Fundamental Analysis

Objectives of the chapter

Importance of fundamental analysis
Fundamental factors affecting companys
earnings
Macro and micro variables impact on corporate
performance
Various dimensions of industry analysis and its
various dimensions in investment
Learning the techniques of analysing a company
for investment purposes
Grasping the use of fundamental analysis along
with technical analysis
 Fundamental Analysis
The movements of prices of securities are
based on various factors relating to the
economy, industry and the company.
The general economic conditions of a
country can have great impact on the stock
prices
These factors are macroeconomic in nature
on which the company has no control
The microeconomic factors are company
specific
 Economic Analysis
GDP Growth
Industrial Production
Infrastructure Facilities
Agricultural Production
Money Supply
Inflation
Savings and Investments
 Economic Analysis
Unemployment
Demographic Factors
Balance of Payment
Current Account
Exchange Rate
Economic Reforms
Government Policies
Indias GDP Growth
Inflation
 Economic Analysis
Government Policies
Industrial Policy
Budget and Management of Budget
Deficit
Fiscal Policies
Monetary Policies
Supply side Policies
Legal Policies
Labour Policies
 Economic Analysis
Government Policies
Regulatory Interventions
Tax Regime
International Relations
Political Philosophy
Disaster Management
Social and Cultural Environment
 Business Cycles
Periods of Boom and Depression
Expansion during boom
Economy contracts during depression
Transition across the cycles are called peaks
and troughs
Peak denotes the end of boom
Trough denotes the bottom level of recession
Expansion and Recession process affects
performance of industry
 Economic Indicators
Leading economic indicators are
those economic indicators that rise
or fall ahead of the economy.
Lagging economic indicators move in
tandem with somewhat or after the
broad economy
A wide range of economic indicators
are released to the public regularly
by publishing an economic calendar.
 Economic Calendar Release
2007-08
Data Category Date of last November 2007 December 2007 January 2008 February 2008
(and, if different, calendar release
national (mm/dd/yy)
descriptor) (Ref. period) Notes
REAL SECTOR
National August/31/07 30 29
accounts 1/ (Jul/07 Sep/07) (Oct/07 Dec/07)
(Apr/07 - Jun/07)
Production index 12 12 11 12
(Index of Oct/12/07 (Sep/07) (Oct/07) (Nov/07) (Dec/07)
industrial (Aug/07)
production)
Price indices: Consumer prices
Consumer price Oct/31/07 30 31 31 29
index (Industrial (Sep/07) (Oct/07) (Nov/07) (Dec/07) (Jan/08)
Workers)
Consumer price Oct/19/07 2/
index (Sep/07) 20 20 18 20
(Agricultural
(Oct/07) (Nov/07) (Dec/07) (Jan/08)
Labourers/Rural
Labourers)
Consumer price Oct/25/07
index (Urban non- (Sep/07) 26 26 25 25
manual (Oct/07) (Nov/07) (Dec/07) (Jan/08)
employees)
Price indices: Producer prices
Wholesale price Oct/26/07 3/ 02 07 04 01
index (Oct/20/07) (Nov/24/07) (Dec/22/07) (Jan/19/08)
(Oct/13/2007) 09 14 11 08
(Oct/27/07) (Dec/01/07) (Dec/29/07) (Jan/26/08)
16 21 18 15
(Nov/03/07) (Dec/08/07) (Jan/05/08) (Feb/02/08)
23 28 25 22
(Nov/10/07) (Dec/15/07) (Jan/12/08) (Feb/09/08)
30 29
(Nov/17/07) (Feb/16/08)
 Economic Forecasting
Stock prices are sensitive to events
that adversely affect economic
fundamentals
Knowledge of such events is
essential for forecasting stock prices
accurately
Various techniques are used for long
term and short term forecasting
 Econometric Modeling
Econometrics applies mathematical and
statistical techniques to economic theory
Econometric model building involves the
specification of a system of simultaneous
equations consisting of endogenous and
exogenous variables
Some of the well known econometric models
are FRB/MIT (Federal Reserve
Bank/Massachusetts Institute of Technology)
Model, Michigan Model, Pennsylvania Model,
Brookings Model etc.
 Industry Analysis
Industrial Environment
Industry/Business Associations
Industrial support to government
Impact of government policies on
industries
General trend in the industry
 Classification of Industries
Small Manufacturing Enterprises
Medium Manufacturing Enterprises
Large Manufacturing Enterprises
Micro Manufacturing Enterprises
 Classification of Industries
According to Activities
Primary Sector
Agriculture and Allied Industries
Secondary Sector:
Manufacturing
Tertiary Sector
Services such as transport,
communication, financial services etc.
 Classification of Industries
Based on Products and Services
Agriculture and Allied Industries
Agriculture products like, rice, wheat,
sugar cane etc.
Agricultural Equipments like tractors,
power tillers, harvesting machines etc.
Transportation
Heavy Motor Vehicles like trucks, Buses etc.
Light Motor Vehicles like car, mini vans etc.
Three Wheeler Vehicles
Two Wheelers
 Classification of Industries
Based on Products and Services
Small and Medium Industries (SME)
Traditional Industries
Khadi and Village Industries
Handlooms
Sericulture
Handicraft
Coir Fibre
Non-traditional
 Classification of Industries
Based on Products and Services
Manufacturing Industries
Wood Products
Other Manufacturing
Basic Metals
Jute Textiles
Leather products
Machinery and Equipments
Rubber and Petroleum
Beverages and Tobacco
 Classification of Industries
Based on Products and Services
Manufacturing Industries
Chemicals
Non-metal Mineral Products
Food Products
Cotton Textiles
Textile Products
Wool. Silk, MM Textiles
Transport Equipments
Paper Products
Metal Products
 Classification of Industries
Based on Performance
Cyclical Industries
Defensive Industries
Cyclical Growth Industries
 Industry Life Cycle
Development Stage
Expansion Stage
Stagnation Stage
Decay Stage
 Industry Life Cycle
Sale
s

