Fundamental Security Analysis

FUNDAMAENTAL SECURITY ANALYSIS

THE FUNDAMENTAL SECURITY ANALYSIS is to appraise the intrinsic value of a security. The intrinsic value is the true economic worth of a financial asset. The fundamentalists maintain that at any point of time every share has an intrinsic value which should in principle be equal to the present value of future stream of income.

To determine the intrinsic value of an equity share, the security analysis must forecast the earning and the dividends expected from the stock and choose a discount rate which reflects the risk of the stock.

The fundamentalists than argue that in case there is something less than complete information, the actual price of the stock is generally away from the is intrinsic value. Thus they believe that market can often be wrong in appraising the value of the share of a company.

Researchers have found that stock price changes can be attributed to the followings factors.

⌂ Economy wide factors; 30-35 percent

⌂ Industry factors; 15-20 percent

⌂ Company factors 30-35 percent

⌂ Others factors 15-20 percent

Based on the above evidence, a commonly advocate procedure of fundamental analysis involves a three steps examination, which calls for;

⌂ Understanding of the macro economic environment and development

⌂ Analyzing the prospectus of the industry to whish the firm belongs

⌂ Assessing the projected performance of the company and the intrinsic value of the shares.

Relying upon the reasoning, the fundamentalists attempts to estimate the real worth of a security by considering the earning potential of a firm which in turn will depend on investment environ factors such as state and growth of national economy .monetary policy of the reserve bank of India, corporate laws social and potential environment and so on.

Fundamental analysis insists that no one should purchase or sell a share on the basis of tips and rumors. The fundamental approach he calls upon the investors to make his buy or sell decision on the basis of a detailed analysis of the information about the company about the industry o whom the company belongs, and the economy.

This results in inform investing for this, a fundamentalists makes use of the EIC framework of analysis. This framework thus involves three steps

1. Economic analysis

2. industry analysis

3. company analysis

ECONOMIC ANALYSIS

The level of economic activity has an impact on investment in many ways. If the economy grows rapidly, the industry can also be expected to show rapid growth and vice versa. When the level of economic activity is low, stock prices are low, and when the level of economic activity is high, stock prices are high reflecting the prosperous outlook for sales and profits of the firms. Economic analysis implies the examination of GDP,; government financing, government borrowing, consumer durable goods market, non-durable goods and capital goods market, savings and investment pattern, interest rates, inflation rates, tax structure, foreign direct investment, and money supply.

A discussion of the economy usually has two components:The national economy and The effect of the international economy on the national economy.

The growth of the national economy is mainly determined by the domestic consumption pattern. Economists point out that higher consumption leads to economic growth. This is based on the argument that growth in consumption pattern fosters sales, which in turn induce production of goods and services in the economy. In addition, the interaction of other economies with the domestic economy also has a large influence on a nation's economic growth. The international trade policies, global demand/supply factors, and so on, hinder or foster relationships with other countries. A domestic economy, which has freely let in interna-”jonal players into its economic environment? will be subject to global trends more drastically than an economy that restricts the entry of foreign participants into its economy.

DIFFERENT FACTORS OR TOOLS OF ECONOMIC ANALYSIS

GROSS DOMESTIC PRODUCT

GDP indicates the rate of growth of the economy. It is one measure of economic activity. This is the total amount of goods and services produced in a country in a year. It is calculated by adding the market values of all the final goods and services produced in a year.

It is a gross measurement because it includes the total amount of goods and services produced, of which some merely replace goods that have depreciated or have worn out.

It is domestic production because it includes only goods and services produced within a country.

It measures current production because it includes only what is produced during the year.

It is a measurement of the final goods produced because it does not include the value of a good when it is sold by a producer, again when it is sold by a distributor, and once more when it is sold by the retailer to the final customer. GDP counts only the final sale

GDP has several components. A component analysis is helpful to the investors, as other economic variables such as interest rates, and exchange rates have Differential effects on the components of GDP :.

The major components of GDP are:

1) Consumption spending

2) Investment spending

3) Government expenditure

4) Goods and services produced domestically for export

5) The production of goods and services consumed in the process of distributing imports to the domestic ending consumer

1) Consumption Spending

Consumption spending represents the production of those domestic goods and services which are consumed by the public. It is often sub classified into spending on durable goods, non-durable goods, and services.

● Durable goods are items such as cars, furniture, and household appliances which are used for several years

● Non-durable goods are items such as food, clothing, and disposable Products, which are used for a short time.

● Services include the rent paid on premises (or estimated values for Owner occupied housing, electricity, and other utilities), airplane tickets, Legal advice and medical treatment and so on.

A buoyant market is very often represented by a significant percentage of consumption spending in the total GDP. This is because an increase in consumption spending leads to an immediate increase in capacity utilization, in turn increasing the profitability of companies.

2) Investment Spending

Investment spending represents using capital for future productive purposes. Investment spending consists of non-residential fixed investment, residential investment, and inventory changes.

