Fundamental Analysis

Equity Research

Equity research is the act of making an ex-ante evaluation of

different investment avenues, especially applicable for the
equity shares. The purpose of the research is to evaluate
investment-worthiness of the equity share and find out the
appropriate timing of investment in such share. Under equity
research, an investor or portfolio manager analyses several
factors to have a fair idea about the growth and development
of the economy as a whole so that the shape of future
outcomes at the aggregate level and future trend of the market
as a whole can be assessed. When future of the economy as
a whole and capital market in particular seems promising then
different equity shares are evaluated by applying an
appropriate technique, the aim of which is to find out
undervalued shares or shares which are likely to do better in
the future.
 Equity Research…Contd.

Similarly, equity research is carried out at the time of

disinvestment too – here, portfolio manager is interested to
identify the appropriate timing for liquidating his investment
too-here, portfolio manager is interested to identify the
appropriate timing for liquidating his investment in a
particular share. Equity research is mainly dividend into
three, i.e. fundamental analysis, technical analysis and
efficient market hypothesis (random walk hypothesis). To
carry out equity research, certain data about the economy,
industries, companies and market trends become the base
for arriving at the conclusion. Collectively, these data are
called investment information.
 Sources of Investment Information

Economic survey containing facts about economic
aggregates and an statement by the government and the
apex bank about the future scenario of the economy

Budget announcement by central and state governments

Planning document issued by the planning commission,
containing plan priorities and growth prospects of different
sectors of the economy

Report by international agencies like the World Bank and
IMF, which contains independent review and opinion about
the growth, development and its direction in the economy and
world markets as a whole

Report by rating agencies like Moody, Standard & Poors (S &
P) – these reports also contain an independent assessment
and sovereign rating, indicating investment in a country
 Sources of Investment Information..Contd.

Publication by regulatory agencies like SEBI, RBI and others

Industry report by FICCI and ASSOCHEM
Publication by stock exchange

Annual report of companies

News reports

Independent advice of portfolio planners like sharekhan and
others

Rating agencies of India

Academic research work by scholars and academicians

Other relevant documents containing price-sensitive information.
 Fundamental Analysis
Fundamental analysis is the analysis of various fundamental factors-
economic aggregates, industrial indicators as well as facts related
to companies. Every investor is interested in knowing the
appropriate timing for investment, as well as the best avenue for
investment. Under this, various factor are analyzed to give answer
for these two questions. Fundamental analysis also aims to arrive
at the intrinsic value of shares.
Intrinsic value is the value of the share, which is supported by
assets, profitability, financial performance, future prospects,
industry scenario, economy wide factors, etc. The idea about the
intrinsic value helps in making investment decisions. It is believed
that shares are likely to command prices around the intrinsic
value; therefore a comparison of intrinsic value and prevailing
market price can help in deciding about the scrips to be purchased
or sold.

Buy, if Intrinsic Value > Market Price

Sell, if Intrinsic Value < Market Price
 Dimensions of Fundamental Analysis
Fundamental analysis is carried in three phases; these phases are
called three dimensions of this analysis:
(a) Analysis of Economy-wide Factors
(b) Analysis of Industry-wide Factors
(c) Analysis of Company-wide Factors

(a) Analysis of Economy-wide factors : Under this phase,

national as well as international economic conditions and different
economic aggregates are analyzed to answer the question of timing
of investment. A thorough analysis of these indicators helps in
predicting the future shape of the trends of economy and expected
growth of different industrial sectors. Following steps are taken:
1. Study of economic aggregates
2. Classification of indicators
3. Forecast about the economy
 1. Study of Economic Aggregates
Economic aggregates are indicators of the health of the economy.
With the help of these, prediction about future outcomes can be
made. These factors are as follows:
 Industrial production
 Gross domestic production (GDP)
 Investment in Infrastructure sector
 Foreign trade
 Inflation
 Monsoon
 Business conditions
 Government policies
 International environment/events
The study of these economic aggregates helps in answering two things-
(a) timing of investment, (b) identification of the industry which is likely to
perform better.
 2. Classification of Factors into indicators
Various economic aggregates and general facts about the economy can
be classified into indicators, indicating the future outcomes and status of
the economy. These indicators can be used to forecast the trends of
economy. Classification may be as follows:

Advance-moving indicators

Coinciding indicators

Lagging indicators
Advance-moving indicators make movement well in advance before an
incidence of actual development take place in the economy. For a factor
to qualify as advance-moving indicators, it must fulfill the following
Condition:

It should move smoothly

It should give enough time gap for action

In majority of the times, it should give fruitful results

It has low default rate
 2. Classification of Factors into indicators….Contd.

With the help of these indicators probable future development in the

economy can be predicted. Movement of these factors helps in
identifying probable industries, in which investment can be made for
earning better returns. Advance-moving indicators are as follows:
(i) Monsoon
(ii) Infrastructural Development
(iii) Industrial Growth
(iv) Per Capita Income
(v) Government Policies
(vi) Inflation
(vii) Interest Rates
These advance-moving indicators help in identifying those industries, which
are likely to perform better in the future. One way of selecting promising
industries is to compare the growth of an industry with the over all industrial
growth.
 2. Classification of Factors into indicators….Contd.

