share of the
stock. The earning per share in the denominator depends on the type of P/E:

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 o "Trailing P/E" or "P/E ttm": Earnings per share is the net income of the company for
the most recent 12 month period, divided by number of shares outstanding. This is the
most common meaning of "P/E" if no other qualifier is specified. Monthly earning data
for individual companies are not available, so the previous four quarterly earnings reports
are used and earning per share is updated quarterly. Note, companies individually choose
their financial year so the schedule of updates will vary.

o "Trailing P/E from continued operations": Instead of net income, uses operating
earnings which exclude earnings from discontinued operations, extraordinary items (e.g.
one-off windfalls and write downs), or accounting changes. Note, longer-term P/E data
such as Schiller's uses net earnings.

o "Forward P/E", "P/E f", or "estimated P/E": Instead of net income, uses estimated
net earnings over next 12 months. Estimates are typically derived as the mean of a select
group of analysts (note, selection criteria is rarely cited). In times of rapid economic
dislocation, such estimates become less relevant as "the situation changes" (e.g. new
economic data is published and/or the basis of their forecasts become obsolete) more
quickly than analysts adjust their forecasts.

v.Fundamental Analysis Benefits

Fundamental analysis helps in:

1. Identifying the intrinsic value of a security.

2. Identifying long-term investment opportunities, since it involves real-time data.

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3. Intuitive Appeal: Most of us accept the precept that one thing causes another. Using
fundamental analysis to predict futures prices has that precept as its foundation, and
attempts to identify the "causing" factors. In this sense, the approach is intuitively appealing.

4. Objectivity: Fundamental analysis is objective in that relationships are tested by sound

mathematical and statistical methods. Those that fail are discarded, while those that pass are
perceived as being credible. There is no room for personal predilection or bias. The reliance
on objectivity is desired by many traders who hold little confidence in their ability to predict
prices purely by discretion.

Attempting to predict variables through fundamental analysis is not exclusive to the futures
trader. Companies attempt to predict sales, governments attempt to predict unemployment
and meteorologists attempt to predict the weather. With all of these industries attempting to
harness the power of fundamental analysis, one benefit is a refinement and improvement in
the pool of fundamental analytic techniques available. For instance, if a good technique is
developed to predict the weather, it can be applied to futures prices and, hopefully, yield
satisfactory results as well. This is exactly how Chaos Theory, a particular type of
fundamental analysis, moved into the realm of the futures trader.

Fundamental Analysis: Drawbacks

The drawbacks of fundamental analysis are:

1. Too many economic indicators and extensive macroeconomic data can confuse novice
investors.

2. The same set of information on macroeconomic indicators can have varied effects on the
same currencies at different times.

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3. It is beneficial only for long-term investments.

4. Data Intensive: Fundamental analysis relies on a considerable amount of data to test the
significance of variables. Such data are often not easy to acquire and, moreover, are
seldom available without charge. As well, data are often contaminated with reporting
errors which must first be identified and corrected.

5. Labor Intensive: Fundamental analysis also requires a considerable amount of human

labor - time and energy. As well, methods have become so complex that few individuals
short of a trained economist can properly apply the available technology. As an example,
large banks often employ teams of economists for formulating their in-house prediction
models.
It is often difficult, even when data, time and energy are available; to determine a
relationship which is robust and which enables satisfactory price prediction. This may be,
in part, because so many variables are linked together, each affecting the other, that it is
difficult to identify causal relationships. You may well spend a lot of time, money and
energy looking for a causal relationship, and never find one.

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55
 CONCLUSION

Fundamental analysis of a business involves analyzing its financial statements and health, its
management and competitive advantages, and its competitors and markets. When applied
to futures and forex, it focuses on the overall state of the economy, interest rates, production,
earnings, and management. When analyzing a stock, futures contract, or currency using
fundamental analysis there are two basic approaches one can use; bottom up analysis and top
down analysis.

 Fundamental analysis is the study of economic factors, industrial environment and the
factors related to the company.
 The state of the economy determines the growth of gross domestic product and
investment opportunities.
 An economy with favourable savings, investments, stable prices, balance of payment, and
infrastructure facilities provides a best environment for common stock investment.
 The leading, lagging and coincidental indicators help to forecast the economic growth. A
rising stock market indicates a strong economy ahead.
 Industrial growth follows a pattern. Buying of shares beyond the pioneering stage and
selling of shares before the stagnation stage are ideal for the investors.
 The cost structure, research and development and the government policies regarding the
industries influence the growth and profitability of the industries. SWOT analysis reveals
the real status of the industry.

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 The competitive edge of the company could be measured with the company’s market
share, growth and stability of its annual sales.
 The financial statements of the company reveal the needed information for the investor to
make investment decision.
 The financial health of the company could be analysed with the fund flow and cash flow
statements. The ratio analysis helps the investor to study the individual parameters like
profitability, liquidity, leverage, and the value of the stock.

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 Bibliography

 BOOKS

 “Security analysis and portfolio management”- Punithavathy Pandian

 “Investment analysis and portfolio management”- Prasanna Chandra

 WEBSITES

 www.wikepedia.org/wiki/Fundamental_Analysis

 www.hubpages.com/hub/Security-Analysis-and-Portfolio-management

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 www.investopedia.com

 http://www.mbaknol.com/investment-management/security-analysis-phase-in-
investement-portfolio-management/

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