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Fundamental Analysis

Fundamental analysis determines the intrinsic value of a security based on its expected future cash flows. It involves economic, industry, and company analysis. Economic analysis examines trends that impact industries. Industry analysis assesses factors like the life cycle and competitive forces. Company analysis evaluates financial metrics and qualitative factors to identify underpriced and overpriced stocks. Intrinsic value is calculated by discounting a company's prospective earnings or dividends. Fundamental analysis seeks to identify mispriced securities based on a range of possible intrinsic values.

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24 views3 pages

Fundamental Analysis

Fundamental analysis determines the intrinsic value of a security based on its expected future cash flows. It involves economic, industry, and company analysis. Economic analysis examines trends that impact industries. Industry analysis assesses factors like the life cycle and competitive forces. Company analysis evaluates financial metrics and qualitative factors to identify underpriced and overpriced stocks. Intrinsic value is calculated by discounting a company's prospective earnings or dividends. Fundamental analysis seeks to identify mispriced securities based on a range of possible intrinsic values.

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Asia Asia
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Fundamental Analysis

Fundamental Analysis is an approach to determine “what ought to be the price” of a


security/ intrinsic value of the security with the objective of identifying overpriced and
underpriced securities so that investment decisions can be made.

EIC Framework for fundamental analysis-


1) Economic Analysis- a study of economic trends and policies (both global and
domestic)
2) Industry Analysis- Impact of projected growth in GNP, government policies, business
cycle on the industry
3) Company Analysis- Assessing the quantitative (ROE, profitability ratios and leverage
ratios) and qualitative aspects of the company

Intrinsic value of a security is the present value of all future cash payments to be paid on the
security. Cash payments may be in the form of dividends, interests, liquidation proceeds, or
repayment of the principal amount.
Calculated by discounting the company’s prospective earning stream or by discounting
shareholder’s prospective dividend stream.
Range of intrinsic values are calculated and if the value of the security lies outside this
range, then it is said to be mispriced.
Since intrinsic value is calculated by discounting uncertain future projections at different
discount rates by different investors, we can safely say that every investor will get a
different intrinsic value of a security. The market price of a security is the consensus intrinsic
value of that security.

Note- Stock prices are determined by the expected stream of benefits and the required rate
of return or the P/E ratio of the company.

MARKET ANALYSIS:
In India, corporate earnings have a huge impact on the stock prices. Economic and fiscal
policies have a great bearing on the corporate earnings of a company.
If the market is up, almost all industries do well whereas if the market is in recession, all
investors will not do well. Fundamental analysis is moot here.
Methods of analysing the market are through economic forecasting of factors that affect the
future stock prices. This is done via-

1) Lead indictor approach- forecasts general economic conditions by identifying


economic indicators that turn ahead of the change in the general level of economic
activity, as they provide advance signals of the turning points. Example- corporate
profits, residential construction, etc. It fails to give the magnitude and duration of
change and also, the usage of different lead indicators can provide mixed results.
2) Diffusion Index- measures how widespread a phenomenon is. Example- a diffusion
index for leading indicators can be measured as the rise in the number of leading
indicators as a proportion of total leading indicators. An increase in this diffusion
index indicates strong economic advancement.
3) Econometric Model Building Approach- provides magnitude and direction to the
dependent variable, like the GNP. It may not be accurate due because of a variety of
reasons like non-validity of the assumptions underlying the model. Not much
practical relevance in a planned economy like India, as the plans may change at any
given point of time.
4) GNP Model Building Approach- forecasts GNP by estimating the magnitudes of
various components constituting GNP. Needs a lot of data, like budget estimates of
the govt., etc. Then the model has to be tested for interlinkage.

INDUSTRY ANALYSIS:
After the market has been analysed and considered to have a conducive environment for
investing, the next step is to analyse the various industries. Key characteristics of all the
industries to be evaluated are – past sales and earnings performance, permanence of the
industry, attitude of the government towards the industry, labor conditions within the
industry, competitive conditions, industry share prices relative to its earnings.
Steps in industry analysis are as follows-

1) Industry life cycle analysis- an industry can be in its pioneering stage, expansion
stage, stabilization stage or declining stage. The expansion stage is of great
importance to the investors as the growth is rapid but orderly.
2) Business life cycle analysis- helps investors predict the performance of the industry
over shorter periods of time by dividing them into growth industry, defensive
industry and cyclical industry. Investors usually lookout for growth industries.
3) Structural Analysis- the strength of the competitive forces in an industry determines
the degree to which this inflow of investment occurs and derives the return to the
free market level, and thus the ability of firms to sustain above average returns. The
competitive forces of an industry include- threat of entry, threat of substitution,
bargaining power of buyers(individuals, retailers and wholesalers), bargaining power
of suppliers and rivalry among current competitors.
4) Study of impact of changes in government policy on the industry

COMPANY ANALYSIS:
After an industry has been shortlisted to be invested in, we analyse which firms are the
superior performers in the industry and are to be invested in. This can be done by examining
the various financial(profitability ratios, leverage ratios and return on equity) and non-
financial(business of the company, top management, product range, diversification, foreign
collaboration, availability of costs of inputs, research and development, governmental
regulations and pattern of shareholding and listing) parameters of the firm.

Notes-
1) Profitability ratios include roi, net profit margin, roe, eps and dividend cover. There
are a few more ratios for the secondary market like earnings-price ratio and market
yield. Investors prefer a company with stable profitability.
2) Leverage ratios include debt-equity ratio and interest coverage ratio. A firm with
lower debt-equity ratio and higher interest coverage ratio is preferred by the
investor.
3) Cash earnings per share is a better indicator than eps as it gives a better idea of the
cash available with a firm for use and also because eps discriminates against growing
companies which have a bigger block of fixed assets.

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