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Fundamental Analysis

Fundamental analysis is really a logical and


systematic approach to estimating the future
dividends and share price.
It is based on the basic premise that share price is
determined by a number of fundamental factors
relating to the economy, industry and company.
It is a detailed analysis of the fundamental factors
affecting the performance of companies.
Each share is assumed to have an economic worth
based on its present and future earning capacity.
This is called its intrinsic value or fundamental value.
Fundamental Analysis
The purpose of fundamental analysis is to evaluate
the present and future earning capacity of a share
based on the economy, industry and company
fundamentals.
The investor can compare the intrinsic value of the
share with the prevailing market price to arrive at an
investment decision.
If the market price of the share is lower than the its
intrinsic value, the investor would decide to buy the
share as it is underpriced.
The price of such a share is expected to move up in
future to match with its intrinsic value.
Fundamental Analysis
When the market price of a share is
higher than its intrinsic value, it is
perceived to be overpriced.
The market price of such share is
expected to comedown in future.
The investor would decide to sell such a
share.
Economy-Industry-Company
Analysis Framework
The analysis of economy, industry and
company fundamentals constitute the main
activity in the fundamental approach to security
analysis.
The logic of this three tier analysis is that the
company performance depends not only on its
own efforts, but also on the general industry
and economy factors.
The multitude of factors affecting the
performance of a company can be classified as
Economy-Industry-Company
Analysis Framework
Economy-wide factors such as growth rate of
the economy, inflation rate, foreign exchange
rates, etc. which affect all companies.
Industry-wide factors such as demand-supply
gap in the industry, the emergence of substitute
products, changes in government policy relating
to the industry.
Company-specific factors such as the age of its
plant, the quality of management, brand image
of its products, its labour-management relations,
etc.
Steps in Fundamental Analysis
Economic Analysis
Industry Analysis
Company Analysis
Economic Analysis
The performance of a company depends
on the performance of the economy.
If the economy grows rapidly, the industry
can also be expected to show rapid growth
and vice versa.
When the level of economic activity is low,
stock prices are low, and when the level of
economic activity is high, stock prices are
high reflecting the prosperous outlook for
sales and profits of the firms.
Economic variables
A study of these economic variables would give an idea about
future corporate earnings and the payment of dividends and
interest to investors.
The following are the some of the key economic variables that
an investor must monitor as part of his fundamental analysis.
1. Growth Rates of National Income
2. Inflation
3. Interest Rates
4. Budget
5. The balance of payment
6. Infrastructure
7. Monsoon
8. Economic and Political Stability
Growth Rates of National Income
GNP (Gross national product), NNP (Net national
product) and GDP (Gross domestic product) are the
different measures of the total income or total
economic output of the country as a whole.
The growth rates of these measures indicate the
growth rate of the economy.
The estimate of GNP, NNP and GDP and their growth
rates are made available by the government from time
to time.
An economy typically passes through different
phases of prosperity known as the different stages of
the economic or business cycle.
Growth Rates of National Income