Development
Stage

Stagnation
Expansion Stage Stage Decay Stage
 Factors affecting Industrial
Perfomance
Demand and Supply Gap
Supply of Raw Materials
Gestation Period
Permanence
Labour Condition
Government Attitude
Industrial Growth
Growth by Industry Group
20

15 13.9 13.5 13 12.3 12.1

10.5 10 9.9
10
6.4
4.8
5 4
3.2
2.1
0.9
0

-2.2
-5

-7.2
-10

-15
-16.2
-20

In percent based on IIP 1993-94=100. Source: indiabudget.nic.in

 Business Cycle
Economic Activity

Peak Peak

Contraction

Expansion

Time
 SWOT Analysis
Michael Porters Five Force Analysis
Threat of Potential Entry
Rivalry between Existing Firms
Pressure from Substitute Products
Bargaining Power of Buyers
Bargaining Power of Suppliers
 Company Analysis
Company Analysis

Project Analysis Product Analysis Financial Health Management Analysis

Project Potential Product/s Financial Economic Environment

Success Stories Technology Analysis Analysis Analysis

Promoters Market

Appraisal Competition Ratio Analysis Financial Statement

Analysis
Environmental Clearances Quality

R&D initiatives Stock Market

Liquidity Economic
Conditions
Conditions
Leverage
Historic Price movements
oInternal
Activity
Current Price
Operating Efficiency oExternal

Profitability
Balance Sheet Analysis Management Team
Valuation
Income & Expense Analysis Key Personnel and their background

Earnings Analysis Capital structure and Promoters contribution

Cash Flow/Fund Flow Analysis Litigations and Legal Issues

 Project Analysis
Project Potential
Success Stories
Promoters and their Background
Appraisal of the Project
Environmental Clearance
Legal Clearance
 Product Analysis
Product
Technology
Market
Sales Growth
Sales Stability
Sales Forecast
Justifiable
Achievable
 Product Analysis
Competition
Comparative Advantage
Competitive Advantage
Market Share
Quality
Cost and Profit Structure
R & D Initiatives
 Financial Health
Financial Analysis
Ratio Analysis
Historical Ratios
Interfirm Comparison
Industry Averages
 Types of Ratios
Liquidity Ratios
Current Ratio = Current Assets/Current
Liabilities
Acid Test Ratio =
Quick Assets (Current Assets Inventories)
Current Liabilities
Leverage Ratios
Debt Equity Ratio = Total Debt/Equity
Debt Ratio = Total Debt/Capital
Employed
 Types of Ratios
Coverage Ratios
Interest Service Coverage Ratio = EBDIT
Interest
Charges
Debt Service Coverage Ratio = EBDIT
Interest + Loan Repayment
Activity Ratios
Inventory Turnover
Cost of Goods Sold
Average Inventory (Opening + Closing Stock/2)
 Types of Ratios
Inventory Holding Period
= 360/Inventory Turnover
Receivable Turnover
=Credit Sales/ Average Receivables
Average Collection Period
= 360/ Receivable Turnover
Fixed Assets Turnover Ratio
= Sales/ Net Fixed Assets
 Types of Ratios
Working Capital Turnover Ratio
= Sales / Working Capital
Total Assets Turnover
= Sales/ Total Assets
Operating Efficiency
Operating Expenses Ratio = Operating
Expenses
Sales
 Types of Ratios
Profitability Ratios
Gross Profit Margin = Gross Profit
Sales
Net Profit Margin = Profit after Tax
Sales
Return on Investments = Net Profit
Total Assets
 Types of Ratios
Valuation Ratios
Earning Per Share (EPS) = Profit after
Tax
Number of Outstanding Shares
Dividend per Share (DPS
=Earnings paid to Equity Shareholders
(dividends)
Number of Outstanding Shares
 Types of Ratios
Valuation Ratios
Dividend and Earnings Yield =
Dividend Yield = Dividend per Share
Market Value per Share

