F Analysis

Fundamental Analysis Investment decisions are part of our economic life. Everybody takes such decisions in different contexts and at different times. Some are able to earn more profits through them while the others simply lose their money. Therefore it is better to understand and know the way sound investments decisions can be taken in order to improve chances of making profits through them. For a long time investment decisions making was regarded as an art. As art is personal and subjective, it was difficult to provide the general framework. Recently it is regarded as a science and body of literature has been developed. It is now regarded as an art and science. It now recognized that investment decisions is an ongoing process in which the decision maker attempts to update himself regarding risk return characteristics of securities. These characteristics keeps on changing and investor go on attempting to understand their impact on his decisions. 1

A simple decision rule is applicable: Buy a security that has highest return per unit of risk or lowest risk per unit of return. And sell the security which does not satisfy the above requirements. The above decision rule to buy and sell securities is highly simple, but very difficult to apply . This is because there are a large number of factors which affects both risk and return in the real world situation. Thus a security which had highest return per unit of risk at one point of time and was considered to be good buy might turn into a less attractive proposition and could be considered later on as possible candidate for disinvestments. Such a situation might arise due to change in management or change in Government Policy or other economic factors. Also opposite might be possible. Investment decisions making being continuous in nature should be attempted systematically. Broadly two approaches are suggested: They are : o o

Fundamental Analysis Technical Analysis. 2

In the first approach the investor attempts to look at fundamental factors that affect risk return of the security. While in the second approach, the investor tries to identify the price trends , demand and supply of securities and prevalent trend in prices. Fundamental analysis In the fundamental analysis attempt is made to analyse various fundamental or basic factors that affect the risk- return of the securities. But why the fundamental analysis? The answer o this lies if we study chemistry of earnings and the macro and micro factors which influence the figure of earnings.

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Broad sources/ form of earnings Sale

Company specific factors Competitive strength

Less: Cost of Sales

Operating Efficiency

Earning before interest, depreciation& Taxes (EBIDT) Less: Interest Capital structure/Financial leverage Policy Less: Depreciation Less: Taxes Net earning after tax Less: preference dividend

Operating leverage Policy Tax planning and management Capital structure Policy

Manage- Industry factors Macro ment economic factors Industry National demand/supply Income, spending, savings, monetary, Fiscal, credit, export- import policies, population, price levels. Industry wage National Wage level, Industrial Policy, price infrastructure. levels, Infrastructure, Raw material, production. Import and export policy

Industry cost of Interest rates in capital the economy, capital market conditions Industry Capital goods practices import policy Industry Lobby Fiscal policy

Industry policy

Interest rate structure, capital market conditions 4

Distributable earnings Less: equity dividend

Dividend policy

Industry practices

Fiscal policy, credit policy, capital market conditions

Retained earnings

It is observed that all the items of revenue and expenses are influenced by company specific, industry level and macro economic factors. This means that the intrinsic value of stream of distributable earnings per share, is in effect influenced by company specific , industry level and macro economic factors. Therefore there is s strong case for analysis of companyindustry and economic factors. That is what fundamental analysis is all about. Economic- industry- company analysis The analysis of economy. Industry and company fundamentals is main ingredients of fundamental approach. Economic analysis The investment decisions of individuals and the institutions are made in the economic set up of particular country. 5

It becomes essential, therefore to understand the state of the economy of that country at macro level. The analysis of the state of economy at macro level incorporates how the economy has performed in the past, how it is performing in the present and how it is expected to perform in the future. It is also important to know how various sectors of the economy are going to grow in the future and which of its sectors are showing signs of stagnation.. Thus we have to undertake historical performance of various sectors in the past, their performance at present and then forming the opinion/ expectation about its performance in the future.. It is through such type of systematic process, one would be able to identify various investment opportunities whenever they arise. Sectoral analysis is therefore very much essential along with overall analysis as the rate of growth in overall economy often differs from the rates of growth of various segments / sectors. There is a great point is doing the economic analysis. The way people earn their income and the way people spend their surplus on which sectors has a great bearing on growth of that sector. 6

Economic forecasting To understand the direction of movement of the economy it is must for an analyst to forecast the economy. The fortunes of specific industry and the firm depends on the how the economic outlook looks like in the future. short term- intermediate term and long term. The forecasting will be more relevant if it is done in: o o o

Short term- upto one year Intermediate term- one to three year. Long term- above three years.

