UNIT II

LESSON

3
FUNDAMENTAL ANALYSIS
CONTENTS
3.0 Aims and Objectives
3.1 Introduction
3.2 Fundamental Analysis
3.2.1 Fundamental Analysis and Efficient Market
3.2.2 Fundamental Analysis and Chemistry of Earnings
3.3 Economy Analysis
3.3.1 Investment Making Process
3.3.2 Economic Forecasting
3.3.3 Anticipatory Surveys
3.3.4 Barometric or Indian Approach
3.3.5 Geometric Model Building Approach
3.4 Industry Analysis
3.4.1 Importance of Industry Analysis
3.4.2 Classification of Industries
3.4.3 Key Indicators in Analysis
3.4.4 Industry Life-cycle Stages (Product Life Cycle Theory)
3.4.5 Forecasting Methods
3.5 Company Level Analysis
3.5.1 Need for Company Analysis
3.5.2 Framework of Company Analysis
3.5.3 Financial Analysis
3.6 Fundamental Analyst’s Model
3.7 Forecasting Earnings
3.7.1 Identification of Variables
3.7.2 Selecting a Forecasting Method
3.8 Determining Earnings – Multiplier (P/E) Ratio
3.9 Dividend Discount Model of Valuation
3.9.1 Forecasting Earnings per Share
3.9.2 Traditional Methods of Forecasting EPS
Contd...
84
Financial and Investment
3.10 Let us Sum up
Management
3.11 Lesson End Activity
3.12 Keywords
3.13 Questions for Discussion
3.14 Suggested Readings

3.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to:
l Understand the concept of fundamental analysis
l Know about economic and industrial analysis

3.1 INTRODUCTION
Investment decision is a part of our economic life. Everybody takes such decision in
different context at different times. Some are able to reap more profits through them;
while other simply lose their money. Attempted should, therefore, be made to understand
and know the way the sound investment decision can be taken in order to improve the
change of making profit through them. Thus, investment decision making is an important
area probing further.
Unfortunately, for long, investment decision making was regarded only as an act as art is
personal subjective, it was difficult to provide a general frame work with in one could
operate. Only, recently it has considered as science with he result that a body of literature
has been considered as science with the that a body of body has been developed which
help us to understand know the way investment decision can be attempted. Recognizing
its art contest, this body of literature works on the thinking that a system general framework
can be suggested for those involved in investment decision who can then modify according
to there requirements. It has, therefore, been recognized that investment decision-making
is both an art as with science. This is indeed an on-going process in which decision
maker attempts to update himself regarding the return characteristic of securities. These
characteristic keep-on changing and investor go on attempting to under their impact on
his decisions. The conceivable investment opportunities were discussed and explained in
.. Block I. The investment decision maker takes them into account in order to decide
which securities show bought or held or sold by him. A very simple decision rule is here
applicable : Buy a security that has highest brought or held or sold by him. A very simple
decision rule is here applicable. Buy a security that the above required per unit of risk or
lowest risk per unit or return. And, sell the security, which does not satisfy the above
required.
The above decision rule to buy/sell securities is highly simple but it is very difficult to
apply both risk and return fashion in actual practice. This is because they are a large
number of factors which affects both risk and return the real world situation. Thus,
security, which had highest, return per unit of risk at one point of time and considered to
be a good buy. Might turn into a less attractive proposition and could be considered later
on possible candidate for disinvestment. Such a situation might arise due to change in the
management concerned company or changes in Government policy at economy level
making it less attractive. The open might also be possible. For example, before 1992-93, 85
Fundamental Analysis
the shares of sugar industry in India were not catching attention of investing public. But
due to changes in the government policy towards this industry around 199.. its share
became quite attractive. Policy changes made by the government related to hike in the
sugar per sold both in open market as well as through public distribution system, increase
in the quantity of sugar for sale in the free market etc. Such factors played a very
important role in making the shares of the companies attractive. In addition to the above,
there may be other factors too, that are more specific to a part company.
Investment decision making being continuous in nature should be attempted systematically.
Broadly approaches are suggested in the literature. These are: fundamental analysis and
Technical Analysis. In the approach, the investor attempts to look at fundamental factors
that affect risk return characteristic of the say. While, in the second approach, the investor
tries to identify the price trends which reflect these characteristics technical analysis
concentrates on demand and supply of securities and prevalent trend in share prices
mean by various market indices in the stock market.

3.2 FUNDAMENTAL ANALYSIS

As has been mentioned earlier, in the fundamental approach, attempt is made to analyze
various fundamental or basic factors that affect the risk-return of the securities. Effort,
here, is to identify those securities which perceive to be mispriced in the stock market.
The assumption in this case is that the ‘market price’ of security and the price as justified
by its fundamental factors called ‘intrinsic value’ are different and the … place provides
an opportunity for a discerning investor to detect such discrepancy. The moment such a
description is identified, the decision to invest or disinvest is taken. The decision rule
under this approach is like this,
If the price of a security at the market place is higher than the one, which is justified by
the security fundamentals, sell that security. This is because, it is expected that the
market will sooner or later realize mistake and price the security properly, a deal to sell
this security should be based on its fundamentals, it should be both before the market
correct its mistake by increasing the price of security in question. The price prevailing in
market is called ‘market price’ (MP) and the one justified by its fundamentals is called
‘intrinsic value’ (IV) session rules/Recommendations.
1. If IV > MP, buy the security
2. If IV < MP, sell the security
3. If IV = MP, No Action.
The fundamental factors mentioned above may relate to the economy or industry or
company or all some of this. Thus, economy fundamentals, industry fundamentals and
company fundamentals are considered while prizing the securities for taking investment
decision. In fact the economy-industry-company framework forms integral part of this
approach. This framework can be properly utilized by making suitable adjustments in a
regular context. A world of caution? Please remember, the use of an analytical framework
does not guarantee a act decision. However, it does guarantee an informed and considered
investment decision which would hopefully latter as it based on relevant and crucial
information.
86
Financial and Investment
3.2.1 Fundamental Analysis and Efficient Market
Management
Before elaborating in detail on the economy-industry-company framework, it is pertinent
to mention that .. are expressed about the utility of this approach in the contest of efficient
stock market set up. Briefly the market efficiency relates to the speed with which stock
market incorporates the information about the economy industry and company in the
share prices rather instantaneously. The result of this assumption is that are prevailing at
the market place can be taken to represent the price of the share justified by its
fundamental extrinsic value (IV). This equality of MP and IV makes the fundamental
analysis or any other analysis useless fondant.
The above given view about share market efficiency implies that no one would be able
to make abnormal to given such a set up. Some research studies in the literature also
support the above view. Practitioners, However, do not agree to such conclusions of
empirical nature.
Once again let us be clear at this stage that the truth lies in between these two extreme
positions-denouncing, the analyses as total redundant to the one that would bring us
profits. In fact, stick market is not efficient to extent the researchers proclaim, many
operational inefficiencies and structural deficiencies prevalent in stock .. have been noted
in Block 2. Secondly, analysis still has an important role to play it is paradoxical but fact
to say the one to assume that stock market is inefficient to make efficient. It is only then
the processing information in the prices quickly if not instantaneously. Thirdly, it is fact of
life that earning abnormal profits is the only and final goal for most of the investors.
Rather, it has been observed that earning the normal returns. The return commensurate
with risk prevalent in the market is a worthwhile objective to pursue which most investors
are not even able to achieve. In nutshell, security analysis has an important role to play
for investment can made in an efficient set up, too.

3.2.2 Fundamental Analysis and Chemistry of Earnings

The logic for fundamental analysis becomes crystal clear once we understand the
chemistry of earnings’ and macro and macro factors which influence the future of
earnings. Exhibits 3.1 indicates some of the major form which affect earnings distributable
among equity shareholders.
You would notice from Exhibit 3.1 that while distributable earning is the difference between
sales revenue the costs of sales, interest, depreciations taxes and preference dividend,
these items of revenue and expense in … by company specific, industry level and
macroeconomic factors. This would mean that the intrinsic … a stream of distributable
earnings per share, is in effect influenced by diverse company specific. Industry and
macroeconomic factors. There is, therefore, a strong case for analysis of company
specific, industry of and economy level factors, which in one word is called fundamental
analysis.
 Exhibit 3.1: Factors Affecting Distributable Earnings 87
Fundamental Analysis
Board Company Specific Industry Macro-Economic
Source/form Factors Factors
of Earnings

Sales Competitive strength M Industry Demand/ National income, sp..

Supply savings, Monetary..
Credit, Export-Import…
Policies, Population
Price level.
A
Less Costs Operating Efficiency Industry wage National Wage policy
of sales Levels: Price levels, Economic
Industrial Infrastructure, Raw …
Infrastructure Production.
N Import-Export Policy
Earnings Before
Interest A
Depreciation
& Taxes (EBIDT)
Less Interest Capital Industry Cost of Interest Rates in the
Structure/financial G capital Economy, Capital
Leverage Policy Conditions
Less Operational leverage
Deprecation Policy Industry practices Capital Goods Import
Less Tax Tax Planning and
Management Industry Lobby Fiscal Policy
Net Earnings E
After Tax
(NEAT)
Less M
(Preference Capital Structure Industry Practices Interest Rate
Dividend) Policy Structure, Capital…
Conditions
Distributable E
Earnings
Less N
Equity Dividend Dividend Policy Industry Practices Fiscal Policy., Credit
Capital Market cond…
Retained T
Earnings

Check Your Progress 1

Describe in brief, the role of fundamental analysis in efficient market.

