Fundamental analysis is the process of examining the underlying forces that impact the well-being of the economy, industry groups, and companies. Its objective is to forecast and profit from future price movements. The interpretation of fundamental information mainly revolves around economic, industry, and company statistics. Evaluating a company typically involves three steps: 1. Assessing the state of the general economy. 2.
The economic analysis involves assessing the industry and company conditions. It examines aspects such as inflation, interest rates, consumer spending, trade balance, and money supply expansion or contraction in order to determine if the stock market is favorable.
The study of industries that are experiencing growth is known as industry analysis. Investing in growing industries is considered ideal. It is often recommended to choose a weak stock in a strong industry over a strong stock in a weak industry. To make successful investments, investors need to be familiar with the industry classification used in the economy. It is also advantageous to understand the characteristics, problems, and practices of different industries. Company analysis is also important.
The company evaluates its financial health by analyzing its economic and industry conditions. This involves studying the financial statements to calculate various ratios in profitability, price, liquidity, leverage, and efficiency. It is crucial to compare these ratios with other companies in the same or similar industry to establish what is considered normal. The fundamental analysis consists of three phases: economic analysis, industry analysis, and company analysis. The economic analysis assesses the general economic situation using indicators like lead, lag, and coincidental indicators. The industry analysis examines prevailing conditions within a specific industry and its segments by analyzing performance indicators such as aggregate demand and supply position, competition (internal and external), and government policies. In the company analysis phase, both financial (EPS, sales profitability) and non-financial aspects (promoters, management quality) are assessed to determine whether to buy/sell/hold shares of a company.The use of fundamental analysis is advantageous for long-term investments as it aids in identifying companies that provide good value. By employing sound fundamental analysis, investors can uncover companies possessing valuable assets, a robust balance sheet, consistent earnings, and enduring viability. Furthermore, fundamental analysis assists in building a comprehensive comprehension of the business.
Investors should familiarize themselves with the key revenue and profit drivers of a company. Understanding a company’s business allows investors to categorize stocks within their relevant industry groups, which can greatly impact relative valuations. The stock market is not isolated and is closely tied to the overall economy of a country. Economic analysis is crucial in gaining insights into the complexities of the stock market, as it requires interpreting important economic indicators. The state of the economy at a given time influences investment decisions. For example, during an expanding economy, an aggressive growth-oriented strategy, such as investing in technology, biotech, semiconductor, and cyclical stocks, may be advisable.
When the economy is predicted to shrink, an investor may choose a more cautious strategy and look for stable income-oriented companies. The economic cycle of a country directly impacts both industries and individual companies. It influences investment decisions, employment, demand, and company profitability. While some industries like shipping or consumer durable goods are significantly affected by the business cycle, others such as the food or health industry are not as affected. This difference occurs because consumers can delay purchasing certain products but not others. Referring to the economic cycle, investors should determine the stage a country is in. They should invest when the economy starts recovering after a depression or a recession. It is advisable for investors to divest just before or during a boom or, at worst, shortly after it. These timing choices will yield the greatest benefits for the investor. Additionally, there are specific economic indicators that can be analyzed to evaluate the overall national economy. Leading indicators are predictive of future economic changes.
Leading indicators are economic trends that can help investors intelligently outline investment strategies. These indicators include the unemployment position, rainfall and agricultural production, fixed capital investment, corporate profits, money supply, credit position, and index of equity share prices. On the other hand, coincidental indicators provide information about the current economic position. Examples of coincidental indicators are Gross National Product (GNP), Index of Industrial Production, money market rates, interest rates, and reserve funds with commercial banks. Lagging indicators explain past events in the economy. Examples of lagging indicators are large-scale unemployment, piled up inventories, outstanding debt, and interest rates of commercial loans. While these indicators are useful for understanding economic trends with caution as they only offer insight into economic trends. The political equation also plays a significant role in understanding economic trends.
A stable political environment is essential for maintaining consistent and equitable growth. It empowers a government to make strategic decisions that promote the prosperity of industries and companies over the long term. In contrast, political instability creates uncertainty. India has encountered significant obstacles in recent times due to prolonged periods of political instability since the late 1980s. Several factors, including multiple elections without a majority party, religious and ethnic tensions, and the Pakistan issue have all contributed to this instability. The state of industrial production also exerts considerable influence on the economy; an upswing indicates strength while a downswing raises concerns.