The central theme of forecasting is to forecast national income, because it summarizes the receipts and expenditures of all segments of the economy, be the Government, business or the households. Some of the techniques of sort term forecasting are: Anticipatory Surveys This is very simple method through which investors form their opinions about the future state of the economy. This is a survey of expert opinions of those prominent in Government, business, trade and industry or academia. 7

Barometric or indicator approach In this approach , various types of indicators are studied to find out how the economy is likely perform in the near future. These indicators are classified as : o o o

Leading indicator Roughly coincidental indicator Lagging indicator.

Leading indicator: These are the indicators which leads economic activity in terms of their outcome. These are those variables that reach their highpoints as well as low points in advance of the economic activity. Some of leading indicators are: o o o o o o o

Average weekly hours of manufacturing production workers. Contracts and orders for plant and machinery. Money Supply Average weekly unemployment claims. Index of stock prices. Change in sensitive material prices Change in manufacturer’s unfilled orders (durable goods)

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Roughly coincidental indicator: These are the indicators that reach their peaks and troughs at approximately the same time as the economy. Some of them are: o o o o

Index of industrial production Manufacturing and trade sales. Employees on non- agricultural payrolls. Personal incomes.

Lagging Indicators: These are the variables that lag behind in their consequences vis-à-vis the economy. These reach their turning points after economy has already reached its own. Some of these are: o o o

Ratio of manufacturing and trade inventories to sales. Commercial and industrial loans outstanding. Change in consumer price index etc.

Indicator approach is quite useful in suggesting the direction of a change in the aggregate economic activity. However it tells nothing about the magnitude of the change. Money and stock prices It is widely recognized that money supply in the economy plays an important and crucial part in the investment decision making . 9

The rate of change in the money supply in the economy affects the corporate profits, GNP, interest rates and stock prices. Accordingly it argued that total money supply and its rate of change play an important in influencing the stock prices. Econometric Model Building approach Econometrics is discipline where the application of mathematics and statistical techniques is made in predicting the direction and flow of economy. Industry Analysis After conducting analysis of the economy and identifying the direction it is likely to take in the short, intermediate and long term, the analyst must look into various sectors of the economy in terms of various industries.. An industry is a homogenous group of companies. That is the companies with similar characteristics can be grouped together in one industrial group. There are many a basis on which grouping can be done. The traditional classification is generally done product wise like : Pharmaceutical, cotton textiles, synthetic fibre etc. Such a classification though useful does not help much in investment decision making . 10

Some of the more useful basis for classifying industries from investment decision making point of view are as follows: Growth Industry: This is the industry which is expected to grow persistently and its growth is likely to exceed the average growth of the economy. Cyclical Industry: In this category of the industry, the firms included are those that move closely with the rate of industrial growth of the economy and fluctuate cyclically as the economy fluctuates. Defensive Industry: It is grouping which move steadily with the economy and decline less than the average decline of the economy. Declining industry: This is that category of firms which either generally decline absolutely or grow less than the average growth of the economy. Another useful criterion to classify the industries is the various stages of their development. Like: Pioneering stage, Fast growing stage, maturity or stabilization stage, relative decline stage etc. The peculiar characteristics of different stages of life cycle of development of industries has a number of implications for investment decisions. Pioneering stage is very risky stage. 11

As risk and return are positively co- related, the investment at this stage is quite rewarding. But for risk averse investor looking for steady long term returns, such stage is to be avoided. These are good for venture capitalist. Another relevant question for an ordinary investor is that it is difficult to identify the stage at which a company is. In order to strengthen the analysis further, it is essential to study the unique feature of the industry in detail. Some of the features that can be studied are given below: 1. State of the competition in the industry: Competition is way of life and it increases the barrier to enter in the industry. No doubt it as an important input in investment decision making. Knowledge of the state of competition in a particular industry is a must. Such question must be probed. o

Which firm in that industry play a leading role and how firms compete among themselves. 12

o

o

How is the competition among domestic and foreign firms both in domestic and foreign markets? How do the domestic firms performs there? Which type of products are manufactured in this industry? Are these homogenous in nature or highly differentiated?

o

What is nature and prospect of demand for the industry.

o

What is stage of the life cycle .

2. Cost conditions and profitability The worth of a share depends on its return which in turn depends on profitability of the company. It very essential that there must be growth but its mere presence does not guarantee profitability. The profitability depends on the state of the competition in the industry, the cost control measures adopted and growth in demand for it products.. In this context certain ratios are relevant like: o o o o

Gross profit margin ratio. Operating profit margin ratio. Rate of return on equity. Rate of return on total capital employed.

