FUNDAMENTAL ANALYSIS

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
Thus, fundamental analysis is a combination of economic, industry and company analyses to obtain a
stock’s current fair value and predict its future value. This is illustrated in figure.
This kind of fundamental analysis is also known as top-down approach because the analysis starts from
analysis of the economy, moves to industry and narrows down to the company. This is also called EIC
(economy, industry and company) analysis.

Economy

Industry

Company Stock Value

Stock valuation analysis

ECONOMIC ANALYSIS
The level of economic activity has an impact on investment in many ways. If the economy grows rapidly,
the industry can also be expected to show rapid growth and vice versa. When the level of economic
activity is low, such prices are low, and when the level of economic activity is high, stock prices are high
reflecting the prosperous outlook for sales and profits of the firms. The analysis of macro-economic
environment is essential to understand the behavior of the stock prices. The commonly analyzed macro-
economic factors are as follows:
1. Gross Domestic Product (GDP)
2. Savings and investment
3. Inflation
4. Interest rates
5. Budgets and fiscal deficit
6. Tax structure
7. Balance of payments
8. Foreign direct investment
9. Investment by foreign institutional investors (FIIs)
10. International economic conditions
11. Business cycles and investor psychology
12. Monsoon and agriculture

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13. Infrastructure
14. Demographic factors.
It is explained as follows:
1. Gross Domestic Product
Gross Domestic Product is one measures of economic activity. This is the total amount of goods
and services produced in a country in a year. It is calculated by adding the market values of all the
final goods and services produced in a year.
The common equation for the calculation of GDP is:
GDP = Consumption + Exports –Imports
The growth rate of GDP points out the prospects for the industrial sector and the return investors
can expect from an investment in shares. A decline in the GDP indicates a potential economic
slowdown. A high GDP growth rate is advantageous to the stock market.

2. Savings and Investment

It is obvious that growth requires investment, which in turn, requires a considerable amount of
domestic savings. Growth in savings naturally leads to more investments. High capital investment
means possibility of more production, more demand and supply, better prices in future and
consequently higher business profits and a positive outlook for the stock markets. Savings are
distributed over different assets like equity shares, deposits, mutual fund units, real estate. The
primary market is a channel through which the savings of investors are made available to
corporate bodies. Over the years, household and private corporate savings have increased and in
turn, the gross domestic investment has also increased.
3. Inflation:
A simple explanation of inflation is that it refers to a situation where too much is chasing too few
goods. Inflation indicates a rise in the price of goods and services. Along with the growth of GDP,
if the inflation rate also increases, then the real rate of growth would be very low. Inflation and
stock markets have a very close relationship. If there is inflation, the stock market is adversely
affected. The price of stock is directly related to the performance of the company. Inflation
typically results in the following:
 High raw material cost
 Non-availability of cheap credit due to rise in interest rates.
 Low earnings.
4. Interest rates:
Interest rates have a direct impact on the economy. The base rate of banks affects the cost of
borrowed funds. The base rate is the minimum rate of interest at which banks lend to anyone. It is
the floor rate below which the RBI will not allow bank to lend.
The interest rate affects the cost of financing to the firms. A decrease in interest rate implies lower
cost of finance for firms and more profitability. More money is available at a lower interest rate
for the brokers who are doing business with borrowed money. Availability of cheap fund
encourages speculation and rise in the price of shares.
An increase in lending rates affects negatively firms which depend on banks for their working
capital and growth requirements.

5. Budget and Fiscal Deficit

The budget draft provides a detailed account of government revenue and expenditure. A deficit
budget may lead to a high rate of inflation and adversely affect the cost of production. A surplus
budget may result in deflation. A balanced budget is highly favourable to the stock market.

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6. Tax structure
Every year in March, the business community eagerly awaits the Government’s announcement
regarding the tax policy. Concessions and incentives given to a certain industry encourage
investment in that particular industry. Tax reliefs given to savings encourage savings. The
Minimum Alternative Tax (MAT) levied by the Finance Minister in 1996 adversely affected the
stock market. Ten years of tax holiday for all industries to be set up in the northeast is provide in
the 1999 budget. The type of tax exemption has impact on the profitability of the industries.
7. Balance of Payments
The balance of payment is the record of a country’s money receipts from and payments abroad.
The difference between receipts and payments may be surplus or deficit. Balance of payment is a
measure of the strength of rupees on external account. If the deficit increases, the rupee may
depreciate against other currencies, thereby affecting the cost of imports. The industries involved
in the export and import are considerably affected by the changes in foreign exchange rate. The
volatility of the foreign exchange rate affects the investment of the foreign institutional investors
in the Indian stock market. A favourable balance of payment renders a positive effect on the stock
market.
8. Foreign Direct Investment
The definition of foreign direct investments (FDI) includes different elements, namely, equity
capital, reinvested earnings of foreign companies, inter-company debt transactions, short and long
term loans, financing leasing, trade credits, investment made by foreign venture, capital investors
and so on. FDIs help in the upgrading of technology, skills, and managerial capabilities and bring
much needed capital into the economy. They also help in providing employment opportunities.
Inflow of capital helps the economy grow and has a positive impact of the stock market.
9. Investment by foreign Institutional Investors (FIIs)
FIIs are considered to be the main drivers of the stock market. Outflows of FII investments affect
the stocks market negatively. Accordingly to a report in the Times of India (3rd April 2012), net
investments by FIIs in the stock market in 2011-12 were the lowest of the past three years, and
stood at Rs 47,935 crore.
Considering the importance of FII investments, in January 2012, the government announced its
decision to allow qualified foreign investors (QFIs) to invest directly in the Indian equity market.
In August 2011, the government allowed foreign investors to invest directly to the extent of US 4
13 billion in equity and debt schemes of mutual funds.
10. Business Cycles and Investor Psychology:
The business cycle contains four phases namely boom, recession, depression and recovery.
Figures show a trade cycle.