An Industry which has growth rate more than the overall industrial growth in the
country is identified as a prospective industry. These indicators also help in
forecasting the overall development of the economy. These indicators show
signals of growth much earlier then the actual growth in the economy.

Coinciding indicators are the indicators that show movement along with the
growth in the economy; these may be like increasing stock index, increasing
consumption, improved living standards. Generally, these indicators do not
help much in predicting the future, but these indicate about the maximum
extent of growth and also help in identification of reversal of the economy.

Lagging indicators are the ones which show signals after an activity has taken
place. Generally these are of academic interest only: these may be like
reasonable imbalance indicating disparity of growth, slow growth areas.
These indicators might help in making identification for the future
developmental allocations by the government.
 3. Forecast about the Economy

With help of advance-moving indicators, forecast about the future scenario

of the economy can be made. The forecast can be made by using:
(a) time series analysis- indicating seasonal and cyclical trends, (b) Delphi
technique- indicating expert opinion, (c) construction diffusion index.

Conclusion of Economic Analysis

The purpose of analyzing economy-wide factors is to identify the right time

for investment and selection of industries, which are likely to perform
better in the future. The final result of this phase of fundamental
analysis is as follows:

An idea about the appropriate timing of investment

Selection of the industries, which might perform better
 (b) Analysis of Industry-wide factors

This is the second phase of fundamental analysis; industries selected

in the previous phase are scanned individually at length in this
phase. In this, a micro study of each and every industry selected a
priori is carried out. The objective of this phase is to provide
information about the best industry, in which investments can be
made. The following steps are taken for industry analysis:

1. Study of industry life cycle

2. Study of quantitative and qualitative factors
 1. Study of Industry life cycle
By industry life cycle, we mean the different stages of the development
of an industry. This helps in making investment decision. Life cycle of
an industry has the following stages:

Pioneering stage- It is the stage of startup of an industry; in this
stage, very few beginners set up their companies. This risk at this
stage is very high due to gestation period effect. One should display
caution at this stage.

Rapid Growth stage- At this stage of industry life cycle demand for
the product in the industry increases at a fast pace and every day
new participants/companies enter the industry. This stage sometimes
witnesses mushroom growth of companies in the industry. ‘Fly by
night operators’ also enter the market at this stage. Due to
competition, the market share of companies keeps fluctuating during
this stage.
 1. Study of Industry life cycle…Contd.

Maturity and stabilization- At this stage, demand almost stabilizes at
a particular level. Product differentiation takes place and companies
start competing on product features. This phase is also of
consolidation-companies consolidate their position by focusing on a
particular segment.

Decline/Diversification- At this stage, poor performers start winding
up their businesses and this phase witnesses the survival of only the
fittest. Only strong companies survive during this stage. Few
companies take up diversification path to overcome this phase. If
companies diversify, then they enter into a new industry life cycle.
Study of these stages help in indicating future results of an industry.
Generally, it is advised to take precaution at the pioneering stage, be
selective at the growth stage, as few ‘fly by night operators’ might enter
the industry and investment with them might not be safe. Investment
position should be synthesized at the maturity stage; investment in an
industry may be continued if there is scope for diversification after the
maturity.
 2. Study of Qualitative and Quantitative
Factors
These factors are as follows:
Qualitative Factors
I. Level of competition and protection by the government
II. Entry barriers
III. Product differentiation
IV. Substitution effect
V. Demand type
VI. Supply of inputs
VII. Technological changes
VIII. Stability
IX. Government support
An in-depth study of all these factors indicate the profit-earning capacity of the
industry as well as its chances of survival and growth. A healthy competition in
the industry indicates instability in the industry. An industry, which has
protection and support from the government, will protect the market share of the
existing players and the earning prospects in such industry are very high.
 Quantitative Factors
These factors indicates the profit-earning capacity of the industry
as a whole; how assets are being used in the industry is also
reflected through these factors. These may be:
(i) Trends of turnover/Sales
(ii) Trends of profitability
(iii) Trends of cost structure
(iv) Trends about margins

Conclusion of Analysis of Industry-wide factors

A thorough study of industry life cycle and qualitative and quantitative
factors helps in filtering those industries, which were selected at the
earlier phase. The main aim is to identify such industries in which
there is: (a) chance of growth, (b) chance of high profits/profitability,
(c) low risk is there, if investment is made.
 (c) Analysis of Company-wide factors

Every industry has more than one company; this phase scans the
companies of those industries, which has been selected in the
second phase. The purpose of this phase is to identify the best
company in each of the industry selected, a priori, because all the
companies in an industry do not perform alike. This is done with the
help of following factors:

1. Financial performance analysis

2. Analysis of qualitative parameters
 1. Financial performance analysis
Financial statements are indicators of two significance factors:-
(i) Profitability
(ii) Financial soundness

Analysis and interpretation of financial statements therefore, refers to

such a treatment of information contained in the income statement
and the balance sheet in order to carry out full diagnosis of the
profitability and financial soundness of the business. Financial
performance analysis can be classified into different categories,
depending upon
(i) the material used, and
(ii) the modus operandi of analysis
 1. Financial performance analysis…Contd.

