Fundamental Analysis

Introduction

Investment management requires that the investor be able to choose the right security from amongst all available in the market.

In case of fixed income securities, i.e. bonds and preference shares, the quantum of returns are known.

The challenge in choosing the right security is of critical importance in case of equity shares as potential future earnings in the form of both dividend as well as capital gain is unknown.

Deciding whether to invest in a stock or not is usually a function of what its future value is likely to be. There are basically two approaches to conduct share valuation:

1.    Fundamental Analysis2.    Technical Analysis

Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock. Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies.

Simply stated, the fundamental approach analyses stocks on the basis of core financial, industrial and economic factors.

Technical analysis is the evaluation of securities by means of studying statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value but instead use stock charts to identify patterns and trends that may suggest what a stock will do in the future.

In short, technical analysis is the study of past share prices and volume for forecasting of future stock price.

The Concept of Intrinsic Value • One of the primary assumptions of fundamental analysis is that the price

on the stock market does not fully reflect a stock’s “real” value. In financial jargon, this true value is known as the intrinsic value.

• Another basic premise is that in the long run, the market price tends to move towards its fair or intrinsic value.

• Keeping these assumptions in mind - if intrinsic value is greater than the mkt. price then the stock is considered to be undervalued and one should be on the lookout for such stocks as they are likely to earn profits.

• On the contrary, stocks whose intrinsic value is lesser than the market price are referred to as overvalued shares and eventually their prices are likely to fall, therefore those holding these stocks would prefer to sell them.

How is Fundamental Analysis Done?

Fundamental analysis is a stock valuation method that uses financial and economic analysis to predict the movement of stock prices.

 The fundamental information that is analyzed can include a company's financial reports, and non-financial information such as estimates of the growth of demand for products sold by the company, industry comparisons, and economy-wide changes, changes in government policies etc..

There are two approaches to fundamental analysis, viz., E-I-C analysis or the Top Down approach to fundamental analysis and C-I-E analysis or the Bottom up approach.

Economy-Industry-Company Analysis

• In the Top down approach, first of all the overall Economy is analyzed to judge the general direction, in which the economy is heading. The direction in which the economy is heading has a bearing on the performance of various industries. That’s why Economy analysis is important.

• The output of the Economy analysis is a list of industries, which should perform well, given the general trend of the economy and also an idea, whether to invest or not in the given economic conditions.

ECONOMIC ANALYSIS

• Economic analysis has an important role to play in investment decisions as overall economic conditions and economic activities affect corporate profits and investors’ expectations which in turn affect the security prices.

Major Tools of Economic Analysis

1) Gross Domestic Product (GDP)2) Monetary Policy & Liquidity3) Inflation4) Interest Rates5) International Influences6) Consumer Sentiments7) Fiscal Policy8) Influences on Long-Term Expectations9) Influences on Short-Term Expectations

INDUSTRY ANALYSIS

• The company's industry obviously influences the outlook for the company. Even the best stocks can post mediocre returns if they are in an industry that is struggling. It is often said that a weak stock in a strong industry is preferable to a strong stock in a weak industry.

Tools of Industry Analysis

• Industry/Product Life Cycle• SWOT Analysis• Cross-Sectional Industry Performance• Past Performance of the Industries• Variation in Industries Risk• Quantitative Industry Analysis

- Employment Data Analysis- Earnings/Emoluments Data Analysis- Input-Output Analysis

Company Analysis

• The third element of the EIC approach is company analysis. In this, the main focus is on identifying the better performing companies from within an industry.

• In fact it is here that an attempt is made to find out the intrinsic value of a share based on which a purchase decision is made.

Profit Potential of Industries: Porter’s Five Forces Model

The Industry(Rivalry Among Existing Firms)

Suppliers Buyers

Potential Entrants

Substitutes

Threat of new entrants

Bargaining Power

Of Buyers

Bargaining Power

Of Suppliers

Threat of Substitute Products

Analysis of Financial Statements

This is usually done by studying the company's financial statements and calculating a number of useful ratios. The ratios that will give a good indicator of financial health vary from one type of firm to another. When performing ratio analysis on 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." Some of the popular ratios normally included in fundamental analysis are:

a) EPS e) Dividend Yieldb) DPS f) Book Value per Sharec) P/E Ratio g) Price to Book Ratio d) PEG Ratio h) Price to Sales Ratioe) D/P Ratio

Earnings Per Share (EPS) Often, a decision to invest in a company is made on its overall

profitability. However, total earnings are not a proper measure for making an investment decision, a better measure would be earnings per share.

EPS = Net Earnings / Outstanding Shares

Note that there are three types of EPS numbers: 

• Trailing EPS – last year’s numbers and the only actual EPS • Current EPS – this year’s numbers, which are still projections • Forward EPS – future numbers, which are obviously projections 

It is important to keep in mind that EPS by itself doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some other ratios.