Boom Boom

Recession

Recovery

Depression

Depression

A typical trade Cycle

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 During a boom, economic activity is at its peak, and the growth of industry and GDP are
prominent. Companies record high turnover and profits. They engage in expansion plans, mergers
and acquisitions. This leads to investor optimism. Retail investors, big and small, are enthusiastic
about the markets and are willing to invest. The market reaches a new high.
Some of the companies may fail to fulfil the goals and as their profit margins fall, the next phase
of the trade cycle, a recession, sets in. Economic growth decline and there is an economic
slowdown. The stock market reacts with a fall in the price and volume of stock. Fear grips the
market. The recession slips into depression. It results in additional fall in growth rates and
increases in unemployment. The investor becomes pessimistic about the market. Panic prevails
and the stock market reaches a low level.
After a while the economy slowly begins to recover. Some entrepreneurs begin to realize that
things cannot get any worse and start investing in the business. The recovery starts. In the stock
market, the mood changes to hope and caution. Once again the cycle goes on.

11. International Economic Conditions:

Worldwide economies are not independent but interdependent. The boom or depression in one
country affects other countries and the stock market. For example, the sub-prime crises in the US,
bankruptcies, and a 20 per cent drop in the Dow Jones and NASDAQ had an impact on the Indian
economy. IT industries, financial sectors, real estate, the automobile industry, investment banking
and other industries faced heavy losses. Further, the global recession resulted in the pulling of FII
funds from the Indian stock market. The Sensex plunged and became highly volatile in 2008.

12. Infrastructure facilities

Good infrastructure facilities affect the stock market favourably. Infrastructure facilities are
essential for the growth of industrial and agricultural sector. A wide net work of communication
system is a must for the growth of the economy. Regular supply of power without any power cut
would boost the production. Banking and financial sectors also should be sound enough to
provide adequate support to the industry and agriculture. Good infrastructure facilities affect the
stock market favourably. In India even though infrastructure facilities have been developed, still
they are not adequate. The government has liberalized its policy regarding the communication,
transport and power sector. For example, power sector has been opened up to the foreign investors
with assured rates of returns.
13. Demographic factors
The demographic data provides details about the population by age, occupation, literacy and
geographic location. This is needed to forecast the demand for the consumer goods. The
population by age indicates the availability of able work force. The cheap labour force in India
has encourage many multinationals to start their ventures. Indian labour is cheaper compared to
the Western labour force. Population by providing labour and demand for products, affect the
industry and stock market.
14. Monsoon and Agriculture
Indian agriculture still depends heavily on the monsoons inspite of technological advancement.
Good monsoon are a boon for agriculture. Agriculture is directly and indirectly linked to many
industries. For example, the sugar, cotton, textile and food processing industries depend upon
agriculture for raw materials, Farm equipments, fertilizer and insecticide industries supply the
inputs used in agriculture. A favourable monsoon leads to higher demand for these inputs, a
bumper crop and more disposable income in rural areas. This leads to buoyancy in the stock
market. When the monsoon fails, agriculture production and hydropower generation decline. They
cast a shadow on the share market.

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 Favourable Climate Conditions Failure of
Monsoon Monsoon

High demand for hybrid Low demand for hybrid

seeds, fertilizers, farm Stock market seeds, fertilizers, farm
equipment’s etc. equipment’s etc.

Bumper crops Failure of harvest

 High rural disposable income

 High rural demand for consumer
 Less rural disposable income
goods, cars etc.
 Non availability of raw
 Raw materials at low prices to sugar,
materials for agro based
textile and food processing industries.
industries.

Economic buoyancy Economic slowdown

Monsoons and the stock market

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INDUSTRY ANALYSIS
An industry is a group of firms that have similar technological structure of production and produce
similar products. For the convenience of the investors, the broad classification of the industry is given in
financial dailies and magazines. Companies are distinctly classified to give a clear picture about their
manufacturing process and products. The table gives the industry wise classification given in Reserve
Bank of India Bulletin.

Industry Groups
S.No Industries
1. Food products and beverages
2. Tobacco products
3. Textiles
4. Clothing apparel, dressing and dyeing of fur
5. Luggage, handbags, saddler, hamess and footwear; tanning and
dressing of leather products
6. Wood and wood products except furniture; articles of straw and
plating material
7. Paper and paper products
8. Publishing, printing and reproduction of recorded media
9. Coke, refined petroleum products and nuclear fuel
10. Chemicals and chemical products
11. Rubber and plastic products
12. Other non-metallic products
13. Basic metals
14. Fabricated metal products, except machinery and equipment
15. Machinery and equipment
16. Office, accounts and computing machinery
17. Electrical machinery and apparatus
18. Radio, TV and communication equipment and apparatus
19. Medical, precision and optical instruments, watches and clocks
20. Motor vehicles, trailers and semi-trailers
21. Other transport equipment
22. Furniture, manufacturing

The table above shows that each industry is different from the other. Textile industry is entirely different
from the steel industry or the power industry in its product and process.
These industries can be classified on the basis of the business cycle i.e. classified according to their
reactions to the different phases of the business cycle. They are classified into growth, cyclical, defensive
and cyclical growth industry.