The decrease in agricultural growth and the significant increase in petroleum prices will impact industrial growth. Inflation plays a major role in the economy by reducing purchasing power and leading to a decline in demand. However, industries flourish when the economy is stable and healthy with low inflation rates. Both the USA and Europe have relatively low inflation rates. Interest rates also influence economic development. A low interest rate encourages investment and stimulates industry growth, while high interest rates lead to higher production costs, reduced consumption, and decreased competitiveness for companies. The infrastructure of an economy is crucial for its development.
Public infrastructure services, such as banking, telecom, coal, and power, are essential for the economy. In the last five decades, there has been a significant focus on investing in these sectors through public spending. However, India’s economy is currently constrained by inadequate infrastructure. The lack of well-defined policies and legal frameworks for critical infrastructure sectors hampers private sector participation. Additionally, it is crucial for a nation to have foreign exchange reserves to fulfill obligations, handle import costs, and manage foreign debts.
The absence of foreign exchange prevents a country from importing materials or goods necessary for its development, ultimately resulting in a lack of international confidence. Another issue arises when governmental expenditure surpasses its income, causing a budgetary deficit. While expenditure stimulates the economy by promoting job creation and demand, it can also lead to deficit financing and inflation. Budget deficits are common among developing economies, including India. Despite India’s remarkable economic performance in recent years, the magnitude of the problem posed by its fiscal deficits remains significant. Furthermore, high employment is crucial for achieving substantial growth in national income.
As the population growth is outpacing economic growth, unemployment rates are rising, posing a threat to the overall economy. Factors such as taxation, EXIM Policy, and international developments contribute to this concerning trend. Additionally, the US Factor and INDUSTRY ANALYSIS play a crucial role in understanding the current state and future prospects of specific industries. Conducting a detailed analysis, including evaluating past performance and industry characteristics, helps identify sectors with potential for growth. This knowledge can guide investment decisions aimed at acquiring equity shares in companies within those promising industries. With the opening of the economy, the presence of new entrants and intensified competition has magnified the significance of industry analysis.
To evaluate the potential of an industry group, an investor should consider the overall growth rate, market size, and importance to the economy. While the individual company remains significant, its industry group can have equal or greater influence on the stock price. Stocks generally move in groups rather than individually. Thus, being in the right industry often holds more significance than being in the right stock. Each industry and company within it goes through a life cycle consisting of four distinct phases: entrepreneurial or nascent stage, expansion or growth stage, stagnation stage, and decay or sunset stage. The diagram below illustrates this industry life cycle.
Figure: Industry Life cycle
1. Entrepreneurial or nascent stage
2. Expansion or growth stage
3. Stagnation stage
4. Decay or sunset stage
Entrepreneurial Stage:
The first stage of the industrial life cycle for a new industry is marked by the introduction of emerging technology and products that are not fully developed. This initial phase experiences a surge in demand for the industry’s output, creating significant profit opportunities. However, multiple companies enter the market, and not all of them survive. Consequently, there is a high rate of business failures as weaker firms are eliminated, allowing only a few select ones to advance beyond the pioneering stage. Analysts encounter the challenge of identifying which companies are likely to thrive and succeed in the future.
Investing in a company in a pioneering industry, also known as sunrise or nascent industries, is highly risky. India has several examples of such industries including telecommunications, computer software, and information technology. The next stage after pioneering is the expansion or growth stage which only includes companies that have successfully made it through. These companies become stronger and establish their position in the market by finding their own market and developing unique strategies. The competition among these surviving companies drives them to offer better products at lower prices.
Investors find companies in the expansion stage of an industry appealing as they offer high returns with lower risk due to high demand and low supply. These companies generate increasing profits and provide attractive dividends.
The stagnation stage, which is the third stage of the industry life cycle, signifies stable growth. The industry’s ability to continue growing seems to decline, with sales increasing at a slower pace compared to competitive industries or the overall economy. As a result, the industry starts stagnating. The transition from the expansion stage to the stagnation stage in the industry is typically a slow process.