Dividend Per Share (DPS)

• It is important to remember that EPS does not reflect the actual returns received from the company, that, in fact, is reflected in the dividends paid per share. Many investors are largely interested in the amount of dividend earned, thus DPS assumes an important role in investment decision.

DPS = total equity dividends paid in a year No. of equity shares outstanding

Dividend Payout Ratio (D/P Ratio)The DPR measures what a company’s pays out to investors in the form of dividends.

D/P Ratio = Yearly Dividend per Share Earnings per Share 

• Growing companies will typically retain more profits to fund growth and pay lower or no dividends.

• Companies that pay higher dividends may be in mature industries where there is little room for growth and paying higher dividends is the best use of profits.

• Either way, the whole DPR issue must be evaluated in the context of the company and its industry. By itself, D/P Ratio communicates very little.

• A reduction in dividends paid is looked poorly upon by investors, and the stock price usually depreciates as investors seek other dividend paying stocks.

• A stable dividend payout ratio indicates a solid dividend policy by the company.

Dividend Yield Ratio

The dividend yield ratio is most useful for an investor looking for dividend income.

Dividend Yield = DPS/Mkt. Price per share

Ratio

Price to Earnings Ratio (P/E Ratio) The P/E looks at the relationship between the stock price and the

company’s earnings. The P/E is the most popular stock analysis ratio, although it is not the only one an investor should consider.

P/E = Stock Price

EPS

Some investors interpret a high P/E as an “overpriced stock”. However, it can also indicate the market has high hopes for this stock’s future and has bid up the price.

Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean that the market has just overlooked the stock. Thus, alert investors can spot such undervalued stocks before the rest of the market discovers their true worth.

It is important to note that the P/E ratio tells you what the market “thinks” of a stock. It tells you whether the market likes or dislikes the stock.

Price to Future Growth Ratio (PEG Ratio)

• The market is usually more concerned about the future than the present, it is always looking for some way to figure out what is going to happen in the companies future. Thus, a PEG ratio is considered an even better measure to base your investment decision upon.

PEG = (P/E) / (projected growth in earnings)

PEG (Contd…)• Technically speaking: The lower the PEG number, the less you pay for each unit of

future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value.

• To put it very simply, we are interested in stocks with a low PEG value.

Understanding PEG requires a perspective on P/E ratio, for instance, a stock could have a low P/E due to either of the following reasons:

- The stock market does not like the stock.- The stock market has overlooked a stock that is actually fundamentally very strong and

of good value.

In order to understand which of these is the cause for the low P/E , you look at the PEG ratio. Now, if the PEG ratio is large (or close to the P/E ratio), you can understand that this is probably because the “projected growth earnings” are low. This is the kind of stock that the stock market thinks is of not much value.

On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio) you know that the projected earnings must be high. You know that this is the kind of fundamentally strong stock that the market has overlooked for some reason.

It is important to understand that the PEG ratio relies on the projected % earnings. These earnings are not always accurate and so the PEG ratio is not always accurate.

Book Value Per Share

• Fundamental analysis is all about determining how much is a company worth and evaluating whether that value is reflected in the stock price.

• One way to determine a company’s value is to determine a firm’s “Book Value”. The Book Value is simply the company’s assets minus its liabilities.

Book Value = Assets - Liabilities

• Book value per share is the ratio, which is calculated by subtracting a company's total liabilities from its total asset value and then dividing it by the total number of equity shares.

• Book value shows the worthiness of a company stock. The stock becomes a valuable stock for investing in when its market price drops below its book value.

Price to Book Ratio

• One of the metrics used to help identify undervalued stocks is the Price to Book ratio or P/B ratio. This measurement looks at the value the market places on the book value of the company.

P/B = Share Price / Book Value Per Share

• The lower the P/B, the better the value. Investors usually use a low P/B as stock screens to identify potential candidates.

Price to Sales Ratio

• The Price to Sales (P/S) ratio looks at the current stock price relative to the total sales per share. 

P/S = Market Capitalisation / Sales Revenues or 

P/S = Stock Price / Sales per Share

To find under valued stocks you can look for low P/S ratios.

The lower the P/S ratio the better is the value of the company. 

Other Important Ratios

I. Liquidity Ratios1. Current Ratio2. Quick Ratio/Acid-Test Ratio3. Super-Quick Ratio

II. Activity/Turnover Ratios1. Asset Turnover Ratio2. Inventory Turnover Ratio3. Debtors’ Turnover Ratio4. Creditors’ Turnover Ratio5. Working Capital Turnover Ratio

Other Important Ratios (contd…)III. Profitability Ratios1. Gross Profit Margin2. Operating Profit Margin3. Net Profit Margin4. Return on Assets5. Return on Investment6. Return on Equity

IV. Solvency Ratios1. Debt/Equity Ratio2. Interest Coverage Ratio