Unit-2 notes

Fundamental analysis

The primary motive of buying a share is to sell it subsequently at a higher price. In manycases, dividends
are also expected. Thus, dividends and prices changes constitute the returnfrom investing in shares.
Consequently an investor would be interested to know thedividend to be paid on the share in the future as
also future price of the share. These valuescan only be estimated and not predicted with certainty. These
values are primarilydetermined by the performance of the company which in turn is influenced by
theperformance of the industry to which the company belongs and the general economic andsocio-
political scenario of the country.An investor who would like to be rational and scientific in his investment
activity has toevaluate a lot of information about the past performance and expected future performanceof
companies, industries and the economy as a whole before taking the investmentdecision.Such evaluation
or analysis is called

fundamental analysis

MEANING OF FUNDAMENTAL ANALYSIS:

Fundamental analysis is really a logical and systematic approach to estimating the futuredividends and
share price. It is based on the basic premise that share price is determined bynumber of fundamental
factors relating to the economy,industry and companyfundamentals have to be considered while analysing
a security for investment purpose.Fundamental analysis is, in other words detailed analysis of the
fundamental factorsaffecting the performance of companies.Each share is assumed to have an economic
worth based on its present and future earningcapacity. This is called its intrinsic value or fundamental
value. The purpose of fundamentalanalysis is to evaluate the present and future earning capacity of a
share based on theeconomy,industry and company fundamentals and thereby assess the intrinsic value of
theshare. The investor can then compare the intrinsic value of the share with prevailing marketprice to
arrive at an investment decision. If the market price of the share price is lower thanits intrinsic value, the
investor would decide to buy the share as it is under-priced.On the contrary when the market price of a
share is higher than its intrinsic value, it isperceived to be overpriced. The market price of such a share is
expected to come down infuture and hence ,the investor would decide to sell such a share. Fundamental
analysis thusprovides an analytical framework for rational investment decision.Fundamental analysis
involves three steps:

1.Economy Analysis

2.Industry Analysis

3.Company Analysis.
ECONOMY ANALYSIS:

The performance of the company depends on the performance of the economy. If theeconomy is
booming, incomes rise, demand for goods increases and hence the industriesand companies in general
tend to be prosperous. On the other hand ,if the economy is inrecession, the performance of the company
will be generally bad.Investors are concerned with those variables in the economy which affect the
performanceof the company in which they tend to invest. Study of these economic variables would givean
idea about future corporate earnings and payment of dividends and interest to investors.Some of the key
economic variables that an investor must monitor as a part of his/herfundamental analysis.

Inflation:

Inflation prevailing in the economy has considered impact on the performance of companies. Higher rates
of inflation upset business planes, lead to cost escalation and resultin a squeeze on profit margins. On the
other hand inflation leads to erosion of purchasingpower in the hands of consumers. This will result lower
demand for products. Thus higherinflation in an economy are likely to affect the performance of
companies adversely.Industries and companies prosper during times of low inflation.

Interest Rates:

Interest rates determine the cost and availability of credit for companies operating in aneconomy. A low
interest rate stimulates investment by making credit available easily andcheaply. Moreover it implies
lower cost of finance for companies and thereby assures higherprofitability. On the contrary ,higher
interest rates result in higher cost of production whichmay lead to lower profitability and lower
demand.The interest rates in the organised financial sector of the economy are determined by
themonetary policy of the government and the trends in the money supply. These rates arethus controlled
and vary within certain ranges. But the interest rates in the unorganisedfinancial sector are controlled and
may fluctuate widely depending upon the demand andsupply of funds in the market.

Government revenues, expenditure and deficits:

As the government is the largest investor and spender of money, the trends in governmentrevenue,
expenditure and deficits have a signifying impact on the performance of industriesand companies.
Expenditure by govt stimulates the economy by creating jobs andgenerating demand. Since a major
portion of demand in the economy is generated by govt

spending, the nature of govt spending is of great importance in determining the fortunes of many an
industry.However ,when the govt expenditure exceeds its revenue, there occurs a deficit. This isknown as
fiscal deficit. All developing countries suffer from fiscal deficits as govt spend largeamounts of money to
build up infrastructure.