On the basis of material used it is of two types:

 External analysis
 Internal analysis

On the basis of modus operandi, it is of two types:

 Horizontal analysis
 Vertical analysis

The analysis of the financial statements requires:

 Methodical classification of the data given in the financial statements
 Comparison of the various inter-connected figures with each other by
different ‘tools of financial analysis’
Methodical classification
In order to have a meaningful analysis, it is necessary that
figures should be arranged properly. Usually, instead of the two
column (T form) statements, single column (vertical) statements
are prepared, in which figures of two financial years are shown
simultaneously. This also facilitates showing the figures of a
number of firms or number of years side by side for comparison.
Techniques of Financial analysis
A financial analyst can adopt one or more of the following
techniques/tools for financial analysis

Financial Analysis Techniques

1 3 5
2 4
Comparative Trend 6
CVP analysis
financial Statement Analysis

Common size Fund Flow Ratio analysis

analysis & cash flow
analysis
 Comparative Financial Statements:

Comparative financial statements are those statements, which have

been designed in a way so as to provide time perspective to the
consideration of various elements of financial position embodied in
such statements. In these statements, figures for two or more
periods are placed along for comparison.

Common size financial statements:

Common size financial statements are those, in which figures

reported are converted into percentages to some common base.
Trend Percentages:
Trends percentages are immensely helpful in making comparative studies
of financial statements of several years. The method of calculating
trend percentages involves the calculation of percentages relationship
that each item bears to the same item in the base year. Any year may
be taken as the base year, it is usually the earliest year.
Fund Flow/cash flow analysis
The technique of fund flow analysis is widely used by the financial
analyst, credit rating institutions and finance managers in assessing
performance of their jobs. It has become a useful tool in their analysis kit.
Fund flow analysis reveals changes in the working capital position. It
tells about the sources from which the working capital was obtained
and purposes for which it was used. It brings out in open the changes ,
which have taken place behind the balance sheet. Working capital being
the lifeblood of the business, such an analysis is extremely useful.
Cost-Volume-profit (CVP) analysis:
CVP analysis is an important tool of profit planning. It studies the
relationship between cost, volume of production, sales and profit.
Since the data is provided by both cost and financial records, hence,
it is an important tool for decision-making. It tells the volume of sales
at which the firm will break even, the effect on profit on account of
variation in output, selling price & cost, and finally , the quantity to
be produced and sold to reach the target profit level.
Ratio Analysis:
This is the most important tool available to financial analyst for their
work. An accounting ratio is the mathematical relationship between
two inter-related accounting figures. The figures have to be inter-
related because no useful purpose will be served if ratio is
calculated between two figures, which are not at all related to each
other. A ratio can be defined as an indicator of the relationship
between two variables having either cause and effect relationship
Ratio Analysis….Contd.:
or connected with each other in some or the other manner. These
two variables may be selected either from the balance sheet or from
the profit and loss account or one from the balance sheet and the
other from the profit and loss account. The usefulness of the ratio lies
in the fact that the data to be analyzed, is reduced and expressed in a
simple form, which makes it very convenient to study and evaluate
the relationship between various related items as well as changes
that have taken place. Ratios have to be expressed in mathematical
terms, like percentages or the number of times or in number.
 Classification of Ratios
Broadly, the analysis and interpretation of ratio can be classified
into four units:
 Liquidity: Ability to meet current dues out of short-term assets

 Solvency: The extent of dependence on outside liabilities and

the feasibility of meeting them, if need arises

 Profitability: Capacity of the unit to generate profits and its

rate of return

 Activity: efficiency of the unit in utilizing present available

resources
 SOME TERMINOLOGY

INVESTED CAPITAL- It is the total of the
amount of EQUITY CAPITAL and DEBT
CAPITAL invested in the Company.

Equity here will include Deferred TAx Liability.

CAPITAL EMPLOYED- It is the total amount
of long term funds invested in the Company.

Capital Employed can be calculated by
deducting Current Liabilities from Total Assets
OR by deducting Working Capital from Non
Current Assets.
 SOME TERMINOLOGY

OPERATING PROFIT- Operating Profit is the
profit before interest and tax from Operating
activities.

PBIT- PROFIT BEFORE INTEREST & TAX-
PBIT includes non operating income &
expenses. It is the total of operating profit and
non operating income (expenses).

For a Company that does not have non
operating income (expenses) PBIT =Operating
Profit.
 SOME TERMINOLOGY

Analysts use PBIT & EBIT (Earnings before
Interest & TAx) interchangeably.

Analysts exclude non-operating items from
financial statements which they use for
Financial Statement Analysis. Therefore, PBIT
in P&L A/C used for Financial Statement
Analysis equals OPERATING PROFIT.
 SOME TERMINOLOGY

PBITDA-PROFIT BEFORE INTEREST, TAX ,
DEPRECIATION & AMORTISATION.

NOPLAT-Net Operating Profit Less Adjusted

TAx. It represents after tax operating Profit.

NOPLAT= Net Profit + Interest (1-Tax Rate).

 RETURN ON
INVESTMENT(ROI)

ROI measures the overall profitability of the
Company in terms of financial rewards to the
suppliers of equity and debt capital. The
following are the different concepts of ROI-

Return on Assets-ROA

Return on Capital Employed- ROCE

Return on Invested Capital- ROIC

Return on Equity (ROE) or Return on Net
Worth (RONW)
 ROI

To calculate ROA, ROCE & ROIC, analysts
consider earnings before interest instead of
net profit. This is appropriate because in the
denominator, we take total investment and
therefore, the number in the numerator should
measure total reward to all investors. Interest
represents reward to debt holders.

