FUNDAMENTAL ANALYSIS

Fundamental analysis measures a security's intrinsic value by examining

related economic and financial factors. Intrinsic value is the value of an
investment based on the issuing company's financial situation and current
market and economic conditions.

Quantitative and Qualitative Fundamental Analysis

The various fundamental factors can be grouped into two categories:

quantitative and qualitative. The financial meaning of these terms isn't much
different from well-known definitions:

 Quantitative: information that can be shown using numbers, figures,

ratios, or formulas
 Qualitative: rather than a quantity of something, it is its quality,
standard, or nature

Quantitative fundamentals are hard numbers. They are the measurable

characteristics of a business. The biggest source of quantitative data is
financial statements. Revenue, profit, assets, and more can be accurately
measured.

Quantitative Fundamentals to Consider: Financial Statements

Financial statements are the medium by which a company discloses

information concerning its financial performance. Followers of fundamental
analysis use quantitative information from financial statements to make
investment decisions. The three most important financial statements
are income statements, balance sheets, and cash flow statements.

Qualitative Fundamentals to Consider:

There are four key fundamentals that analysts always consider when
regarding a company. All are qualitative rather than quantitative. They
include:

1) The Business Model: What exactly does the company do? This isn't as
straightforward as it seems. If a company's business model is based on selling
fast-food chicken, is it making its money that way? Or is it just coasting on
royalty and franchise fees?

2) Competitive Advantage: A company's long-term success is primarily

driven by its ability to maintain a competitive advantage—and keep it.
Powerful competitive advantages, such as Coca-Cola's brand name and
Microsoft's domination of the personal computer operating system, create a
competitive advantage around a business allowing it to keep competitors at
bay and enjoy growth and profits. When a company can achieve a competitive
advantage, its shareholders can be well rewarded for decades.

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Assistant Professor
M.Com, NET
3) Management: Some believe management is the most important criterion
for investing in a company. It makes sense, even the best business model is
doomed if the company's leaders fail to execute the plan properly.

4) Corporate Governance: Corporate governance describes the policies in

place within an organization denoting the relationships and responsibilities
between management, directors, and stakeholders. An investor want to do
business with a company that is run ethically, fairly, transparently, and
efficiently. Particularly note whether management respects shareholder
rights and shareholder interests.

5) Industry: It's also important to consider a company's industry, its

customer base, market share among firms, industry-wide growth,
competition, regulation, and business cycles. Learning how the industry
works will give an investor a deeper understanding of a company's financial
health.

Top – down and Bottom – up Analysis:

In a top-down approach, an investor adopts EIC approach to investing. ‘E’

refers to the economy, he first takes a call on whether the domestic and global
economic scenario is conducive for investment. Once the economy condition
is satisfied then he assess the ‘I’, which represents the industry in which the
company operates. While analyzing industry he looks into factors like how the
industry is growing, what are the input costs, what are the output price
trends, entry barriers in the industry etc. Once the investor is convinced that
the strengths and opportunities outweigh the threats and weaknesses of the
industry, then he moves to the last step. ‘C’ refers to the specific company
where he wants to invest. While analyzing ‘C’ he considers financials like
profitability, solvency, liquidity, efficiency, etc.

The bottom – up approach looks at stock triggers straight away. The company
is the starting point. Bottom – up approach is based on the premise that good
companies can successfully create wealth even in tepid markets and when
the economy is not performing great. This is true if you look at specific
instances like TTK Prestige, Eicher and Indo Count which actually gave
phenomenal returns at a time when the markets did not show any great
performance. This method will pay less attention to market conditions,
macroeconomic indicators, and business fundamentals. Instead, focus is on
how a single company in a sector performs compared to other companies.

Fundamental Analysis:

I) Economic Analysis: Economic analysis is one of the studies that form part
of the fundamental analysis. This relates to study about the economy in detail
and analyses whether economic conditions are favourable for the companies
to prosper or not.

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Economic analysis tools:

 Gross Domestic Product: GDP or gross domestic product is the

measure of the value of goods and services produced within the
domestic boundary of a country. The gross domestic product (GDP) is
one the most important indicators used for the measurement of the
strength of a country's economy.