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3.3 ECONOMY ANALYSIS

The analysis of economy, industry and company fundamentals as mentioned above is the
main ingredient of fundamental approach. The analyst should take into account all the
three constituents which from different but special steps in making investment decision.
Theses can be looked at as different stages in the investment decision-making
operationally,. To base the investment decision on various fundamentals, all the three
stages must be taken into account. In this Unit, we will concentrate on economy and
industry analyses while in the next Unit focus on company level analysis.
In actual practice, you must have noticed that investment decision of individuals and the
institute made in the economic set up of a particular country. It becomes essential,
88 therefore, to understand the star economy of that country at macro level. The analysis of
Financial and Investment
Management the state of the economy at macro level incorporate the economy has performed in the
past, how it is performing in the present and how it is expected to perform future. Also
relevant in this context is to know how various sectors of the economy are going to grow
in the economic analysis.

Economy

Industry

Company
Analysis

Figure 3.1

3.3.1 Investment Making Process

Each of the sectors are showing signs of stagnation and degradation in the economy.
This, we can being by bring historical performance of various sectors of the economy in
the past, there performances and then forming the expectation about its performances in
the future. It is through this systematic process, one would be able early various relevant
investment opportunities whenever these arise. Sectoral analysis, therefore, is .. along
with overall economy analysis as the rate of growth in overall economy often differs
from the rate with in various segments/sectors.
Rational of the above type of analysis depends on economic considerations too. The
way people in general that income and the way they spend these earnings would in
ultimate analysis decide which industry or many would grow in the future. Their spending
affect corporate profits, dividends and prices of the shares at the many would grow in
the future. Their spending affect corporate profits, dividends and prices of the shares at
the at place. Research study conducted by King (1966) reinforces the need of economic
and industry analysis of context. According to him on an average, over half the variation
in stock returns are attributed to market price that affect all the market indices. Over
and above this, industry specific factors account fro approximately percent of the variation
of stock returns. Thus taken together two-third of the variation of stock prices/returns
reported to market and industry related factors. Kin’s study, despite the limitations of its
period of … and use of U.S. date etc., highlight the importance of economic and industry
analyses in making investment come. To neglected this analysis while deciding where to
invest would be at one’s peril.
It must be clear by this now that analysis of historical performance of the economy is a
starting point ; albeit, an importent step. But, for the analyst to decide where to invest or
not, expected future performance of the overall only along with its various segments is
most relevant. Thus, all efforts should be made to forecast the economy so that the 89
Fundamental Analysis
decision to invest or to disinvest the securities can be made in the most had manner.
Interestingly this calls for using same of the indicators that describe how the economy
has gone up in the past and how it is likely to take shape in the future from the current
state of affairs. A healthy outlook about the economy goes a long way to boost the
investment climate in general and investment in securities in particular.

3.3.2 Economic Forecasting

Still it will properly understood at this stage that economic forecasting is a must for
making investment decision has been mentioned earlier too, the fortunes of specific
industry and the firm depends upon how the economic book looks like in the future-short
term and long term. Accordingly, forecasting techniques can also be divided and categories:
Short term forecasting techniques in details, these terms should be clearly understood.
Context. Short term refers to a period up to three years. Sometimes, it can also refer to
much shorter period .. as a quarter or a few quarters. Intermediate period refers to a
period of three to five years period. Long term cast refers to the forecast made for more
than five years. This may mean a period of ten years or more. In this .. and the next one,
these terms would be used as described above.
We shall discuss some short-term forecasting techniques in the following:
All the very outset, let it be mentioned that the central theme of economic forecasting is
to forecast national some with its various components. This is because it summarizes the
receipts and expenditures of all segments of the economy, be the government, business
or household. These macro economic accounts describe of economic activities over a
period of time. Not surprisingly, therefore, all the techniques focus on forecast national
income and its various components; particularly, those components that have bearing on
a industry and the particular industry and the company to be analysed.
GNP is a measure to quantity national income and is the total value of the total value of
the final output of goods and produced in the economy. It is an important indicator of the
level and the rate of growth in economic, act is of central concern to analysis for forecasting
overall as well as various component during a certain. Following are some of the techniques
of short-term economic forecasting.

3.3.3 Anticipatory Surveys

This is very simple method through which investors can form their opinion/expectations
with respect future state of the economy. As is generally understood, this is the survey
of expert opinions of those prominent in the government, business, trade and industry.
Generally, it incorporates expert opinion with construction activities, plant and machinery
expenditure, level of inventory etc. which have important to the economic activities.
Anticipatory survey can also incorporate the opinion or future plan of consumer regard
to their spending. As long as people plan and budget their expenditure and implement
their plans act such surveys should provide valuable input as a starting point.
Despite the valuable inputs provided by this method, care must be exercised in using the
information .. trough this method. Precautions are needed because:
1. Survey results cannot be regarded as forecasts per se. A consensus of opinion may
be used investor in forming his own forecasts.
2. There is no guarantee that the intentions surveyed would certainly materialize. To
this extent, they cannot rely solely on these.
90 Despite the above limitations, surveys are very popular in practice and used for short
Financial and Investment
Management term forecast of course, requires continuous monitoring.

3.3.4 Barometric or Indian Approach

In this approach, various types of indicators are studied to find out how the economy is
likely to period future. For meaningful interpretations, these indicators are calcified into:
leading, roughly coincidental indicators.
Leading Indicators: As the name suggests, these are indicators that lead the economic
activity in their outcome. That is, these are those time series data of the variables that
reach their high points as well low points in advance of the economic activity.
Lagging indicator: These are time series data of variables that leg behind in their
consequences visit .. economy. That is, these reach their turning points after economy
has already reached its own.
In developed countries, data relating to various indicators are published at short intervals.
For examples Department of Commerce publishes data regarding various indicators in
each of the following categories:
Leading Indicators
l Average weekly hours of manufacturing production workers
l Average weekly in initial unemployment claims
l Contacts and orders for plant and machinery
l Index of S&P 500 stock prices
l Money supply (M2)
l Change in sensitive material prices
l Change in manufacture’s unfilled orders (durable goods industries)
l Index of consumer expectations.
Coincidental Indicators
l Index of industrial production
l Manufacturing and trade sales
l Employee on non-agricultural payrolls
l Personal income less transfer payment
Lagging Indicators
l Average duration of unemployment
l Ratio of manufacturing and trade inventories to sales
l Average prime rate
l Commercial and industrial loans outstanding.
The above list is not exhaustive. It is only illustrative of various indicators used by investors.
A word of caution not be out of place here as forecasting based solely on leading indicators
is a hazardous business. One can be quite careful in using them. There is always a delay
in it with result that interpretation even if it is not done well in advance. There is always
a delay in it with the result that interpretation even if performed cannot be fruitfully
utilized. Further, problems with regard to their interpretations as well exits. Indicators
under broad category of leading indicators, its various measures may give conflicting 91
Fundamental Analysis
signals in future direction of the economy, the use of diffusion index or composite index
has been suggested. This takes the problem by combining several indicators into one
index in order to measure the strength or weaknesses the problem by combining several
indicators into one index in order to measure the strength or weaknesses government of
a particular kind of indicator. Care has to be exercised even in this case as diffusion
indices without problems either. Apart from the fact that its computations are difficult, it
does not eliminate the governments in the series. Despite these limitations, indicator
approach/diffusion index can be useful tool goods of a skilful forecaster.
Money and Stock Prices: It recognized that money supply in the economy plays a
crucial part in the investment decision. Per rate of change in the money supply in the
economy affect the GNP, corporate profits, interest rates prices. Accordingly, monetarists
argue that total money supply in the economy and its rate of change is important part in
influencing the stock prices as a hedge against inflation, stock prices increases during
some times.

3.3.5 Geometric Model Building Approach

Another approach in determining the precise relationship between with dependent and
the independent of fact, econometrics’ is a discipline where in application of mathematics
and statistical techniques is economic theory. It presupposes the precise and clear
relationship between the dependent and independent the onus of such well defined
relationship with its attendant assumptions rest with the analyst. Thus by geometrics, the
analysis is able to forecast a variable more precisely than by any other approach. But
this derived would be as good as the data inputs used and assumptions made.
Static Model Building or GNP Model Building or Sectoral Analysis is frequently used in
particle and is that methods discussed earlier. It uses national accounting framework in
leave short term forecasts, various steps while using this approach are:
1. Hypothesize the total demand in the economy as measured by its total income
(GNP) based on likely on the country like war, peace, political instability, economic
changes level and rate of inflation etc.
2. Forecast the GNP figure by estimating the levels of its various components like
v Consumption expenditure
v Private cosmetic investment
v Government purchases of goods and services
v Net Exports
3. Forecasting the individual components of GNP, the analysis then adds them up get
a figure of the GNP.
4. The analyst compares total of GNP so arrives with an independently arrived at
priori, forecast of GNP test overall forecast for internal consistency. This is done
to ensure that both his total forecast and permanent forecast make sense and fit
together in a reasonable manner.
5. Thus Opportunistic model building involves all the details described above with a
vast mount of judgment.
6. What was accounted fro this suddenly revived economy? One of the answer is
definitely to cut in customs and a corresponding reduction in excise, which has
helped to reduce the cost structure of a number of products. This has made a
92 number of products cheaper in the domestic market and expanded the demand for
Financial and Investment
Management them in the process.
Future Scenario: What of the future? The scenario could emerge strongly bullish if the
cut in implement in the finished product is accompanied by a cut in the import tariff for
the raw materials as well Besides excise component would have to be lowered as well,
resulting in an expansion of demand with in the … Once this transpires, more goods will
be sold, the recession will history and if installed capacities fall to meeting the demands
we could even have a temporary shortage in certain areas on our hands
Given this scenario, only the stubborn would continue to be bearish. It is the times perhaps
to current shorts on the sensex and place and place all our big chips on the shares of
polyesters companies. Stock polyester, Sanghi Polyester and Haryana petro look cheap
when viewed against projected 1993-94 earnings the festive season round the bend, the
buoyancy in yarn prices is expected to continue giving investors turn around for the first
half of the current financial year.

