sapm fundamental analysis

Notes Compiled by Prof.V.S.Gopal

FUNDAMENTAL ANALYSISFundamental analysis is examination of the underlying forces that affect the well being of

examination of the economy, industry groups, and companies. As with most analysis, the

goal is to derive a forecast and profit from future price movements.

INTERPRETATION

Most fundamental information focuses on economic, industry, and company statistics.

The typical approach to analyzing a company

involves three basic steps:

1. Determine the condition of the general

economy.

2. Determine the condition of the industry.

3. Determine the condition of the company.

ECONOMIC ANALYSIS

The economy is studied to determine if overall conditions are good for the stock

market. Is inflation a concern? Are interest rates likely to rise or fall? Are consumers

spending? Is the trade balance favorable? Is the money supply expanding or contracting?

These are just some of the questions that the fundamental analyst would ask to determine

if economic conditions are right for the stock market.

INDUSTRY ANALYSIS

It is the study of industries which are on the upswing. The ideal investment is the

investment in the growing industries. It is often said that a weak stock in a strong industry

is preferable to a strong stock in a weak industry. In order to make productive

investments the investor should know the industry classification used in the economy. It

is also enviable to know the characteristics, problems and practices in different industries.


COMAPNY ANALYSIS

After determining the economic and industry conditions, the company itself is

analyzed to determine its financial health. This is usually done by studying the company's

financial statements. From these statements a number of useful ratios can be calculated.

The ratios fall under five main categories: profitability, price, liquidity, leverage, and

efficiency. While performing ratio analysis of a company, the ratios should be compared

to other companies within the same or similar industry to get a feel for what is considered

"normal."

Phase Fundamental Analysis: -

Phase Nature of analysis

Purpose Tools & Techniques

First Economic Analysis

To assess the general economic situation both within the country and internationally

Economic indicators – lead, lag and coincidental indicators

Second Industry Analysis

To review prevailing conditions within a specific industry and its segments

Performance indicators – aggregate demand & supply position, internal & external competition, government policies

Third Company Analysis

To analyze the financial & non-finance aspects of a company to determine whether to buy, sell, or hold onto the shares of a company

Non-financial aspects analysis like promoters, management, vital product quality, corporate image, etc. financial aspects like EPS, sales, profitability, dividend record, asset growth


BENEFITS OF FUNDAMENTAL ANALYSIS

Long-term trends: Fundamental analysis is good for long-term investments based

on long-term trends.

Value Spotting: Sound Fundamental Analysis will help identify companies that

represent good value. It can help discover companies with valuable assets, a strong

balance sheet, stable earnings and staying power.

Business Expertise: Fundamental Analysis helps to develop a thorough

understanding of the business. The investor becomes familiar with the key revenue and

profit drivers behind a company.

Categorization: Stocks move as a group, by understanding a company’s business,

investors can better position themselves to categorize stocks within their relevant industry

groups. Knowing a company’s business and being able to place it in a group can make a

huge difference in relative valuations.

The stock market does not operate in a vacuum. Similarly no industry or company can

exist in isolation. It is an integral part of the whole economy of a country, more so in a

free economy like that of US and to some extent in a mixed economy like that of ours.

The importance of Economic Analysis:

To gain an insight into the complexities of the stock market, one needs to develop

a sound economic understanding and be able to interpret the important economic

indicators on stock markets.

The economy is like the tide and the various industry groups and individual

companies are like boats. When the economy expands, most industry groups and

companies benefit and grow. When the economy declines, most sectors and

companies usually suffer.

Investment decisions depend on the state of the economy existing at that

particular point of time. E.g. if the economy is expanding then, an aggressive


growth-oriented strategy might be advisable. A growth strategy might involve the

purchase of technology, biotech, semiconductor and cyclical stocks. If the

economy is forecast to contract, an investor may opt for a more conservative

strategy and seek out stable income-oriented companies.