 Fiscal Policy: Fiscal policy is the policy through which government

adjusts its spending and tax rates to stabilize the economy. Fiscal policy
is in principal based on the thought that governments could transform
economic performance by adjusting tax rates and government
spending. Government spending in the form of subsidies usually
reduces the cost of product and thus leaving scope for larger profit of
the firm .The larger profit in turn leads to larger earning per share. This
increase in earnings per share will lead to increase in value of share
prices. On the other hand increase in taxes for the company reduces
the amount of profit available for shareholders. Thus increase in taxes
has the effect of reducing the amount of Earning per share and thus
leads to fall in share prices of the company.

 Monetary Policy: Monetary Policy is the instrument of central bank of

a country i.e. RBI in India through which it controls the supply of
money. If RBI raises the interest rate, it will impact the interest rate on
debentures and bonds. With increase in interest rates on debentures
and bonds there will be change in risk perception of investors and thus
they will want higher return on their equity investment.

 Saving rate: With increase in individual saving rate there will be flow
of larger funds into investments. This will result in an increase in
demand for equity shares and thus share market will be bullish as it
has an impact of increase in share prices. On the other hand, a lower
saving rate means lesser disposal of funds by household into equity
market which will reduce the demand for equity. Thus there will be
reduction in share prices and market will be bearish.

 Trade Deficit: Trade deficit occurs when countries imports are more
than its export. In other words we can see it that a country is buying
more of foreign goods than it is selling to them. Thus this will impact
domestic producers. More imports mean more purchase of foreign
goods and less purchase of domestic goods. This will result in more
profitability to foreign companies than domestic producers. The lesser
the profit lesser will the amount of profits available to equity
shareholders. Thus it will result in decline in the prices of shares of the
domestic company.

II) Industry Analysis:

Industry analysis is a method that helps an investors to understand a
company’s position relative to other participants in the industry. It helps them
to identify both the opportunities and threats that a company might face
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which gives them a strong idea of the present and future scenario of the
industry.

Types of Industry Analysis:

Porter’s Five Forces: Michael Porter, an American academic, devised five

forces in his book Competitive Strategy: Techniques for Analysing Industries
and Competitors to conduct a thorough study of any industry. The five forces
are:

a) Rivalry with Peers: It is important to know about the position of a

company with peers from the same industry. You cannot rank a
manufacturing company against a pharmaceutical company for comparison.
For the same, one needs to look at the competition levels. According to Porter,
competition is intense when there are more players, when the products are
similar and the companies are fighting to find an edge over other products, in
case of perishable products, etc.

b) Threat of New Competition: The second competitive force that Porter

emphasizes is the ability of new companies to enter the industry and intensify
the competition. Industries, where it is difficult for new competitors to enter,
benefit extended periods profitability and very limited rivalry. Competition
basically tells us how difficult it is for the company to make money and how
far it has been successful. The success, therefore, will translate into the stock
prices.

c) Threat of Substitutes: Substitutes are products that can be used in place

of the other. For example, Domino’s Pizza and Pizza Hut pizza are substitutes
for each other. If the price of one rises, the demand for the other one will
increase. Since it is so easy to switch to the substitute when there is a price
rise or quality drop, the threat remains and the pressure to continuously
perform better and in a cost-efficient way is essential. The better the company
executes against its substitutes, the higher it goes.

d) Bargaining Power of Buyers: This power refers to the power buyers have
where they can force the sellers to give them better quality products and at
lower prices. The bargaining power is high in the following cases:
 if the number of buyers is lesser than the number of suppliers in the
market,
 if the buyer has more similar products in the market and depends less
on a particular supplier and if the switching cost is low.
This will help you understand how the company’s profits will be impacted in
the long term.

e) Bargaining Power of Suppliers: Many small and mid-sized companies

face a threat from an industry where the suppliers hold bargaining powers.
Imagine a fashion company that has a specific dress line and design, which
makes it famous but needs a specific cloth type available only with a handful
of suppliers. In such cases, the suppliers can increase the prices, which will
impact the dress’s final cost and impact the brand’s business.
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Large corporations may remain unaffected by this power since they have the
resources to establish an extensive supplier network and create buyers’
bargaining power instead.

III) Company Analysis:

Company analysis is all about study of profitability, solvency, liquidity and
efficiency of a company with the help of financial statement analysis and using
financial ratios:

Income statement analysis: The income statement, also known as the profit
and loss (P&L) statement, is the financial statement that depicts the
revenues, expenses and net income generated by an organization over a
specific period of time. The data provided in this document is relatively
simple, there is a great deal of useful information that can be used to assess
a firm's historical financial performance and develop an estimate of its
prospects.