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Kinds of Industries
Industries can be classified on the basis of the business cycle, i.e., classified according to their
reactions to the different phases of the business cycle. They are classified a growth, defensive, and
cyclical growth industries.
Growth industry.
Growth industries have special features of high rate of earnings and growth in expansion, independent of
the business cycle. The expansion of the industry depends mainly on technological change. For instance,
despite the recession in the global economy, there was a spurt in the growth of the alternative energy
industry in 2011-12. It defied the business cycle and continued to grow. Similarly, in each phase of
history, certain industries like colour televisions, pharmaceuticals and telecommunication industries have
shown remarkable growth.
Cyclical industry
The growth and profitability of an industry move in tandem with the business cycle. During a boom,
industries enjoy growth and during a depression they suffer a setback. For example, while goods like a
fridge, washing machine and kitchen range products command a good market in a boom, while demand
for them slackens during a recession.
Defensive industry
A defensive industry defies the movement of the business cycle. For example, food and shelter satisfy
basic human needs. The food industry withstands recessions and depressions. The stock of defensive
industries can be held by the investor for income earning purposes. They expand and earn income in a
depression too, under the government umbrella of protection, and are counter cyclical in nature.
Cyclical growth industry
This is a new type of industry that is cyclical and at the same time growing. For example, the automobile
industry experience periods of stagnation and decline but also grows tremendously. Changes in
technology and introduction of new models can help the automobile industry to resume its growth path.
Industry Life Cycle
The industry life cycle theory is generally attributed to Julius Grodinsky, a professor at the
Wharton School of Business. The life cycle of the industry is separated into four well defined stages
as given below:
1. Pioneering stage
2. Rapid growth stage
3. Maturity and stabilization stage
4. Declining stage

It is explained as follows:
1. Pioneering stage:
In this stage, the prospective demand for the product is promising and the technology of the
product is low. The demand for the product encourages many producers to produce that particular
product. There is severe competition and only the fittest companies survive this stage. The
producers try to develop the brand name, differentiate the product, and create a product image.
This leads to non- price competition too. The severe competition often leads to the change of
position of the firms in terms of market shares and profits. In this situation it is difficult to select
companies for investment because the survival rate is unknown.

2. Rapid growth stage:

This stage starts with the appearance of surviving firms from the pioneering stage. The companies
that have withstood the competition steadily improve their market share and financial
performance. The technology used in production improves resulting in low cost of production and

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 good quality products. The companies have stable growth rate in this stage and they declare
dividend to their shareholders. It is advisable to invest in the shares of these companies. The
pharmaceutical industry has improved its technology and the top companies in this sector are
giving dividend to their shareholders. The power and telecommunication industries can also be
cited as examples of industries in this expansion stage. In this stage the growth rate is more than
the industry’s average growth rate.

3. Maturity and stabilization stage

In the stabilization stage, the growth rate tends to moderate and the rate of growth more or less
equals the industrial growth rate or the gross domestic product growth rate. Symptoms of
obsolescence may appear in technology. To keep going, technological innovations in the
production process and products have to be introduced. Investors must closely monitor the events
that take place in the maturity stage of the industry.

4. Declining stage
In this stage demand for the particular product and the earnings of the companies in the industry
decline. Nowadays, a very few consumers demand black and white television sets. Innovations
and changes in consumer preferences lead to this stage. The specific features of the declining
stage is that even in a boom, the growth of the industry is low and declines at a higher rate during
a recession. It is better to avoid investing in the shares of the low-growth industry even during a
boom. Investment in the shares of these types of companies leads to erosion of capital.

Other Factors
Apart from industry life cycle analysis, an investor must also analyse factors such as those given
below:
1. Growth of the industry
2. Cost structure and profitability
3. Nature of the product
4. Nature of the competition
5. Government policy
6. Labour
7. Research and Development.
It is explained as follows:
1. Growth of the industry
The historical performance of the industry in terms of growth and profitability should be
analyzed. Industry wise growth is published periodically by the Centre for Monitoring Indian
Economy. The past variability in return and growth in reaction to macroeconomic factors provide
an insight into the future. Even though history may not repeat in the exact manner, by looking into
the past growth of the industry, an analyst can predict the future. The information technology
industry has witnessed tremendous growth in the past as have the scrip prices of the IT industry.
2. Cost structure and profitability
The cost structure, that is the proportions fixed and variable costs, affects the cost of production
and profitability of the firm. In the case of the oil and natural gas industry, and the iron and steel
industry, the fixed cost portion is high and the gestation period is also lengthy. The higher the
fixed cost component, the greater is the sales volume required to reach the firm’s break even
point. Once the break even point is reached and production is on track, profitability can be
increased by utilizing the capacity to full. Once the maximum capacity is reached , capital must
again be invested in the fixed equipment. Hence, the lower the fixed costs, the easier it is to adjust
to changing demand and to reach break-even point.
3. Nature of the product
The product produced by industries are demanded by consumers and other industries. Demand for
industrial goods like iron sheets and coil for example, comes from the construction industry.
Likewise, the textile machine tools industry produces tools for the textile industry and the entire
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 demand depends upon the health of the textile industry. Several such examples can be cited. An
investor must analyse the condition of the feeder industry as well as the end-user industry to
assess the demand for industrial goods.
In the case of the consumer goods industry, a change in consumer preference, technological
innovations, and substitute products affect demand. A simple example is the demand for ink pens,
which has been affected by the ball point pen as consumer preferences have changed in favour of
ease of use.
4. Nature of the competition
The nature of competition is an essential factor that determines the demand for a particular
product, its profitability, and the price of the scrip concerned. The supply may arise from
indigenous producers and multinationals. Take detergents produced by indigenous manufacturers
and distributed locally at competitive prices. This poses a threat to the products made by a big
company. Multinationals are also entering the field with sophisticated product processes and
better quality products. The company ability to withstand the competition locally and from the
multinationals affects its earnings. If too many firms are present in the organized sector, the
competition will be serve. It will lead to a decline in the price of the product. The investor, before
investing in the scrip of a company, should analyse the market share of the particular company’s
product and compare it with the top five companies.