Exchange rates

:The performance and profitability of industries and companies that are major importers andexporters are
considerably affected by the exchange rates of the rupee against majorcurrencies of the world. A
depreciation of rupee improves the competitive position of Indianproducts in foreign markets, thereby
stimulating exports. But it would also make importsmore expensive.The exchange rates of the rupee are
influenced by the balance of trade deficit, the balanceof payments deficit and also the foreign exchange
reserves of the country. The excess of imports over exports is called balance of trade deficit. A country
needs foreign exchangereserves to meet several commitments such as payment for imports and servicing
of foreigndebts. Balance of payment deficit typically leads to decline in foreign exchange reserves asthe
deficit has to be met from reserve.

Monsoon

:The Indian economy essentially an agrarian economy and agriculture forms a very importantsector of
Indian economy. Because of the strong forward and backward linkages betweenagriculture and industry,
performance of several companies and industries are dependenton the performance of agriculture.
Moreover ,as agriculture incomes rise, the demand forindustrial products and services will be good and
industry will prosper.

Economic and political stability

:A stable political environment is necessary for steady and balanced growth. No industry orcompany can
grow and prosper in the midst of political turnmoil.Stable long term economicpolices are what needed for
industrial growth. Stable govt with clear cut long termeconomic polices will be conducive to good
performance of the economy.

INDUSTRY ANALYSIS

The mediocre firm in the growth industry usually out performs the best stocks in a stagnant industry.
Therefore, it is worthwhile for a security analyst to pinpoint growth industry, which has good investment
prospects. The past performance of an industry is not a good predictor of the future- if one look very far
into the future. Therefore, it is important to study industry analysis. For an industry analyst- industry life
cycle analysis, characteristics and classification of industry is important.

INDUSTRY LIFE CYCLE ANALYSIS

Many industrial economists believe that the development of almost every industry may be analyzed in
terms of following stages

1. Pioneering stage: During this stage, the technology and product is relatively new. The prospective
demand for the product is promising in this industry. The demand for the product attracts many producers
to produce the particular product. This lead to severe competition and only fittest companies survive in
this stage. The producers try to develop brand name, differentiate the product and create a product image.
This would lead to nonprice competition too. The severe competition often leads to change of position of
the firms in terms of market share and profit.

2. Rapid growth stage:

This stage starts with the appearance of surviving firms from the pioneering stage. The companies that
beat the competition grow strongly in sales, market share and financial performance. The improved
technology of production leads to low cost and good quality of products. Companies with rapid growth in
this stage, declare dividends during this stage. It is always adisable to invest in these companies.
3. Maturity and stabilization stage:

After enjoying above-average growth, the industry now enters in maturity and stabilization stage. The
symptoms of technology obsolescence may appear. To keep going, technological innovation in the
production process should be introduced. A close monitoring at industries events are necessary at this
stage.

4. Decline stage:

The industry enters the growth stage with satiation of demand, encroachment of new products, and
change in consumer preferences. At this stage the earnings of the industry are started declining. In this
stage the growth of industry is low even in boom period and decline at a higher rate during recession. It is
always advisable not to invest in the share of low growth industry.

CLASSIFICATION OF INDUSTRY

Industry means a group of productive or profit making enterprises or organizations that have a similar
technically substitute goods, services or source of income. Besides Standard Industry Classification (SIC),
industries can be classified on the basis of products and business cycle i.e. classified according to their
reactions to the different phases of the business cycle.

These are classified as follows:

1. Growth Industries:

These 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 or an
innovative way of doing or selling something. For example-in present scenario the information
technology sector have higher growth rate. There is some growth in electronics, computers, cellular
phones, engineering, petro-chemicals, telecommunication, energy etc.

2. Cyclical Industries:

The growth and profitability of the industry move along with the business cycle. These are those
industries which are most likely to benefit from a period of economic prosperity and most likely to suffer
from a period of economic recession. These especially include consumer goods and durables whose
purchase can be postponed until persona; financial or general business conditions improve. For example-
Fast Moving Consumer Goods (FMCG) commands a good market in the boom period and demand for
them slackens during the recession.

