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Learning Objectives
Elements of Top-Down Fundamental Analysis Macroeconomic Factors Classification of Industries Techniques for industry analysis Techniques for company analysis
Macroeconomic analysis: evaluates current economic environment and its effect on industry and company fundamentals Industry analysis: evaluates outlook for particular industries Company analysis: evaluates companys strengths and weaknesses within industry
The performance of a company depends much on the performance of the economy if the economy is BOOM, the industries and companies in general said to be prosperous. On the other hand, if the economy is in RECESSION, the performance of companies will be generally poor. Investors are interested in studying those economic varieties, which affect the performance of the company in which they proposed to invest. An analyzed of those economic variable would give an idea about future corporate earnings and the payment of dividends and interest to investors.
Fiscal policy Government spending , stimulates the demand for goods. Monetary policy Manipulation of money supply in an economy.
Indian Approach
Lagging Indicators
Duration of unemployment. Ratio of mfg. Commercial loans.
Leading Indicators Money supply. Consumer expectations. Orders for plant & machinery
Savings and investment denote that position of GNP, which is saved and invested savings increases in India since eighties now the rate of savings is 25% from 21% in 80s, which indicates the growth of capital market. The higher the level of savings interest, the more favorable is it for the stock marketed vice versa
Inflation
Inflation has considerate impact on the performance of companies. Higher rates of inflation upset business plans and erode purchasing power in the hands of consumers. This will result in lower demand for products. Thus high rates of inflation in an economy are likely to affect the performance of companies adversely. However industries and companies prosper during periods of low inflation. Hence an investor has to evaluate the inflation rates prevailing in the economy currently as well as the trend of inflation likely to prevail in the future.
Agriculture
Agriculture forms a major part of the Indian economy. Some companies are using agricultural raw material as inputs and some others are supplying inputs to agriculture. Such companies are directly affected by changes in agricultural production. Hence, the increase/decrease in agricultural production has a significant bearing on the industrial production and corporate performance
Rate of interest
The cost and availability of credit for companies are determined by the rates of interest prevalent in an economy. A low interest rate stimulates investment by making credit available easily and cheaply. As a result cost of finance for companies decreases which assures higher profitability. On the other hand, higher interest rates result in higher cost of production, which may lead to lower profitability and lower demand. Hence an investor has to consider the interest rates prevailing in the economy and evaluate their impact on the performance and profitability of the companies.
Infrastructure
The development of an economy very much on the availability of infrastructure. It includes electricity, roads and railways, communication channels etc. The availability of infrastructural facilities affects the performance of companies. Bas infrastructure leads to inefficiencies, lower productivity, wastage and delays and vice versa. Thus an investor should assess the status of infrastructural facilities available in the economy before finalizing his investment avenues.
Monsoon
The Indian economy is essentially an agrarian economy and agriculture forms a very important sector of the Indian economy. But the performance of agriculture to a very great extent depends upon the monsoon. The adequacy of the monsoon ensures the success of the agricultural activities in India and vice versa. Hence the progress and adequacy of the monsoon becomes a matter of great concern for an investor in India.
Political Stability
A stable political environment is necessary for steady and balanced growth. No industry or company can grow and prosper in the midst of political turmoil. Such long term economic policies are needed for industrial growth. Such stable policies can be framed only by stable political systems.
Industry Analysis
Industry analysis indicates to an investor whether the industry is a growth industry or not. It gives an investor a choice of the industry in which the investments should be made. Industry analysis refers to an evaluation of the relative strength and weakness of particular industries which can be divided in to three parts, viz., 1. Life cycle of an industry 2. Characteristics of an industry 3. Profit potential of an industry
Life Cycle
(a) Pioneering Stage: Technology and product are newly introduced. (b) Expansion stage: Those companies which reached first stage grow further and becomes stronger. (c) Stagnation Stage: In this stage the growth of the industries Stabilizes. Sales increases at slower rate.
The
industry
becomes
obsolete
and
Characterstics of an industry
Relationship between Demand & supply: Excess supply reduces the profitability of the industry and insufficient supply tends to improve the profitability. Thus an investor should estimate the demand and supply gap in an industry. (b) Period of life: Life of the industry depends on the products and the technology used by the industry. Technological changes leads to product obsolete. No investment should be made in such industries.