ROA= EBIT/( Average Total Assets) or

ROA= NOPLAT/ (Average Total Assets).

Analysts, in computing ROA exclude non-
operating income ( adjusted for tax)
 ROI & ROCE

From the numerator and non operating assets
from the denominator.

Use of NOPLAT measures ROI as if the
Company is unlevered. This makes ROI
comparable across Companies.

ROCE= EBIT/(Average Capital Employed) OR

ROCE= NOPLAT/(Average Capital
Employed).
 ROIC

ROIC= NOPLAT/(Average Invested Capital)
OR ROIC= EBIT/( Invested Capital)

ROIC is also called ROTC ( Return on Total
Capital). ROIC is very appropriate in
measuring profitability as it excludes only
interest free credits and takes into account
total capital.

Examples of interest free credits – Creditors
and Accrued Liabilities.
 RETURN ON EQUITY

ROE= Net Profit/ ( Average total shareholders’
equity)

ROOE= Return on Ordinary Shareholders’
Equity= (Net Profit- Preference Dividend)/(
Average Ordinary Shareholders’ Equity)

Indian Companies are allowed to issue only
redeemable preference shares. IAS-32
requires companies to present redeemable
preference shares as debt. ICAI has also
adopted this.Until the Companies Act is
revised these will be a part of SHARE
CAPITAL
 Liquidity Ratio

The sound principle of finance is to meet long-term requirements out of

long-term sources and never from short-term funds. Rather, some part of
the long-term sources should be invested in current assets. Liquidity ratio
are also termed as ‘working capital’ or short-term solvency ratio. The
important liquidity ratio are:
1. The current ratio: Current Assets

Current liabilities
This ratio is an indicator of the firm’s commitment to meet its short-term
liabilities. Current assets are either used up or converted into cash
within a year’s time or normal operating circle of the business,
Whichever is longer. Current liabilities are payable within a year or
operating cycle, whichever is longer, out of existing current assets or by
creation of current liabilities. If this ratio is more than 1, it suggests that
the current assets are adequate to pay off all current liabilities. If it is 1,
they are just sufficient and if less than 1, a company shall be unable to
pay current dues when asked for.
 Liquidity Ratio….Contd.

2. The quick or acid test ratio: Quick Assets

Current Liabilities

Quick Assets = Current Assets- Inventory and prepaid exp.

Some Analysts deduct Bank Overdraft from Current Liabilities.

All the current assets are not equally current or liquid. Cash is the most
liquid asset, receivable can also be discounted and converted into
cash. Marketable-securities can also fetch cash very easily when
sold. But inventory is the most non-liquid assets since it cannot be
sold till there are buyers available. The standard result of the quick
ratio is considered as 1:1, which means that the cash yield from the
most liquid assets is sufficient to pay off short-term liabilities.
 Cash Ratio

Cash Ratio= (Cash+ Marketable Securities)/
Current Liabilities.

Cash Includes Cash Equivalents.

Cash Flow From Operations Ratio= Cash
Flow from Operations/ Current Liabilities.

Defensive Interval=365*(Cash+ Marketable
Securities+ Accounts Receivable)/Projected
Expenditure. It measures the liquidity of the
Company by comparing the currently available
quick assets with projected cash outflows
needed to operate the Company.
 Defensive Interval

Projected Expenditure is the sum of operating
expenses minus depreciation and
amortisation.

Defensive Interval measures the period for
which the Company will be able to maintain
the current level of operations with its present
cash resources.

Cash Burn Ratio- Term used by PEs. Formula
same as Defensive Interval.
 Liquidity Ratio….Contd.

Net sales
3. The working capital turnover ratio:
Net working capital

The NWC is also called the ‘liquid surplus’, i.e. excess of

liquidity. If liquid surplus or NWC is too high, it may indicate

less effective utilization of funds & vice-versa.

 DEBT RATIOS

Debt to Total Capital= Total Debt/ Total
Invested Capital

Debt to Equity= Total Debt/ Total Equity

Interest Coverage Ratio= Earnings before
interest and taxes/ Interest Expense( Interest
is both charged to P&L & that capitalised)

Fixed Charge Coverage= Earnings before
Fixed Charges and Taxes/ Fixed Charges.

Egs of Fixed Charges- Interest on Loan
Funds, Preference Dividend, Lease Payments
and repayment of principal.
 INTEREST & FIXED CHARGE
COVERAGE

Some analysts calculate coverage ratios using
adjusted operating cash flow as the
numerator. Adjusted operating cash flow is the
sum of cash from operations, interest expense
and tax payments.

ICR (cash basis)=Adjusted Operating Cash
Flow/Interest expense

FCCR( cash basis)= Adjusted Operating Cash
Flow/ Fixed Charges.
 CAPEX & CFO TO DEBT
RATIO

The solvency of a Company depends upon its
ability to finance the replacement & expansion
of investment in productive capacity, as well
as, to generate cash for Debt repayment.