Ratios are not an end in itself, but they indicate possible areas for further investigation. 13

3. Technology and Research Due to increasing competition in general, technology and research play a crucial part in the growth and survival of a particular industry. However technology itself is subject to change; sometimes, very fast, leading to obsolescence. Thus only those industries which are updating themselves in the field of technology could have competitive advantage over others in terms of the quality, pricing of products etc. The relevant questions to be probed further by the analyst could be like this: o

o

o

o

o

What is the nature and type of technology used in the industry? Are there any expected changes in the technology. What has been the relationship of capital expenditure and sales over time. What has been the amount of money spent in research and development activities of the firm. What is the assessment of this industry in terms of its sales and profitability in the short, intermediate and long run.

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The impact of all these factors have to be translated in terms of two most crucial numbers i.e., sales and profitability- their level and expected rate of change during short, intermediate and long term. Company Level Analysis Every investor, be it individual or an institution has only one goal while investing i.e., maximizing the return on his investment. For earning profits, investor apply a simple and common sense decision rule. That is, o o

Buy the share at a low price Sell the share at a high price

The above decision rule is very simple to understand but difficult to apply in actual practice. The crucial question is how to find out whether the price of company’s share is high or low. To which price it should be compared, to find out whether it is high or low. The fundamental analysis infact provided the benchmark against which the market price of share can be compared. By fundamental analysis one can find the intrinsic value.

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This value is dependant on economic, industry and company fundamentals. Out of these, i.e., the company level analysis provide a direct link between investor’s action and his investment goal in operational terms. This is because the investor buys the equity share of a company and not that of industry or economy. Industry and economy framework indeed provide him with a proper background against which he buys share of a particular company. But it is the company which affords him the potential to earn. Therefore a careful examination of the company with its quantitative and qualitative fundamentals is therefore very much essential. It must be clear that all the companys in a particular industry may not be having same gross profit margin, same net profit margin and growth potential. The share prices, growth in share prices of Tata Steel, SAIL and Ispat etc will be quite different. So apart from knowing which industry to invest is not enough but to know which company in that industry will give more return per unit of risk.

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That is what the investor will find out after undertaking company analysis. It is not that in steel industry you will buy the share of the company with lowest price. Estimation of future price There is no denying the fact that all investors look for increasing their return on their investment. The return to an equity investor consists of capital gain and stream of income in the form of dividends. Assuming he wants to hold shares for one year only (known as holding period). If sells at the end of the year, the total returns received by him would be capital gains and dividend received at the end of the year, i.e, Rt = (Pt – Pt-1) +Dt Where Pt = Price of the share at the end of the year. Pt-1

= Price of share at the beginning of the year

Dt

= Dividend received at the end of the year

Rt

= Return for the holding period, t

In order to calculate the return received by him on his original investment (i.e., on purchase price ) total return should be divided by Pt-1 . 17

These are expressed in percentage terms and known as holding period yield (HPY) Thus

HPY (%)

(Pt – Pt-1) +Dt = --------------------- × 100 Pt-1

This looks very simple so long as the value of the variables are available. In actual practice investors knows the beginning price of the share called the purchase price. But the price which will be at the end of his holding period and the dividend he is going to receive is not known to him. This what is to be found out. The time series data relating to dividend paid by the company will help one to estimate with fair degree of accuracy the dividend likely to be declared in the coming year. As the company generally follow a stable dividend policy and dividend will be increased if a company hopes to maintain that level of dividend in near future . The amount of dividend though is an income for the investor but does not form a large part of total return of the investor.

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Nevertheless it is an important part. It is said that the investors do not invest in shares for dividends but for capital gains Now the question arises as how to estimate the future price of a share. In order to estimate the future price of a share two approaches are followed i.e, Quantitative analysis and Qualitative analysis. Quantitative analysis This approach helps us to provide a measure of future value of equity share based on quantitative factors. The two methods commonly used are: o o

Dividend discounted method, and Price earning ratio method

Dividend discounted method The dividend discounted method is based on the premise that the value of an investment is the present value of its future returns. The present value (PV) is calculated by discounting the future returns which are dividend receipts.

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The formula is: D

D

1 PV = ------1 (1+k)

2 + ---------2 (1+k)

+ ………..