Non-residential fixed investment is the creation of tools and equipment to use in the production of other goods and services. For example, the establishment of factories, installation of new machines, and computers for business use are non-residential fixed investment.

Residential investment is the building of a new house or apartment.

Inventory changes consist of changes in the level of stocks of goods necessary for production, and finished goods ready to be sold.

Investment spending does not necessarily lead to an immediate release of productive goods and services. There is a time lag before which investment spending results in increased profitability for companies.

3) Government Expenditure

Government expenditure consists of spending by the central, state, and local Governments on goods and services such as infrastructure, research, roads, defense, schools, and police and fire departments. This spending does not include the amount spent in the form of relief or compensation, since they do not represent production of goods and services.

Government expenditure as a percentage of GDP will be more in the case of regulated markets and relatively less in a liberalized economy. A regulated market hence looks for the government expenditure component to determine the scope of industrial growth. In a fully liberalized market, however, the extent of government expenditure does not dramatically affect the overall GDP position and, hence, the capital market outlook.

4) Exports

Exports are items produced in a country and purchased by foreigners. Exports lead to an exchange of productive goods and services for an equivalent foreign currency. Exports increase the purchasing power 1 of a nation in an international market.

5) Consumption in the Process of Import Distribution

Consumption of services in the process of import distribution also leads to local productivity. Imports are terns produced by foreigners and purchased by local consumers. For the purpose of computing GDP, cnditures involving localization or internalization of the imported goods are considered.

The sources of growth identify industries or sectors deserving closer scrutiny for possible investment. Figure 9.1 shows the almost similar movements of GDP and average BSE Sensex index for the respective years. This can be interpreted to mean that the movement of GDP and capital markets is highly correlated aid that the prediction of capital market movement through GDP expectations can be very useful and relevant for investors. In the figure, a sudden decline in the GDP movement during 1998-99 has ■nstabilised the BSE Sensex averages. The recovery of GDP during 2000-01 has been followed by a i Kcovery of the BSE Sensex average.

Monetary Policy and Liquidity

Businesses need access to funds in order to borrow, raise capital, and invest in assets. Likewise, individuals also may need access to funds to borrow to purchase house, car, and other high-priced durable goods.

If the monetary policy is very tight and banks have little excess reserves to lend, the sources of capital become scarce and economic activity may slow down or decline.

Although a good monetary policy and liquidity is essential for the economy excess liquidity can be harmful. Excess money supply growth can lead to inflation, higher interest rates, and higher risk leading to costly sources of capital and slow growth.

Money supply can be measured through Ml, M2, and M3. Ml is the amount of currency in circulation,. M2 is defined as Ml plus small time and savings deposits. M3 measures the money supply that includes M2, plus large time deposits, repose at commercial

Savings and investment

It is obvious that growth requires investment which in turn requires substance-amount of domestic savings. Stock market is a channel through which the savings of the investors are ade available to the corporate bodies. Savings are distributed over various assets like equity shares, deposits, itual fund units, real estate and bullion. The saving and investment patterns of the public affect the stock to great extent.

Interest rates

The interest rate affects the cost of financing to the firms. A decrease in interest rate implies lower cost of finance for firms and more profitability. More money is available at a lower interest rate for the brokers who are doing business with borrowed money. Availability of cheap fund, encourages speculation and rise in the price of shares. The bank rate of the

RBI is given below.

Table 12.2 Bank Rate from 1997-2003

Bank Rate %p.a. Bank Rate %p.a.April 1997 11 Oct. 2000 8June 1997 10 Feb 2001 7.5October 1997 9 March 2001 7.0January 1998 11 22 Oct 2001 6.5March 1998 10.5 29 Oct 2001 625April 1998 10 April 2003 6.0March 1999 8

Inflation

Inflation can be defined as a trend of rising prices caused by demand exceeding supply. Over time, even a small annual increase in prices of say 1 per cent will tend to influence the purchasing power of the nation. In other words, if prices rise steadily, after a number of years, consumers will be able to buy only fewer goods and services assuming income level does not change with inflation.) '

The economic effects of minor inflationary effects can be positive and often can be taken as a sign that the economy is in an expansionary phase. 'Although inflation is mainly a monetary phenomenon, at times, outside factors, such as raw material shortages can increase the inflation rate. Inflation occurs when short-term economic demand exceeds the long-term supply constraint. The effects of inflation on capital markets are numerous.

