Unit II: Fundamental Analysis

Fundamental Analysis: Economic Analysis

Objectives:

At the end of the topic, the student should be able to:

 Discuss the importance of economic analysis as a first step in assessing the

intrinsic value of an investment
 Explain the indicators necessary in conducting economic analysis
 Use a few indicators to analyze the Philippine Economy amid the COVID-19
Pandemic.
 Apply forecasting technique to predict the future of the Philippine Economy after
the COVID-19 Pandemic.

Introduction

The intrinsic value of an equity share depends on a multitude of factors. The earnings of
the company, the growth rate and the risk exposure of the company have a direct
bearing on the price of the share. These factors in turn rely on the host of other factors
like economic environment in which they function, the industry they belong to, and
finally companies’ own performance.

The fundamental school of thought appraised the intrinsic value of shares through

 Economic Analysis
 Industry Analysis
 Company Analysis

Economy-Industry-Company Analysis Framework

The analysis of economy, industry and company fundamentals constitute the main
activity in the fundamental approach to security analysis. In this era of globalization we
may add one more circle to the diagram to represent the international economy.

The logic of this three tier analysis is that the company performance depends not only
on its own efforts, but also on the general industry and economy factors. A company
belongs to an industry and the industry operates within the economy. As such, industry
and economy factors affect the performance of the company.

The multitude of factors affecting the performance of a company can be broadly

classified as:

1. Economy-wide factors such as growth rate of the economy, inflation rate, foreign
exchange rates, etc. which affect all companies.

2. Industry-wide factors such as demand-supply gap in the industry, the emergence of

substitute products, changes in government policy relating to the industry, etc. these
factors such as the age of its plant, the quality of management.

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3. Company specific factors such as the age of its plant, the quality of management
brand image of its products, its labour-management relations, etc. these factors are
likely to make a company’s performance quite different from that of its competitors in
the same industry.

Fundamental analysis thus involves three steps:

1. Economy Analysis
2. Industry Analysis
3. Company analysis

Economic Analysis

The performance of a company depends on the performance of the economy. If the

economy is booming, incomes rise, demand for goods increases, and hence the
industries and companies in general tend to the prosperous. On the other hand, if the
economy is in recession, the performance of companies will be generally bad.

Investors are concerned with those variables in the economy which affect the
performance of the company in which they intend to invest. A study of these economic
variables would give an idea about future corporate earnings and the payment of
dividends and interest part of his fundamental analysis.

1. Growth Rates of National Income

The rate of growth of the national economy is an important variable to be considered by

an investor. GNP (gross national product), NNP (net national product) and GDP (gross
domestic product) are the different measures of the total income or total economic
output of the country as a whole. The growth rates of these measures indicate the
growth rate of the economy. The estimates of GNP, NNP and GDP and their rates are
made available by the government from time to time.

The estimated growth rate of the economy would be a pointer towards the prosperity of
the economy. An economy typically passes through different phases of prosperity known
as the different stages of the economic or business cycle. The four stages of an
economic cycle are depression, recovery, boom and recession. The stage of the
economic cycle through which a country passes has a direct impact on the performance
of industries and companies.

Depression is the worst of the four stages. During a depression, demand is low and
declining. Inflation is often high and so are interest rates. Companies are forced to
reduce production, shut down plant and lay off workers. During the recovery stage, the
economy begins to revive after a depression. Demand picks up leading to more
investments in the economy. Production, employment and profits are on the increase.

The boom phase of the economic cycle is characterized by high demand. Investments
and production are maintained at a high level to satisfy the high demand. Companies

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generally post higher profits. The boom phase gradually slows down. The economy
slowly begins to experience a downturn in demand, production, employment, etc. The
profits of companies also start to decline. This is the recession stage of the business
cycle.

While analyzing the growth rate of the economy, an investor would do well to determine
the stage of the economic cycle through which the economy is passing and evaluate its
impact on his investment decision.

2. Inflation

Inflation prevailing in the economy has considerable impact on the performance of

companies. Higher rates of inflation upset business plans, lead to cost escalation and
result in a squeeze on profit margins.

On the other hand, inflation leads to erosion of purchasing power in the hands of
consumers. This will result in lower demand for products. Thus, high rates of inflation in
an economy are likely to affect the performance of companies adversely. Industries and
companies prosper during times of low inflation.

Inflation is measured both in terms of wholesale prices through the wholesale price
index (WPI) and in terms of retail prices through the consumer price index (CPI). These
figures are available on weekly or monthly basis. As part of the fundamental analysis, an
investor should evaluate the inflation rate prevailing in the economy currently as also the
trend of inflation likely to prevail in the future.

3. Interest Rates

Interest rates determine the cost and availability of credit for companies operating in an
economy. A low interest rate stimulates investment by making credit available easily and
cheaply. Moreover, it implies lower cost of finance for companies and thereby assures
higher profitability. On the contrary, higher interest rates result in higher cost of
production which may lead to lower profitability and lower demand.

The interest rates in the organized financial sector of the economy are determined by
the monetary policy of the government and the trends in money supply. These rates are
thus controlled and vary within certain ranges.