Capital Expenditure Ratio= Cash from
Operations/ Capital Expenditure

Cash from Operations to Debt Ratio= Cash
from operations/ Total Debt.
 ROI

ROA=EBIT/Total Assets= (Sales/Total
Assets)* ( EBIT/Sales)

ROA= NOPLAT/Total Assets= ( Sales/Total
Assets)*(EBIT/Sales)*(NOPLAT/EBIT)

The difference between NOPLAT & EBIT is
that NOPLAT is operating profit after Income
Tax while EBIT is operating profit before
income tax. Therefore, the ratio of NOPLAT to
EBIT may be viewed as adjustment for income
tax.
 ROIC & ROE

ROIC=NOPLAT/ Invested Capital= (Sales /
Invested Capital) * (EBIT/ Sales) * ( NOPLAT/
EBIT).

ROE= PAT/ Equity= (NOPLAT/ Invested
Capital)*( Invested Capital/ Equity)*( PAT/
NOPLAT).

Effective Post Tax Interest Rate= Interest( 1-
Tax rate)/ Average Outstanding Debt.
 Solvency Ratio….contd.

Total outside liabilities (T/L+C/L)

II. The total indebtedness ratio:
Net tangible worth

Tangible net worth=Net worth – Intangible assets.

This ratio is different from debt-equity ratio. In this term liabilities as

well as current liabilities are used to show complete solvency.
This may reflect the solvency position in a better way. In this case
too, the lower the ratio, the better it shall be, as it indicates, the
adequacy of the firm’s equity in making payment of outside
liabilities.
 Solvency Ratio….contd.

III. The fixed assets ratio: Net fixed Assets

` Long-term
Liabilities
This ratio indicates whether the value of fixed assets is sufficient to
cover the amount of the loan granted to the firm. The ratio should
not be more than 1. If it is less than 1, it shows that a part of the
working capital has been financed through long-term debt.

IV. The proprietary ratio: Capital or shareholders funds

Total tangible assets

It is a variant of debt-equity ratio. It established relationship between the
proprietors’ fund, and the total tangible assets. The higher the ratio,
the stronger is the financial position of the company and the higher is
the capability of bearing financial stress. A low ratio indicates weak
financial strength to bear the stress resulting from financial crisis.
 Profitability Ratio
Profitability is an indication of the efficiency with which business
operations are carried on. In order to have a ratio, we can compare
profit to the factors, which regulate the quantum of profit directly like
sales and total capital employed. The main ratios are:

Gross Profit
I. The Gross Profit ratio: X 100
Net Sales

This ratio expresses relationship between gross profit and net sales.
This ratio indicates the degree to which the selling price of goods per
unit may decline without resulting in losses from operations to the
firm.
Net profit
II. Net Profit Ratio: X 100
Net Sales

This ratio indicates net margin earned on a sale of 100. This ratio helps
in determining the efficiency with which affairs of the business are
being managed.
 Profitability Ratio…Contd.

Operating profit
III. The operating Profit Ratio: X 100
Net Sales

The ratio denotes the margin of profit on sales revealing the

operational efficiency of the unit.
Operating Profit Margin= Gross Profit Margin-(Operating
Expenses/Sales) * 100

IV. Overall-profitability ratio: It is also called return on investment (ROI)

or return on capital employed (ROCE). It indicates the percentage of
return on the total capital employed in the business.

Operating Profit
X 100
Capital employed

Pretax Profit Margin= ( Profit before Income
Tax)/Sales * 100

Cash Profit Margin= PBITDA/Sales * 100

Operating Ratio=

Operating Expenses/Sales*100
 Profitability Ratio…Contd.
Net Profit before interest & tax
(e) Return on average capital employed: X100
Average capital employed

Net profit after tax and preference dividend

(V) Earning per share: X 100
Number of equity shares

The EPS helps in determining the market price of the equity shares of
the company. It also helps in estimating the company capacity to pay
dividend to its equity shareholders.
Market Price per equity share
(VI) Price Earning Ratio: X 100
Earning per share
Dividend per equity share
(VII) Pay out Ratio: X 100
Earning per equity share

This ratio indicates what proportion of earning per share has been used
in paying dividend.
 Profitability Ratio…Contd.

Dividend per share

(VIII) Dividend Yield Ratio: X 100
Market price per share

This ratio is particularly useful for these investors, who are

interested only in dividend income.

(IX) Debt service coverage ratio: EAT+ interest

Interest (1-t)+ (Principal Repayment)
 Activity Ratio
These are ratios which indicate efficiency of the enterprise in the
utilization of available funds, particularly of a short-term nature.
Following are the ratio that fall under this category:
I. Inventory turnover ratio: Cost of goods sold
Average inventory

The cost of goods sold can be derived by deducting the gross profit from
the sales. Average inventory indicates the average of opening and
closing stocks of the goods. This ratio indicates as to how quickly
the goods are sold in the business or how many times the inventory
turns over during a year. A high ratio would mean accumulation of
lesser inventory and thus, a lesser chance of the stock containing
obsolete or unsalable items
 Activity RAtio

Average Number of Days inventory in stock=
365/ Inventory Turnover

Raw Material Turnover Ratio= Cost of
Materials Consumed/ Average Raw Material
Stock

WIP Turnover Ratio= Cost of
Production/Average WIP Stock

Finished Goods Turnover Ratio= COGS/
Average finished goods stock
 Activity Ratio…Contd.