(c) State of labour: When there is labour revolution, industries cannot become bright.
(d) Governments attitude: The Government may encourage the growth and development of certain industries by giving much assistance to such industries. (e) Availability of Raw Material: An industry may depend on internal / external country for raw material. Sometimes they depend on import of raw material. (f) Cost structure: It refers to the proportion of fixed costs to variable costs. (Discuss about Marginal Cost)
Macroeconomic Analysis
Business Cycles
Goals of Policy
Full Employment
Economic Growth
irrational expectations on part of policy makers Adverse influence of speculators Adverse global responses
Consumer behavior (rational expectations) Incorrect analysis, actions, or timing by policy makers
Industry Analysis
Classifying industries
Cyclical industry - performance is positively related to economic activity Defensive industry - performance is insensitive to economic activity Growth industry - characterized by rapid growth in sales, independent of the business cycle
Industry Analysis
Birth (heavy R&D, large losses - low revenues) Growth (building market share and economies of scale) Mature growth (maximum profitability) Stabilization (increase in unit sales may be achieved by decreasing prices) Decline (demand shifts lead to declining sales and profitability - losses)
Industry Analysis
Start-up stage: many new firms; grows rapidly (example: genetic engineering) Consolidation stage: shakeout period; growth slows (example: video games) Maturity stage: grows with economy (example: automobile industry) Decline stage: grows slower than economy (example: railroads)
Industry Analysis
Qualitative Issues
Competitive Structure Permanence (probability of product obsolescence) Vulnerability to external shocks (foreign competition) Regulatory and tax conditions (adverse changes) Labor conditions (unionization)
Industry Analysis
identify demand for industrys products estimates of future demand identification of substitutes
examining data over time identifying favorable/unfavorable trends determining the relationship between variables
Ratio analysis
Regression analysis
Organizational performance
Management functions
Understanding of the global environment Adaptability to external changes Track record of the competitive position Sustainable growth Public image
Marketing strategy
Finance Strategy - adequate and appropriate Employee/union relations Effectiveness of board of directors
Operating efficiency
Importance of Q.A.
Past financial ratios With industry, competitors, and Forecast Revenues, Expenses, Net Income Forecast Assets, Liabilities, External Capital Requirements
Regression analysis
An Adage
Financial statements are like fine perfume;
Balance Sheet
Income statement
Liquidity (ability to pay bills) Debt (financial leverage) Profitability (cost controls) Efficiency (asset management)
Top-down analysis of company operations Objective: increase ROE
DuPont Analysis
Liquidity Ratios
Current assets / current liabilities (Current assets less inventories) / current liabilities
Quick ratio
Debt Ratios
Measure extent to which firm uses debt to finance asset investment (risk attribute) Debt-equity ratio
Total long-term debt / total equity (Current liabilities + long-term debt) / total assets EBIT / interest charges (EBIT + Lease Exp.) / (Int. Exp. + Lease Exp.)
Profitability Ratios
Measure profits relative to sales Gross profit margin ( % ) = Gross profit / sales Operating Profit Margin = Operating profits / sales Net profit margin = Net profit after taxes / sales ROA = Net Profit / Total Assets ROE = Net Profit / Stockholder Equity*
* Excludes preferred stock balances
Efficiency Ratios
Other Ratios
Earnings per share (EPS): (Net income after taxes preferred dividends)/ number of shares Price-earnings (P/E): Price per share/expected EPS Dividend yield: Indicated annual dividend/price per share Dividend payout: Dividends per share/EPS Cash flow per share: (After-tax profits + depreciation and other noncash expenses)/number of shares Book value per share: Net worth attributable to common shareholders/number of shares
Ratio 2
Ratio 3
Ratio 3 = Equity Kicker
Ratio 2 = TATO
The DuPont System suggests that ROE (which drives stock price) is a function of cost control, asset management, and debt management.
Five Steps
1. 2. 3. 4. Estimate next years sales revenues Estimate next years expenses Earnings = Revenue - Expenses Estimate next years dividend per share
5. Estimate the fair market value of stock given next years earnings, dividend, ROE, and growth rate for dividends.
Woerheides Conclusions
Fundamental analysis critical when dealing with private companies Necessary condition for market efficiency of publicly traded companies (although worthless at the margin) Earnings surprises major component of performance