In terms of valuing financial assets, inflation reduces the value of fixed-income securities. An increase in the expected rate of inflation is expected to cause a nominal rise in interest rates. Also, it increases uncertainty of future business and investment decisions, which in turn, increases risk premiums. As inflation increases, it results in extra costs to businesses (they are generally unable to pass all the cost increases through to the consumer), thereby squeezing their profit margins and leading to real declines in profitability

International Influences

Rapid growth in the overseas market can create surges in demand for exports, leading to growth in export-sitive industries and overall GDP. In contrast, the erection of trade barriers, quotas, nationalistic our, and currency restrictions can hinder the free flow of currency, goods, and services, and harm the rt sector of an economy. Although some attempts at policy coordination have been made by the G-7 nations, most coordination has focused on strengthening or weakening the exchange rates of some of its members, most notably those of the United States and Japan. The business cycles of the developed, developing, and less-developed nations do not rise and fall together. Therefore, a strong economy such as that of the US can, at times, assist economies experiencing a recession by importing their products, and vice versa.One important measure of influence of international economies is the exchange rate—the rate at which one currency may be converted into another. It is also called rate of exchange, or foreign exchange rate, or currency exchange rate. The purchasing power parity (PPP) approach derives from the assumption that, identical goods should be sold at identical prices globally. The existence of one price implies that exchange rates should adjust to compensate for price differentials across countries. In other words, if we are in a mango-world (where only mangos exist), and a mango is sold in the US at $1, and the same mango is sold in India for Rs 48, then the exchange rate has to be Rs 48 per dollar. Though it is unlikely that one country will have a total influence on the share market, any major fluctuations in the international scenario tends to affect the local market when it is open to international players. A liberalized economy hence, will have a high impact of international influences.

Consumer Sentiment

Optimistic consumer sentiment may lead consumers to make a long-delayed purchase of durable goods or Id be more free with their money at gift giving or vacation time. Such variations in consumer sentiment will lead to alternating periods of sales growth and decline for consumer-oriented industries, particularly manufacturers of consumer durables. It is also known that risk premiums are influenced by consumers and hence lead to change in investor attitudes over the course of a business cycle. As a result, consumer sentiment can be expected to affect both cash flow (that is, higher or lower sales and operating incomes) is well as the required risk premiums on financial market investments.

Consumer sentiment is usually expressed in terms of the future expenditures planned and the feeling about the future economy. A high interest rate and no tax savings opportunities would induce a consumer sentiment of current purchases. This would lead to a high current demand for products. A favorable savings environment with high interest rates would induce the customers to postpone current purchases for future spending.The Asian Consumer Growth and Prospects Index measures the predicted consumer demand growth in 14 Asian countries. The Asia Market Research editors, staff and partners are developing this index. The index is designed to provide a forecast of relative index of consumer sentiment and demand for a year. At present, several algorithms are being used in the computation of the index and include subjective perceptions from 24 industry; market research, and management professionals in Asia; unemployment figures; salary growth; job vacancies; consumer confidence; sales growth in key consumer industries, country risk, GDP, and a lagged indicator of share market performance. The Consumer Growth Prospect Index is prepared every month.

The tax structure

Every year in March, the business community eagerly awaits the Government s announcement regarding the tax policy. Concessions and incentives given to a certain industry encourage investment in that particular

industry. Tax relief’s given to savings encourage savings. The Minimum Alternative Tax (MAT) levied by the Finance Minister in 1996 adversely affected the stock market. Ten years of tax holiday for all industries to be set up in the northeast is provided in the 1999 budget. The type of tax exemption has impact on the profitability of the industries.

Long-term Growth Expectations

The long-term growth path of the economy is determined by supply factors. Growth will be constrained in the long run by limits in technology, size and training of the labour force, and availability of adequate resources and incentives to expand.The rate of growth of output can be separated into two distinct categories: 1) growth from an increase in the factor inputs to production and 2) growth in output relative to the growth of all factor inputs, or tool factor productivity (TFP). The implementation of technology acts to increase TFP, as does increased education and training of the workforce, reallocation of resources to their highest and most valued use, and increasing economies of scale.The Cobb-Douglas production function to look at the contribution of each factor input to long-term growth is: Y = T x L x K x E

Total output (Y) is equal to the contribution to production of technology (T), multiplied by labor (L), by capital (K), and by other factors (E).

□ Technology Effect

Technological change allows for increased output with prevalent factor inputs. Technological change is an important determinant of growth of output because it increases productivity and the efficiency of all other inputs to production. Technological change can be exogenous or endogenous. Endogenous change in technology is through an input to production, such as machinery or better managerial techniques. Exogenous change in technology is through external influence such as innovation and collaboration.

□ Labour Effect

Labour can be broken down into three factors: number of laborers, allocation of labour, and increased education of the labour force. Labour effect is measured by the product of population and labour participation rate. Labour participation rate, on the other hand, is determined by the percentage of labour forcethat is employed. The quality of the labour force will depend on the work force, hours worked per employee, total hours worked, extent of business training undergone by the labour force, and educational background of the labour force.Labour Effect = Population x Labour force participation rate x Average number of hours worked per week x Labour productivity

□ Capital Effect

Capital formation is directly influenced by the rate of national savings. Private savings including household and business savings is equal to domestic investment. Capital effect can also be measured in terms of the net capital share held by the economy. This is determined by the quantum of capital employed in the economy, amount spent on technology and Research and Development, and industrial capacity utilisation.