5. Government policy
Government policies affect the very nerve of the industry and the effects differ from industry to
industry. Tax subsidies and tax holidays are provided for export oriented products. The
government regulates the size of production and the pricing of the certain products. The sugar,
fertilizer, and pharmaceutical industries are often affected by inconsistent government policies.
Control and decontrol of sugar prices affect the profitability of the sugar industry. In some cases,
entry barriers are placed by the government. In the airline sector, private corporations are
permitted to operate only the domestic flights. When selecting an industry, government policy
regarding that particular industry should be carefully evaluated. Liberalization and delicensing
have brought immense threat to existing domestic industries in several sectors.
6. Labour
The analysis of the labour scenario in a particular industry is of great importance. The number of
trade unions and their operating mode have an impact on labour productivity and modernization
of the industry. The textile industry is known for its militant trade unions. If the trade unions are
strong and strike occur frequently, it will lead to a fall in production. In an industry of high fixed
costs, the stoppsge of production may lead to losses. When trade unions oppose the introduction
of automation, in the product market the company may stand to lose owing to the high cost of
production. An unhealthy labour relationship also leads to loss of customer’s goodwill.
Skilled labour is needed for certain industries. In the case of the Indian labour market even in the
IT and other industries, a skilled and well-qualified labour is available at a cheaper rate. This is
one of the many reasons attracting multinationals to set up companies in India.
7. Research and development
For any industry to survive the competition in the national and international markets, the product
and production processes have to be technically competitive. This depends on the R& D in the
particular company or industry. Economies of scale and new markets can be obtained only
through R& D. The percentage of expenditure on R&D should be studied diligently before
making an investment.

8. Pollution standards
Pollution standards are very high and strict in the industrial sector. This is particularly so in the
leather, chemical and pharmaceutical industries that have significant industrial effluents.

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Analytical Tools
The strength of the industry and its competitiveness can be analyzed with the help of SWOT and Porter’s
Five Force Model.
SWOT Analysis
The above mentioned factors themselves would becomes strengths, weaknesses, opportunities and threats
(SWOT) for the industry. Hence, the investor should carry out a SWOT analysis for the chosen industry.
Take the instance, increase in the demand for an industry’s product becoming the strength, and the
presence of numerous players in the market, i.e., competition becoming a threat to a company in the
industry. The progress in the research and development in that particular industry is an opportunity while
the entry of multinationals in the industry and cheap imports of the products are a threat to it. This is the
way the factors are arranged and analyzed. To make the industry analysis more clear, the pharmaceutical
industry has been analyzed and its SWOT results presented in the subsequent section.

PORTER’S FIVE FORCE MODEL

The competitive structure of an industry affects its profitability. The competitive structure differs from
industry to industry. Michael E. Porter of Harvard Business School in 1979 came up with a model to
analyse the competitive structure of an industry. In his opinion, five competitive forces decide the
attractiveness and profitability of an industry
1. Entry of new competitors
2. Threat of substitutes
3. Bargaining power of suppliers
4. Bargaining power of buyers
5. Rivalry among the existing firm

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 Availability of substitutes

Suppliers bargaining power

Threat of new entry

Degree of competition

Rivalry among the existing

firms Buyers bargaining power

1. Entry of new competitors

The entry of new companies in the market increases the competition and reduce profitability. The
barriers to entry decide the number of new entrants. Entry barriers are higher in industries like
aircraft manufacture than in the car industry. The government rules and regulations for
establishing a company in such industries as the steel industry may be more stringent than in
others. The investment requirements to establish a company, economies of scale, customer
switching costs, creation of distribution channels, and the resistance of existing players are the
main barriers for an entrepreneur to start a company.
2. Threat of substitutes
Availability of substitute products reduces the sale of the industry’s product and in turn, the
profitability. The threats posed by substitutes depend on the following factors:
 Willingness of the buyers to utilize substitute products
 The price level of the substitute
 The degree of similarity and performance of the substitutes
 The cost incurred in switching over to substitutes.
3. Suppliers’ bargaining power
Every industry requires raw materials for productions. Suppliers may be individuals or companies
that provide the required raw materials to the firm. The cost of raw materials forms a significant
portion of the total cost of production. If there are few suppliers and they are also organized as
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 cartels, the suppliers bargaining power is high. When there are many suppliers who are
fragmented, their bargaining power is less. The bargaining power of the supplier is high when:
 Number of suppliers is low
 There are many buyers
 Products are similar and of high worth
 There is the possibility of suppliers integrating forward into the industry
 There is the possibility of buyers integrating backwards into supply is lower
 The product may be demanded by not just a single industry but by others also.
4. Buyers’ bargaining power
Here, customers of the industry’s product are referred to as buyers. A strong customer can
demand a higher quality product or service for the same price. If they cannot get that, they may
move over to other similar products. Usually, the more the number of customers for the industry’s
product, the less their commercial power over it. If the number of producers is high, they can
switch from one to the other. When the products are similar and standardized, the possibility of a
switch is high.
5. Rivalry among existing firms
In an industry, all the firms try to improve their market share. If it is a fast-moving consumer
goods industry or the telecommunication industry, the players compete fiercely with each other to
improve their market share and keep their existing share intact. The intensity of competition
depends on the following factors.
a. The structure of competition
When there are more players, the competition is high. It is less when there is a market leader,
and if there are cartels.
b. Cost structure of the industry
In some industries, the fixed costs are high. To make use of unutilized capacity, firms may cut
the price of the end product. This may create a market for their products and create problems
for the other players. At the same time, if the variable costs are more than the fixed costs, the
problem of using the unutilized capacity may not arise.

c. Degree of differentiation
Firms in industries with similar products and specification typically face the following:
i. Stiff competition: usually, coal and steel product are similar in nature
ii. Cost of switching: If the cost of switching from one product to another is high, there
will be less competition. In consumer goods, the switching cost is less and hence the
competition is high.
iii. Strategies: The strategies followed by the competitors affect the level of rivalry. If
they follow an aggressive growth strategy, the marketing strategy will be aggressive.
This will affect the level of competition.
iv. Exit barriers: When firms face high exit barriers, the competition may be severe.