The Economic Cycle:

Countries go through the business or economic cycle and the stage of the cycle at

which a country is in has a direct impact both on industry and individual companies. It

affects investment decisions, employment, demand and the profitability of companies.

While some industries such as shipping or consumer durable goods are greatly affected

by the business cycle, others such as the food or health industry are not affected to the

same extent. This is because in regard to certain products consumers can postpone their

purchase decisions, whereas in certain others they cannot.

Fig.: Economic Cycle

THE INVESTMENT DECISION

Investors should attempt to determine the stage of the economic cycle the country is in.

They should invest at the end of a depression when the economy begins to recover, and at

the end of a recession. Investors should disinvest either just before or during the boom, or

BOOM

RECOVERY RECESSION

DEPRESSION

INVEST

DISINVEST


at the worst, just after the boom. Investment and disinvestments made at these times will

earn the investor the greatest benefits.

Key Economic Indicators:

There are certain economic indicators, which may be studied to assess the national

economy as a whole.

Leading Indicators: These indicators predict what is likely to happen to the

economy. Perfect examples of leading indicators are the unemployment position, rainfall

and agricultural production, fixed capital investment, corporate profits, money supply,

credit position and index of equity share prices.

Coincidental Indicators: These indicators highlight the current position. Some

examples are Gross National Product, Index of Industrial Production, money market

rates, interest rates and reserve funds with commercial banks.

Lagging Indicators: These explain what has already taken place. Some examples are

large-scale unemployment, piled up inventories, outstanding debt, interest rates of

commercial loans, etc.

Though useful, these indicators must be used with caution. These can only help in

understanding economic trends and outlining your investment strategy intelligently.

Political Equation

A stable political environment is necessary for steady, balanced growth. A stable

government is able to take decisions regarding long-term development of the country,

which leads to prosperity of industries and companies. On the other hand, instability

causes insecurity. India has been going through a fairly difficult period. There had been

terrible political instability since the late eighties. Various elections with no majority

power to any one party, religious and ethnic issues, the Pakistan issue etc. lead to

instability in the Government.


Industrial Production:

An upswing in industrial production is good for the economy and a downswing

rings an alarm. The decline in agricultural growth and the steep hike in petroleum prices

would affect industrial growth.

Inflation:

Inflation has an enormous effect on the economy. Within the country it erodes

purchasing power considerably. As a result, demand falls. A low rate of inflation

indicates stability and healthy economic conditions and industries prosper at such times.

The USA and Europe have fairly low inflation rates.

Interest Rates:

A low rate of interest rate is must for economic development. It stimulates

investment and industry. On the contrary, high interest rates result in high cost of

production, low consumption and decrease in company’s competitiveness.

Infrastructure:

The development of an economy is dependent on its infrastructure. Public

infrastructure services like banking, telecom, coal and power etc play a crucial role in

deciding the fate of an economy. Investments into these sectors have accounted for a

major share of public spending for most of the last fifty years. A key constraint facing

the Indian economy is the country's seriously inadequate infrastructure. Uncertainties

over the policy, legal, and regulatory frameworks in key infrastructure sectors continue to

act as a constraint to increasing private sector involvement.

Rainfall and Agricultural Production:


Foreign Exchange Reserves:

A country needs foreign exchange reserves to meet its commitments, pay for its

imports and service foreign debts. Without foreign exchange, a country would not be able

to import materials or goods for its development and there is also a loss of international

confidence in such a country.

Budgetary Deficit:

A budgetary deficit occurs when governmental expenditure exceeds its income.

Expenditure stimulates the economy by creating jobs and stimulating demand. However,

this can also lead to deficit financing and inflation. All developing economies including

India suffer from budget deficits. The performance of India's economy in recent years has

been overwhelmingly encouraging, but that doesn't reduce the magnitude of the problem

posed by its fiscal deficits.

Domestic Savings and Capital Output Ratio:

Employment

High employment is required to achieve a good growth in national income. As the

population growth is faster than the economic growth unemployment is increasing. This

is not good for the economy.

