Fundamental analysis

Fundamental analysis is a method of evaluating a security or asset 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.

The fundamental approach is based on an in-depth and all-around study of the underlying forces of the economy, conducted to provide data that can be used to forecast future prices and market developments.

Fundamental analysis can be composed of many different aspects: the analysis of the economy as the whole, the analysis of an industry or that of an individual company.

A combination of the data is used to establish the true current value of the underlying asset, to determine whether they are over- or under-valued and to predict the future value of the underlying asset based on this information.

As far as short-term trading is concerned, fundamental analysis cannot be used as a "tactical", short-term decision-making method.

It helps an investor obtain information about the overall state of the market, attractiveness and state of a specific security as compared to other securities, However, when and how to react to the information, derived through fundamental analysis, is determined using technical analysis.

Though the basic approach is the same while doing fundamental analysis, the various factors that affect the value of the underlying asset keep changing depending upon the class and nature of the asset under focus.

For example weather may not play a major factor while analysing the value of the share of a company, which is in the business of Information technology.

Thus it is important for an analyst to identify the factors that are likely to affect the value of the underlying asset and then resort to the study of the said factors.

Fundamental analysis seeks to identify the fundamental economic and political factors that determine a commodity’s price.

It is basically an analysis of the (current and future) demand and supply of a commodity to determine if a price change is imminent, andin which direction and by how much prices are expected to

change.

This approach requires gathering substantial amounts of economic data and political

intelligence, assessing the expectations of market participants, andanalyzing these information to predict futures price movement

The end goal of performing fundamental analysis is to produce a value that an investor can compare with the underlying assets current price in hopes of figuring out what sort of position to take with that security(under priced = buy, overpriced = sell).

Fundamental analysis focuses on cause and effect — causes

external to the trading markets that are likely to affect prices in the market. These factors may include the weather, current inventory levels,

government policies, economic indicators, trade balances and even how traders are likely to react to certain events.

Fundamental analysis maintains that markets may misprice a commodity in the short run but that the "correct" price will eventually be reached. Profits can be made by trading the mispriced commodity and then waiting for the market to recognize its "mistake" and correct it.

Various Techniques of Fundamental Analysis

The Demand-Supply Framework Price Elasticity

The Balance Table Stocks-to-Disappearance Ratio

The Tabular and Graphic Approach

The Regression Analysis Econometric Models

Seasonal Price Index

Market Demand: Market demand represents how much people are

willing to purchase at various prices. Thus, demand is a relationship between price and quantity demanded, with all other factors remaining constant.

2001 1,899 9,503 10 11,412 7,911 1,905 9,815 1,5962002 1,596 8,967 14 10,578 7,903 1,588 9,491 1,0872003 1,087 10,089 14 11,190 8,332 1,900 10,232 9582004 958 11,807 11 12,776 8,844 1,818 10,662 2,1142005 2,114 11,114 9 13,237 9,136 2,134 11,270 1,9672006 1,967 10,535 12 12,514 9,086 2,125 11,210 1,3042007 1,304 13,168 15 14,487 10,240 2,350 12,590 1,897

Imports Total Dom. Use Exports TotalEnding Stocks

Corn: Supply and Disappearance, 1996-2007 (million bushels)

YearSupply Disappearance

Beg. stocks

Production

The Balance Table summarizes the key components of current-season supply and disappearance, along with prior-season comparisons.

Fundamental Analysis:

Seasonal Price IndexMarch Sugar Contract: Average Monthly Prices

Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Avg.