Bill receivable + Sundry Debtors

II. The debtors velocity: X 365
Annual credit sales
This ratio indicates the average time lag in days between sales and
the collection of debt, i.e., the number of days the credit remains
outstanding at a time . An increasing trend means more credit
being extended, which may be due to poor realization or
competitive forces compelling a liberal policy of credit. A decreasing
trend would mean less profitability of doubtful debts.

Average number days receivables outstanding= 365/Receivables

turnover.
 Activity Ratio…Contd.

Bills payable + Sundry creditors

III. The creditors velocity: X 365
Annual credit purchases

This ratio indicates the period for which credit is enjoyed by the unit. An
increasing trend shall mean an increasing credit-worthiness of the
party, resulting in lesser dependence on banks. A declining trend
may mean that the company is promptly paying its creditors.

IV. The fixed assets turnover ratio: Annual sales

Average Net Fixed Assets

The ultimate object of fixed assets is to generate sales and this ratio can
indicate efficiency if the company has utilized its fixed assets
acquired through internal or external sources of funds. An increasing
trend shall indicate an efficient utilization and a falling trend shall
mean inadequate utilization.

Working Capital Turnover Ratio=
Sales/Average Working Capital

Average Number of Days Payables

Outstanding= 365/ Accounts payable turnover.

Total Assets Turnover Ratio= Sales/Average

Total Assets

=Sales/ Average Invested Capital
 Prominent Ratios to be Considered
Although each ratio has its importance, still, following are the prominent
ratios to be considered for investment decision:
 Operating profit ratio
 Return on investment (ROI)
 EPS
 Return on equity capital
 Leverage ratio
 Price earning ratio (P/E Multiplier).
Decision-Making
To identify the best company, financial ratios of companies can be
compared either against the overall industry ratio or against the
standards. Generally, a company showing financial performance
above the industry average is considered the best.
 Analysis of Qualitative Parameters

These are as follows:

i. Technological advancement in the company
ii. Marketing and distribution network
iii. R & D efforts
iv. Diversification
v. Disputes/claims against the company
vi. Ownership structure

These parameters indicate the future and survival of a company in

competition; at the same time, an assessment of risk can also be
made with the help of these.
 Conclusion of Analysis of Company-wide
Factors

The analysis of company-wide factors helps in identifying the

company in each of the industry, which is likely to perform better
in the respective industry. The final result of this phase is the
identification of those companies in which investments can be
made.
 Estimation of Intrinsic Value

By Intrinsic value, we mean value of a share, which is supported by asset

quality, performance, earning capacity, risk, future prospects and
happenings in the economy. It is believed that in the long run, a share is
likely to command a market price around its intrinsic value. Therefore
knowledge about this can help in investment decision-making.
Steps for calculating intrinsic value:

Estimation of expected EPS of the company

Expected risk in the company

Estimation of P/E multiplier

P/E multiplier can be estimated by taking into consideration several
factors – (a) past performance of the company, (b) investor friendliness
of the company, (C) expectation about future, (d) diversification and
modernization. These factors can be rated on a five or seven-point scale.
P/E multiplier is the addition of the rated score on these factors.

Estimation of Intrinsic value: Intrinsic value= Expected EPS x P/E
multiplier
 Estimation of Intrinsic Value…Contd.

Decision-making with the help of intrinsic value:

Buy, if Intrinsic Value > Current Market Price
Sell, if Intrinsic Value < Current Market Price

End-result of Fundamental Analysis

With the help of fundamental analysis the following two are identified:

The right time to invest

The company in which investment is to made
Findings of fundamental analysis hardly fail, as results of this are based on
factors ranging from macro factors-economy-wide factors, and micro
factors-industry-wide and company-wide factors. The outcome of this is
to provide gain for long-term. Decision to buy or sell a particular share
can be made by comparing intrinsic value and prevailing market price of
shares.
 Share Valuation Model

The valuation model used to estimate the intrinsic value of a share is

the present value model. The intrinsic value of a share is the
present value of all future amounts to be received in respect of the
ownership of that share, computed at an appropriate discount rate.

The major receipts that come from the ownership of a share are the
annual dividends and the sale proceeds of the share at the end of
the holding period. These are to be discounted to find their present
value, using a discount rate that is the rate of return required by the
investor, taking into consideration the risk involved and the
investor’s other investment opportunities. Thus, the intrinsic value
of a share is the present value of all the future benefits expected to
be received from that share.
 One Year Holding Period
It is easy to start share valuation with one year holding period
assumption. Here an investor intends to purchase a share now, hold
it for one year and sell it off at the end of one year. In this case, the
investor would be expected to receive an amount of dividend as well
as the selling price after one year. The present value of the share
may be expressed as:

S0 = D1 + S1
(1+k) (1+k)
Where
D1= Amount of dividend expected to be received at the end of one
year.
S1= Selling price expected to be realized on sale of the share at the
end of the year.
k = Rate of return required by the investors.
 One Year Holding Period…Contd.
For example, if an investor expects to get Rs.3.50 as dividend from a
share next year and hopes to sell off the share at Rs. 45 after
holding it for one year, and if his required rate of return is 25 per
cent, the present value of this share to the investor can be
calculated as follows:
3.50 45
S0= (1.25) + (1.25)

= Rs. 2.80 + Rs. 36 = Rs. 38.80

This is the intrinsic value of the share. The investor would buy this
share only if its current market price is lower than this value.
 Multiple-year Holding Period
An investor may hold a share for a certain number of years and sell it off
at the end of his holding period. In this case, he would receive annual
dividends each year and the sale price of the share at the end of the
holding period. The present value of the share may be expressed as:

D1 D2 D3 Dn + Sn
S0= + + +.....+
(1+k)1 (1+k)2 (1+k)3 (1+k)n

Where
D1,D2,D3,….Dn = Annual dividends to be received each year.
Sn = Sale price at the end of the holding period.
k= Investor’s required rate of return.
n= Holding period in years.
 Multiple-year Holding Period…Contd.
For example, if an investor expects to get Rs. 3.50, Rs. 4 and Rs. 4.50
as dividend from a share during the next three years and hopes to
sell it off at Rs. 75 at the end of the third year, and if his required rate
of return is 25 per cent, the present value of this share to the investor
can be calculated as follows:

3.50 4.00 4.50 75

S0= + + +
(1.25)1 (1.25)2 (1.25)3 (1.25)3

= 2.80 + 2.56 + 2.30 + 38.40

= Rs. 46.06
In order to use the present value model for share valuation, the
investors has to forecast the future dividends as well as the selling
price of the share at the end of his holding period. It is not possible to
forecast these variables accurately. Hence, this model is practically
infeasible. Modifications of this model have been developed to render
it useful for practical purposes of stock valuation.
 Multiple-year Holding Period…Contd.
In the case of most equity shares, the dividend per share grows
because of the growth in earnings of a company. In other words,
equity dividends grow and are not constant over time. The growth
rate pattern of equity dividends have to be estimated. Different
assumptions about the growth rate patterns can be made and
incorporated into the valuation models. Two assumptions that are
commonly used are:
1. Dividends grow at a constant rate in future, i.e. the constant growth
assumption.
2. Dividends grow at varying rates in future, i.e. multiple growth
assumption.

These two assumptions give rise to two modified versions of the

present value model of share valuation: (a) Constant growth model,
and (b) Multiple growth model.
 Constant Growth Model
In this model it is assumed that dividends will grow at the same rate
(g) into the indefinite future and that the discount rate (k) is greater
than the dividend growth rate (g). By applying the growth rate (g) to
the current dividend (D0), the dividend expected to be received after
one year (D1) can be calculated as:
D1= D0(1 + g)1
The dividend expected to be received after two years, three years, etc.
Can also be calculated from current dividend as :

D2 = D0(1 + g)2
D3 = D0(1 + g)3
Dn = D0(1 + g)n
 Constant Growth Model..Contd.
The present value model for share valuation may now be written as:

D0(1+g)1 D0(1+g)2 D0(1+g)n

S0= + + …….+
(1+ k)1 (1+k)2 (1+k)n

When ‘n’ approaches infinity, this formula can be simplified as:

S0 = D1 or D0 (1 + g)
k-g k-g

Thus, according to this model, the intrinsic value of a share is equal to

next year’s expected dividend divided by the difference between
the appropriate discount rate for the stock and its expected
dividend growth rate.
 Constant Growth Model..Contd.
The constant growth model is also known as Gordon’ Share valuation
model, named after the model’s originator, Myron J. Gordon. This is
one of the most well-known and widely used models because of its
simplicity. The model does not require forecasts of future dividends
and future selling price of the share. All that the model requires is a
dividend growth rate assumption and a discount rate. Both of these
can be estimated without much difficulty. The growth rate may be
estimated from past growth rates of dividends and earnings. The
discount rate is the investor’s required rate of return which is
somewhat subjective and would depend upon the investor’s
alternative investment opportunities and his perception of risk
involved in purchasing the share.
To illustrate the application of Gordon share valuation model, let us
consider an example. A company has declared a dividend of Rs. 2.50
per share for the current year. The company has been following a
policy of enhancing its dividends by 10 per cent every year and is
expected to continue this policy in the future also.
 Constant Growth Model..Contd.
An investor who is considering the purchase of the shares of this
company has a required rate of return of 15 per cent.
The intrinsic value of the company’s share can be calculated as:

D0(1 + g) Rs. 2.50 (1.10) 2.75

S0 = = =
k-g 0.15 - 0.10 0.05

= Rs. 55

The investor would be advised to purchase the share if the current

market price is lower than Rs. 55.
 Multiple Growth Model
The constant growth assumption may not be realistic in many situations.
The growth in dividends may be at varying rates. A typical situation
for many companies may be that a period of extraordinary growth
(either good or bad) will prevail for a certain number of years, after
which growth will change to a level at which it is expected to continue
indefinitely. This situation can be represented by a two-stage growth
model.
In this model, the future time period is viewed as divisible into two
different growth segments, the initial extraordinary growth period and
the subsequent constant growth period. During the initial period
growth rates will be variable from year to year, while during the
subsequent period the growth rate will remain constant from year to
year. The investor has to forecast the time N upto which growth rates
would be variable and after which the growth rate would be constant.
This would mean that the present value calculations will have to be
spread over two phases, where one phase would last until time N and
the other would begin after time N to infinity.
 Multiple Growth Model…Contd.
The intrinsic value of the share is then the sum of the present values of
two dividend flows: (a) the flow from period 1 to N which we will call
V1, and (b) the flow from period N+1 to infinity, referred to as V2. This
means,
S0= V1 + V2
The growth rates during the first phase of extraordinary growth is likely
to be variable from year to year. Hence, the expected dividend for
each year during the first phase may be forecast individually. The
multiple year holding period valuation model may be used for this first
phase, using the dividend forecasts developed for each of the years
in the first phase. Then