3. Defensive Industries:

Defensive industries are those, such as the food processing industry, which hurt least in the period of
economic downswing. For example- the industries selling necessities of consumers withstands recession
and depression. The stock of defensive industries can be held by the investor for income earning purpose.
Consumer nondurable and services, which in large part are the items necessary for existence, such as food
and shelter, are products of defensive industry.

4. Cyclical-growth Industries:

These possess characteristics of both a cyclical industry and a growth industry. For example, the
automobile industry experiences period of stagnation, decline but they grow tremendously. The change in
technology and introduction of new models help the automobile industry to resume their growing path.

CHARACTERISTICS OF AN INDUSTRY ANALYSIS

In an industry analysis, the following key characteristics should be considered by the analyst. These are
explained as below:

1. Post sales and Earnings performance:

The two important factors which play an important role in the success of the security investment are sales
and earnings. The historical performance of sales and earnings should be given due consideration, to
know how the industry have reacted in the past. With the knowledge and understanding of the reasons of
the past behavior, the investor can assess the relative magnitude of performance in future. The cost
structure of an industry is also an important factor to look into. The higher the cost component, the higher
the sales volume necessary to achieve the firm’s break-even point, and vice-versa.

2. Nature of Competition:

The numbers of the firms in the industry and the market share of the top firms in the industry should be
analyzed. One way to determine competitive conditions is to observe whether any barriers to entry exist.
The demand of particular product, its profitability and price of concerned company scrip’s also determine
the nature of competition. The investor before investing in the scrip of a company should analyze the
market share of the particular company’s product and should compare it with other companies. If too
many firms are present in the organized sector, the competition would be severe. This will lead to a
decline in price of the product.

3. Raw Material and Inputs:

Here, we have to look into the industries, which are dependent upon imports of scarce raw material,
competition from other companies and industries, barriers to entry of a new company, protection from
foreign competition, import and export restriction etc. An industry which has a limited supply of materials
domestically and where imports are restricted will have dim growth prospects. Labour is also an input and
industries with labour problems may have difficulties of growth.

4. Attitude of Government towards Industry:

It is important for the analyst or prospective investor to consider the probable role government will play
in industry. Will it provide financial support or otherwise? Or it will restrain the industry’s development
through restrictive legislation and legal enforcement? The government policy with regard to granting of
clearance, installed capacity and reservation of the products for small industry etc. are also factors to be
considered for industry analysis.
5. Management:

An industry with many problems may be well managed, if the promoters and the management are
efficient. The management likes Tatas, Birlas, Ambanies etc. who have a reputation, built up their
companies on strong foundations. The management has to be assessed in terms of their capabilities,
popularity, honesty and integrity. In case of new industries no track record is available and thus, investors
have to carefully assess the project reports and the assessment of financial institutions in this regard. A
good management also ensures that the future expansion plans are put on sound basis.

6. Labour Conditions and Other Industrial Problems:

The labour scenario in a particular industry is of great importance. If we are dealing with a labour
intensive production process or a very mechanized capital intensive process where labour performs
crucial operations, the possibility of strike looms as an important factor to be reckoned with. Certain
industries with problems of marketing like high storage costs, high transport costs etc leads to poor
growth potential and investors have to careful in investing in such companies.

7. Nature of Product Line:

The position of the industry in the life cycle of its growthinitial stage, high growth stage and maturing
stage are to be noted. It is also necessary to know the industries with a high growth potential like
computers, electronics, chemicals, diamonds etc., and whether the industry is in the priority sector of the
key industry group or capital goods or consumer goods groups. The importance attached by the
government in their policy and of the Planning Commission in their assessment of these industries is to be
studied.

8. Capacity Installed and Utilized:

The demand for industrial products in the economy is estimated by the Planning Commission and the
Government and the units are given licensed capacity on the basis of these estimates. If the demand is
rising as expected and market is good for the products, the utilization of capacity will be higher, leading
to bright prospects and higher profitability. If the quality of the product is poor, competition is high and
there are other constraints to the availability of inputs and there are labour problems, then the capacity
utilization will be low and profitability will be poor.

9. Industry Share Price Relative to Industry Earnings:

While making investment the current price of securities in the industry, their risk and returns they promise
is considered. If the price is very high relative to future earnings growth, the investment in these securities
is not wise. Conversely, if future prospects are dim but prices are low relative to fairly level future
patterns of earnings, the stocks in this industry might be an attractive investment.