1998 12.8 11.4 9.9 8.8 9.3 8.4 7.5 7.1 7.8 7.2 6.7 6.7 8.6

1999 8.5 9.3 11.5 12.5 12.1 12.5 11.2 10.8 9.6 8.7 7.7 6.9 10.1

2000 9.1 8.6 7.5 7.2 6.0 5.4 5.5 5.9 5.6 4.6 4.4 4.0 6.2

2001 5.5 5.0 4.2 3.8 4.0 5.0 5.8 5.6 6.1 6.1 5.6 5.8 5.2

2002 8.3 9.0 8.6 7.5 6.8 6.9 6.1 6.6 6.8 6.5 7.0 7.6 7.3

2003 8.3 7.6 7.7 7.4 7.0 6.7 6.9 7.4 7.7 8.6 9.8 8.5 7.8

2004 8.6 8.7 9.1 10.3 12.4 10.4 9.8 9.8 10.4 11.3 10.0 10.7 10.1

2005 11.3 11.7 11.6 12.0 13.0 12.9 13.5 14.0 14.8 13.5 14.5 14.7 13.1

2006 14.0 14.4 14.1 12.3 11.4 10.7 10.7 9.7 9.9 9.7 9.0 8.7 11.2

2007 8.5 8.3 7.8 8.3 8.7 8.4 8.8 8.8 8.6 8.9 8.4 8.1 8.5

2008 8.6 8.8 9.0 9.5 9.4 9.1 8.9 8.8 8.7 8.3 8.5 8.8 8.9

Fundamental Analysis thus involves 3 steps

Economic analysis Company analysisIndustry analysis

Economic AnalysisThe performance of a company depends much on

the performance of the economy if the economy is BOOM, the industries and companies in general said to be prosperous. On the other hand, if the economy is in RECESSION, the performance of companies will be generally poor.

Investors are interested in studying those economic varieties, which affect the performance of the company in which they proposed to invest. An analyzed of those economic variable would give an idea about future corporate earnings and the payment of dividends and interest to investors.

Classes of Macro economic policiesFiscal policy – Government spending ,

stimulates the demand for goods.Monetary policy – Manipulation of money

supply in an economy.

Techniques for Economic forecasting(1) GNP(2) SAVINGS AND INVESTMENT(3) INFLATION (4) AGRICULTURE(5) RATES OF INTEREST(6) GOVT. REVENUE, EXPENDITURE &

DEFICITS(7) INFRASTRUCTURE(8) MONSOON(9) POLITICAL STABILITY

Diffusion IndexAn indicator of the extensiveness of an

expansion or contraction.Developed by NBER, USA. Categories Composite index- combines several index

into single measure.Component Index – examines a particular

series for components.D.I. = no. of members in the set in same

direction/ total no. of members in the set.

Coincidental Indicators

Index of industrial Production.Mfg. & sales.Personal income.

Indian ApproachLagging Indicators –Duration of unemployment.Ratio of mfg.Commercial loans.

Leading Indicators – Money supply.Consumer expectations.Orders for plant & machinery

Anticipatory surveysOpinion of experts regarding the spending of

consumers, future plans of customers.Investors can also form their opinion for the

economy.

GNP/ Geometric ModelGNP represents the aggregate value of goods

and services produced in the economy. It reflects the over all performance of the economy. The growth rate of GNP indicates the growth rate of the economy the higher the rate of growth of GNP, the more favorable is it for the stock market and vice versa

Saving & investmentSavings and investment denote that position

of GNP, which is saved and invested savings increases in India since eighties now the rate of savings is 25% from 21% in 80’s, which indicates the growth of capital market. The higher the level of savings interest, the more favorable is it for the stock marketed vice versa

InflationInflation has considerate impact on the

performance of companies. Higher rates of inflation upset business plans and erode purchasing power in the hands of consumers. This will result in lower demand for products. Thus high rates of inflation in an economy are likely to affect the performance of companies adversely. However industries and companies prosper during periods of low inflation. Hence an investor has to evaluate the inflation rates prevailing in the economy currently as well as the trend of inflation likely to prevail in the future.

AgricultureAgriculture forms a major part of the Indian

economy. Some companies are using agricultural raw material as inputs and some others are supplying inputs to agriculture. Such companies are directly affected by changes in agricultural production. Hence, the increase/decrease in agricultural production has a significant bearing on the industrial production and corporate performance

Rate of interestThe cost and availability of credit for companies

are determined by the rates of interest prevalent in an economy. A low interest rate stimulates investment by making credit available easily and cheaply. As a result cost of finance for companies decreases which assures higher profitability. On the other hand, higher interest rates result in higher cost of production, which may lead to lower profitability and lower demand. Hence an investor has to consider the interest rates prevailing in the economy and evaluate their impact on the performance and profitability of the companies.

GOVT. REVENUE, EXPENDITURE & DEFICITS

Government is the largest investor and spender of money. So the trends in government revenue expenditure deficits have a significant impact on the performance of industries and companies. So the investor has to evaluate these carefully to assess their impact on his investments.

InfrastructureThe development of an economy very much on

the availability of infrastructure. It includes electricity, roads and railways, communication channels etc. The availability of infrastructural facilities affects the performance of companies. Bas infrastructure leads to inefficiencies, lower productivity, wastage and delays and vice versa. Thus an investor should assess the status of infrastructural facilities available in the economy before finalizing his investment avenues.

MonsoonThe Indian economy is essentially an agrarian

economy and agriculture forms a very important sector of the Indian economy. But the performance of agriculture to a very great extent depends upon the monsoon. The adequacy of the monsoon ensures the success of the agricultural activities in India and vice versa. Hence the progress and adequacy of the monsoon becomes a matter of great concern for an investor in India.