□ Other Contributing Factors

Other long-term expectation contributors are the prevalent economic mix (manufacturing versus service) energy availability, economic stability, foreign competition, and incentives provided by the government. The incentives of the government could be in the form of regulation, tax policies, and government's direct contribution to productive output. Besides, a country's politics, societal influences and demographics may also affect long-term growth expectation.Positive or negative changes in these factors may lead to changes in future economic growth.

Influences on Short-term Expectations

In contrast to long-term expectations, mainly driven by supply factors, short-term expectations about the economy are mainly caused by demand factors. Fluctuations in demand relative to long-term supply constraints create fluctuations in real GDP, which are known as business cycles. When demand exceeds supply, the result is inflation. When demand is less than supply, rising unemployment and recession may occur. Short-term economic forecasting focuses on sources of demand as a means to predict future trends in economic variables.Increases and decreases in demand, relative to long-term constrained supply growth result in business cycles and associated fluctuations in cash flows, interest rates, and risk premiums. As part of the top-down investment approach, analysts hence examine short-term demand trends and influences. These influences can then be evaluated to estimate their influence on different economic sectors, industries, and investments.

A business confidence index (BCI) is published periodically by various organizations/institutions to assess the short-run expectations from the economic perspective. The FDI Confidence index in the US: lfo business climate index, Germany, Business Confidence index, Japan, South Africa, and so on given an insight into the short-term expectations of business in the respective economies.

The National Council of Applied Economic Research (NCAER) computes a business confidence index through the business expectation survey in India. NCAER constructs a business confidence index based on business

perceptions of four indicators: current investment climate, current capacity utilization, overall economic conditions, and financial performance of firms in the next six months. Of these four components, three pertain to the outlook specific to the respondent company's financial position, capacity utilization and investment climate.

These perceptions are based on questionnaires and interview responses of surveyed companies. The BCI is published quarterly and is an estimate of the short-term expectations of the business. The component's change is also examined to assess the overall future impact on business. The improvement/ decline in the index hence is analysed in terms of micro/macro-level business performance. The extent of support from capacity utilisation and perception of investment environment to a large extent determines the fundamental economic backup of the BCI.The survey also reports the business confidence index on a regional basis, that is, north, south, east, and western regions. The differentiation is also made in terms of industry segments hence, the confidence due to industry sector performance can be interpreted from the index. Based on this analysis NCEAR also presents its forecasts of economic and industry performance in the short-term.

Economic Forecasting

To estimate the stock price changes, an analyst has to analyse the macro economic environment and the factors peculiar to the industry he is concerned with. The economic activities affect the corporate profits, investors, attitude and the share prices. Fall in the GDP or a slackness in the economic growth may lead to fall in corporate profit and consequently the security prices. For the purpose of economic analysis, an anaiysi should be familiar with the forecasting techniques. He should know the advantages and disadvantages of various techniques. The common techniques used are analysis of key economic indicators, diffusion index, surveys and econometric model building. These techniques help him to decide the right time to invest and the type of security he has to purchase i.e. stocks or bonds or some combination of stocks and bonds.

Economic indicators

The economic indicators are factors that indicate the present status, progress or slow down of the economy. They are capital investment, business profits, money supply, GNP, interest rate, unemployment rate, etc. The economic indicators are grouped into leading, coincidental and lagging indicators. The indicators are selected on the following criteria ▲Economic significance

▲ Statistical adequacy ▲ Timing Conformity

The leading indicators indicate what is going to happen in the economy. It helps the investor to predict the path of the economy. The popular leading indicators are the fiscal policy, monetary policy, productivity, rainfall, capital investment and the stock indices. The fiscal policy shows what the government aims at and the fiscal deficit or surplus has an effect on the economy. The tax policy of the government may act as a boost or a deterrent to the industry. The sops given to the export oriented industries may improve the exports of the economy. Likewise the cheap money or the tight money policy adopted by the monetary authorities also indicates the future effects of the policy on the industry. The rise of BSE Sensex and NSE Nifty shows that the economy is heading for recovery..The changes that are occurring in the leading and coincidental indicators are reflected in the lagging indicators. Lagging indicators are identified as unemployment rate, consumer price index and flow of foreign funds. These leading, coincidental and lagging indicators provide an insight into the economy's current and future position.

Econometric Model Building

For model building several economic variables are taken into consideration. The assumptions underlying the analysis are specified. The relationship between the independent and dependent variables is given mathematically. While using the model, the analyst has to think clearly all the inter-relationship between the variables. When these inter-relationships are specified, he can forecast not only the direction but also the magnitude. But his prediction depends on his understanding of economic theory and the assumptions on which the model has been built. The models mostly use simultaneous equations.