Check Your Progress 2

Define the following:

1. Leading indicator
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2. Lagging indicator
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3.4 INDUSTRY ANALYSIS

After conducting analysis of the economy and identifying the direction it is likely to take
in the sort. Inter and long term, the analyst must look into various sectors of the economy
in terms of various industry. Industry is a homogenous group of companies. That is,
companies with the similar characteristic can be divided in to one industrial group. There
are many-a-basis on which grouping of companies can be done. For example traditional
classification is generally done product wise like pharmaceutical, cotton textile. Synthetics
fiber etc. Such a classification through useful does not help much in investment decision-
making. Some of the useful basis for classifying industries from the investment decision
point of view are as follows:
Growth Industry: This is the industry which is expected to grow persistently and its
growth is exceed the average growth of the economy.
Cyclical Industry: In this category of the industry, the firms included are those that
move closely rate of industrial growth of the economy and fluctuated cyclically as the
economy fluctuates.
Defensive industry: It is a grouping that includes firms, which move steadily with the
economy and less than the average decline of the economy in a cyclical downturn.
Another useful criterion to classify to classify industries is the various stages of there
development. In with different stages of their life cycle development exhibit different
characteristic. In fact, each development is quite unique. Grouping firms with similar
characteristic of development help investors to properly different investment opportunities 93
Fundamental Analysis
in the companies. Based on the stage in the life cycle, industries classified as follows:
1. Pioneering Stage: This is the first stage in industrial life cycle of a new industry.
Being the first .. technology and its products are relatively new and have not reached
a stage of perfection. Experimental order both in product and technology. However,
there is a demand for its products in the market, the profits opportunities are in
plenty. This is a stage where the venture capitalists take a lot of interest and end
industry and sometimes organize the business. At this stage the risk of man firms
begin out the industry also more, hence, mortality rate is very high in the industry,
with the result that if an industry withstand them being out of the market, the
investors would reap the rewards substantially or else substantial risk of investment
exists. A very pertinent example of this stage of industry in India was leasing
industry, which trying to come-up during mid eighties. There was a mushroom
growth of companies in this period. Hundred companies came into existence. Initially,
lease rental charged by them were very high. But as the completive grew among
firms, lease rentals reduced and came down to a level where it became difficult for
a number companies to survive. This period saw many companies that could not
survive the onslaught of competition of those, which could tolerate this onslaught of
price war, could remain in the industry. Leasing industry today. In much pruned
compared to mid-eighties.
2. Fast Growing Stage: This is the second stage when the chaotic competition and
growth that we hallmark of the first stage is more or less over. Firms that could not
survive this onslaught have already died. The surviving large firms now dominate
the industry. The demand of its product still grow faster in the leading to increasing
amount of profits companies could reap. This is stage where companies grow
order rapidly. These companies provide a good investment opportunity to the
investors. In fact, as the firms during stage of development grow faster, they
sometimes break the records in various areas like payment of divided us becoming
more and more attractive for investment.
3. Security and Stabilization Stage: The third stage where industries grow roughly
at the rate of the economy developed reach a stage of stabilization. Looked at
differently, this is a stage where the ability of the appears to have more or less lost.
As compared to the competitive industries. Rate it is at this industry is facing the
problem of what Grodinsky called “latent obsolescence” a term used to … where
earliest signs of decline have emerged investors have to be very cautions to examine
those sings before it is too late.
4. Relative Decline Stage: The fourth stage of industrial life cycle development is
the relative decline stage. This stage has grown old. New products, new technologies
have come in the market. Customers have ..bits, styles, liking etc. Its products are
not much in demand as was in the earliest stage. Still, an continue to exit for some
more time. Consequently, the industry would grow less than the of the economy
during the best of the times of the economy. But as is expected, the industry such
faster than the decline of the economy in the worst of times.
Characteristic of different stages of life cycle development of industries has a number of
implications and decision. Investment at this stage is quite rewarding. However, for an
investor looking for steady correlated, investment at this stage is quite rewarding. However,
for an investor looking for steady forms with risk aversion, it is suggested that he should
in general avoid investing at this stage. The risk aversion, it is suggested that he should in
general avoid investing at this stage. These nature capitalists. But if he is still keen to
94 invest, he should try to diversify or disperse his investment price the risk. It would be
Financial and Investment
Management quite prudent on this part to look for companies that are in the second date i.e., fast
growth. This probably explains the prevalent higher stock prices of the companies of
this. …
Investment point of view, selection of the industries at the third stage of development is
quite crucial more growth of the industry that is relevant and not its past performance.
There are a number of share the share prices of accompany in declining industry have
been artificially hiked up in the market. On the basis of good record of its performance.
But the fact of the matter is that a company in industry would sooner or later feel the
pinch of its features and an investor investing in companies at the experience reduction
in the value of his investment in due course.
Discussed various investment implications, it may be pointed out that one should be
careful while signification. This is because the above discussion assumes that the investor
would be able to identify from the industrial life cycle. In practice, it is a very difficult
proposition to detect which stage of the industry is at Needless to say, it is only a general
framework that is presented above and he can spangle analysis with suitable modifications.
In order to strengthen the analysis further, it is essential figure features of the industry in
detail. Due to its unique characteristic, unless the specific industry properly and in depth
with regard to these, it will be very difficult to form an opinion for profitable opportunities
1. The competition among domestic and foreign firms both in the domestic and the
foreign markets? How Firms perform there?
2. … types of products are manufactured in this industry? Are these homogenous in
nature or highly?
3. Is the nature and prospect of demand for the industry? Are these homogenous in
nature or highly/….?
4. Is the nature and prospect of demand for the industry? This may also incorporate
the analysis of … markets of its products: Customer-wise and geographical area –
wise, identifying various determinants this type of industry is it :growth, cyclical,
defensive or relative decline industry?

3.4.1 Importance of Industry Analysis

Why should a security analyst do industry analysts?
To answer this question, logically, two arguments are presented:
(i) Firms in each different industry do typically experience similar levels of risk and
similar rates of return. As such industry analysis, can also be useful in knowing
investment worthiness of a firm.
(ii) Mediocre stocks in a growth industry usually outperform the best stocks in a stagnant
industry. This points out the need for knowing not only company prospects but also
industry prospects.
Risk – Return Patterns
Economic theory points out that competitive firms in an industry try to maximize their
profits by adopting fairly similar policies with respect to the following:
1. The labour – capital ratio utilized by each firm
2. Mark ups, profit margins and selling prices
3. Advertising and promotional programmes 95
Fundamental Analysis
4. Research and development expenditures
5. Protective measures of Government.
As such, they have the same risk level as well as rates of return, on an average. Empirical
evidence shown by research done by Fabozzi and Francis supports this argument.
Growth Factor
All industries do not have an equally good or equally bad experiences and expectations,
their fortunes keep on changing. It implies that the past is not a good indicator of the
future – if one looks very far into the future.
This view is well supported by research. Researchers have ranked the performance of
different industries over one period of year then ranked the performance of the same
industries over subsequent periods of years. They compared the ranking and obtained
near zero correlations. It implies that an industry that was good during one period of
time, cannot continue to be good in all periods.
Another observation is every industry passes through four distinct phases of the life
cycle. The stages may be termed as pioneering, expansion, stagnation and decline.
Different industries may be in different stages. Consequently their prospects vary. As
such separate industry analysis is essential.

3.4.2 Classification of Industries

There are different ways of classifying industrial enterprises.
1. Classification by Reporting Agencies: In India, Reserve bank of India has
classified industries into 32 groups. Stock exchange has made a broad classification
of industry into 10 groups.
Business media have their own classification. The Economic Times classifies into
10 groups and the Financial Express into 19 groups. The groups are further sub-
divided.
2. Classification by Business Cycle: The general classification in this framework is
growth, cyclical, defensive and cyclical-growth. Growth industries are characterized
by high rates of earnings expansion, often independent of business cycle. These
industries are pioneers of a major change in the state of the art i.e., innovation
diffusing concerns. In the ongoing revolution in electronics industry, communications
equipments is an example of this kind.
Cyclical industries are closely related to business cycle. Prosperity provides consumer
purchasing power and boom to industry whereas depression adversely affects them.
Consumer durables are subject to this kind of changes.
Defensive industries are those the products of which have relatively inelastic demand.
Food processing industry is an example.
Cyclical growth industries are those which are influenced greatly by technological and
economic changes. Airline industry can be cited as an example.

3.4.3 Key Indicators in Analysis

The analyst is free to choose his or her own indicators for analyzing the prospects of an
industry. However, the following indicators are commonly adopted by many.
96 A. Performance factors like
Financial and Investment
Management v Past sales
v Past earnings
B. Environment factors like
v Attitude of government
v Labour conditions
v Competitive conditions
v Technological progress
C. Outcome factors like
v Industry share prices
v Price earnings multiples
v With reference to these key factors, evaluations shall be done to identify
v Strengths and weaknesses
v Opportunities and threats
Some relevant questions which may be asked in this connection are given here. They
are only illustrative and not exhaustive.
1. Are the sales of industry growing in relation to the growth in Gross National Product
(GNP)?
2. What is overall return on investment (ROI)?
3. What is the cost structure of the industry?
4. Is the industry in a stable position? Does the success or failure of the industry
depend upon any single critical factor?
5. What is the impact of taxation non the industry?
6. Are there any statutory controls in matters of raw materials allotment, prices,
distribution etc.? Are they protective or crippling?
7. What is the industrial relations scenario of the industry?
8. Is the industry highly competitive? Is it dominated by one or two major companies?
Are they Indian or foreign? Is there sufficient export potential? Are international
prices comparable to domestic prices?
9. Is the industry highly technology – based? At what pace technological advancements
are taking place?
10. How does the stock market evaluated the industry?
How are the leading scrips in the industry evaluated by the stock market?
Analytical Frameworks: We have identified various factors and questions relating to
industry analysis. Now, we shall consider the frameworks within which the analysis may
be carried out.
3.4.4 Industry Life-cycle Stages (Product Life Cycle Theory) 97
Fundamental Analysis
Every industry passes through different stages in its life time. The stages can be identified
as follows:
l Pioneering Stage (Introduction)
l Expansion Stage (Growth)
l Stagnation Stage (Maturity)
l Decay Stage (Decline)
l Pioneering Stage: This stage is characterized by introduction of a new product,
and an uptrend in business cycle which encourages new product introductions.
Demand keeps on growing, at an increasing rate Competition is generated by the
entry of new firms to grab the market opportunities. Weaker firms face premature
death while stronger one survive to grow and expand.