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 COMPANY ANALYSIS
Evaluating the financial performance of a company on the basis of qualitative and quantitative factors is
called company analysis. Qualitative factors are non-quantifiable factors that represent certain aspects of
a company’s business. Integrating such information into evaluation of stock prices can be quite difficult.
At the same time, they cannot be ignored. The management factor is a qualitative factor. It is difficult to
measure, yet exerts tremendous influence on the profitability, or even the existence of the company.
Satyam Computers is an example of the collapse of a company because of the mismanagement of funds.
Quantifiable factors are measurable factors like earnings, sales and cost of production, which directly
affect the revenue of the company. This is explained in Figure.

Qualitative Factors Quantitative Factors

 Business Model  Earnings

 Management  Competition edge
 Corporate Governance  Financial leverage
 Corporate culture  Operational Leverage
 Production efficiency

Value of the shares

Factors that affect the value of a company’s shares

QUALITATIVE FACTORS
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The qualitative factors that affect the value of a company’s shares are discussed as follows:
1. Business Model
The business model describes the way in which a company makes money. A business model may
be simple or very complex. Even before making a financial analysis an investor must know what
exactly the company does. This is explained by the business model. It provides a description of
the company’s operations and mode of revenue generation, nature of expenses, organizational
structure and its sales and marketing efforts. A review of the business model reveals the possible
success level of the company. For example, knowing that Tata Motors is in the automobile sector
is not enough for an investor. Tata Motors produces trucks, buses and cars. Further , they
manufacture the world’s cheapest car, namely Tata Nano, which has a place in the Guinness Book
of world Records. Thus, it caters to the car needs of a large segment and the business model
ensures some safety of returns.
2. Management
Good and capable management teams generate profits for investors. The management of a firm
should efficiently plan, organize, actuate, and control the activities of the company. The basic
objective of management is to attain the stated objectives of the company for the good of the
equity holders, the public, and the employees. If the objectives of the company are achieved,
investors will receive a profit. A management team that ignores profits does more harm to
investors than one that over emphasizes it.
Every public limited company provides corporate information on its website. For example www.
Infosys.com, under the heading <Home> , gives the management profile of the company. On the
other hand, www. Wipro.com gives this information under the heading < Wipro leadership
team> .Despite these differences, they both give a brief profile of each executive such as his
employment history, educational background, achievement and awards. All the positive aspects
are detailed. For a more critical analysis the investor has to look for other sources.
Sources of Management Analysis
There are many sources for management analyses such as the following
a. Conference calls
Quarterly conference calls are generally hosted by the chief executive officer (CEO) and chief
financial officer (CFO) and sometimes involve other executives. In the first part of the call,
the host reads the financial results of the company. the next part consists of a question and
answer session. This session is of importance to the investor. In this session, the analyst can
ask direct questions to the management. Answer may reveal facts regarding the company. The
investor should listen carefully for truthfulness. Avoiding questions or giving evasive answers
may indicate problem areas.
b. Management discussion and analysis
The company annual report begins with a section called Management discussion and analysis
(MD&A). in theory, it is assumed that MB&A is a frank commentary on the outlook of the
management. It contains the overview, financial overview, business overview, etc. The
overview shows the company’s business model, alliances, joint ventures and judgment
regarding disputes. Sometimes the content is revealing and at other times it may be just
standard and routine.
An investor can compare the promises and accomplishments of the company. They can find
out the gaps between the stated and implemented strategies. If any mention of a switch
between net income and gross income has been made in the statement, the investor must read
it carefully because this can affect the amount of EPS. Analysing the previous five years of
MB&A can explain the outlook of the management.

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 c. Management ownership of the equity stock
If the management team owns stock of the company, it shows that the management has
confidence in their own venture. It indicates that they have invested in the company’s future
success. The team’s interests tend to coincide with the shareholder’s interests. It is said that if
the management team owns 10 per cent of the equity stock or more, the company is likely to
perform better and more efficiently than its competitor.
The investor has to be cautious when the management team sells its stock, unless it is being
considered as a short-selling opportunity. Technical analysts show the purchase and sale of
shares by the management team with the help of flags in the stock charts. Such activity reveals
the attitude of the management towards the company.
3. Corporate Governance
Corporate governance refers to the set of systems and practices put in place by a company to
ensure accountability, transparency and fairness in dealings to safeguards the interests of the
stakeholders. A stakeholder include everyone from members of the board of directors,
management and shareholders to customers, employees and society. The system and practices are
defined and determined in the company charter and by-laws as well as in corporate laws and
regulations. Corporate governance is needed for the following reasons:
 To provide the framework for the creation of long-term trust between the company and the
stakeholders
 To encourage induction of independent directors with rich experience and innovative
ideas.
 To enable the management to monitor and face risk
 To facilitate a careful decision-making process and reduce the liability of top management
and directors
 To ensure that proper checks and balances are in place to prevent non-ethical and illegal
activities in company management.
Areas of corporate governance
Corporate governance typically covers the following areas:
 Structure of the board of directors
 Financial and information transparency
 Stakeholder rights
 Corporate culture

4. Corporate Culture
Corporate culture refers to the collective beliefs, value systems and processes of a company.
It gives a company a unique entity. Every company has a set of values and goals that helps
to define what the business is all about. The basis of corporate culture is usually expressed
in terms of the policies and procedures adopted in the company’s functioning. A strong
corporate culture that enables adaptation to a changing market leads to strong financial
results. A corporate culture that values employees, customers and owners and encourages,
leadership from everyone in the company is bound to perform well. If the customer needs
change, a firm’s corporate culture changes its practices to meet these new needs.