Two important factors contributing to this transition are changes in social habits and advancements in technology. Occasionally, an industry may experience a period of stagnation, but it can resume growth through the introduction of new products or technological innovations, initiating a new cycle. As a result, investors and analysts must diligently monitor industry developments. The next stage after stagnation is the decay stage. This occurs when there is no longer demand for the industry’s products. New products and technologies have emerged in the market, and customer preferences and habits have changed. Consequently, the industry becomes obsolete and eventually fades away.
Changes in social habits, technology, and declining demand are the primary factors leading to the decline of any industry. It is advisable for investors to exit the industry before it reaches the decay stage. The profit trends throughout an industry’s life cycle can be visualized in the form of an inverted ‘S’ curve, as depicted in the figure. Determining the current stage of development for an industry is often challenging. The transition from one stage to another occurs gradually and may not be easily identifiable. Thorough analysis is necessary to detect this transition. Additionally, while the classification of industries according to this approach follows a general pattern, there may be exceptions.
Adapting to changes in the environment can help extend the life of an industry after it reaches a stage of stagnation and decay. Detecting such exceptions requires careful analysis. In an industry analysis, it is important to consider several key characteristics that relate to the operational and structural aspects of the industry. These characteristics have an impact on the industry’s prospects. One such characteristic is the demand-supply gap, where the demand for a product typically changes at a steady rate while the production capacity fluctuates irregularly based on the installation of additional capacity.
The industry can face both under-supply and over-supply of capacity, leading to decreased profitability from excess supply and improved profitability from insufficient supply. The demand-supply gap in an industry is indicative of its short or medium-term prospects, making it important for investors to estimate. Competitive conditions within the industry also play a significant role in industry analysis.
The level of competition in an industry is influenced by several competitive forces including barriers to entry, threat of substitution, bargaining power of buyers, bargaining power of suppliers, and rivalry among competitors. When new companies enter an industry, they can increase its capacity, but they may encounter obstacles that prevent them from entering. These barriers can stem from factors such as product differentiation, absolute cost advantage, or economy of scale. Product differentiation describes the bias buyers have towards products from established players.
The market values their products highly. Established companies have a competitive advantage because they can produce their products at a lower cost compared to new companies. In order to achieve cost efficiency, a significant level of production is needed, which may not be practical for setting up small capacities in certain industries. Industries that are well protected from new companies making progress are considered suitable for investment. In the analysis of industries, the longevity of an industry is an important factor to consider in this era of rapid technological advancements.
Permanence is a phenomenon that is connected to the products and technology used in the industry. If an analyst believes that a certain industry’s need will disappear soon, it would be unwise to invest in it. The state of labor conditions in the industry being analyzed is an important factor, particularly in our economy where unions hold significant power. If the labor force in a specific industry tends to be rebellious and frequently goes on strike, the future prospects of that industry will not be positive. The government’s attitude towards an industry also greatly affects its potential success.
The government can influence the growth of industries and offer support through favorable legislation. Conversely, certain industries like alcoholic drinks and cigarettes have faced disapproval and legal restrictions in India. When investing, it is important to consider the government’s role. The availability of raw materials also plays a significant role in determining industry profitability, with some industries having no difficulty sourcing them while others have limited resources.
Industry analysis is an important aspect that should consider the availability of raw materials and its impact on industry prospects. COMPANYANALYSIS is the final stage of fundamental analysis, and it helps investors choose the industry that offers rewarding investment opportunities. In this stage, investors focus on predicting the future earnings of a company since there is evidence indicating that earnings strongly affect share prices.
The earnings of a company, including their level, trend, and safety, are influenced by various operational factors. These factors directly impact the financial state of the company. To assess a company’s profitability and financial health, we rely on the periodic publication of financial statements. Companies typically provide two key financial statements: the balance sheet and the profit and loss account (P&L A/C). The balance sheet presents a snapshot of a company’s assets and liabilities, while the P&L A/C provides an overview of its earnings. Fixed and current assets are the primary categories listed in the balance sheet.