Political StabilityA stable political environment is necessary

for steady and balanced growth. No industry or company can grow and prosper in the midst of political turmoil. Such long term economic policies are needed for industrial growth. Such stable policies can be framed only by stable political systems.

Industry AnalysisIndustry analysis indicates to an investor whether

the industry is a growth industry or not. It gives an investor a choice of the industry in which the investments should be made.

Industry analysis refers to an evaluation of the relative strength and weakness of particular industries which can be divided in to three parts, viz.,

1. Life cycle of an industry2. Characteristics of an industry3. Profit potential of an industry

Life Cyclea) Pioneering Stage: Technology and product are

newly introduced.

(b) Expansion stage: Those companies which reached first stage grow

further and becomes stronger.

(c) Stagnation Stage: In this stage the growth of the industries

Stabilizes. Sales increases at slower rate.

(d) Decay stage: The industry becomes obsolete and gradually

ceases to exist.

Characterstics of an industryRelationship between Demand & supply: Excess supply reduces the profitability of the industry and

insufficient supply tends to improve the profitability. Thus an investor should estimate the demand and supply gap in an industry.

(b) Period of life: Life of the industry depends on the products and the technology used by the industry. Technological changes leads to product obsolete. No investment should be made in such industries.

(c) State of labour: When there is labour revolution, industries cannot become bright.

(d) Governments attitude: The Government may encourage the growth and development of certain industries by giving much assistance to such industries.

(e) Availability of Raw Material: An industry may depend on internal / external country for raw material. Sometimes they depend on import of raw material.

(f) Cost structure: It refers to the proportion of fixed costs to variable costs. (Discuss about Marginal Cost)

Profit potential of industry(i) Threat new entrants: New entrants inflate cost, push down the prices and reduce

profitability. An industry which is well protected from the entry of new firms would be ideal for investment.

(ii) Competitions among existing firms: The firm competes with each other on the basis of price, quality, promotion, service, warranties and so on. If the rivalry between the firms in an industry is strong average profitability of the industry may be discouraged. The rivalry in an industry is high when the following conditions prevail in the market: (a) There is a sustained competitive battle(b) The industry growth is dull(c) The level of fixed cost is high(d) There is over capacity in the industry continuing for a long time.(e) The industry product is considered as a commodity, which

stimulates strong competition.(f) The industry struggles much to withstand.

Pressure from substitute products: Each firm

in an industry face competition from other firms in the same industry producing substitute products. Substitute products may affect the profit potential of the industry badly. The pressure from the substitute products is found to be high under the following circumstances:(a) When the price of the products is attractive(b) When the cost for the prospective buyers to switch over to a substitute product is minimum.(c) When the substitute products are earning greater profits.

Bargaining power of buyers: Buyers can

bargain for price reduction asks for better quality and better service. The bargaining power of a buyer group is said to be high under the following conditions:(a) If its capacity to buy is more than the capacity of the seller to sell. (b) If the cost of the switch over to a substitute product is low.(c) If it poses a threat of backward integration strongly.

Bargaining power of sellers: Sellers also can exert a

competitive force in an industry and bargain for rise in prices, lower quality, curtail some of the free services they offer etc. Powerful suppliers can affect the profitability of the buyer industry badly. Suppliers are said to be powerful under the following circumstances.(a) Few suppliers dominate the entire market.

(b) There is no viable substitute for the products supplied.

(c) The switching poses a strong threat of forward integration.

(d) Suppliers also pose a strong threat of forward integration.

Company Analysis It involves a close investigative scrutiny of the

companies financial and non financial aspects with a view to identifying its strength, weaknesses and future business prospects.

The financial and non financial aspects are as follows:

Marketing successAccounting PoliciesProfitability

Mktg. SuccessThe success of the market of the firm

depends on (a) The share of the company in the industry (b) Growth of its sales and stability of sales (c) Sales.

Accounting PoliciesA. Inventory Pricing

Cost/market value method FIFO LIFO

B. Depreciation methods Straight line method Sum of the years digit method

C. Non operating income Dividend Interest

D. Tax Carry over Provision for taxation

ProfitabilityA.(a) Gross profit Margin

(b) Net profit Margin(c) Earning power(d) Return on equity(e) Earning per share(f) Cash EPS

B. Financial Statement Analysis Trading, P& L A/C Analysis Balance Sheet Analysis

C. Ratio Analysis Liquidity Ratios Leverage Ratios Profitability Ratios Activity / Efficiency Ratio