QUANTITATIVE FACTORS
The quantitative factors that affect the value of a company’s shares are as follows:
1. Earnings of the Company
The earnings of a company decide its stock value in the market. The company pays dividends
from its earnings. Growing earnings result in high valuation of the stock. Sometimes, the
prices of a stock may be high but not the earnings. This is because the market anticipates a
future rise in the earnings of the company. In simple terms, earnings are the operating profits
of a company. The income for a company is generated through operating sources and non-
operating sources. The sources of operating income vary from industry to industry. For the
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 service industry no tangible product is involved and income is generated through the sale of
services. Take the case of commercial bank; its income is the interest on loans and
investments. Interest income is referred to as the operating income. But in the case of
industries producing tangible goods, earnings arise from the sale of goods.
A company may derive revenue from sources other than sales. The non-operating income may
be generated from interest from bonds, rentals from lease, dividends from securities, and sale
of assets. The investor should analyze the income source diligently to know whether it is from
the sale of assets or from the investments. Sometimes, earning per share may seem to be
attractive in a particular year but in actual case the revenue generated through sales may be
comparatively lower than in the previous year. The earnings might have been generated
through the sale of assets. An investor should be aware that the income of the company may
vary due to the following reasons:
 Changes in sales
 Change in costs
 Depreciation method adopted
 Depletion of resources in the case of oil, mining, forest products, gas, etc.
 Inventory accounting method
 Replacement cost of inventories
 Wages, salaries and fringe benefits
 Income tax and other taxes.
Measurement of Earnings
A company’s earnings are measured as follows:
Gross Profit = Sales – cost of goods sold
EBITDA (Earning before interest, taxes, depreciation and amortization)
= Gross profit – operating expenses
EBIT (earnings before interest and tax) = EBITDA – (depreciation and amortization)
EAT (earnings after tax) = EBIT –tax
Net income decide the cash flow and is if primary concern to an investor because it shows the health of a
company.
Earnings per share
Earnings give an overall picture of the financial performance of a company. Yet for a comparative
analysis, it may be misleading. Take for instance, the earnings of Omega and Vega companies. Omega
has Rs 200 million and Vega has Rs 150 million in earnings, employing the same amount of capital.
Omega’s earnings are greater than that of Vega. Should we conclude that Omega is doing better than
Vega? This is incorrect from the point of view of the investor, because the number of outstanding shares
may be different for the two companies. If the number of outstanding shares is 100 million for Omega
and 60 million for Vega, the Vega shares reward the investor more than the Omega shares (Omega EPS =
200/100 =2; Vega EPS = 150/60 = 2.5).
Earnings per share (EPS) are calculated as the earnings after tax divided by the number of common
shares outstanding.

Net Income – Dividends on Preferred Stocks

EPS = -----------------------------------------------------------
Average Outstanding Share

For accuracy, the average outstanding shares is used. It is a weighted average number of shares
outstanding over the reporting period. The number of shares may change in any part of the accounting
period. The company may issue new shares or conversion of warranty or debenture into equity may

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happen. Sometimes, equity shares may be reduced through buyback. Factors that affect the number of
outstanding shares are listed below.
 Stock options
 Conversion of warrants
 Convertible preferred stock
 Secondary equity offerings
 Bonus and right issue to existing shareholders

This requires additional calculations. For example, Omega Company has 10 lakh outstanding common
shares for eight months and has 12 lakh outstanding shares for the remaining four months due to a follow
on offer. The weight for 10,00,000 shares would be 8/ 12 (0.77) and the weight for 12,00,000 shares
would be 4/12 (0.33).
The weighted average of outstanding shares for Omega
= (0.77 x 10) + (0.33 x 12) = 7.7 + 3.96 = 11.66 lakh
2. Competitive Edge
Major industries in India are composed of hundreds of individual companies. In the information
technology industry, even though the number of companies is large, a few companies like TCS,
Infosys and Wipro (IT), control the major market share. Likewise in other industries, where some
companies rise to a position of eminence and dominance. The large companies are successful in
meeting the competition. Once companies attain a leadership position in the market, they seldom
lose it. Over time, they prove their ability to withstand the competition and retain a sizeable share of
the market. The competitiveness of a company can be assessed by looking at the following aspects:
 Market share
 Growth of annual sales
 Stability of annual sales
The market share: The market share of the annual sales helps to determine a company’s relative
competitive position within the industry. If the market share is high, the company would be able to meet
the competition successfully. In the information technology industry, NIIT and Tata InfoTech topped the
list in terms of sales in 1997. While analyzing the market share, the size of the company also should be
considered because the smaller companies may find it difficult to survive in the future. The leading
companies of today’s market will continue to lead at least in the near future. The companies in the market
should be compared with like product groups otherwise, the results will be misleading. A software
company should be compared with other software companies to select the best in that industry.
Growth of sales: The Company may be a leading company, but if the growth in sales is comparatively
lower than another company, it indicates the possibility of the company losing the leadership. The rapid
growth in sales would keep the shareholder in a better position than one with the stagnant growth rate.
The company of large size with inadequate growth in sales will not be preferred by the investors. Growth
in sales is usually followed by the growth in profits. Investor generally prefers size and the growth in
sales because the large size companies may be able to withstand the business cycle rather than the
company of similar size.
The growth in sales of the company is analysed both in rupee terms and in physical terms. Physical term
is very essential because it shows the growth in real terms. The rupee term is affected by the inflation.
Companies with diversified sales are compared I rupee terms and percentage of growth over time.
Stability of sales: If a firm has stable sales revenue, other things being remaining constant, will have
more stable earnings. Wide variation in sales leads to variations in capacity utilization, financial planning
and dividend. Periodically all the financial newspapers provide information about the market share of
different companies in an industry. The fall in the market share indicates the declining trend of the
company, even if the sales are stable in absolute terms. Hence the stability of sales also should be
compared with its market share and the competitors’ market shares.

