Fundamental analysis

1. Fundamental analysis “The secret of financial success is to buy sound stock, wait until it goes up and then sell it. If it does not go up, don’t buy it” – Calvin Coolidge

2. Basic Premise • Price of a share is based on the benefits the holders of the share expect to receive in the future in the form of dividends (Concept of intrinsic or fundamental value) • Forecasting future dividends call for forecasting future earnings or future performance and hence analyzing the economic factors that influence the financial performance of the firm

3. Concept of “Efficient Market” • It is believed that in an efficient market, market takes into account all the fundamental factors relating to the financial performance of a firm in pricing a security • An efficient market is one where all information percolates down to all investors “instantly” and all investors process the available information rationally, so that no single investor has an edge over others. (Understand the meaning of this statement clearly! )

4. Signals • If the prevailing price or the P/E multiple of a security is higher than the estimated fundamental value i.e. the security appears to be overpriced, then “selling” is recommended. • If the security is under-priced in the market, the prevailing price of the P/E multiple of the security being lower than the estimated fundamental value, then, “buying” is recommended.

5. Assimilation of Information in Pricing of shares • Not all information may be of equal relevance to all securities • Some of the information may be relevant only for a particular company, while other information may be relevant for an entire industry or even the market as a whole • Any information or news reaching the market will be interpreted by it in terms of their perceived impact on the future financial performance of a firm

6. Information affecting the industry or economy as a whole Concerned with • Changes or expected changes in the government • Overall monetary or fiscal policies • Balance of payment situation • Death of a major leader • A major war • Monsoons • Other macro economic or political factors - These would buoy up or depress the entire capital market

7. Key economic variables that an investor must monitor • Growth rates of National Income and Related Measures • Growth rates of Industrial Sector • Inflation • Interest Rates • Foreign Trade, Balance of Payments and Exchange Rates • Government Revenues, Spending and Deficits • Savings and Investment • Demographic Data • Monsoon

8. Barometric Approach • Leading Indicators – Time Series of economic data that historically reach their high points (peaks) or their low points (troughs) in advance of total economic activity • Coincident indicators – Reach their peaks or troughs at approximately the same time as the economy • Lagging indicators – Reach their turning points after the economy has already reached its own

9. Information relevant to a specific industry • Various trade related governmental policies, rules and regulations • Indirect taxes and duties • Price Controls • Licensing or introducing quota system of distribution of a raw material • Administering of prices of products which form the output of an industry

10. Information to look for in industry analysis • Product Life Cycle (industry permanence) • Demand Supply Gap • Barriers to Entry • Market for the Product • Supply of Inputs • Government Attitude… • Past sales and Earnings Performance • Labor Conditions • Competitive Conditions • Industry Life Cycle (Pioneering, Expansion, Stabilization)

11. Classification of Industry • Classification by product • Classification according to Business Cycle • Growth industries : Abnormally high rates of expansion in earnings, often independent of the business cycle (Mobile handsets in India now) • Cyclical industries : Most likely to benefit from a period of economic prosperity and most likely to suffer from a period of economic recession (Consumer durables) • Defensive industries : Hurt least in periods of economic downswings (Food processing)

12. Information concerning a specific company • Indifferent health of a key executive • Major accident • Strike, or lockout • Dissension among promoters’ groups which may result in exit of senior executives • Undesirable control practices leading to low morale of the people who work for the company • Lack of management control leading to wastage of resources and improper utilization

13. Company Specific Analysis • Financial Statement Analysis – Ratio Analysis, Fund Flow / Cash Flow analysis, • Cross Sectional and Time Series Analysis • Break Even and Contribution Analysis • Analysis of Leverage • Reading of the accounting policies to understand the quality of accounting information • Segmental analysis…

14. What do these information lead to? • Essentially to reassessment of merely two fundamental parameters, namely, • Expected future growth rate of dividends • Expected returns of the shareholders

15. EIC Framework (Economy, Industry, Company) • Economy wide factors – Factors like the growth rate of the economy, rate of inflation, foreign exchange rates, etc. which affect the profitability of all companies • Industry wide factors – Factors specific to an industry in which the firm is operating, say, demand supply gap in the industry, emergence of substitute products and changes in government policy relating to the industry • Firm specific factors – Factors like age of the plant, quality of the management, brand image of the products, labor relations (all these reflect in the competitive position and hence the profitability)

16. Data Sources • Economy Data – Central Statistical Organization (CSO), RBI, Economic Survey Report, CMIE, Publications of Discount and Finance House of India, Ministry of Commerce… • Industry Data- CSO’s Annual Survey of Industry, RBI, CMIE • Company Specific Data – Stock Exchange Directory, CMIE…