Taxation

EXIM Policy

International Developments

US Factor


INDUSTRY ANALYSIS

The second phase of fundamental analysis consists of a detailed analysis of a

specific industry; its characteristics, past record, present state and future prospects. The

purpose of industry analysis is to identify those industries with a potential for future

growth, and to invest in equity shares of companies selected from such industries.

Industry analysis has become very important after the opening of the economy, new

entrants and intense competition.

To assess an industry groups’ potential, an investor should consider the overall growth

rate, market size, and importance to the economy. While the individual company is still

important, its industry group is likely to exert just as much, or more, influence on the

stock price. When stocks move, they usually move as groups; there are very few lone

guns out there. Many times it is more important to be in the right industry than in the

right stock!

Every industry, and company with in a particular industry, undergoes a life cycle with

four distinct phases as shown in the diagram below:

Figure: Industry Life cycle

1 32 4

Years

Profits


1. Entrepreneurial or nascent stage

2. Expansion or growth stage

3. Stagnation stage

4. Decay or sunset stage

Entrepreneurial Stage:

This is the first stage of the industrial life cycle of a new industry where the

technology as well as the product are relatively new and have not reached a stage of

perfection. The pioneering stage is characterized by rapid growth in demand for the

output of the industry. As a result there is great opportunity for profit. As a large number

of companies attempt to capture their share of the market, there arises a high business

mortality rate. Weak firma are eliminated and a lesser number of firms survive the

pioneering stage.

It is difficult for the analyst to identify those companies that are in the likely to

survive and come out strong later on. Therefore, investment in a company in an industry

which is in the pioneering stage is highly risky. Industries in the entrepreneurial stage are

also called as sunrise or nascent industries. Telecommunications, computer software,

information technology are the examples of the sunrise industries in India.

Expansion or Growth Stage:

The second stage of expansion includes only those companies that have survived

the pioneering stage. These companies continue to become stronger. Each company finds

a market for itself and develops its own strategies to sell and maintain its position in the

market. The competition among the surviving companies brings about improved products

at lower prices.

Companies in the expansion stage of an industry are quite attractive for

investment purposes. Investors can get high returns at lower risk because demand

exceeds supply in this stage. Companies will earn increasing amounts of profits and pay

attractive dividends.


Stagnation Stage:

This is the third stage in the industry life cycle. In this stage, the growth of the

industry stabilizes. The ability of the industry to grow appears to be lost. Sales may be

increasing but at a lower rate than that experienced by the competitive industries or the

overall economy. The industry begins to stagnate. The transition of the industry from

expansion to stagnation stage is often very slow. Two important reasons for this transition

are change in social habits and development of new technology.

Sometimes an industry may stagnate only for a short period. By the introduction

of a technological innovation or a new product, it may resume a process of growth,

thereby starting a new cycle. Therefore an investor or analyst has to monitor the industry

developments constantly and with diligence.

Decay Stage:

From the stagnation stage the industry passes to the decay stage. This occurs

when the products of the industry are no longer in demand. New products and

technologies have come to the market. Customers have changed their habits style and

liking. As a result the industry becomes obsolete and gradually ceases to exist. Thus,

changes in social habits, technology and declining demand are the causes of decay of any

industry. An investor should get out of the industry before the decay stage.. The profits

associated with the different stages in the life of an industry can be illustrated in the form

of an inverted ‘S’ curve as shown in the figure.

It is not always easy to detect which stage of development an industry is in at any

point in time. The transition form one stage to the next is slow and unclear. It can be

detected only by careful analysis. Further, the classification of industries under this

approach is the general pattern. There can be exceptions to the general pattern. The life of

industry may, for instance, be extended after the stagnation and decay stage through

appropriate adaptation to changes in the environment. Careful analysis is needed to detect

such exceptions.