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Sales forecast: The Company may be in a superior position commanding more sales both in monetary
terms and physical terms but the investor should have an idea whether it will continue in future or not.
For this purpose, forecast of sales has to be done. He can forecast the sales in different ways.
1. The investor can fit a trend line either linear or non linear whichever is suitable.
2. Historical percentage of company sales to the industry sales can be analyzed. Even simple least
square technique could be used to find out the function C s = f (Is) i.e. C s – Company sales;
I=Industry sales,
3. The sales growth can be compared with the macro economic variables like gross domestic
product, per capita income and population growth
4. The different components of demand for the company’s product have to be analyzed because the
demand may arise from different sources. For some product the demand may be from the consumers as
well as from the industries. For example, steel and petroleum products are demanded by consumers and
industries.
5. The demand for the substitute and competitors’ product also should using least square techniques.

3.FINANCIAL LEVERAGE
The degree of utilization of borrowed money in a business is known as financial leverage. This
depends on the financing decisions of the company. These decisions involve the selection of the
appropriate financing mix and deciding the capital structure or leverage. Capital structure refers to the
proportion of long-term debt capital and equity capital in the company. The long-term debt capital
includes bonds, debentures, etc., and preference share capital. A fixed rate of interest has to be paid for
long-term debt capital and payment is obligatory. A high degree of financial leverage (high usage of debt
capital) results in high interest payments. This will affect the bottom-line earnings per share negatively.
As a company increases debt and preferred equities, interest payment increase. This reduces the EPS and
increases the risk of stock returns.
The leverage effect of debt is highly advantageous to equity holders during a boom because the positive
side of the leverage effect increases the earnings of shareholders. At the same time, during a recession the
leverage effect induces instability in earnings per share and can lead to bankruptcy. Hence, it is important
to limit the debt component of the capital and keep it to a reasonable level. The limit depends on the
firm’s earning capacity and its fixed assets.

Earnings limit of debt

The earnings determine whether the debt is excessive or not. The earnings indicate the probability of
insolvency. The ratio used to find the limit of the debt is the interest coverage ratio, i.e., the ratio of net
income after taxes to interest paid on debt. The ratio shows the firm’s ability to pay the interest charges
and the number of times interest is covered by earnings.
Asset limit to debt
This asset limit is found out by looking at the fixed assets to debt ratio. The financing of fixed assets by
debt should be within a reasonable limit. For industrial units, the recommended ratio is below 0.5
Degree of financial Leverage
According to Brigham in 1995, the degree of financial leverage (DFL) is the percentage change on
earnings per share (EPS) that results from a given percentage change in earnings before interest and taxes
(EBIT).
Percentage change in EPS
DFL = ---------------------------------
Percentage change in EBIT

Or it can be calculated with the following formula

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 EBIT
DFL = --------------------
EBIT – Interest

If the DFL is 1.58, it means that a 100 per cent increase in EBIT with result in a 1.58 per cent increase in
earnings per share.
4. OPERATING LEVERAGE
If a firm’s fixed costs are major portion of total costs, the firm is said to have a high degree of
operating leverage. Leverage means the use of a lever to raise a heavy object with little force. A
high degree of operating leverage implies that, other factors being constant, a relatively small
change in sales results in a large change in return on equity. This can be explained with the help
of the following example.
Let us take firms A and B. Firm A has a relatively small amount of fixed charges, say, Rs 40,000.
It also does not have much automated equipment, so its depreciation and maintenance costs are
low. The variable cost percentage is higher than it would be if the firm used more automated
equipment.
In the other case, firm B has high fixed costs of Rs 120,000. Here the firm uses automated
equipment to a much larger extent. The break-even occurs at 40,000 units in firm A and at 60,000
units in firm B. The selling price (P) is Rs 4; the variable cost is Rs 3 fir Firm a and Rs 2 for firm
B per unit.
The break even occurs when the return on equity (ROE) = 0 and hence EBIT =0.
EBIT = 0 = PQ –VQ – F
Here P is the average sales price per unit of output, Q is units of outputs, v is the variable cost per
unit and F is the fixed operating costs. The break-even quantity is

F
---------
P - V

For Firms a and B this is:

Rs 40,000
A = -------------------- = 40,000 units
Rs 4 -Rs 3

Rs 120,000
B = ------------------- = 60,000 units
Rs 4 -Rs 2

To a large extent, operating leverage is determined by technology. For example, telephone

companies, iron and steel companies, and electric utilities have heavy investments in fixed assets
leading to high fixed costs and operating leverage. On the other hand, cosmetic companies and
consumer goods companies may need significantly lower fixed costs, and hence lower operating
leverage.
The investor should understand the operating leverage of the firm because the firm with high
operating leverage is affected significantly by the cyclical decline. The operating efficiency of the
firm determines the profit expectations of the company.