The stage of the economic cycle through


which a country passes has a direct
impact on the performance of industries
and companies.
While analysing the growth rate of the
economy, an investor would do well to
determine the stage of the economic cycle
through which the economy is passing and
evaluate its impact on his investment
decision.
Inflation
Inflation prevailing in the economy has
considerable impact on the performance of
companies.
High rates of inflation in an economy are likely to
affect the performance of companies adversely.
Industries and companies prosper during times
of low inflation.
Inflation is measured both in terms of wholesale
prices through the wholesale price index (WPI)
and in terms of retail prices through the
consumer price index (CPI).
Interest Rates
Interest rates determine the cost and
availability of credit for companies operating
in an economy.
A low interest rate stimulates investment by
making credit available easily and cheaply.
It implies lower cost of finance for companies
and thereby assures higher profitability.
Higher interest rates result in higher cost of
production which may lead to lower
profitability and lower demand.
Interest Rates
The interest rate in the organised sector
of the economy are determined by the
monetary policy of the government and
the trends in the money supply.
An investor has to consider the interest
rates prevailing in the different segments
of the economy and evaluate their
impact on the and profitability of
companies.
Budget
The budget draft provides an elaborate
account of the government revenues
and expenditures.
A deficit budget may lead to high rate of
inflation and adversely affect the cost of
production.
Surplus budget may result in deflation.
Hence, balanced budget is highly
favorable to the stock market.
The balance of payment
The balance of payment is the record of a
countrys money receipt from and payments
abroad.
The difference between receipts and
payments may be surplus or deficit.
Balance of payment 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 balance of payment
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 investment of the FII in
the Indian stock market.
Infrastructure
The development of an economy depends
very much on the infrastructure available.
The availability of infrastructural facilities
such as power, transportation and
communication systems affects the
performance of companies.
An investor should assess the status of the
infrastructural facilities available in the
economy before finalising his investment
plans.
Monsoon
The performance of agriculture to a very
great extent depends on the monsoon.
The adequacy of the monsoon
determines the success or failure of the
agricultural activities in India.
The progress and adequacy of the
monsoon becomes a matter of a great
concern for an investor in the Indian
context.
Economic and political stability
A stable political environment is
necessary for steady and balanced
growth.
Stable long-term economic policies are
needed for industrial growth.
A stable government with clear cut long-
term economic policies will be conducive
to good performance of the economy.
Economic Forecasting
Economy analysis is the first stage of
fundamental analysis and starts with an analysis
of historical performance of the economy.
Investment is a future-oriented activity, the
investor is more interested in the expected
future performance of the overall economy and
its various segments.
For this, forecasting the future direction of the
economy becomes necessary.
Economic forecasting becomes a key activity in
economy analysis.
Economic Forecasting
The central theme in economic forecasting is
to forecast the national income with its various
components.
GNP is a measure of the national income.
It is the total value of the final output of goods
and services produced in the economy.
It is a measure of the total economic activities
over a specified period of time and is an
indicator of the level and rate of growth of
economic activities.
Economic Indicators
The economic indicators are factors that
indicate the present status, progress or
slowdown of the economy.
They are capital investment, business
profits, money supply, GNP, interest
rate, unemployment rate, etc.
The economic indicators are grouped
into leading, coincidental and lagging
indicators.
Leading Indicators
The leading indicators indicate what is
going to happen in the economy.
It helps the investor to predict the path
of the economy.
The popular leading indicators are the
fiscal policy, monetary policy,
productivity, rainfall, capital investment
and the stock indices.
Coincidental Indicators
The coincidental indicators indicate what the
economy is.
The coincidental indicators are gross
national product, industrial production,
interest rates and reserve funds.
GDP is the aggregate amount of goods and
services produced in the national economy.
The gap between the budgeted GDP and
the actual GDP attained indicates the
present situation.
Lagging Indicators
The changes that are occurring in the
leading and coincidental indicators are
reflected in the lagging indicators.
Lagging indicators are identified as
unemployment rate, consumer price
index and flow of foreign funds.
Forecasting Techniques
Economic forecasting may be carried out for short-
term periods (up to three months), intermediate terms
periods (three to five years) and long-term periods
(more than five years).
An investor is more concerned about short-term
economic forecasts.
Some of the techniques of short-term economic
forecasting are discussed below:
1. Anticipatory Surveys
2. Barometric or Economic Indicator Approach
3. Econometric Model Building
4. Opportunistic Model Building
Anticipatory Surveys
Anticipatory surveys are the surveys of
intentions of people in government, business,
trade and industry regarding their construction
activities, plant and machinery expenditures,
level of inventory, etc.
Such surveys may also include the future plans
of consumers with regards to their spending on
durables and non-durables.
Based on the results of these surveys, the
analyst can form his own forecast of the future
state of the economy.
Econometric Model
Building
This is the most precise and scientific of the different
forecasting techniques.
This technique makes use of Econometrics.
Econometrics is a discipline that applies
mathematical and statistical techniques to economic
theory.
In the economic field we find complex
interrelationship between the different economic
variables.
The precise relationship between the dependent and
independent variables are specified in a formal
mathematical manner in the form of equations.
Econometric Model
Building
In applying this technique, the analyst is forced
to define clearly and precisely the
interrelationship between the economic
variables.
Econometric models used for economic
forecasting are generally complex.
Vast amounts of data are required to be
collected and processed for the solution of the
model.
This may cause delay in making the results
available.
Opportunistic Model
Building
This is one of the most widely used forecasting
techniques.
It is also known as GNP model building or
sectoral analysis.
Initially, an analyst estimates the total demand in
the economy, and based on this he estimates the
total income or GNP for the forecast period.
This initial estimate takes into consideration the
prevailing economic environment such as the
existing tax rates, interests rates, rate of inflation,
fiscal policies, etc.
Opportunistic Model
Building
After initial forecast is arrived at, the analyst now
begins building up a forecast of the GNP figure by
estimating the levels of various components of GNP
such as consumption expenditure, gross private
domestic investment, government purchase of
goods and services and net exports.
The two GNP forecasts arrived at by two different
methods will be compared and necessary
adjustments will be made.
This model building approach makes use of other
forecasting techniques to build up the various
components.
Industry Analysis
Industry analysis refers to an evaluation
of the relative strengths and
weaknesses of particular industries.
An industry is generally described as a
homogenous group of companies.
An industry is a group of firms that have
similar technological structure of
production and produce similar
products.
Industry Classification
Industries can be classified on the basis
of the business cycle.
They are classified into growth, cyclical,
defensive and cyclical growth industry
Growth Industry
The growth industries have special features
of high rate of earnings and growth in
expansion, independent of the business
cycle.
The expansion of the industry mainly
depends on the technological change.
In every phase of the history certain
industries like colour televisions,
pharmaceutical and telecommunication
industries have shown remarkable growth.
Cyclical Industry
The growth and profitability of the industry
move along with the business cycle.
During the boom period they enjoy growth
and during depression they suffer a set
back.
For example Refridgerator, washing
machine and kitchen range products
command a good market in the boom period
and the demand for them slackens during
the recession.
Defensive Industry
Defensive industry defies the movement
of the business cycle.
Food and shelter are the basic
requirements of humanity.
The food industry withstands recession
and depression.
The stocks of the defensive industries
can be held by the investors for income
earning purpose.
Cyclical growth Industry
This is a new type of industry that is
cyclical and at the same time growing.
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.
Industry Life Cycle
The industry life cycle theory is generally
attributed to Julius Grodensky.
The life cycle of the industry is
separated into four well defined stages
such as
1. Pioneering stage
2. Rapid growth stage
3. Maturity and stabilisation stage
4. Declining stage
Pioneering stage
The prospective demand for the product
is promising in this stage and the
technology of the product is low.
The demand for the product attracts
many producers to produce the
particular product.
There would be severe competition and
only fittest companies survive this stage.
The producer try to develop brand
name, differentiate the product and
create a product image.
Rapid growth stage
This stage starts with the appearance of
surviving firms from the pioneering stage.
The companies that have withstood the
competition grow strongly in market share and
financial performance.
The technology of the production would have
improved resulting in low cost of production and
good quality products.
The companies have stable growth rate in this
stage and they declare dividend to the
shareholders.
Rapid growth stage
It is advisable to invest the shares of
these companies.
In this stage the growth rate is more
than the industrys average growth rate.
Maturity and stabilisation stage