But the interest rates in the unorganized financial sector are not controlled and may
fluctuate widely depending upon the demand and supply of funds in the market. Further,
long-term interest rates differ from short-term interest rates.

An investor has to consider the interest rates prevailing in the different segments of the
economy and evaluate their impact on the performance and profitability of companies.

4. Government Revenue, Expenditure and Deficits

As the government is the largest investor and spender of money, the trends in
government revenue, expenditure and deficits have a significant impact on the

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performance of industries and companies. Expenditure by the government stimulates the

economy by creating jobs and generating demand. Since a major portion of demand in
the economy is generated by government spending, the nature of government spending
is of great importance in determining the fortunes of many an industry.

However, when government expenditure exceeds its revenue, there occurs a deficit. This
deficit is known as budget deficit. All developing countries suffer from budget deficits as
government spend large amount of money to build up infrastructure. But budget deficit
is an important determinant of inflation, as it leads to deficit financing which fuels
inflation.

5. Exchange Rates

The performance and profitability of industries and companies that are major importers
or exporters are considerably affected by the exchange rates of the pesos against major
currencies of the world. A depreciation of the pesos improves the competitive position of
Filipino products in foreign markets, thereby stimulating exports. But it would also make
imports more expensive. A company depending heavily on imports may find devaluation
of the pesos affecting its profitability adversely.

The exchange rates of the pesos are influenced by the balance of trade deficit, the
balance of payments deficit and also the foreign exchange reserves of the country. The
excess of imports over exports is called balance of trade deficit. The balance of
payments deficit represents the net difference payable on account of all transactions
such as trade, services and capital transaction. If these deficits increase, there is a
possibility that the pesos may depreciate in value.

A country needs foreign exchange reserves to meet several commitments such as

payment for imports and servicing of foreign debts. Balance of payment deficit typically
leads to decline in foreign exchange reserves as the deficit has to be met from the
reserve. The size of the foreign exchange reserve is a measure of the strength of the
pesos on external account. Large foreign exchange reserves help to increase the value
of the pesos against other currencies.

The exchange rates of the pesos against the major currencies of the world are
published daily in the financial press. An investor has to keep track of the trend in
exchange rates of pesos. An analysis of the balance of trade deficit, balance of payments
deficit and the foreign exchange reserves will help to project the future trends in
exchange rates.

6. Infrastructure

The development of an economy depends very much on the infrastructure available.

Industry needs electricity for its manufacturing activities, roads and railways to transport
raw materials and finished goods, communication channels to keep in touch with
suppliers and customers.

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The availability of infrastructural facilities such as power, transportation and

communication systems affects the performance of companies. Bad infrastructure leads
to inefficiencies, lower productivity, wastage and delays. An investor should assess the
status of the infrastructural facilities available in the economy before finalizing has
investment plans.

7. Weather/ Climate

The Filipino economy is essentially an agrarian economy and agriculture forms a very
important sector of the Filipino economy. Because of the strong forward and backward
linkages between agriculture and industry, performance of several industries and
companies are dependent on the performance of agriculture. Moreover, as agricultural
incomes rise, the demand for industrial products and services will be good and industry
will prosper.

But the performance of agriculture to a very great extent depends on the monsoon. The
adequacy of the monsoon determines the success or failure of the agricultural activities
in Philippines. Hence, the progress and adequacy of the monsoon becomes a matter of
great concern for an investor in the Filipino context.

8. Economic and Political Stability

A stable political environment is necessary for steady and balanced growth. No industry
or company can grow and prosper in the midst of political turmoil. Stable long-term
economic policies are what are needed for industrial growth. Such stable policies can
emanate only from stable political systems as economic and political factors are
interlinked. A stable government with clear cut long – term economic policies will be
conducive to good performance of the economy.

9. Economic Forecasting

Economy analysis is the first stage of fundamental analysis and starts with an analysis of
historical performance of the economy. But as investment is a future-oriented activity,
the investor is more interested in the expected future performance of the overall
economy and its various segments. For this, forecasting the future direction of the
economy becomes necessary. Economic forecasting thus becomes a key activity in
economy analysis.

The central theme in economic forecasting is to forecast the national income with its
various components. Gross national product or GNP is a measure of the national income.
It is the total value of the final output of goods and services produced in the economy. It
is a measure of the total economic activities over a specified period of time and is an
indicator of the level and rate of growth of economic activities. An investor would be
particularly interested in forecasting the various components of the national income,
especially those components that have a bearing on the particular industries and
companies that he is analysing.

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Forecasting Techniques

Economic forecasting may be carried out for short-term periods (up to three
years), intermediate term periods (three to five years) and long-term periods (more than
five years). An investor is more concerned about short-term economic forecasts for
periods ranging from a quarter to three years. Some of the techniques of short-term
economic forecasting are discussed below:

1. Anticipatory Surveys

Much of the activities in government, business, trade and industry are planned in
advance and stated in the form of budgets. Consumers also plan for their major
spending in advance. To the extent that institutions and people plan and budget for
expenditures in advance, surveys of their intentions can provide valuable input to short-
term economic forecasting.