Behavior of Economic Indicators and their Suggestive Impact On the Share Market

Economic Indicator Situation Impact on the Share Market

1. Gross domestic product

Growth Positive (Bullish market)

Decline Negative (Bearish market)

2. Inflation Constant Prices Positive (Bullish market)Inflationary/deflationary prices Negative (Bearish

market)3. Unemployment Increase Negative (Bearish

market)Decline Positive (Bullish market)

4. Individual savings Increase Positive (Bullish market)Decline Negative (Bearish

market)5. Interest rate High Negative (Bearish

market)Low Positive (Bullish market)

6. Exchange rate Favorable (Strong against foreign currency)

Positive (Bullish market)

Unfavorable (Weak against foreign currency)

Negative (Bearish market)

7. Domestic corporate tax rate

High Negative (Bearish market)

Low Positive (Bullish market)8. Balance of trade Positive trade balance (exports

greater thanimports) Positive (Bullish market)Negative trade balance (imports greater thanexports) Negative (Bearish

market)

INDUSTRY ANALYSIS

An industry is a group of firms that have similar technological structure of production and produce similar products and Industry analysis is a type of business research that focuses on the status of an industry or an industrial sector (a broad industry classification, like "manufacturing"). The industry classification is economy specific. The boundary of each industry may vary from country to country or from analyst to analyst. A complete industrial analysis usually includes a review of an industry's recent performance, its current status, and outlook for the future. Many industry analyses include a combination of qualitative and statistical data.

Irrespective of specific economic situations, some industries might be expected to perform better, and share prices in these industries may not decline as much as in other industries. This identification of economic and industry specific factors influencing share prices will help investors to identify the shares that fit individual expectations

Industry analysis usually tries to find answers to the following questions:

▲ Is there a difference between the returns for alternative industries during specific time periods?

▲Will an industry that performs well in one period continues to perform well in the future? That is, can we use past relationships between the market and an industry to predict future trends for the industry?

▲Do companies within an industry show consistent performance over time?

▲Are there risk differences between different industries? ▲Does the risk for individual industries vary or does it remain relatively constant over time?

Industry classification

These industries can be classified on the basis of the business cycle i.e. classified according to their reactions to the different phases of the business cycle. They are classified into growth, cyclical, defensive and cyclical growth industry

Growth industry

The growth industries have special features of high rate of earnings and growth in expansion, independent of the business cycle. The expansion of the industry mainly depends on the technological change. For instance, inspite of the recession in the Indian economy in 1997-98, there was a spurt' the growth of information technology industry. It defied the business cycle and continued to grow. Like in every phase of the history certain industries like colour televisions, pharmaceutical and telecommunicate industries have shown remarkable growth.

Cyclical industry

The growth and the profitability of the industry move along with the business cydt During the boom period they enjoy growth and during depression they suffer a set back. For example, white goods like fridge, washing machine and kitchen range products command a good market in the period and the demand for them slackens during the recession.

Defensive industry

Defensive industry defies the movement of the business cycle. For example, food and shelter are the basic requirements of humanity. The food industry withstands recession and depression. The stocks of the defensive industries can be held by the investor for income earning purpose. They expand and earn income in the depression period too, under the government's umbrella of protection and are countercyclical in nature.

Cyclical growth industry

This is a new type of industry that is cyclical and at the same time growing. For example, the automobile industry experiences periods of stagnation, decline but they grow tremendously. The changes in technology and introduction of new models help the automobile industry to resume their growth path.

A common method of classifying businesses or industries by type is the Standard Industrial Classification System, commonly referred to as the SIC Code. It divides virtually all economic activity into divisions that are further broken up into numbered, major groups. SIC codes get progressively more specific as the number of digits increases. A two digit SIC code indicates the broad industry category (eg, furniture).Adding a third digit might further specify a type of furniture (eg, home furniture or office furniture). The fourth digit narrows the industry categories still further (wooden household furniture or metal household furniture). A full listing of SIC codes is an important tool in industry analysis.

The table gives the industry wise classification given in Reserve Bank of India Bulletin.Industries

1. Food products2. Beverages, Tobacco and Tobacco products3. Textiles4. Wood and wood products5. Leather and leather products6. Rubber and plastic products7. Chemical and chemical products8. Non-metallic mineral products9. Basic metals, Alloys and metal products10. Machinery and Machine tools11. Transport equipment and parts

Links between the Economy and Industry Sectors

The economic performance of a country, to a large extent, determines the—favorable or unfavorable— climate for its industrial participation. With

global movement of funds/investments made easy, the world itself is a market place and industries tend to sprout in countries where economic policies and environment are conducive. Industries cluster in a specific economic locality because:

■ Businesses will have to respond to customers' demands for solutions that match their specific needs.

■ Businesses will innovate infinite models of their products to suit different specifications and ensure the maximum amount of applications.

■ Market places will become the interfaces for these efficiently assembled commodities, often in real time.

■ An increasingly competitive world where only the strongest, most successful companies will survive makes businesses choose their economic environment.