Earnings Yield = Earnings per Share

Market Value per Share
 Types of Ratios
Valuation Ratios
Price Earnings Ratio (P/E)= Market Price of Share
Earnings per Share
Intrinsic Value
Expected P/E ratio in terms of normalized EPS
Can be arrived at by dividing the expected dividend
with an appropriate discount rate
If the current market price is lower than its intrinsic
value buy
Stocks having market price above intrinsic value are
recommended for sale
 Financial Statement
Analysis
Balance Sheet Analysis
Vertical Form of Balance Sheet
Horizontal Form of Balance Sheet
Audited Balance Sheet
Un-audited Balance Sheet
Certified Copy of Accounts
Audit Report
Qualified Audit Reports
Notes on Accounts
Vertical Form of Balance
Sheet
 Horizontal Form of Balance
Sheet
Balance Sheet of High Waves Ltd. as at the end of March 31, 2010
Amount (Rs. Lakhs)
Liabilities 2010 2009 Assets 2010 2009
Share Capital
Equity 200 200 Fixed Assets less Depreciat1 250 1150
Preference 100 100 Current Assets
Reserves and Surpluses 500 300 Inventories 95 105
Profit and Loss Account 395 255 Sundry Debtors 85 95
Secured Loans Short-term investments1 15 125
10% Debentures 400 500 Cash and Bank Balances 355 135
Term Loans 100 150
Current Liabilities & Provisions
Bills Payable 50 60
Sundry Creditors 40 35
Other Current Liabilities 15 10
Total 1800 1610 Total 1800 1610
Sample Audit Report
Sample Notes on Accounts
 Financial Statement
Analysis
Directors Report
Profit and Loss Account
Analysis of Balance Sheet
Percentage Analysis
Income and Expenses Analysis
Trend Analysis
Earning Power Analysis
DuPont Chart
Sample Profit and Loss
Account
 DuPont Chart
Return on Net
Assets
(RONA) =
EBIT/NA Profit
Return on Margin
20%
Equity (ROE) EBIT/Sales
= PAT/ NW Financial
Leverage = 10%
18% PAT/EBIT
57% Asset
Turnover
Financial Sales/NA =
Leverage 2.05%
NA/NW
157%
 Financial Statement
Analysis
Cash Flow/ Fund Flow Analysis
Sources of Cash
Profit from operations
Decrease in assets except cash
Increases in liabilities such as secured loans, issue of
debentures, bond etc.
Issue of equity or preference shares or both
Uses of Cash
Increase in assets except cash
Decrease in liabilities including repayment of loans, redemption
of debentures, bonds etc.
Redemption of redeemable preference shares
Buy back of shares
Payment of cash dividend
 Financial Statement
Analysis
Cash Flow/ Fund Flow Analysis
Fund Flow Analysis
Source of Working Capital
Increase in assets except cash
Decrease in liabilities including repayment of
loans, redemption of debentures, bonds etc.
Redemption of redeemable preference shares
Buy back of shares
Payment of cash dividend
 Financial Statement
Analysis
Cash Flow/ Fund Flow Analysis
Fund Flow Analysis
Use of Working Capital
Adjusted net loss from operations
Purchase non-current assets like shares, bonds
debentures etc., tangible fixed assets like land,
buildings, machinery, equipments etc., intangible items
like good will, patents, trademarks, copy right etc.
Repayment of long and short-term debt
Redemption of redeemable preference shares
Payment of cash dividend
Buy back of shares.
Economic Condition Analysis
Internal Economic Conditions
Economy of scale of operation
Better accessibility for mobilization of
resource
Good financial governance
Consistency in growth
Consistency in financial policies
Top line growth Vs Bottom line growth
External Economic Conditions
 Financial Environment
Analysis
Stock Market Condition
Historic Price Movements
Current Price
Target Price
 Management Analysis
Management Team
Co-ordination and co-operation among the top
management, middle-level management and the
junior level managers
Knowledge about companys products and operations
among the staff and management team
Healthy work culture and employee management
relationship
Effective feedback system and follow up mechanism
Members of management team, their background,
qualification and experience
Key Personnel and their background
 Management Analysis
Capital Structure and Promoters
Contribution
Litigation and Legal Issues
Causes of litigation
Legal violation and prosecution process
Involvement in financial frauds and money
laundering