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 5. Production Efficiency
Production efficiency means producing the maximum output at minimum cost per unit of output.
This efficiency measures how well the production or transformation process is performing.
Increasing efficiency boosts the capacity of a business, without any change in the number of
inputs employed. All businesses should try to operate efficiently. However, this is particularly
important for a growing business. To withstand the competition, a business must be at least as
efficient as its main competitors to survive successfully in the long run. Efficient production
efficiency enables the firm to produce goods at a lower cost than competitors and generate more
profit possibly at lower prices. An expanding company that maintains high operating efficiency
with a low break-even point earns more than the company with a high break-even point. This
ultimately benefits the investor in the form of high earnings per share. Thus, an increase in
production efficiency results in the following:
 Increase in profitability
 Low operational costs
 Optimum use of company resources
 Enhanced competitiveness and market share
 Superior return to the investor

Productivity
Efficiency of the inputs is measured in terms of their productivity. In simple terms, productivity measures
the relationship between inputs and outputs in a company. For example, labour productivity is measured
in terms of the output produced or services rendered by them. Productivity of the employee or labour can
be measured by output per hour/ day/ week. Productivity of the employees should be given importance.
Upgrading the skills of employees improves productivity. Providing relevant, role-specific training to
employees enhances company productivity. Investments made in management development can yield
potentially high productivity and output returns for firms.
Unit costs
The cost per unit is the total cost divided by the total number of units produced. Cost per unit should be
kept at a possible minimum level. A falling ratio is a reflection of improving efficiency.
Stock levels
Inventory level of finished goods should be able to satisfy the demand projected by the marketing
department and be based on what the production department thinks it can produce. If the stock level falls
below the expected level, it shows that productive efficiency has suffered. At the same time, keeping too
much inventory will result in locked up finance.
Capacity utilization
Utilizing inputs of production to its maximum capacity improves the operational efficiency and earnings
of the company. Management should keep track to see if resources are not in constant use in business. It
has to find out whether employees have adequate work to turn out, and equipment are fully utilized. The
presence of unutilized resources indicates operative inefficiency.
MODE OF ANALYSIS
In the past, investors relied greatly on the annual earnings per share and return on equity to measure the
performance of the company. But now, investors are aware that these measures alone do not reflect the
value of a company’s share. Earnings do not reflect changes in risk and inflation. Further, they do take
account of additional cost of capital invested in the business in the growth process. Hence. Alternative
methods are used to assess the performance of the company. Yet, financial analysis is the most common
analysis the investor carries out.

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FINANCIAL ANALYSIS
The best source of financial information about a company is its own financial statement. This is a primary
source of information for evaluating the investment prospects in the particular company’s stock.
Financial statement analysis is the study of a company’s financial statement from various viewpoints. The
statement gives the historical and current information about the company’s operations. Historical
financial statement helps to predict the future. The current information aids to analyze the present status
of the company. The two main statements used in the analysis are:
 Balance sheet
 Profit and loss account.
Analysis of Financial Statements
The analysis of financial statements reveals the nature of relationship between income and expenditure,
and the sources and application of funds. The investor determines the financial position and the progress
of the company through analysis. The investor is interested in the yield and safety of his capital. He cares
much about the profitability and the management’s policy regarding the dividend. Towards this end, he
can use the following simple analysis:
 Comparative financial statements
 Trend analysis
 Common size statement
 Fund flow analysis
 Cash flow analysis
 Ratio analysis
Comparative financial statement: In the comparative statement balance sheet figures are provided for
more than one year. The comparative financial statement provides time perspective to the balance sheet
figures. The annual data are compared with similar data of previous years, either in absolute terms or in
percentages.
Trend analysis: Here percentages are calculated with a base year. This would provide insight into the
growth or decline of the sale or profit over the years. Sometimes sales may be increasing continuously,
and the inventories may also be rising. This would indicate the loss of market share of the particular
company’s product. Likewise sales may have an increasing trend but profits may remain the same. Here
the investor has to look into the cost and management efficiency of the company.
Common size statement: Common size balance sheet shows the percentage of each asset item to the total
assets and each liability item to the total liabilities. Similarly, a common size income statement shows
each item of expense as a percentage of net sales. With common size statements comparison can be made
between two different size firms belonging to the same industry. For a same company over the years
common size statement can be prepared.
Fund Flow analysis: The balance sheet gives a static picture of the company’s position on a particular
date. It does not reveal the changes that have occurred in the financial position of the unit over a period of
time. The investor should know,
a. How are profits utilized?
b. Financial source of dividend
c. Source of finance for capital expenditures
d. Source of finance for repayment of debt
e. The destiny of the sale proceeds of the fixed assets and
f. Use of the proceeds of the share or debenture issue or fixed deposits raised from public.
These items of information are provided in the funds flow statement. It is a statement of the sources and
applications of funds. It highlights the changes in the financial condition of a business enterprise between
two balance sheet dates. The investor could see clearly the amount of funds generated or lost in
operations. He could see how these funds have been divided into three significant uses like taxes,
dividends and reserves. Moreover, the application of long term funds towards the acquisition of current
assets can be found out. This would reveal the real picture of the financial position of the company.
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Cash flow statement: The investor is interested in knowing the cash inflow and outflow of the enterprise.
The cash flow statement is prepared with the help of balance sheet, income statement and some additional
information. It can be either prepared in the vertical form or in the horizontal form. Cash flows related to
operations and other transactions are calculated. The statement shows the causes of changes in cash
balance between two balance sheet dates. With the help of this statement the investor can review the cash
movements 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.
Ratio analysis: Ratio is a relationship between two figures expressed mathematically. Financial ratio
provides numerical relationship between two relevant financial data. Financial ratios are calculated from
the balance sheet and profit and loss account. The relationship can be either expressed as a percent or as a
quotient. Ratio summaries the data for easy understanding, comparison and interpretation. Financial
ratios may be divided into six groups. They are as follows:

 Liquidity Ratios
 Turnover Ratios
 Leverage Ratios
 Profit Margin Ratios
 Return on Investment ratios
 Valuation Ratios

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