■ Business opportunities across economies arise from rapid technological changes, privatization of state enterprises and relaxation of trade barriers.

■ In a global economy, the location of business's functional areas is relevant since companies compete with other companies in their industry.

Industry analysis is more relevant than economic analysis since the final investment decision is to identify investment opportunities. This helps in the next process, that of focusing on companies with sustainable competitive advantage in their respective industries. The ability to compute the growth rate of an industry helps in the better pricing of specificCompanies/securities.

Industry life cycle

The industry life cycle theory is generally attributed to Julius Grodensky. The life cycle of the industry is separated into four well defined stages such as ◘ Pioneering stage

◘ Rapid growth stage

◘ Maturity and stabilization stage ◘Declining stage

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

Rapid growth stage This stage starts with the appearance of surviving firms from the pioneering stage. The companies that have withstood the competition grow strongly in market share and financial performance. The technology of the production would have improved resulting in low cost of production and good quality products. The companies have stable growth rate in this stage and they declare dividend to the shareholders. It is advisable to invest in the shares of these companies. The pharmaceutical industry has improved its technology and the top companies in this sector are giving dividend to the shareholders. Likewise power industry, and telecommunication industry can be cited as examples of expansion stage. In this stage the growth rate is more than the industry's average growth rate.

Maturity and stabilisation stage

In the stabilisation stage, the growth rate tends to moderate and the rate of growth would be more or less equal to the industrial growth rate or the gross

domestic product. Growth rate Symptoms of obsolescence may appear in the technology. To keep going, technological innovations in the production process and products should be introduced. The investors have to closely monitor the events that take place in the maturity stage of the industry.

Declining stage

In this stage, demand for the particular product and the earnings of the companies in the industry decline. Now-a-days very few consumers demand black and white TV. Innovation of new products and changes in consumer preferences lead to this stage. The specific feature of the declining stage is that even in the boom period, the growth of the industry would be low and decline at a higher rate during the recession. It is better to avoid investing in the shares of the low growth industry even in the boom period. Investment in the shares of these types of companies leads to erosion of capital.

Business Life Cycle

Business/product life cycle overlap

TOOLS FOR INDUSTRY ANALYSIS

Industry analysis examines the performance in terms of certain established accounting parameters, and qualitative grading. In other words, industry analysis involves the analysis of data in terms of:

■ Cross-sectional industry performance,

■ Industry performance over time,

■ Differences in industry risk,

■ Prediction about market behavior, and

■ Competition over the industry life cycle.

Cross-sectional Industry Performance

Cross-sectional industry performance is aimed at finding out if the rates of return among different industries varied during a given time period. Analysts usually compare the performance measured in terms of growth in sales, profits, market capitalization and the dividend of various industries. Similar performances during specific time periods for different industries would indicate that such type of industry analysis is unnecessary. As an example, assuming the stock market registered a growth of 10% and an analysis of all industries showed a uniform growth of around 5% to 8%, it might seem futile to find out an individual industry that is a best performer. On the other hand, a wide variation in growth across industries, ranging from 80% to -20% to a stock market growth rate of 50%, would require the examination of those industries that contribute heavily towards a stock market up trend.

Industry Performance over Time

Analysts also perform a detailed exploration of industry performance over time, to identify the stage of product life cycle that the industry is expected to face. Usually a time duration of 3 to 5 years is considered to determine

whether industries that perform well in one time period would continue to perform well in subsequent time periods. In many economies, the forecast of industrial performance has been the most difficult task. The compositional change in the industry and the product definition variation, due to tech-nological change and innovation, restrict the ability to successfully forecast the future performance of the industry

Differences in Industry Risk

Industry analysis besides focusing on industry rates of return, also has to consider industry risk measures. Industry risk specifically investigates two questions:

▲Does risk differ across industries in a given time period?▲Are industry risk measures stable over time?

Risk is measured in terms of variability in returns/productive value. Business risks inherent in industries measured though the operating profit margin deviations, usually confirm a wide variation in the risk pattern of industries.

Risk pattern can also be expected to vary depending on the economic situation/ expectations associated with that time duration. Stability of risk measures over time hence would examine the nature of risk.

Industry risk measured in terms of market performance of shares belonging to a particular industry group also identifies the investment market perception about industry risk.

Prediction about Market Behaviour

Predicting market behaviour can be through a qualitative assessment of the strengths and weaknesses of the industry on the whole. Assessing strengths (S) and weaknesses (W) also leads to the evaluation of opportunities (O), and threats (T). This is termed "SWOT analysis".

A SWOT analysis places an industry between environmental trends (opportunities and threats) and internal capabilities. SWOT analysis is equally applied in industrial analysis as well as in evaluating individual organizations. It helps to evaluate an industry's position to exploit its competitive advantages or defend against its weaknesses. Strengths and weaknesses involve identifying the industry's own (internal) abilities or lack thereof. Opportunities and threats include external situations such as competitive forces, technologies, and government regulations, domestic and international economic trends and so on.