D1 D2 DN
V1 = + + …… +
(1 + k)1 (1 + k)2 (1 + k)N
 Multiple Growth Model…Contd.
This may be summarized as:

N
Dt
V1 = ∑ (1 + k)t
T=1

The second phase present value is denoted by V2 and would be based

on the constant growth model, because the dividend growth is
assumed to be constant during the second phase. The position of
the investor at time N, after which the second phase commences,
can be viewed as a point in time, when he is forecasting a stream of
dividends for time periods N+1, N+2, N+3 and so on, which grow at
a constant rate, g. The second phase dividends would be:
DN+1= DN(1+g)1
DN+2= DN(1+g)2
DN+3= DN(1+g)3 and so on to infinity.
 Multiple Growth Model…Contd.

The present value of the second phase stream of dividends from period
N+1 to infinity can be calculated using Gordon share valuation model
as:
DN (1 + g)
k-g

It may be noted that this value is the present value at time N of all future
expected dividends from time period N + 1 to infinity. When this value
has to be viewed at time ‘zero’ time for the second phase dividend
stream. When so discounted the present value of the second phase
dividend stream viewed at ‘zero’ time may be expressed as:

DN(1 + g)
V2 =
(k-g)(1+k)N

The present values of the two phases, V1 and V2, may be added to
provide the intrinsic value of the share that has a two-stage growth.
 Multiple Growth Model…Contd.
The summation procedure of the two phases may be expressed as :

N
Dt DN(1+g)
S0 = ∑ (1 + k)t +
(k-g)(1+k)N
t=1

To illustrate the two-stage growth model, let us consider an example. A

company paid a dividend of Rs. 1.75 per share during the current
year. It is expected to pay a dividend of Rs. 2 per share during the
next year. Investors forecast a dividend of Rs. 3 and Rs. 3.50 per
share respectively during the two subsequent years. After that it is
expected that annual dividends will grow at 10 per cent per year into
an indefinite future.
If the investor’s required rate of return is 20 per cent, the intrinsic value
of the share can be calculated as shown below.
 Multiple Growth Model…Contd.
In this, the dividend growth rate is variable upto the third year. From the
fourth year onwards dividend growth rate is constant. V1 would be the
present value of dividends receivable during the first three years and
can be calculated as:

2 3 3.50
V1 = + +
(1.2)1 (1.2)2 (1.2)3

= Rs. 5.78
Now, V2 would be the present value at time ‘zero’ of dividend receivable
from the fourth year to infinity. This is calculated as:

3.50(1.1) 3.85
V2 = =
(0.20 – 0.10)(1.2)3 (0.10)(1.2)3

= Rs. 22.28
 Multiple Growth Model…Contd.

The intrinsic value of the share is the sum of the two present values V1
and V2

S0 = V1 + V2
= 5.78 + 22.28
= Rs. 28.06
 Discount Rate
The discount rate used in the present value models is the investor’s
required rate of return. This has to take into consideration the time
value of money as well as the risk of the security in which investment
is proposed to be made. The time value of money is represented by
the risk-free interest rate such as those on government securities. A
premium is added to this risk-free interest rate to take care of the risk
to be borne by the investor by investing in the particular share. The
more risky the investment, the greater the risk premium that the
investor will require. The assessment of risk and the estimation of risk
premium required are usually done by investors on a subjective
basis. Though other objective methods are available for the purpose,
they are not popularly used. Thus, the investor’s required rate of
return would comprise the risk-free interest rate plus a risk premium.
The present value models discussed above are also known s dividend
discounted valuation models because they discount the stream of
dividends expected to be received from a share in the future.
 Multiplier Approach to Share valuation
Many investors and analysts value shares by estimating an appropriate
multiplier for the share. The price-earnings ratio (P/E ratio) is the
most popular multiplier used for the purpose.
The price-earnings ratio is given by the expression:

Share price
P/E ratio =
Earnings per share

The intrinsic value of a share is taken as the current earnings per share
or the forecasted future earnings per share times the appropriate P/E
ratio for the share. For example, if the current EPS of a share is Rs. 8
and if the investor feels that the appropriate P/E ratio for the share is
12, then the intrinsic value of the share would be taken after
comparing this intrinsic value with the current market price of the
share.
 Multiplier Approach to Share
valuation..Contd.
The major difficulty for the analyst using the multiplier approach to
share valuation is the determination of an appropriate price-
earnings ratio for the share. Different approaches may be adopted
for the determination of the appropriate P/E ratio. It may be arrived
at by the analyst on a subjective basis based on his evaluation of
various fundamental factors relating to the company. The major
factors considered would be growth rate in earnings and the risk
factor. The higher the expected growth and the lower the risk, the
greater would be the appropriate price-earnings ratio for the share.
Another approach would be to use the historical P/E ratios of the
company itself or the P/E ratios of other companies in the same
industry. In the first case, the mean of the historical P/E ratios of the
company in the past may be taken as the appropriate P/E ratio for
share valuation. In the latter case, the median P/E ratio of
companies in the same industry may be taken as the appropriate
P/E ratio.