INDUSTRY CHARECTERISTICS:

In an industry analysis, there are a number of key characteristics that are to be

considered by the analyst. These features broadly relate to the operational and structural

aspects of the industry. They have a bearing on the prospects of the industry. Some of

these are discussed below:

Demand Supply Gap:

The demand for a product usually tends to change at a steady rate, whereas the

capacity to produce the product tends to change at irregular intervals, depending on the

installation of additional production capacity. As a result an industry is likely to

experience under-supply and over-supply of capacity at different times. Excess supply

educes the profitability of the industry through a decrease in the unit price realization. On

the contrary, insufficient supply tends to improve the profitability through higher unit

price realization. Therefore, the gap between the demand and supply in an industry is a

fairly good indicator of its short term or medium-term prospects. As part of industry

analysis, an investor should estimate the demand supply gap in the industry.

Competitive Conditions in the Industry:

Another significant factor to be considered in industry analysis is the competitive

conditions in the industry. The level of competition among various companies in an

industry is determined by certain competitive forces. These competitive prices are:

barriers to entry, threat of substitution, bargaining power of the buyers, bargaining power

of the suppliers and the rivalry among competitors.

New entrants to an industry increase the capacity in the industry. But these new

entrants may face certain barriers to their entry. The barriers to their entry may arise

because of product differentiation, absolute cost advantage or economy of scale. Product

differentiation refers to the preference the buyers have to the products of the already

established players. Their products enjoy a premium in the market. Absolute cost

advantage refers to the ability of established firms to produce their products at a lower

cost than any new entrant.


Economy of scale refers to a situation in which it is necessary to attain a fairly high level

of production in order to obtain economically feasible levels of cost. In some industries it

may not be economical to set up small capacities. An industry that is well protected from

the inroads of new firms would be ideal for investment.

Permanence:

In this age of rapid technological change, the degree of permanence of an industry

is an important consideration in industry analysis. Permanence is a phenomenon related

to the products and technology used by the industry. If an analyst feels that the need for a

particular industry will vanish in a short period, it would be foolish to invest in such an

industry.

Labor Conditions:

The state of labor conditions in the industry under analysis is an important

consideration in an economy such as ours where the unions are very powerful. If the

labor in a particular industry is rebellious and is inclined to strikes frequently, the

prospects of that industry cannot become bright.

Attitude of Government:

The attitude of the government towards an industry has a significant impact on its

prospects. The government may encourage the growth of certain industries and can assist

such industries through favorable legislations.

On the contrary, the government will look with disfavor on certain other

industries. In India, this has been the experience of alcoholic drinks and cigarette

industries. The government may place different kinds of legal restrictions on its

development. A prospective investor must therefore consider the role the government is

likely to play.


Supply of Raw Materials:

The availability of raw materials is an important factor determining the

profitability of an industry. Some industries may have no difficulty in obtaining the raw

materials while the others have to depend on limited resources. Industry analysis must

take into consideration the availability of raw materials and its impact on the industry

prospects.

COMPANYANALYSIS:

Company analysis is the final stage of fundamental analysis. The economy

analysis provides the investor a broad outline of the prospects of growth in the economy.

The industry analysis helps the investor to select the industry in which investment would

be rewarding. Now he has to decide in which company he has to invest. Company

analysis provides the answer to this question.

In company analysis the investor tries to predict the future earnings of the company

because there is strong evidence that the earnings have a strong effect on the share prices.

The level, trend and safety of earnings of a company, however depend upon a number of

factors concerning the operations of the company.

FINANCIAL STATEMENTS

The prosperity of a company will depend upon its profitability and financial

health. The financial statement published by a company periodically helps us to access

the profitability and financial health of the company. The two basic financial statements

provided by the companies are the balance sheet and the P&L A/C. The first gives us a

picture of the company’s assets and liabilities while the second gives us a picture of its

earnings.

The balance sheet gives us the list of assets and liabilities of a company on a

specific date. The major categories of assets are fixed and current. The P&L A/C, also

called as the income statement, reveals the revenue earned, the cost incurred and the

resulting profit or loss of the company for one accounting year. The profit after tax


(PAT) divided by the number of shares gives the Earnings per Share (EPS), which is a

figure which most investors are interested. The P&L A/C summarizes the activities of a

company during an accounting year.