PV= Current price of share. D = Dividend expected to be paid at the end of the year 1 and so on. 1 k = equity shareholders’ required rate of return. If dividends are expected to grow at a constant rate of ‘g’ per cent per year, then above equation becomes: 2 D D (1+g) D (1+g) 1 1 1 PV= ---------+ ---------------- + ----------------- +.. infinity 1 2 3 (1+k) (1+k) (1+k) D 1 This simplify to PV = -----------k–g

DPS = EPS - EPS×b EPS (1-b) Where DPS = Dividend per share. b = proportion of earning retained such that (1-b) is the dividend payout. 20

Substituting the above in our formula we get EPS (1-b) PV = ------------k- g On the basis of the above model the following inferences can be drawn. 1. Higher the EPS , the other things like b, k, g remaining the same higher would be the value of share. 2. Higher the b the retention rate or lower the (1-b)i.e., dividend payout, the lower would be the value of share. 3. Higher the k i.e. the discount rate, other things remaining the same lower would be the value of the equity. 4. Higher the growth rate, other things remaining the same, higher would be the value of the equity. These inferences clearly highlight the effect of various variables on the future price of equity shares. While applying this approach one has to be careful about using the discount rate, k. A higher value of discount rate would unnecessarily reduce the value of an equity, while a lower value would unreasonably increase it. That will have implications to invest or divest the shares. 21

A discount rate is based on risk free rate and risk premium. Discount rate = Risk free rate + risk premium k = r f + rp Thus higher the risk free interest rate (rf) with risk premium (rp) remaining same would increase the discount rate and thus will decrease the value of the equity. In the same way the higher risk premium with risk free rate remaining same would increase the discount rate and consequently decrease the value of equity. Like discount rate, the growth rate ‘g’ is equally critical variable in this method of share valuation. The growth from internal sources depend on amount of earning retained and return on equity. Thus higher is the retention rate, higher would be the value of the firm if they can earn more than the market rate.. Higher return on equity would lead to higher value of equity with other things remaining same. Price earning approach According to this method the future price of an equity is calculated by multiplying the P/E ratio with EPS

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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 share. It is frequently reported in the financial papers and widely talked about among the brokers community. The approach is quite straight forward and simple. There are however, important problems with respect to calculation of both P/E ratio and EPS. The important questions being asked are: o o o o

How to calculate P/E ratio? What is the normal P/E ratio? What determines P/E Ratio? How to relate company P/E ratio to market P/E. ratio.

The problem often confronted in calculating this ratio are: Which earning – past present or future are to be taken into account in the denominator of the ratio? Likewise, which price should be put in the numerator of this ratio? These questions need to be answered while using this method.

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Indeed both these methods are interrelated. In fact, if we divide the equation of dividend discounted method under constant growth assumption by E0 (Earning per share), we get: P0/E0

D0/E0 (1-g) = --------------k-g

D0 (1-g) = D1 If we analyze the above equation we can formulate the following decision rules: o

o

Higher the P/E ratio, other things remaining the same the higher will be value of the security. Lower the P/E ratio other things remaining the same, lower would be the value of an equity

It is therefore seen that the investors always prefer the shares with higher P/E ratios. The factors that determine the P/E ratio are: o o o o o

Dividend payout Growth Risk free rate Business Risk Financial risk. 24

Thus other things remaining the same, 1. Higher would be the P/E ratio if higher is the growth rate or dividend payout or both. 2. Lower would be the P/E ratio, if higher is : (i) (ii) (iii)

Risk free rate. Business risk Financial risk

Forecasting earning per share The most important and principle source of geting information about earning of the company is its financial statements. Therefore one has to estimate future earning and expenses under the economic and industry outlook. Various methods are used like: o o o o o o

ROI approach Market share approach Independent estimate approach. Regression and co-relation analysis Use of trend analysis Decision tree approach

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Qualitative analysis The methods discussed so far were quantitative methods and these methods are quite useful. But caution is to be exercised in using them. It must be complimented by qualitative analysis factors. Such information can be gathered from the following sources: Company’s financial statements o Financial press, magazines etc. o Company officials This information may relate to the following factors: o

o o o o o o o o o o o

Availability of infrastructure Inventory size, value, risk Order book position Product risk Marketing and distribution Components of cost as , fixed and variable Availability of raw materials and other inputs Cost of inputs Quality of personnel Quality of management Future Plans

With the qualitative factors in mind, an investor / analyst can judge whether the quantitatively derived measures of value of an equity is reasonable or not and accordingly take an informed decision. 26

Of all the qualitative factors the quality of management is most important. There is a saying “ I do not invest in products, I invest in managements.” In the present scenario it is very difficult to assess the quality of management.

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