Figure 3.2
Table 3.1: Characteristics

Sales Low Sales Rapidly rising Peak sales Declining sales

Costs High cost per Average cost Low cost per Low cost per
Customer Customer Customer
Profits Negative Rising Profits High Profits Declining profits
Customers Innovators Early adopters Middle majority Laggards
Customers Innovators Early adopters Middle majority Laggards
Competitors Few Growing Stable number Declining
Number Beginning to number
Decline

Sources: This table was assembled by Philip Kotler from several sources. Chester R Wasson.
‘Dynamic competitive Strategy and Product Life Cycle’ (Austin, Tex : Austin Press, 1978); John A
Weber, ‘Planning Corporate Growth with Inverted Product Ltd of the Product Life Cycle’, Quarterly
Review of Marketing. Summer 1976, pp. 1-6.
l Expansion Stage: This is characterized by the hectic activity of firm surviving
from the pioneering stage. After overcoming the teething problems, the firms
continue to improve financially and competitively. The market continues to grow
but slowly offering steady and slow growth to sales of industry. It is a phase of
consolidation wherein companies establish durable policies relating to dividends
and investments.
l Stabilization Stage: This stage shows signs of slow progress and also prospects
of decay. The stagnation in economy and pedestrian nature of the product call for
innovative strategies to begin a new life cycle. This transition from rising to crawling
age is explained by Grodinsky with reference to latent obsolescence.
“Latent obsolescence – while an industry is still expanding economic and financial
infection may develop. Though its future is promising, seeds of decay may have
already been planted. These seeds may not germinate, the latent decay becomes
98 real. These seeds may be described as “Latent obsolescence”, because they may
Financial and Investment
Management not become active, and they are the earliest signs of decline. Such factors must be
examined and interpreted by the investor”.
Symptoms of latent obsolescence include changing social habits. High labour costs,
changes in technology, stationary demand.
l Decay Stage: Industry reaches this stage when it fails to defect the death signal
and implement proactively or reactively appropriate strategies. Obsolescence
manifests effecting a decline in sales, profit, dividends, and share prices.
Implications to the Investor
This approach is useful to analyst as it gives insights not apparent merits and demerits of
investments in a given industry at a given time. What he investor has to do is:
(i) Collect relevant data to identify the industry life cycle stage
(ii) Forecast the probable life period of the stage
(iii) Decide whether to buy, hold or sell.
Figure 3.2 shows the diagrammatic presentation along with the indicators of each stage.
Although, industry life cycle theory appears to be very simple. It is no so in practice.
Proper identification of the life cycle stage is difficult. Temporary set backs or upheavals
may confuse the analyst. Further, how long the stage continues is difficult to predict.
The internal analysis can be done periodically to evaluate strengths and weaknesses
either by inside company executives or outside consultants. This can be done by using a
form such as the one shown in Table 3.2. Each factor, minor weakness or major weakness.
Of course not all factors are equally important for succeeding in business. Therefore, it
is necessary to rate the importance of each factor – high, medium or low. When combining
performance and importance levels. Four possibilities emerge. These are illustrated in
Figure 3.3.
Performance
Low High
High A. Concentrate Here B. Keeping the good
work
Importance
Low C. Take enough Care D. If overkill divert

Figure 3.3: Importance – Performance Matrix

This analysis provides norms for management attention. For example, An industry is
performing poorly in a high priority area. It should hence concentrate here. If the industry
strategy is not addresses to this it becomes unattractive to the investor.
Table 3.2: Strengths Weaknesses Analysis
S.No. Factor Performance Importance
Major Minor Neutral Minor Major High Medium

Marketing
1. Popularity and regard
2. Relative market share
3. Quality image
4. Service reputation
5. Distribution costs

Contd...
 6. Sales force 99
Fundamental Analysis
7. Market locations

Finance

1. Cost of Capital

2. Funds availability

3. Financial stability

4. Profitability

Manufacturing

1. Facilities

2. Economics of scale

3. Capacity utilization

4. Labour productivity

5. Manufacturing costs

6. Raw material availability

7. Technology of process

Human Resources

1. Leadership

2. Management capabilities

3. Worker attitudes

4. Entrepreneurial competence

5. Skill development

6. Structural flexibility

7. Adaptation

8. Industrial Relations

3.4.5 Forecasting Methods

The techniques for analyzing information about industry within a time framework are
briefly explained in this section.
The market profile: A market profile consists of those endogenous characteristics
which have a significant bearing on demand or the way in which it can be developed.
The basic elements of it are:
l Number of establishments
l Geographical location of establishment
l Number of employees
l Value of sales
l Value added by manufacturing
l Capital expenditures
l Degree to which establishments are specialized
100 l Importance of their output in the national total
Financial and Investment
Management The trend of these elements when analysed reveal vital information about the position
and progress of the industry. Illustratively some lead points are given here.
l A decrease in number of establishments and employment accompanied by an increase
in the other elements of the profile means increased automation.
l An increase in value of sales, unaccompanied by an increase in value added and
capital expenditure signifies rising prices.
l An increase in value added without an increase in capital expenditure signifies
increase in labour productivity.
l A fall in the share of industry in national total implies decline of industry.
Cumulative Methods
These are based either on market surveys or statistical measurements,
(a) Surveys: Surveys are carried out by Research agencies, consultants, industry
association and research bureau of media. The surveys generally study the current
facilities and demand, future demand and proposed investment, and thereby the
expansion prospects vis-à-vis demand gap. Other factors like, strengths &
weaknesses of organization, environmental forces are also brought focus to evaluate
the future of industry.
Survey adopt the methodology of inquiry, through questionnaires and interviews.
The subjects will be either manufacturer or dealers/end users.
(b) Correlation and Regression Analysis: Statistical methods like correlation and
regression analysis can be of much help in demand measurement. The following
steps have general application:
(i) Determine the total requirement for the type of product in question by present
customers in each industry classification.
This can be done by asking the customer or getting the estimate form the
salesmen. Or by comparing with other customers of same size and class.
(ii) Correlation product requirement of customer establishments with a variable
to output for which accurate published data are available. Generally,
employment is the most useful variable.
The correlation can be observed by preparing a scatter diagram or calculating
mathematically using the formula given below.
n ∑ (xy) − (Σx)(Σy )
Degree of relationship (r) =
[ nΣx 2 − (Σx )2 ][ nΣy 2 − (Σy )2 ]

Where X = Number of employees

Y = Number product items
… observation
The nearer the correlate n coefficient is to +1 or -1, the closer the relationship
of the two variables under study.
The significance of the relationship can be determined using hypothesis testing
procedure.
 (iii) apply the relationship to estimate demand. If the degree of correlation between 101
Fundamental Analysis
purchases of a given product by present customers and their employment
size is considered significant the demand estimation can be done as follows:
t Computing the average number of items purchased per employee and
applying this ratio to total employment.
t Formulating an estimating equation through regression methods.
Σy = na + b Σx
Σxy = a Σx + b Σx2
Where,
(a) equals the number of products purchased when employment is zero.
(b) equals the amount of change in the number of products purchased with
every change in total employment
The latter method is more accurate because it is more sensitive to the
influence of independent variable on dependent variable.
Multiple regression analysis facilitates the study of impact of more than
one independent variable on the dependent variable.
Y = a + b x1 + c x2 + d x3 + e x4 + f x5
Where,
Y = Yearly sales in lakhs of rupees;
x1 = yearly sales (lagged one year) in lakhs of rupees
x2 = yearly advertising expenditure in lakhs of rupees
x3 = a dummy variable
x4 = year
x5 = disposable personal income in lakhs of current rupees
(c) Time Series Analysis: Time series analysis consists of decomposing the original
sales series over a period of time. The elements derived are:
Trend (T): It is the result of basic developments in population, capital formation,
and technology. It is found by fitting a straight or curved line through past sales.
Cycle (C): It captures the wave-like movement of sales. Many sales are affected
by swings in general economic activity, which tends to be somewhat periodic. The
cyclical component can be useful in intermediate range forecasting.
Season (S): It refers to a consistent pattern of sales movements within the year.
The term season describes any recurrent sales pattern. The seasonal component
may be related to weather factors, holidays, and trade customs. The seasonal
pattern provides a norm for forecasting short range sales.
Erratic Events (E): It refers to the unpredictable sales caused by unforeseen
events like strikes, riots, war scares, floods, and other disturbances.
Another time series technique is exponential smoothing. For industrial with several
items in product line, this technique is useful to product efficient and economical
short-run forecasts. It requires only three pieces of information.
l This period’s actual sales (Qt)
102 l This period’s smoothed sales (Qt)
Financial and Investment
Management l A smoothing parameter (a), where
Sales forecast for next period (Qt+1) = Qt + (1-a)Qt
The initial level of smoothed sales can simply be the average sales for the last few
periods. The smoothing constant is derived by trial and error testing of different
smoothing constants between zero and one, to find the constant that produces the
best fit of past sales.

Check Your Progress 3

What are the different stages of industry life cycle?

........................................................................................................................................
........................................................................................................................................