■ Strength is a resource or capacity the industry can use effectively to achieve its objectives. The strengths of an industry provide a comparative advantage in the marketplace. Perceived strengths can include good customer service, high quality products, strong customer need, customer loy-alty, innovative R&D, or strong financial resources.

■ Weakness is a limitation, fault, or defect in the industry that will keep it from achieving its objectives. Weaknesses result when competitors have potentially exploitable advantages over the industry. Once weaknesses are identified, the industry can select strategies to mitigate or correct the weaknesses.

■ Opportunity is any favorable situation in the industry's environment. It is usually a trend or change, or an overlooked need that increases demand for a product or service and permits the industry to enhance its position. Opportunities are environmental factors that favour the industry.

■Threat is any unfavorable situation in the industry's environment that is potentially damaging to its strategy. The threat may be a barrier, a constraint, or anything external that might cause problems to the industry. Threats are environmental factors that can hinder the industry in achieving its goals.

Nature of the competition

Nature of competition is an essential factor that determines the demand for the particular product, its profitability and the price of the concerned company scipts. The supply may arise from indigenous producers and multinationals. In the case of detergents, it is produced by indigenous manufacturers and distributed locally at a competitive price. This poses a threat to the company made products. The multinationals are also entering into the field with sophisticated product process and better quality product. Now the companies' ability to withstand the local as well as the multinational competition counts much. If too many firms are present in the organized sector, the competition would be severe. The competition would lead to a decline in the price of the product. The investor before investing in the scrip of a company, should analyze the market share of the particular company's product and should compare it with the top five companies.

Government policy

The government policies affect the very nerve of the industry and the effects differ from industry to industry. Tax subsidies and tax holidays are provided for export oriented products. Government regulates the size of the production and the pricing of certain products. The sugar, fertiliser and phar-maceutical industries are often affected by the inconsistent government policies. Control and decontrol of sugar price affect the profitability of the sugar industry. In some cases entry barriers are placed by the government. In the airways, private corporates are permitted to operate the domestic flights only. When selecting an industry, the government policy regarding the particular industry should be carefully evaluated. Liberalisation and delicensing have brought immense threat to the existing domestic industries in several sectors.

COMPANY ANALYSIS

Analysis of a company consists of measuring its performance and ascertaining the cause of this performance. , When some companies have done well irrespective of economic or industry failures, this implies that

there are certain unique characteristics for this particular company that had made it a success. The identification of these characteristics,-whether quantitative or qualitative, is referred to as company analysis

Quantitative indicators of company analysis are the financial indicators and operational efficiency indicators. Financial indicators are the profitability indicators and financial position indicators analyzed through the income and balance sheet statements, respectively, of the company

Operational efficiency indicators are capacity utilization and cost versus sales efficiency of the company, which includes the marketing edge of the company. These might not be revealed through financial statements, but can be inferred through the annual reports published by the company for the benefit of investors and the general public. An analysis of the published statements provides an analysis of the past. Usually the formats, as published by the companies, might not be directly understandable to investors. To overcome this, the investor has to identify the factors/variables that are needed separately. To help an investor in this task, many financial magazines, newsletters, and web sites supply consolidated reports of the companies. Such consolidated reports would provide items such as net sales, profit before tax, profit after tax, dividend payment, book value, debt equity components, liquidity position of the company, etc. An examination of these consolidated reports would also help the investors in analysing the performance of a company.

Quantitative factors, qualitative factors of a company also influence investment decisions to a large extent. Qualitative factors are the management reputation, name of the company, operational plans of the company for the future, and so on, as revealed in the Director's/Auditor's reports, as also information revealed by the management to the media. The notice to the annual general meeting supplies the investor with the transactions that are to be finalized by the board of directors hence is a prior indicator of company performance.

TOOLS FOR COMPANY ANALYSIS

Company analysis involves choice of investment opportunities within a specific industry that comprises of several individual companies The choice

of an company broadly depends on the expectations about its future performance in general Here, the business cycle that a company is undergoing is a very useful tool to assess the future performance from that company.Company analysis ought to examine the levels of competition, demand, and other forces that affect the company's ability to be profitable. Of these factors, understanding the competitive environment is most important.A business faces five forces of competition (Porter's Model); namely, seller's competition, buyer's competition, competition from new entrants, exit competition, and existing competition. Competitive forces include the power of those who sell to the business, those who buy from the business, how easily new businesses can enter the industry, how costly it is to exit, and finally, the competition from those already in that industry. How well a company deals with each of these forces will determine whether the company earns above or below average profits. Each of these forces are discussed below.