The P&L A/C, also known as the income statement, displays the revenue earned, the costs incurred, and the resulting profit or loss of the company for a single accounting year. The Earnings per Share (EPS), which is a figure of significant interest to investors, can be obtained by dividing the profit after tax (PAT) by the number of shares. The P&L A/C provides a summary of a company’s activities during an accounting year. The financial statement of a company can be assessed to evaluate its financial position, with financial ratios being extensively used for this purpose. Ratio analysis enables investors to identify the strengths and weaknesses of the company.
It additionally aids in the examination of whether the financial performance and financial strengths are improving or declining. Ratios can be utilized for comparative analysis, either with other firms in the industry through cross-sectional analysis or with past data through a time-series analysis. Various ratios gauge different aspects of a company’s performance or health. Four groups of ratios can be used for analyzing a company’s performance. Liquidity Ratios: These ratios assess the company’s capacity to meet its short-term obligations and showcase its short-term financial strength or liquidity. The commonly used ratio is the Current Ratio, which is calculated as Current Assets divided by Current Liabilities.
Quick Ratio = Current Assets – Inventory – Prepaid Expenses / Current Liabilities. A higher Quick Ratio would allow a company to fulfill its short-term obligations even in the event of a decline in the value of current assets. The Quick Ratio represents the proportion of quick assets to current liabilities, serving as a more stringent measure of liquidity. However, it is essential to use both these ratios together when analyzing the company’s liquidity. Leverage Ratios, also known as capital structure ratios, assess the company’s ability to meet its long-term debt obligations and indicate its long-term solvency. Commonly used leverage ratios include: Debt-Equity Ratio = Shareholder’s Equity / Long-term Debt and Debt to Total Asset Ratio = Total Debt / Total Assets.
The Proprietary Ratio represents the proportion of Shareholders’ Equity to Total Assets. The Interest Coverage Ratio measures the ability of a company to meet its interest payments, calculated using EBIT and Interest. The first three ratios indicate the financing contribution of owners and creditors in relation to the company’s assets, reflecting the safety margin for long-term creditors. The coverage ratios assess the company’s ability to meet interest payments on its debt. Profitability Ratios evaluate the profitability of a company, which can be calculated by relating profits to sales, investment, or equity shares. Thus, we have three groups of profitability ratios.
The following are listed below:
A. Profitability related to Sales
Gross Profit Ratio = Gross Profit (Sales – Cost of Goods Sold) / Sales
Operating Profit Ratio = Earnings Before Interest and Taxes (EBIT) / Sales
Net Profit Ratio = Earnings After Taxes (EAT) / Sales
Administrative Expenses Ratio = Administrative Expenses / Sales
Selling Expenses Ratio = Selling Expenses / Sales
Operating Expenses Ratio = Administrative Expenses + Selling Expenses / Sales
The Operating Ratio is the sum of Cost of Goods Sold (COGS) and Operating Expenses divided by Sales. It measures profitability in relation to investment. Return on Assets is calculated by dividing Earnings After Taxes (EAT) by Total Assets. Return on Capital Employed is determined by dividing Earnings Before Interest and Taxes (EBIT) by Total Capital Employed. Return on Equity is calculated by dividing Earnings After Taxes (EAT) by Shareholders Equity. Earnings Per Share is determined by dividing Net Profit available to Equity Shareholders by the Number of Equity Shares.
The formula for Earnings Yield is EPS (Earnings per Share) divided by Market Price per Share. The formula for Dividend Yield is DPS (Dividend per Share) divided by Market Price per Share. The formula for Dividend Payout Ratio is DPS divided by EPS. And the formula for Price Earning Ratio (P/E Ratio) is Market Price per Share divided by EPS. The overall profitability, or Earning Power, is determined by the Return on Investment (ROI), which is calculated by dividing EAT (Earnings After Taxes) by Total Assets.
It represents the earning power or operating efficiency of a company and is a central measure. These ratios, also known as turnover ratios, measure the efficiency in asset management by showing the speed at which assets generate sales. Some important activity ratios include: Current Asset Turnover (Sales / Current Assets), Fixed Assets Turnover (Sales / Fixed Assets), and Total Assets Turnover (Sales / Total Assets). [pic] BOOM RECOVERY RECESSION DEPRESSION INVEST DISINVEST 4 3 2 1 Profits Years
