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Fundamental analysis by P. Sai Prathyusha (1st m.com Business finance)

meaning # intrensic value estimation # advantages # dimensions

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Fundamental analysis by P. Sai Prathyusha (1st m.com Business finance)

  1. 1. Fundamental Analysis Meaning: Fundamental Analysis is a holistic approach to study a business; when an investor wishes to investor wishes to invest in a business for the long term. Long term investment it is extremely essential to understand the business from various perspective because the stock prices of a fundamentally strong company tend to appreciate which will create wealth for its investors. Therefore this fundamental analysis is a necessary tool to be used by an investor. Fundamental Analysis is the analysis of various fundamental factors like economic aggregates, industrial indicators and factors related to companies. All these factors are analysed to give an answer to know the appropriate timing for investment and the best avenue for investment. Intrinsic value is the value of the share, which is supported by assets, profitability, financial performance, future prospects, and industry scenario and economy wide factors. This value will help to take decision to make investments. The determined intrinsic value is compared with prevailing market price and take decision to purchase or sell the shares in the market. Buy if intrinsic value > Market Price Sell, if intrinsic value < Market Price Estimation of Intrinsic Value: Intrinsic Value = Expected EPS x PE multiplier First Estimate the expected EPS of the Company Then determine the expected risk in the company Finally estimate the Price Earning (PE) multiplier. Fundamental Analysis is a method of evaluating the intrinsic value of an asset and analysing the factors that would influence its price in the future. This analysis is based on the events from external sources and their influences and also the financial statements and industrial trends. There are two methods available for analysing the stock market and fundamental analysis is one those two methods and other being technical analysis. Technical analyst considers information from charts derived from the prices as a result of trade and whereas fundamental analyst considers the factors outside the price movements. Fundamental analysis attempts to measure a security's intrinsic value by examining related economic and financial factors including the balance sheet, strategic initiatives, microeconomic indicators, and consumer behaviour. Fundamental analysts study anything that can affect the security's value, from macroeconomic factors such as the state of the economy and industry conditions to microeconomic factors like the effectiveness of the company's management. The ultimate goal of fundamental analysis is to arrive at a number that an investor can compare with a security's current price in order to see whether the security is undervalued or overvalued. Fundamental analysis uses public data to evaluate the value of a stock or any other type of security.
  2. 2. For example; Fundamental analysis for a stocks uses revenues, earnings, future growth, return on equity, profit margins, and other data to determine a company's underlying value and potential for future growth. These data are taken from the financial statement. Two types of Fundamental Analysis: There are two types of fundamental analysis namely top-down analysis and bottom-up analysis. Top-down analysis takes a broader view of the economy starting with the entire market before narrowing down into a sector, industry and finally a specific company. Whereas the bottom-up analysis starts with a particular stock and widens to all factors that impact the share price. Tool to be used by the trader is depending upon the asset being trader whether it is shares, bonds or forex. Advantages of fundamental analysis: 1. It helps traders and investors to gather the right information to make rational decision for buying or selling the stock. 2. Very less chances for personal biases as the decisions are based on financial data. 3. Fundamental analysis is not focusing on entry and exit points rather it considers the value of an asset, so that investors can take much longer-term view of the market. 4. The intrinsic value of shares determined through fundamental analysis is useful to compare with current market price to understand whether shares are over price or under-priced. 5. Fundamental analysis aims to profit from the market correction. Disadvantages of fundamental analysis: 1. It is time consuming. 2. It requires multiple areas of analysis which is extremely complicated. 3. Since it takes longer-term view of the market, the results are not suitable for quick decisions. 4. It cannot be used by the investors or traders who are interested to decide about entering or exiting the market. 5. There is a possibility for negative economic, political or legislative changes and which will surprise the markets than what was analysed through fundamental analysis. Dimensions of Fundamental Analysis: Fundamental analysis is carried out in three different phases and these phases are called as dimensions of analysis. A. Analysis of Economy – wide factors B. Analysis of Industry – wide factors C. Analysis of Company – wide factors A. Analysis of Economy – wide factors: First phase deals with national and international economic conditions and in this phase different economic aggregates are analysed and decided on the timing of investment Analysis of these indicators helps to predict the future shape of the trends of economy and expected growth of different industrial sectors. Following steps are undertaken to do this analysis:
  3. 3. 1. First to study the economic aggregates 2. Second to classify the indicators 3. Third to forecast about the economy 1. Study the economic aggregates: Economic aggregates indicates about the health of the economy and with the help of these prediction about future are made. The factors considered in this aggregates are and studying these economic factors helps to answer the timing of investment and identification of the industry which is likely to perform better. a. Industrial Production b. Gross Domestic Production (GDP) c. Investment in infrastructure sector d. Foreign Trade e. Inflation f. Monsoon g. Business Conditions h. Government Policies i. International Environment/events 2. Classification of Factors into indicators: All these economic aggregates and general facts about the economy are classified into indicators to indicate the future outcomes and status of the economy. These indicators are used to forecast the trends of economy and they are classified as follows: i. Advance- moving indicators: These indicators make movement well in advance before an incidence of actual development takes place in the economy. In other words these indicators are the front runner before the actual development in the economy takes place. Following conditions are to be fulfilled to call indicator as advance-moving indicators: i) It should move smoothly ii) It should give enough time gap for action iii) In majority of the times, it should give fruitful results. iv) it has low default rate. These indicators help to predict the future development of the economy; and movement of these factors help in identifying probable industries, in which investment can be made for earning better returns. Examples of advance moving indicators are:  Monsoon  Infrastructural development  Industrial Growth  Per Capita Income  Government Policies  Inflation  Interest Rates ii. Coinciding indicators: These indicators show movement along with the growth in the economy. Example like increasing stock index, increasing consumption, improved living standards. Important point to be considered is that these indicators do not help much in predicting the future but they
  4. 4. indicate the maximum extent of growth and also help in identification of reversal of the economy. iii. Lagging indicators: Lagging indicators are indicators which are showing signals after an activity has taken place. Generally these are like slow growth areas, regional imbalance indicating disparity of growth. These indicators help in making identification for the future development allocations by the government. 3. Forecast about the Economy: Forecast on the future scenario of the economy can be made with the help of advance moving indicators. The forecasts can be made by using a) Time series analysis – indicating seasonal and cyclical trends b) Delphi technique – indicating expert opinion and c) construction diffusion index. B. Analysis of Industry – wide factors: In this second phase of fundamental analysis, industries selected through the first phase are analysed individually at a micro level of each and every industry with an objective to provide information about the best industry, in which investment can be made. The following steps are taken: 1. Study the industry life cycle 2. Study of qualitative and quantitative factor. 1. Study the industry life cycle: Industry life cycle means the different stages of the development of an industry and analysis of these stages helps inn making investment decisions. The following are the stages in life cycle of an industry.  Pioneering Stage: It is the stage at which industry just started and therefore there will be very few beginners set up their businesses. The risk involved at this stage is very high due to gestation period and therefore investor should be cautious at this stage.  Rapid Growth Stage: At this stage demand for the product increases at faster rate and industry will find new entrants frequently. Some times the growth will be like mushroom growth of companies in particular industry. Fly by night operators also enter the market and which will lead for severe competition. Due to competition, the market share of companies keeps fluctuating.  Maturity and stabilization Stage: At this stage, demand for products are getting stabilized at a particular level and therefore product differentiation take place and companies start competing on product features. This phase will also be called as stage of consolidation; wherein companies consolidate their position by focusing on a particular segment.  Decline and Diversification Stage: At this stage, companies which are not in a position to face the competition or whose performance is not good would automatically be forced to wind up their businesses and this phase witnesses the survival of the fittest. Only strong companies would be able to survive at this stage and few
  5. 5. companies take up diversification path to overcome the difficult faced by which they enter into a new life cycle. Studying about these stages help in indicating future results of an industry and it is suggested to cautious at the pioneering stage, be selective in the growth stage and investment position should be synthesized at the maturity stage; investment may be continued in an industry where there is scope for diversification after the maturity. 