3.5 COMPANY LEVEL ANALYSIS

3.5.1 Need for Company Analysis
We have discussed the relevance of economy and industry analysis and how conducted.
In this unit, we will discussed in the company level analyses. In order to provide a proper
person this analysis, let us begin by discussing the way investor takes the investment
decision given his goal maximization. For earning profits, investors apply a simple and
common sense decision rule. That is maximization. For earning profits, investors apply a
simple and common sense decision rule. That is,
l Buy the share at a low price
l Sell the share at a high price
The above decision rule is very simple to understand but difficult to apply in actual
practice. Did efforts are generally made to operationalise it by using proper formal and
analytical framework? To begin problems faced by the investor are: how to find out
whether the price of a company’s share is high or low benchmark to use to compare the
price of the share? The first question becomes easier of some benefits agreed upon with
which the prevailing market price can be compared. Fundamental analysis in fact investor
in this respect by providing a benchmark in terms of intrinsic value. This value is dependent
upon industry and company fundamentals. Out of these three. Company level analysis
provides a direct link investor’s action and his investment goal in operational terms. This
is because an investor buys the equal of company ad not that of industry and economy
framework indeed provides him with proper background which he buys the shares of a
particular company. This setting. A careful examination of the company quantitative and
qualitative fundamentals is, therefore, very essential. As Fischer and Jordan have apply
in which he might invest. If the economic outlook suggests purchase at the time, the
economic analysis of the industry analysis will aid the investor selecting their proper
industry in which to invest. Nonetheless when to invest and in which industry is not
enough. It is also necessary to know which companies industries should be selected”.
The real test of an analyst’s competence lies in his ability to see not only the forest but
also the trees. Superior judgment is an outcome intelligence, synthesis and inference
drawing. It is why, besides economic analysis and industry analysis, individual company
analysis is important.
3.5.2 Framework of Company Analysis 103
Fundamental Analysis
The two major components of company analysis are:
(i) Financial and (ii) Non-financial. A good analyst gives proper weight age to both these
aspects and tries to make an appropriate judgment. In the process of evaluating the
investment worthiness of a company securities, the analyst will be concerned with two
broad categories information: (i) internal and (ii) external. Internal information consists
the data and events relating to the enterprise as publicized by it. Extend information
comprises the reports and analyses made by sources outside the company viz., media
and research agencies.

3.5.3 Financial Analysis

Financial analysts interested in making investments in equality shares of a company will
be concerned with the prospects of rise in value of the firm.
Asset Value vs Earnings Value
The asset value of a security is determined by estimating the liquidating value of the firm,
deducting the claims of firm’s creditors and allocating the remaining net asset value of
the firm over the outstanding shares of stock. The asset value is usually estimated by
consultation with.
A Specialist who appraises asset values and /or
An accountant who gives book value of the firm
This method is suitable only for companies heading towards bankruptcy. For them, the
firm’s income and dividends will be declining and discontinuous. Hence, they will have
negligible value. On the other hand, for going concerns, the intrinsic value far exceeds
the value of the firm’s physical assets. There is a definite lack of relationship between
book value and real value, in the case of prosperous firms.
Therefore, investment analysis focus their attention on the trends of earnings and the
related factors like dividends, bonus issues, rights shares, and appreciation of the market
value of the share. It is believed that the appropriate indices for a company’s performance
are market price per share (MPS) and earnings per share (EPS).

3.6 FUNDAMENTAL ANALYST’S MODEL

The true economic value or intrinsic value of a share of common stock. Like the value of
bond or other asset equal the present value of all cash flows from the asset.
∞ d
it
P = ∑
iO t =1 (1 + k ) t
t
t
∞ d 0 (1 = g t )
= ∑
t =1 (1 + k t ) t
d
= il
k−g
Where Pio = Value of share i
Dit = dividends of share I in the t period
K1 = equity capitalization rate
Git = Growth rate of dividends of share I (a constant)
104 This value is obtained by stock analysts y multiplying the ‘i’ the stock’s normalized earnings
Financial and Investment
Management per share (e) with price-earnings ratio or earnings multiplier (m)
Pio = eio. Mio
Where Pio = Value of share ‘I’
eio = Earning of share ‘c’
mio= Earnings multiplier of share ‘i’
The ratio of dio/eio is known as dividend payout ratio. From the above model it is obvious
that, to determine the appropriate earnings multiplier an analysis must consider the
following:
l The earnings of the security
l The risk of the security
l The growth rate of the dividend stream
l The duration of the expected growth and
l The dividend payout ratio
Earnings Analysis
As seen earlier, to value common stocks or other risky assets the present value model is
employed.
Present value =
Where t = time period
This model gives rise to two questions.
1. How does the investor measure the income from the common stocks?
2. What discount or capitalization rate should be used?
The income question is discussed here
Income Concepts: Accountants and economists have provided two different concepts
of income. Accountant’s income is the revenue over the above all the costs incurred.
Economists define the income of a firm as the maximum amount which can be consumed
by the owners of the firm in any period without decreasing their future consumption
opportunities.
Adjusting for Economic Income: Since Income, which is very important is determining
the value of a security, is vaguely reported by accountants, it is necessary to adjust or
normalize it in a consistent manner.
The economic can be stated as under:
“The economic income from an equity share during a given period equals the maximum
amount of real, physical consumption opportunities which can be withdrawn from the
share during that period without diminishing the consumption opportunities which can be
obtained from it in future periods”.
Illustratively, the key aspects of this definition are presented below:
(1) Real, physical consumption opportunities
It refers to inflation adjusted rupees rather than to inflated rupees
(2) Can be withdrawn
It implies there should be a genuine opportunity to withdraw for consumption. For example, 105
Fundamental Analysis
if a firm must retain some of its earnings to survive, then the earrings do not represent
economic income. The reason is such a withdrawal would diminish consumption
opportunities in future period. “Likewise depreciation cannot be part of economic income,
since it is to be re-invested to maintain asset’s future productivity.”
Ambiguities in Measurement: Table 3.3 shows a model of income statement. Despite
the model’s seeming simplicity, in practice there are many variations and ambiguities. In
most cases, acceptable accounting procedures are determined by the general acceptance
of the practicing accountants. To his dismay one may find on reference to an accounting
text book a multiplicity of generally accepted accounting procedures, which may be used
to many situations. Megin, Johnson and Keller give an excellent description of this pathetic
situation.
“Arriving at an estimate of the periodic income of a business enterprise is perhaps the
foremost objective of the accounting process.” The word estimate is unfortunately, proper
because income is the most elusive concept in the business and economic world. The art
of accounting has not progressed (and never will) to the point where periodic business
income can be measured with certainty?
Fundamental analysts find it necessary to alter significantly the income statements, to
obtain estimates for two reasons:
(i) The accountant has used an accounting procedure which is inappropriate for the
relevant economic transaction, and/or
(ii) The accountant perhaps under the pressure of top management, has adopted a
procedure to minimise the firm’s income taxes or window dress the firm’s financial
statements.
We will now discuss four differences in accounting procedures
These are only illustrative of the controversy in reporting incomes.
Sales – Revenue Recognition Principle: Sales can e either cash sales or credit sales.
Sales can be recognized as early as the date the sale order is signed. However, in the
case of long-term construction contracts the sale may not be recognized until as late as
the day the cash is fully paid Between these two extremes, accountant may choose a
suitable time point to recognize the sales revenue in the financial statements. He may do
it either in an attempt to improve current income or because the has grows confident
about its collect ability. In the case of credit sales. Companies may factor their accounts
receivable and realize cash proceeds. One firm may recognize this immediately whereas
another firm may wait until the customer final cash payment is actually received may
recognize this immediately whereas another firm may wait unit the customer’s final
cash payment is actually received.
Table 3.3: Model of Accounting Income Statement
Sales Sales
Less: Cost of goods sold -COGS
Gross operating margin GM
Less: Selling and administrative expenses and Depreciation -Op.Exp
Earnings before interest and taxes EBIT
Less Interest I
Earnings before taxes EBT
Contd...
106
Financial and Investment Taxes T
Management Earnings after taxes EAT
Less Dividends on preferred stock DP
Net Income for common equity DP
Less: Dividends for common equity DE
Retained Earnings Ret.E

Inventory: Inventory valuation is done based on two methods

FIFO – First in, first out method
LIFO – Last in, first out method
During periods of inflation, the FIFO method tends to result in higher reported profits.
Table 3.4 demonstrated this.
Table 3.4: LIFO and FIFO Methods of Valuation

Item Value (Rs.)

LIFO FIFO

Beginning inventory (1tonne of steel at Rs. 5000) 5000 5000

Plus purchase (2 tonnes of steel at Rs. 8000 per tonne) 16000 16000
Cost of goods available per sale 21000 21000
Less: Ending inventory (1 tonne of steel) 5000 5000
Cost of goods sold 16000 13000

Depreciation: Several depreciation methods may be used in financial statements that a

firm to the public
1. Straight line method
2. Sum-of-digit method
3. Double declining balance method
4. Units of production method
The second and third methods are accelerated methods of deprecation. The second
method may be used to accelerate depreciation during a period of rapid production. To
understand the variations between the straight line method and sun-of-digits method a
numerical example is given here. IT shows that the amount of depreciation is same, only
the timing is altered. Imagine as asset that costs Rs. 1000 with an expected life n = 4
years
By use of straight line method
Depreciation/year = 1000/4 = Rs. 250
By use of sum-of-digit method.
Sum of digit = 1 + 2 + 3 + 4 = 10
Depreciation at the end of 1st year = 1000 × 4/10 = Rs. 400
Depreciation at the end of 2nd year = 1000 × 3/10 = Rs. 300
Depreciation at the end of 3rd year = 1000 × 2/10 = Rs. 200
Depreciation at the end of 4th year = 1000 × 1/10 = Rs. 100
It is clear that, the sum-of-digits method, provides, large amounts depreciation in the 107
Fundamental Analysis
early years of new asset’s life, it thereby decreased profit, income tax, and net accounting
income.
Expending vs Capitalising: Another are of controversy is in realize to some items
which may be viewed either as costs or investments.
Example
Welfare expenditure on employees
Advertising expenditure
R&D outlays
Some financial executives and accountants take advantage of the discretionary leeway
in accounting procedures. They use them at their discretion to manipulate their firm’s
income to suit their current purposes.
Accounting Income Effect on Balance Sheet: A balance sheet is a summary of account
balance carried after the appropriate closing of the books. Income statements deal with
flows, whereas balance sheet deals with stocks. Since stocks are accumulations of
flows, vagaries which undermine the estimates of accounting income are cumulated in
certain sheet items.
For instance, the impact of inflation should be considered to make the balance sheet
items realistic. Measures suggested are:
(a) Assets side:
1. Report marketable securities at current value
2. Inventory should be valued at replacement cost
3. Land and natural resources to be shown at net realizable value (current market
price-future development, selling or interest costs)
4. Plant & machinery at replacement cost
5. Good will
6. R & D expenses
(b) Liabilities side:
1. Debt. In future, at the time of maturity it is repaid in cheaper money units
(rupees), it is a gain to shareholders.
2. Deferred taxes.
3. Retained earnings.