In the stabilisation stage, the growth


rate tends to moderate and the rate of
growth would be more or less equal to
the industrial growth rate or GDP growth
rate.
To keep going, technological
innovations in the production process
and product should be introduced.
The investors have to closely monitor
the events that take place in the maturity
stage of the industry.
Declining stage
In this stage, demand for the particular product
and the earnings of the companies in the
industry decline.
Innovation of new products and changes in
consumer preferences lead to this stage.
The specific feature of the declining stage is that
even in the boom period, the growth of the
industry would be low and decline at higher rate
during the recession.
It is better to avoid investing in the shares of the
low growth industry even in the boom period.
Factors to be considered
Apart from industry life cycle analysis, the
investor has to analyse some other factors too.
They are as follows
1. Growth of the industry
2. Cost structure and profitability
3. Nature of the product
4. Nature of the competition
5. Government policy
6. Labour
7. Research and development
Company Analysis
Company analysis deals with the estimation of return
and risk of individual shares.
This calls for information.
Information regarding companies can be broadly
classified into two broad group: internal and external.
Internal information consists of data and events made
public by companies concerning their operations.
The internal information sources include annual
reports to shareholders, public and private statements
of officers of the company, the companys financial
statements, etc.
Company Analysis
External sources of information are
those generated independently outside
the company.
In company analysis, the analyst tries to
forecast the future earning of the
company.