2. Study of Qualitative and Quantitative factors: Quantitative factors are measurable units are available and whereas qualitative factors do not have any accepted measurable units. Following are the factors: 1. Qualitative Factors: a. Level of Competition and protection by the Government b. Entry barriers c. Product differentiation d. Substitution effect e. Demand type f. Supply of inputs g. Technological changes h. Stability i. Government support Analysis of these factors will indicate the profit-earning capacity of the industry as well as its chances of survival and growth. A healthy competition in the industry indicates stable market share of the companies, whereas mushrooming growth indicates instability in the industry. An industry which has protection and support from the government will protect the market share of the existing players and the earning prospects in such industry are very high. 2. Quantitative Factors: These factors indicate the profit-earning capacity of the industry as a whole and also it reflects how assets are being used in the industry; Examples: a. Trends of turnover/sales b. Trends of profitability c. Trends of cost structure d. Trends about margins C. Analysis of Company – wide factors: After selecting industries as per the second phase, in this phase efforts are made to analyse and scrutinize the companies in those selected industries. The purpose is to identify the best company in each of the industry because all the companies in an industry do not perform like other companies. Therefore the following factors are to be considered for each companies. 1. Financial performance analysis 2. Analysis of qualitative parameters. 1. Financial performance Analysis: This is done by considering the financial statements of companies and these financial statements would indicate two important factors
  6. 6. namely; Profitability and Financial Soundness. Income statement and Balance sheets are analysed and interpreted to diagnosis the profitability and financial soundness of the business. These analysis are classified into different categories based on the material used and the modus operandi of analysis. On the basis of material used it is of two types: i) External Analysis ii) Internal Analysis On the basis of modus operandi, it is of two types: i) Horizontal analysis ii) Vertical analysis The analysis of financial statements requires: 1. Methodical classification of the data given in the financial statements: It is necessary to arrange the data to have a meaningful analysis. For example: instead of two column (T form) statement, single column (Vertical) statements are prepared for two years together. This facilitates the comparison between years and between figures. 2. Techniques of financial analysis (Comparison of the various inter-connected figures with each other by different “tools of financial analysis”): Any or many of the following techniques can be used for analysis of financial statement depending upon the available information and results required. a. Comparative Financial Statements: Comparative financial statements are designed in such a way that it provides time perspective to the consideration of various elements of financial position embodied. In these statements figures for two or more periods are placed along for comparison. b. Trend Percentages: This technique is helpful to make comparison of financial statements of many years. It involves the calculation of percentages relationship that each item bears to the same item in the base year. Any year may be taken as the base year normally the earliest year is taken as the base year. c. Funds Flow/Cash Flow analysis: Funds flow analysis reveals changes in the working capital position of a company. It tells about the source from which the working capital was obtained and purpose for which it was used. Cash flow statement would reveal the cash generated or paid through various specialised activities like cash from operation, cash from investment and cash from financing activities. d. Cost Volume Profit analysis: It is an important tool for profit planning. It considers and studies about the relationship between cost, volume of production, sales and profit. Data required are sourced through financial and cost accounting sources and therefore it is an important tool for decision- making. It tells the volume of sales at which he firm will break even, the effect on profit on account of variation in output, selling price and cost and finally, the quantity to be produced and sole to reach the profit targeted.
  7. 7. e. Ratio Analysis: Ratio is the mathematical relationship between two inter related figures taken from accounting sources. The usefulness of the ratio lies in that the data to be analysed, is reduced and expressed in simple form, which makes it convenient to study and evaluate the relationship between various related items as well as changes that have taken place. Ratios are classified into four types namely: Liquidity ratios, Solvency ratios, Profitability ratios and Activity ratios. Liquidity ratio reveals the ability to meet current dues out on short term assets, Solvency considers the extent of dependence on outside liabilities and the feasibility of meeting them, profitability ratios assesses the capacity of the unit to generate profits and its rate of return and Activity ratios talk about the efficiency of the unit in utilizing present available resources. (More details about these individual ratios like formula to be used, advantages and disadvantages, are to taken from Management Accounting paper studied in the previous semesters) Tools of Fundamental Analysis: The tools required for fundamental analysis are extremely basic, most of which are available and specifically the following are required: 1. Annual Report of the Company: Annual report of companies are required for getting information about that particular company; which can be downloaded from the company’s website for free. 2. Industry related data: In order to understand the performance of a company it is essentiall to compare it with industry details for which investor needs industry data. Basic data on industry is available for free from industry associations’ website. 3. Access to News: Investors are expected to be updated with latest developments happening both in the industry and the company in which investors are interested in. Good business newspapers or services such as Google Alert can help the investor to keep abreast of the latest news. 4. MS Excel: MS Excel will be extremely useful or helpful tool in fundamental calculations. With these four tools investors can develop fundamental analysis.