Cash flow statement analysis: Cash flow analysis refers to the evaluation
of inflows and outflows of cash in an organisation obtained from financing,
operating and investing activities. In other words, we can say that it
determines the ways in which cash is earned by the company.

Position statement analysis: A company's financial situation is defined by

its assets and liabilities. A company's financial position also
includes shareholder equity. All of this information is presented to
shareholders in the balance sheet. While analysing financial position of
company various financial ratios are used. They are

 Liquidity ratios - Liquidity ratios are financial ratios that measure a

company’s ability to repay both short- and long-term obligations. Important
ratio is current ratio which measures a company’s ability to pay off short-term
liabilities with current assets.
 Leverage ratios - measure the amount of capital that comes from debt.
In other words, leverage financial ratios are used to evaluate a company’s debt
levels. Debt – equity ratio is one of the important leverage ratio.
 Efficiency ratios - Efficiency ratios, also known as activity financial
ratios, are used to measure how well a company is utilizing its assets and
resources. Asset turnover ratio, inventory turnover ratio and receivables
turnover ratio are analysed.
 Profitability ratios - measure a company’s ability to generate income
relative to revenue, assets, operating costs, and equity. Gross profit ratio,
Operating profit ratio, return on assets and return on equity are commonly
used profitability ratios.
 Market value or Industry market ratios - used to evaluate the share
price of a company’s stock. PE ratio, PEG ratio, Price over sales, Price over
book value.

Price Earnings ratio: The price-to-earnings (P/E) ratio measures a

company's share price relative to its earnings per share (EPS). The P/E ratio
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is one of the most widely used by investors and analysts reviewing a stock's
relative valuation. It helps to determine whether a stock is overvalued or
undervalued.

P/E Ratio= Market value per share/Earnings per share

Price Earning to Growth Ratio (PEG): The PEG ratio is a company's

Price/Earnings ratio divided by its earnings growth rate over a period of
time (typically the next 1-3 years). The PEG ratio adjusts the traditional P/E
ratio by taking into account the growth rate in earnings per share that are
expected in the future.

PEG = (Market price per share / EPS) / EPS Growth Rate

Price over sales ratio: The price to sales ratio (P/S ratio) is a valuation ratio
that compares the total value that investors are paying for each rupee of a
company's sales or revenues.

P/S ratio = Stock Price / Sales per share

Price over Book Value Ratio: Ratio of the market value of a company's
shares (share price) over its book value of equity.

P/B Ratio = Company’s stock price per share / Book value per share.

Economic Value Added: Economic value added (EVA), also known as

economic profit, aims to calculate the true economic profit of a company. It
is used to measure the value a company generates from funds invested in it.

Shareholding Pattern of the Company:

A shareholding pattern refers to the distribution of a company’s equity among

different classes of shareholder. It provides a snapshot of who owns how much
of a company’s stock. Shareholders can include a diverse range of entities,
such as individual investors, institutional investors, and the company’s
promoters. This pattern offers a clear view of the ownership structure,
influencing decisions, control, and the overall direction a company takes.

Components of the shareholding pattern:

Promoter and promoter shareholding: Promoters are the individuals or

groups who founded the company and hold a significant stake in it. Their role
is pivotal in shaping the company’s direction and decision making. Promoter
holding indicates the percentage of company shares held by the promoters.
This information is essential for understanding the level of control and
influence the promoters have over the company. A higher promoter holding
signifies a stronger commitment to the company’s success.

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Public Shareholding: It includes all shares held by entities other than the
promoters. It includes retail investors, institutional investors, foreign
investors, and other non-promoter shareholders. The distribution of shares
among the public is a critical aspect of the shareholding pattern. It reflects
the level of interest and confidence that the market has in the company.

Understanding Shareholding Pattern:

While studying shareholding pattern, there are thumb rules to keep in mind:
 Promoter holding significance: higher the promoter shareholding,
greater their influence on the company. However, excessively high
promoter holding may also indicate limited public participation.
 Increasing public holding: An increase in public shareholding often
indicates positive market sentiment and can be a sign of confidence in
the company.
 Institutional holdings: Institutional investors, such as mutual funds
and foreign investors can have a significant impact. A higher
institutional holding reflect professional confidence in the company’s
prospects.
 Retail investors: The participation of retail investors in a company’s
shareholding pattern can be a sign of its popularity and attractiveness
to individual investors.

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PRASAD R
Assistant Professor
M.Com, NET