ANALYSIS OF FINANCIAL STATEMENTS

The financial statement of a company can be used to evaluate the financial

position f the company. Financial ratios are most extensively used for this purpose. Ratio

analysis helps an investor to determine the strengths and weakness of the company. It

also helps him to analyze whether the financial performance and financial strengths are

improving or deteriorating. Ratios can be used for comparative analysis either with other

firms in the industry through a cross sectional analysis or with past data through a time

series analysis.

Different ratios measure different aspects of a company’s performance or health.

Four groups of ratios may be used for analyzing the performance of a company.

Liquidity Ratios: These measure the company’s ability to fulfill its short-term

obligations and reflect its short-term financial strength or liquidity. The commonly used

ratios are

Current Ratio = Current Assets / Current Liabilities.

Quick Ratio = Current Assets- Inventory – Prepaid Expenses

Current Liabilities

A higher current ratio would enable a company to meet its short-term obligations even if

the value of current assets decline. The quick ratio represents the ratio between quick

assets and current liabilities. It is a more rigorous measure of liquidity. However, both

these ratios are to be used together to analyze the liquidity of the company.


Leverage Ratios: These ratios are also known as capital structure ratios. They measure

the ability of the company to meet its long-term debt obligations. They throw light on the

long-term solvency of a company. The commonly used leverage ratios are:

Long-term DebtDebt-Equity Ratio = Shareholder’s Equity

Debt to Total = Total DebtAsset Ratio Total Assets

Proprietary Ratio = Shareholders Equity Total Assets

Interest Coverage Ratio = EBIT Interest

The first three ratios indicate the relative contribution of owners and creditors in

financing the assets of the company. These ratios reflect the safety margin available to

the long-term creditors. The coverage ratios measures the ability if the company to meet

its interest payments arising from the debt.

Profitability Ratios: The profitability of a company can be the profitability ratios. These

ratios are calculated be relating the profits either to sales, or to investment, or t the equity

shares. Thus we have three groups of profitability ratios. These are listed below.

A. Profitability related to Sales

Gross Profit Ratio = Gross Profit (Sales – Cost of Goods Sold)

Sales

Operating Profit Ratio = EBIT / Sales

Net Profit Ratio = EAT

Sales


Administrative Expenses Ratio = Administrative Expenses

Sales

Selling Expenses Ratio = Selling Expenses

Sales

Operating Expenses Ratio = Administrative Expenses + Selling Expenses

Sales

Operating Ratio = COGS + Operating Expenses

Sales

B. Profitability related to Investment.

Return on Assets = EAT

Total Assets

Return on Capital Employed = EBIT

Total Capital Employed

Return on Equity = EAT

Shareholders Equity

C. Profitability related to Equity Shares.

Earnings Per Share = Net Profit available to Eq.Sh.Holders

Number of Equity Shares

Earnings Yield = EPS

Market Price per Share


Dividend Yield = DPS (Dividend per Share)

Market Price per Share

Dividend Payout Ratio = DPS

EPS

Price Earning Ratio (P/E Ratio) = Market Price per Share

EPS

D. Overall Profitability (Earning Power)

Return on Investment (ROI) = EAT

Total Assets

The overall profitability is measured by the ROI, which is the product of the net profit

ratio and the investment turnover. It is a central measure of the earning power or

operating efficiency of a company.

Activity or Efficiency Ratios:

These are also known as turnover ratios. These ratios measure the efficiency in

asset management. They express the relation between the sales and the different types of

assets, showing the speed with which these assets generate sales. Important activity ratios

are enumerated below.

Current Asset Turnover = Sales / Current Assets

Fixed Assets Turnover = Sales / Fixed Assets

Total Assets Turnover = Sales / Total Assets

sapm fundamental analysis

Documents