3.7 FORECASTING EARNINGS

It is necessary to estimate a stock’s future income because the value of the share is the
present value of its future income. This can be done by focusing on.
(a) identification of variables which will have impact on income, and
(b) determining the extent of change in income due to change in the identified variables,
by employing appropriate method of forecasting.
108 3.7.1 Identification of Variables
Financial and Investment
Management Basically changes in income result from changes in (i) operations of business and for
(ii) in the financing of the business.
(i) Operations and Earnings: The operating cycle of a firm starts with cash converted
into inventory. Inventory turns into sale and accounts receivables which become
cash finally.
Return on investment (ROI) is the measure of the firm’s operating result.
EBIT EBIT SALES
ROI = = ×
INVESTMENT SALES INVESTMENT
This is a product of (i) profit margins on sale and (ii) turnover of assets.
(ii) Financing and Earnings: The two main sources of financing an enterprise are
(i) Borrowings (ii) Issue of new shares.
Debt financing provides leverage to common shareholders. It raised the earnings
per share but also risk. Equity financing is advisable where new shares can be sold
at a price in excess of asset value per share. As it improves EPS. This is possible
only when company management can maintain a reasonably higher ROI.
From the above, it is clear that EPS and changes in earnings are function of
(i) turnover of investment
(ii) margin on sales
(iii) effective interest rate (cost of borrowed funds)
(iv) debt equity ratio
(v) equity base
(vi) effective tax rate.

3.7.2 Selecting a Forecasting Method

Different methods of forecasting earnings are available. The two categories into which
the methods fall are given below with a brief list of some of methods.
1. Earlier methods
l Earnings methods
l Market share/profit margin Approach (Break even analysis)
2. Modern techniques
l Regression and correlation analysis
l Trend analysis (Time series analysis)
l Decision trees
l Simulation
The methods are briefly explained in the following sections:
(i) Earnings method: The ROI method which has been earlier introduced as a device
for analyzing the effects of and interaction between the earnings and assets can be
used as a forecasting tool. If predicted data relating to assets, operating income,
interest, depreciation and forces are available the new values can be substituted in
the model and EAT can be forecasted.
(ii) Market share/profit margin approach: This is derivative of industry forecast of 109
Fundamental Analysis
market. Once the total market is known, the market share of the individual company
can be determined either using historical tract second or subjective probabilities.
The next step is estimating net income after taxes and dividends. This can be done
by cost analysis and estimates in relation to quantity of sales or operating capacity.
Break even analysis is the appropriate tool to carry out such an analysis.
(iii) Projected financial statement: This method makes an item-wise analysis of
revenues and expenses and predicts them over a number years, based on the
variations in the key determining variables. It possible only when the forecaster
has through information about the inner working of the company.
A simplified approach involves consideration of branch/divisional total in place of
item-wise amounts.
The above three approaches are not mutually exclusive. They are not without
shortcomings. They are based on subjective evaluations made at various stages of
the analysis.
(iv) Regression and correlation analysis: These methods as applicable to industry
analysis can be sued at company level. The methods permit analyzing the
relationships between several variables of company, industry and economy to develop
more accurate forecasts.
Because of the facility of considering many variables and analysis them, this method
is more advantageous.
(a) analysis are forced to think through various problems of company and the
various interrelationship internal and external variables and company revenues
and expenses.
(b) Analysts can clearly explain the causal variables of changes and improve the
confidence in forecasts.
(v) Trend analysis: Trend analysis is a time series analysis that permits identification
of seasonal, cyclical and erratic fluctuations of the variables under consideration
over a time period. Analysis employ trend analyzed by plotting the data on a special
kind of graph paper, semi logarithmic or semi log paper, in order to reveal starkly
different growth rates.
(vi) Decision trees: This can be used to forecast earnings and security values. Decision
tree is an advanced technique because it considers possible outcomes with their
probabilities and analyses them.
A decision tree contains branches, each one representing a possible outcome.
Probabilities of the end points of the branches add up to 1.
The decision tree of security analysis starts with sale. If sales are expected at two
levels high and low, there will be two branches ; on the other hand if medium level
sales are included, there will be three branches. Each one indicates sales expected
and their probabilities. For each sale branch, different levels of earnings expected
can be given with their probabilities. Finally for each of the earnings branch, different
expected P/E ratios can be presented. Based on the data MPS can be calculated
for each alternative course of events and outcomes.
The advantages of this method are:
(a) Stage-wise analysis of probable events and outcomes help improve accuracy
in forecasting, and
110 (b) Final recommendations can be made with more understanding and confidence.
Financial and Investment
Management (vii) Simulation: This method can be applied to forecast earnings and also security
values. Simulation is a technique that systematically repeats the application of a
rule or formula to know outcomes indifferent situations. It answers the question –
what happens to the outcome, if one or more variables influencing it change?
All that is to be done is to set up formulae
For example,
Sales × Margin (%)
EPS =
No. of shares outstanding
MPS = EPS × P/E
Now data relating to variables viz., Sales, profit margin, No. of shares outstanding and
P/E ratio are generated along with their probability distributions as in the case of decision
tree.
The formula is applied to compute MPS under varying conditions. Computer programming
will help analyse security values rapidly and accurately.

3.8 DETERMINING EARNINGS–

MULTIPLIER (P/E) RATIO
So far focus is on determining Earnings Per Shares (EPS). This is to be translated into
Market Price per share (MPS). As such, most of the fundamental security analysis
work centres on determining the appropriate multiplier.
Research Findings: Bing (4) carried out a survey of practitioners’ stocks evaluation
methods and found that several approaches were in vogue. He found that analysts
(1) used time horizon from 1 to 3 years and (2) preferred to use several techniques in
combinations. Seventy-five percent of the analysts followed rules of thumb to normalize
P/E ratios.
1. They compared current actual P/E with what they considered normal for the stock
in question.
2. They compared price times estimated future earnings (1 to 3 years out) with what
they considered normal for the stock in questions.
3. They compared the multiplier and growth or earnings of individual stocks with
industry group multiple and earnings growth.
With and Kisor based on their study of a number of stocks opined that differences in
P/Es between stocks were due to projected earnings growth, expected dividend pay out,
and variation in rate of earnings growth or growth risk. Bower and Bower came up with
similar conclusion.
They divided risk into marketability of stock, price variability, and conformity with market
behaviour. Malkiel and Cragg found positive effect of earnings growth on P/E. They
further found that dividend payout effect was not clear.