10. Research and Development:

For any industry to survive in the national and international markets, product and production process have
to be technically competitive. This depends upon the research and development in the particular industry.
Proper research and development activities help in obtaining economic of scale and new market for
product. While making investment in any industry the percentage of expenditure made on research and
development should also be considered.

11. Pollution Standards:

These are very high and restricted in the industrial sector. These differ from industry to industry, for
example, in leather, chemical and pharmaceutical industries the industrial effluents are more.

COMPANY ANALYSIS:

THE STUDY OF FINANCIALS STATEMENTS Financial statement means a statement or document

which explains necessary financial information. Financial statements express the financial position of a
business at the end of accounting period (Balance Sheet) and result of its operations performed during the
year (Profit and Loss Account). In order to determine whether the financial or operational performance of
company is satisfactory or not, the financial data are analyzed. Different methods are used for this
purpose. The main techniques of financial analysis are:

1. Comparative Financial Statements

2. Trend Analysis

3. Common Size Statement

4. Fund Flow Statement

5. Cash Flow Statement

6. Ratio Analysis

1) Comparative Financial Statements:

In comparative financial statement, the financial statements of two periods are kept by side so that they
can be compared. By preparing comparative statement the nature and quantum of change in different
items can be calculated and it also helps in future estimates. By comparing with the data of the previous
years it can be ascertained what type of changes in the different items of current year have taken place
and future trends of business can be estimated.

2) Trend Analysis:

In order to compare the financial statements of various years trend percentages are significant. Trend
analysis helps in future forecast of various items on the basis of the data of previous years. Under this
method one year is taken as base year and on its basis the ratios in percentage for other years are
calculated. From the study of these ratios the changes in that item are examined and trend is estimated.
Sometimes sales may be increasing continuously and the inventories may also be rising. This would
indicate the loss of market share of a particular company’s product. Likewise sales may have an
increasing trend but profit may remain the same. Here the investor has to look into the cost and
management efficiency of the company.

3) Common Size Statement:

Common size financial statements are such statements in which items of the financial statements are
converted in percentage on the basis of common base. In common size Income Statement, net sales may
be considered as 100 percent. Other items are converted as its proportion. Similarly, for the Balance sheet
items total assets or total liabilities may be taken as 100 percent and proportion of other items to this total
can be calculated in percentage.

4) Fund Flow Statement:

Income Statement or Profit or Loss Account helps in ascertainment of profit or loss for a fixed period.
Balance Sheet shows the financial position of business on a particular date at the close of year. Income
statement does not fully explain funds from operations of business because various non-fund items are
shown in Profit or Loss Account. Balance Sheet shows only static financial position of business and
financial changes occurred during a year can’t be known from the financial statement of a particular date.
Thus, Fund Flow Statement is prepared to find out financial changes between two dates. It is a technique
of analyzing financial statements. With the help of this statement, the amount of change in the funds of a
business between two dates and reasons thereof can be ascertained. The investor could see clearly the
amount of funds generated or lost in operations. These reveal the real picture of the financial position of
the company.

5) Cash Flow Statement:

The investor is interested in knowing the cash inflow and outflow of the enterprise. The cash flow
statement expresses the reasons of change in cash balances of company between two dates. It provides a
summary of stocks of cash and uses of cash in the organization. It shows the cash inflows and outflows.
Inflows (sources) of cash result from cash profit earned by the organization, issue of shares and
debentures for cash, borrowings, sale of assets or investments, etc. The outflows (uses) of cash results
from purchase of assets, investment redemption of debentures or preferences shares, repayment of loans,
payment of tax, dividend, interest etc. With the help of cash flow statement the investor can review the
cash movement over an operating cycle. The factors responsible for the reduction of cash balances in
spite of increase in profits or vice versa can be found out.

6) Ratio Analysis:

Ratio is a relationship between two figures expressed mathematically. It is quantitative relationship

between two items for the purpose of comparison. Ratio analysis is a technique of analyzing financial
statements. It helps in estimating financial soundness or weakness. Ratios present the relationships
between items presented in profit and loss account and balance sheet. It summaries the data for easy
understanding, comparison and interpretation