Anticipatory surveys are the surveys of intentions of people in government,

business, trade and industry regarding their construction activities, plant and machinery
expenditures, level of inventory, etc. Such surveys may also include the future plans of
consumers with regard to their spending on durables and non-durables. Based on the
results of these surveys, the analyst can form his own forecast of the future state of the
economy.

The greatest shortcoming of the anticipatory surveys is that there is no

guarantee that the intentions surveyed will certainly materialise. The forecast based on
anticipatory surveys or surveys of intentions will be valid only to the extent that the
intentions are translated into action. Hence, the analyst cannot rely solely on these
surveys.

2. Barometric or Indicator Approach

In this approach to economic forecasting, various types of indicators are studied

to find out how the economy is likely to perform in the future. These indicators are time
series data of certain economic variables. The indicators are classified into leading,
coincidental and lagging indicators.

The leading indicators are those time series data that reach their high points
(peaks) or their low points (troughs) in advance of the high points and low points of
total economic activity. The coincidental indicators reach their peaks and troughs at
approximately the same time as the economy, while the lagging indicators reach their
turning points after the economy has already reached its own turning points. In this
method, the indicators1 act as barometers to indicate the future level of economic
activity. However, careful examination of historical data of economic series is necessary
to ascertain which economic variables have led, lagged behind or moved together with
the economy.

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The US Department of Commerce, through its Bureau of Economic Analysis, has

prepared a short list of the different indicators. Some of them are given below for
illustrative purpose.

1. Leading Indicators

 Average weekly hours of manufacturing production workers

 Average weekly initial unemployment claims
 Contracts and orders for plant and machinery
 Number of new building permits issued Index of S and P 500 stock prices
 Money supply (M2)
 Change in sensitive materials prices
 Change in manufactures’ unfilled orders (durable goods industries)
 Index of consumer expectations

2. Coincidental Indicators

 Employees on non-agricultural pay rolls

 Personal income less transfer payments
 Index of industrial production
 Manufacturing and trade sales

3. Lagging Indicators

 Average duration of unemployment

 Ratio of manufacturing and trade inventories to sales
 Average prime rate
 Commercial and industrial loans outstanding
 Change in consumer price index for services

Of the three types of indicators, leading indicators are more useful for economic
forecasting because they measure something that foreshadows a change in economic
activity.

The indicator approach has its own limitations. It is useful in forecasting the direction of
the change in aggregate economic activity, but it does not indicate the magnitude or
duration of the change. Further, the leading indicators may give false signals. Moreover,
different leading indicators may give conflicting signals. The indicator approach becomes
useful for economic forecasting only if data collection and presentation are done quickly.
Any delay in presentation of data defeats the purpose of the indicators.

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Econometric Model Building

This is the most precise and scientific of the different forecasting techniques. This
technique makes use of Econometrics, which is a discipline that applies mathematical
and statistical techniques to economic theory.

In the economic field we find complex interrelationships between the different economic
variables. The precise relationships between the dependent and independent variables
are specified in a formal mathematical manner in the form of equations. The system of
equations is then solved to yield a forecast that is quite precise.
In applying this technique, the analyst is forced to define early and precisely the
interrelationships between the economic variables. The accuracy of the forecast derived
from this technique would depend on the validity of the assumptions made by the
analyst regarding economic interrelationships and the quality of his input data.

Econometric models used for economic forecasting are generally complex. Vast amounts
of data are required to be collected and processed for the solution of the model. This
may cause delay in making the results available. Undue delay may render the results
obsolete for purpose of forecasting.

Opportunistic Model Building

This is one of the most widely used forecasting techniques. It is also known as GNP
model building or sectoral analysis.

Initially, an analyst estimates the total demand in the economy, and based on this he
estimates the total income or GNP for the forecast period. This initial estimate takes into
consideration the prevailing economic environment such as the existing tax rates,
interest rates, rate of inflation and other economic and fiscal policies of the government.

After this initial forecast is arrived at, the analyst now begins building up a forecast of
the GNP figure by estimating the levels of various components of GNP. For this, he
collects the figures of consumption expenditure, gross private domestic investment,
government purchase of goods and services and net exports. He adds these figures
together to arrive at the GNP forecast.
The two GNP forecasts arrived at by two different methods will be compared and
necessary adjustments will be made to bring the two forecasts into line with each other.

The opportunistic model building approach makes use of other forecasting techniques to
build up the various components. A vast amount of judgement and ingenuity is also
applied to make the overall forecast reliable.

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Economic forecasting is an extremely complex and difficult process. No method is

expected to give accurate results. The investor must evaluate all economic forecasts
critically before making his investment decision.

Economy analysis is an important part of fundamental analysis. It gives the investor an

overall picture of the expected performance of the economy in the near future. This is a
valuable input to investment decision-making.

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Activity 8: Using the indicators mentioned above, create your own analysis of the
Philippine Economy within the last five years. You can also forecast what will be the
economic situation in the country as affected by COVID 19- Pandemic.

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