3.9 DIVIDEND DISCOUNT MODEL OF VALUATION

In determination of the P/E ratio, the factors to be considered are:
l Capitalization rate (K)
l Growth rate of dividend stream (g) and 111
Fundamental Analysis
l Dividend pay-out ratio (d/e)
Capitalization rate (k): Capitalization rates very with the firm’s risk-class and the
prevailing market conditions. Three risk classes may be considered for analysis-High,
medium and negligible.
Based on market level and directions of change, markets can be classified as:
(a) Normal Market: In which most securities prices are experiencing slow steady
growth and the average price-earnings ratio is the low mid teens (13-18 times).
(b) Bear Market: When average earnings multipliers drop below 13 times, many market
prices are deflated.
(c) Bull Market: When average earnings multipliers rise above approximately 18,
many stocks are over-priced.
Since future expectations are influenced by past experience, a good way to estimate a
firm’s risk-class is to examine historical data. Capital Asset Pricing Model (CAPM) or
Security Market Line (SML) depicts the risk return relationships based on historical
data. It illustrates the positive relationship between an assets undiversifiable (as measured
ROR) for the asset. The fundamental analyst can measure the risk of the company in
recent periods, adjust it for anticipated changes and then us, these forecasted risk statistics
to obtain capitalization rates. Also adjustment upward or downward are to be made in
earnings multipliers in line with prevailing conditions, i.e., depressed or inflated.
Growth rate (g): Next step is determination of growth rates of earnings. If payout ratio
in constant, the multiplier is influenced by growth rate (g) conditions viz., zero growth,
perpetual growth and temporary growth.
Pay-out ratio (d/e): The effects of changes in dividend payout ratio (d/e) are direct and
proportional, direct as can be observed from the P/E model. The EPS and DPS are not
equal, for the reason some companies prefer a stable dividend policy and some others
retain earnings and maintain low dividend pay out ratios. It implies, analysts have to
study the history of dividends announcements by the firm to make proper prediction of
future pay out ratios.
Empirical studies have produced the following relevant findings
(1) Companies appear to have a predetermined pay out ratio that the appear to adhere
to over the long run;
(2) Dividends are raised only if corporate management feels that a new higher level of
earnings can be supported in the future; and
(3) Managements are extremely reluctant to cut the absolute monetary amount of
cash dividends.
Illustration: A firms’s earnings per share are Rs. 8. Dividend pay out ratio is 0.5
systematic risk coefficient is 0.1. What will be the firm’s share value when
(i) Growth rate is zero
(ii) Growth rate is 6% perpetual
(iii) Growth rate is expected to grow 6 percent for 5 years
112 Solution:
Financial and Investment
Management The firm’s normalized EPS (e) = Rs. 8
Average payout ratio d/e = 50%
Beta Coefficient (B) = 0.1
Capitalisation rate (k) = 10%
(i) When growth rate (g) is zero
di/e
earining multiplier = k-g
di/e 0.5
When g = 0 earning multiplier = = =5
k 0.10
Firm share value = 7 × 5 = Rs. 40
(ii) When growth rate (g) is 6% perpetual:
Capitalization rate of 10% and growth rate of 6% earnings multiplier is 26.5 (di/3)
Earnings multiplier = 26.5 × 0.5 13.25
Firms Share value = 8 × 13.25 = Rs. 106.
(iii) When growth rate (g) is 6% for 5 years
Earnings multiplier = 123.8 (d/e)
Firm’s share value = 8 × 12.8 × 0.5 = 51.2
Comparative P/E Approach
Comparative or relative valuation, makes use of the average P/E of market or industry
to determine the P/E for an individual stock. The procedure is as follows:
(i) Determine the market P/E using dividend discount model.
(ii) Determine the market pay back period based on earnings growth rate of market.
(How many years it takes to obtain market P/E at the given growth factor?)
(iii) Assign P/E to the stock based on its growth rate and market pay back period.
(iv) Make adjustments for dividend pay out ratio and earnings volatility.
(v) Find volume of stock by multiplying normal earnings with the determined P/E.
Ratio Analysis
Based on the financial data available in Income statement and Balance sheets relents
ratios may be calculated and analyzed to apiaries the financial soundness of a company
Table 3.5 presents the ratios in common use
Table 3.5: Financial Ratios for Company Analysis
S. No. Indicator Ratios
A. Technical Solvency Current ratio
Liquidity ratio
Net Income to Debt service ratio
B. Actual Solvency Debt-equity ratio
Return on investment
Profit margin
Fixed Assets to total assets
Contd....
 C. Profitability Gross profit margin 113
Fundamental Analysis
Net profit margin
Return on investment
Earnings per share
Dividend yield ratio
P/E ratio
D. Efficiency Operating ratio
Expense ratio
Current assets turnover
Inventory turnover
Credit collection period

Non-financial Aspects
A general impressionistic view is also important in evaluating the worthiness of a company
for investing in securities. This could be obtained by gathering and analyzing information
about companies publicized in the media. Stock Exchange Directory, annual reports, and
prospectus.
1. History and business of the company
2. Top management team
3. Collaboration agreements
4. Product range
5. Future plans of expansion/diversification
6. R&D
7. Market standing – competition and market share
8. Corporate social responsibility
9. Industrial relations Scenario
10. Corporate Image etc.
Besides these internal factors the external environment related to company survival and
image:
1. Statutory controls
2. Government policy
3. Industry life cycle stage
4. Business cycle stage
5. Environmentalism
6. Consumerism, etc.

Growth Stocks
Investors are interested I not only current dividends but also in future earnings through
dividends and capital gains. Those who look for future growth stocks.
Characteristics of growth stocks: The following features help identify growth stocks:
(i) Substantial and steady growth in EPS
114 (ii) Low current DPS, because retained earnings are high and reinvested
Financial and Investment
Management (iii) High returns on book value
(iv) Emphasis on R & D
(v) Diversification plans for strategic competitive advantage
(vi) Marketing competence and edge.
Benefits: Investment in growth stocks would benefit investors in many ways:
1. The market value goes up at a rate much faster than the rate of inflation.
2. Higher capital gains.
3. Long range tension free holding without any need for sell & buy operations and
associated problems.
Valuation: The investor interested in growth shares can either employ (1) comparative
P/E ratios approach or (2) Dividend Discount model for valuation of the stocks:
Guidelines for Investment
The following guidelines will be helpful to investors interested in growth stocks:
1. Tuning is not very important but with appropriate timing one may be able to pick up
shares at the threshold of high growth rate.
2. Choice of stock should not be based on simple factor. Multiple criteria using different
appraisal techniques may be employed.
3. It is better to diversify investment in growth stocks industry – wise. Because different
industries grow at different by evening out differences.
4. One should hold the stock for more than 5 years to gain advantage.
Estimation of Future Price
Before attempting to discuss the approach that can be adopted for company level analysis,
let us about the objective of investor and how it can be quantified. It is to reiterate the
proposition that an investor looks for increasing his returns from the investment returns
are composed of capital gains and a stream of income in the form of dividends. Assuming
he has equity shares for a period of one year (known as holding period), i.e., he sells it at
the end of the total return received by him would be equal to capital gains plus dividends
received at the end of the year.
Where R1 = (P1-P1-1) + Dt
P1 = Price of the share at the end of the year
P1-1 = Price of the share at the beginning of the year
D1 = Dividend received at the end of the year
R1 = Return for the holding period,
In order to calculated the return received by him on his original investment (i.e. purchase
price), total should be divided by Pt -1. These are expressed in percentage terms and
known as holding period yield, Thus,

(P1 − P1 − 1) + D1
HRY (%) =
P1 − 1
The above computation is quite simple so long as the value of the variables is available. 115
Fundamental Analysis
In actual however, investor would know the beginning price of the share (called purchase
price) as this is the priced paid to buy the shares but the price at the end of the year (i.e.
Selling price) as well as dividend income received would have to be estimated. This is
where the problem lies. How to estimate the future price of the … as well as dividends?
Becomes the main challenge. The series data relating to dividends paid by … provide us
useful clues in estimating the dividends likely to be declared by companies. There is, it
seems dividends policy followed by most firms in general. Thus, an investor would be
able to estimate dividend …
The year with reasonable degree of accuracy under normal circumstances. It has been
found the management is very conservative in increasing the amount of dividend paid to
shareholders. Management increase the dividend unless this increase is sustainable in
the long run. This is to avoid further cuts if need count of dividend, in actual practice,
does not form large part of the total returns of the investor …it an important constituents,
as indicated above.
Estimation of future price of the share that contributes a major portion in the total returns
of the investor is the problematic and is discussed in detail in the following section. In
order to estimate future price of share, you may adopt two approaches, namely Quantitative
analysis and attractive analysis. Let us elaborate each of the two approaches.
Quantitative Analysis
This approach helps us to provide a measure of future value of equity share based on
quantitative factors. The method is commonly used under this approach are:
l Dividend discounted method, and
l Price-earnings ratio method
Dividend discounted method: Dividend discounted method is based on the premise
that the value of an investment is the present value, its future returns. The present value
(PV) is calculated by discounting the future returns, which are divided the Formula,
thus, is
D1 D1 D1
PV = + +
(1 + K) (1 + K)2 (1 + K)3

Under the constant growth assumption, this boils down to

D1
PV =
(K-g)

K = Discount rate
g = Growth rate
DPS = EPS × (1-b)
DPS = Dividend Per Share
b = Proportion of earnings retained such that (1-b) is the dividend payout
Substituting the above in the formula, it becomes
EPS (1-b)
K-g
116 On the basis of the above model, the following inferences can be drawn:
Financial and Investment
Management (a) Higher the EPS, other things like b,k,g remaining the same, higher would be value
of the share
(b) Higher the b, retention rate, or lower the 1-b i.e., g remaining the same, higher
would be value of the share
(c) Higher the k, i.e. Discount rate, other things like b,g remaining the same, higher
would be value of a equity
(d) Higher the growth rate, other things like EPS, b,k. remaining constant, higher would
be value of the share.
These inferences clearly highlight the effect of carious variables on the future price of
equity share.
The applying this approach, one has to be careful about using discount rate k. A higher
value of discount could unnecessary reduce the value of and equity while a lower value
unreasonably increase it, that will have complication to invest/disinvest the shares. A
discount rate is based on the risk rate and risk premium. That is,
Discount risk free rate + risk premium
K = r1 +r2
Where rt = risk free rate of return
r2 = risk premium
Thus, higher the risk free interest rate with rp remaining the same would increase the
discount rate which in turn would decrease the value of the equity. In the same way,
higher risk premium with ff remaining the same increase the overall discount rate and
decrease the value of the equity. Like discount rate, growth equally critical variable in
this method of share valuation. It may be pointed out that growth from internal of depends
on the amount of earnings retained and return on equity. Thus, higher is the retention
rate, highly be the value of the firm, other things remaining constant.
Price Earnings Approach: According to this method the future price of an equity is
calculated by multiplying the P/E ratio by the Thus,
P = EPS × P/E ratio
The P/E ratio or multiple is an important ratio frequently used by analyst in determining
the value of a... It is frequently reported in the financial press and widely quoted in the
investment community. In India it could verify its popularity by looking at various financial
magazines/newspapers
This approach seems quite straight and simple. There are, however, important problems
with respect calculation of both P/E ratio and EPS. Pertinent questions often asked are:
l How to calculate the P/E ratio?
l What is the normal P/E ratio?
l What determines P/E ratio?
l How to relate company P/E ratio to market P/E ratio?
The problems often confronted in calculating this ratio are: which of the earnings – past,
present or future to be taken into account in the denominator of this ratio? Like wise,
which price should be put in the numerator ratio? These questions need to be answered
while using this method.
Indeed, both these methods are inter-related. In fact, if we divide the equation of dividend 117
Fundamental Analysis
discounted made under constant growth assumption by E0 (Earnings per shares), we get

P0 /E 0 (1 + g)
K-g

Here D0 (1+g) – D1
Based on the above model, decision rules become:
Table 3.6: Decision Rules
l Higher the P/E ratio, other things remaining the same, higher would be the value of an
equity.
l Lower the P/E ratio, other things remaining the same, lower would be the value of an
equity.
Looking at the above decision rules, it is not uncommon to find that investor prefer
shares of companies higher P/E multiple.
You will appreciate that the usefulness of the above model lies in understanding the
various factors determine P/E ratio is broadly determined by:
l Dividend payout
l Growth
l Risk free rate
l Business risk
l Financial risk
Thus, other things remaining the same
1. Higher would be the P/E ratio, if higher is the growth rate or dividend or both
2. Lower would be P/E ratio, if higher is
(a) Risk free rate,
(b) Business risk
(c) Financial risk
The foregoing presentation helps us provide a quantities measure of the value of equity
share. However, remains the problem of estimating earning per share, which has been
used in both the methods, discussed this is a key number, which is being quoted. Reported
and used most often by company management analysts, financial press etc. It is this
number every body is attempting to forecast. The starting point to earnings per share,
however, is to understand the chemistry of earnings as described in the previous unit
describe various approach to forecast earnings per share in the following sections.

3.9.1 Forecasting Earnings per Share

Things are the most important number in the arsenal of the investor. The most important
and the principal is getting information about the earnings of the company is its financial
statements. Analyst must be the fact that there is more to the financial statements than
what meets his eyes. Out of the two statements, Balance Sheet and Income Statement,
it is the income statement that is more often used in order to the future state of the firm.
Research studies have indicated the significance of this number in influencing prices and
dividends. The research study conducted by Niederhoffer and Regan for example found
118 that the prices are strongly dependent on the changes in the earnings, both absolute and
Financial and Investment
Management relative to the analysis.
The above study and some others indicate the importance of the forecast of earnings as
the most variable to work on in the investment decision-making process. The critical
aspects of the earnings its level, trend and stability.
There are various methods employed to assess the future outlook of the revenue, expensed
and the earnings from given the economic and industry outlook. These methods can be
broadly classified into two categories. Traditional and Modern. Under the traditional
approach, the forecaster obtains the estimate the single value variable. While in the case
of modern approach, he gets the range of values with the probability of each since. Let
us discuss these two approaches in details.

Check Your Progress 4

State whether the following statements are true or false:

1. The end goal of performing fundamental analysis is to produce a value that
an investor can compare with the security’s current price.
2. Fundamental analysis is performed on historical and present data, but with
the goal of making financial forecasts.
3. The objective of fundamental analysis is to conduct a company stock valuation
and predict its probable price evolution.
4. The objective of fundamental analysis is to make a projection on its business
performance.
5. The use of fundamental analysis for a finance manager is to evaluate and
take its managerial and internal business decisions.

3.9.2 Traditional Methods of Forecasting EPS

Under the traditional approach the following methods of forecasting are adopted:
1. ROI approach
2. Market share approach
3. Independent estimates approach
Starting the discussion on the forecasting techniques, it will not be out of place to briefly
mention the things per share is measured from the financial statement. This will provide
us an understanding of its changes, Broadly, changes in earnings are affected by operating
and financing decisions. Both these decisions are, however, interdependent, This is done
by various companies by presenting the information in the income statement reflecting
both types of decisions. Given below are the format, which analysis
Income Statement for the year ended ………..
1. Sales Revenue
2. Less Interest expenses
3. Earnings before Interest and Tax (EBIT)
4. Less interest expenses
5. Earnings before Tax (EBT)
6. Number of shares outstanding 119
Fundamental Analysis
7. Earning after tax (EAT)
8. Number of shares outstanding
9. EPS = EAT/number of shares outstanding
Let us now explain the ROI approach to forecast earnings per share
ROI Approach: Under this approach, attempts are made to relate the productivity of
assets with the earnings. That is, returns on the total investment (assets) are calculated
and estimates regarding per share are made stated.
Return on Assets = EBIT/Assets
Return on assets is a function of the two important variables viz., turnover of assets, and
margin of profit
Return on Assets = Assets Turnover × Profit Margin.

3.10 LET US SUM UP

To sum up, the concept of fundamental analysis is the cornerstone of investing. In fact,
some would say that you aren’t really investing if you aren’t performing fundamental
analysis. Because the subject is so broad, however, it’s tough to know where to start.
There are an endless number of investment strategies that are very different from each
other, yet almost all use the fundamentals.
A method of evaluating a security by attempting to measure its intrinsic value by examining
related economic, financial and other qualitative and quantitative factors. Fundamental
analysts attempt to study everything that can affect the security’s value, including
macroeconomic factors (like the overall economy and industry conditions) and individually
specific factors (like the financial condition and management of companies).
The end goal of performing fundamental analysis is to produce a value that an investor can
compare with the security’s current price in hopes of figuring out what sort of position to
take with that security (under priced = buy, overpriced = sell or short). This method of
security analysis is considered to be the opposite of technical analysis. Fundamental
analysis is about using real data to evaluate a security’s value. Although most analysts
use fundamental analysis to value stocks, this method of valuation can be used for just
about any type of security.
For example, an investor can perform fundamental analysis on a bond’s value by looking
at economic factors, such as interest rates and the overall state of the economy, and
information about the bond issuer, such as potential changes in credit ratings. For assessing
stocks, this method uses revenues, earnings, future growth, return on equity, profit margins
and other data to determine a company’s underlying value and potential for future growth.
In terms of stocks, fundamental analysis focuses on the financial statements of a the
company being evaluated.

3.11 LESSON END ACTIVITY

Write a study note on the concept of fundamental analysis.
120
Financial and Investment 3.12 KEYWORDS
Management
Growth Industry: This is the industry which is expected to grow persistently and its
growth is exceed the average growth of the economy.
Cyclical Industry: In this category of the industry, the firms included are those that
move closely rate of industrial growth of the economy and fluctuated cyclically as the
economy fluctuates.
Defensive industry: It is a grouping that includes firms, which move steadily with the
economy and less than the average decline of the economy in a cyclical downturn.
Pioneering Stage: This is the first stage in industrial life cycle of a new industry.
Fast growing stage: This is the second stage when the chaotic competition and growth
that we hallmark of the first stage is more or less over.
Security and Stabilization stage: The third stage where industries grow roughly at the
rate of the economy developed reach a stage of stabilization.
Relative decline stage: The fourth stage of industrial life cycle development is the
relative decline stage.
Industry life-cycle stages (product life cycle theory): Every industry passes through
different stages in its life time.
Pioneering Stage: This stage is characterized by introduction of a new product, and an
uptrend in business cycle which encourages new product introductions.
The market – profile: A market profile consists of those endogenous characteristics
which have a significant bearing on demand or the way in which it can be developed.
Time series Analysis: Time series analysis consists of decomposing the original sales
series over a period of time.
Trend (T): It is the result of basic developments in population, capital formation, and
technology. It is found by fitting a straight or curved line through past sales.
Cycle (C): It captures the wave-like movement of sales. Many sales are affected by
swings in general economic activity, which tends to be somewhat periodic.
Season (S): It refers to a consistent pattern of sales movements within the year.
Erratic Events (E): It refers to the unpredictable sales caused by unforeseen events
like strikes, riots, war scares, floods, and other disturbances.
Simulation: This method can be applied to forecast earnings and also security values.
Normal market: In which most securities prices are experiencing slow steady growth
and the average price-earnings ratio is the low mid teens (13-18 times).
Bear Market: When average earnings multipliers drop below 13 times, many market
prices are deflated.
Bull Market: When average earnings multipliers rise above approximately 18, many
stocks are over-priced.
Pay-out ratio (d/e): The effects of changes in dividend payout ratio (d/e) are direct and
proportional, direct as can be observed from the P/E model.
Price Earnings Approach: According to this method the future price of an equity is
calculated by multiplying the P/E ratio.
 121
3.13 QUESTIONS FOR DISCUSSION Fundamental Analysis

1. Write a brief note on fundamental analysis.

2. What is Company analysis? Why does investor should consider?
3. Write the difference between fundamental analysis and technical analysis.
4. What do you understand by industrial analysis and economic analysis?
5. Based on the implications of random walk model. What guidelines do you
recommend? Can a series of historical stock prices or rates of return be an aid in
predicting future stock prices or rates of return?
6. What sequences of events might bring about on “efficient market”?
7. Do you think that security prices fluctuate randomly because of part-time amateur
investors? Are there any other factors?
8. Explain the weakly, semi-strongly and strongly efficient market hypotheses.
9. What do you understand by the concept of security analysis and investment decision?

Check Your Progress: Model Answers

CYP 1
Briefly the market efficiency relates to the speed with which stock market
incorporates the information about the economy industry and company in the share
prices rather instantaneously. The result of this assumption is that are prevailing at
the market place can be taken to represent the price of the share justified by its
fundamental extrinsic value (IV). This equality of MP and IV makes the fundamental
analysis or any other analysis useless fondant.
CYP 2
1. As the name suggests, these are indicators that lead the economic activity in
their outcome. That is, these are those time series data of the variables that
reach their high points as well low points in advance of the economic activity.
2. These are time series data of variables that lag behind in their consequences
visit .. economy. That is, these reach their turning points after economy has
already reached its own.
CYP 3
Every industry passes through different stages in its life time. The stages can be
identified as follows:
l Pioneering Stage (Introduction)
l Expansion Stage (Growth)
l Stagnation Stage (Maturity)
l Decay Stage (Decline)
CYP 4
1. T, 2. T, 3. T, 4. T, 5. T.
122
Financial and Investment 3.14 SUGGESTED READINGS
Management
Sudhindra Bhat, Security Analysis and Portfolio Management, Excel Books, Delhi.
Preeti Singh, Security Analysis and Portfolio Management.
V.A. Avadhani, Investment Management.
M.Y. Khan, Fianacial Services.
V.K. Bhalla, Financial Services.
G.S. Batra, Financial Services and Markets.
Mahana Rao, Financial Services, Cases and Strategies.
L. M. Bhole, Financial Markets and Services.