Threat of New Entrants

If the company is working in a niche market with high profits, there is always the threat that new competitors will enter the market. The high profit margins attract prospective players into the industry and need not necessarily be interpreted as danger signals for the company. The new entry also suggests that the possibility of profit is quite high. Prospects of healthy competition stepping into the industry will lead to higher growth rates.In many instances, companies that are facing a tough time are continuously on the look out for diversification/consolidation. They will be on the watch and if they see an opportunity, they will utilise it. So, company analysis will have to consider the threat from new competition and find out how safe or risk free it is from this and examine if the company can cope up with such competitors. The new competitors, however will face entry barriers.

Threat of Substitute Products and Services

The issue of whether the prospected goods or services are in danger and are likely to be substituted by new developed products is examined here. An indication from the market that consumers will change their preferences due to new developments is to be appraised. This indicates future business prospects as well as potential loss if the company is not flexible and is not able to adapt to changing market conditions

Bargaining Power of Suppliers

Supplier bargaining power to a large extent determines if cost reduction is possible within an organization. It evaluates how strong the bargaining power of the suppliers is and how it will tend to develop in the near future. If there is complete competition between suppliers and new suppliers are likely to join the market, then there will be no risk of increasing costs of inputs. On the other hand, if there are very few suppliers then the company might face difficulties in the future.

Customer Bargaining Power

The bargaining power of customers depends on the local competition, whether or not the buyers can move from one company to another or on their willingness to do so. The company's capability to withstand this shift determines the superiority position occupied by a company in the market. A company that is subject to the threat from suppliers due to the following factors faces relatively more risk.Existing RivalryExisting rivalry indicates the extent of dependence of one company on the other. Many companies are mutually dependent on each other either in terms of products/customers/technology/investment etc. These relationships have to be examined to position the organization with respect to others.

The Financial Statements of Companies

The financial statements of companies are the base data through which company analysis is performed. Financial statements reflect the nature of business of the company. Financial statements are presented in the form of the balance sheet and the income statement.

The balance sheet is one of the financial statements that companies prepare every year for their shareholders. It is like a financial snapshot, the company's financial situation at a moment in time. It is prepared at the year end, listing the company's current assets and liabilities.

The money invested in the business may have been used to buy long term assets or short term assets. The long term assets are known as fixed assets, and help the firm to produce. Examples would be machinery, equipment, computers, and so on, none of which actually get consumed in the production process. The short term assets are known as current assets—assets that are used day to day by the firm. The current assets may include cash, stocks, and debtors

The extraordinary income/expenses may include profits/loss from selling assets or parts of the company, and so on. The final retained profit figure is the one that goes to the balance sheet as a source of fund* for the company to use. This retained profit may be used to buy fixed assets (machinery, equipment, e\ or it may remain as current assets (cash in bank balances).

The contents of the statements differ according to the nature of business of the company. Broadly, the tools that are used for company analysis can be distinguished in terms of whether they are manufacturing companies, financial service companies, trading companies, or multinational companies

Accounting Ratios

Ratios for investment purposes can be classified into profitability ratios, turnover ratios, and leverage ratios. Profitability ratios are the most popular ratios since investors prefer to measure the present profit performance and use this information to forecast the future strength of the company. The most often used profitability ratios are return on assets, price earnings multiplier, price to book value, price to cash flow, price to sales, dividend yield, return on equity, present value of cash flows, and profit margins.

Return on Assets (ROA)

Return on assets (ROA) is computed as the product of the net profit margin and the total asset turnover ratios.

ROA = (Net Profit/Total income) x (Total income/Total Assets)

This ratio indicates the firm's strategic success. Companies can have one of two strategies: cost leadership, or product differentiation. ROA should be rising or keeping pace with the company's competitors if the company is successfully pursuing either of these strategies, but how ROA rises will depend on the company's strategy. ROA should rise with a successful cost leadership strategy because the companion’s 'increasing, operating efficiency. An example is an increasing, total asset, turnover ratio as theCompany expands into new markets, increasing its market share. The company may achieve leadershipby using its assets more efficiently.With a successful product differentiation strategy, ROA will rise because of a rising profit margin. The company can charge a premium price for its product, control costs, or dispose off less profitable operations.

Return on Investment (ROI)

ROI is the return on capital invested in business, ie, if an investment Rs 1 crore in men, machines, land and material is made to generate Rs. 25 lakhs of net profit, then the ROI is 25%. Again, the expected ROI by market analysts could differ from industry to industry. For the software industry it could be as high as 35-40 per cent, whereas for a capital intensive industry it could be just 10-15 per cent.

The computation of return on investment is as follows:

Return on Investment (ROT) = (Net profit/Equity investments) x 100

The definition of equity investments could vary between investors. Usually equity investments refer to amount contributed as paid up capital by the owners of the funds in addition to the capital reserves that are due to the owners. These investments are related to net profit to identify the return on investment.

Return on Equity

Return on equity measures how much an equity shareholder's investment is actually earning. The return on equity tells the investor how much the invested rupee is earning from the company. The higher the number, the better is the performance of the company and suggests the usefulness of the projects the company has invested in.The computation of return on equity is as follows:

Return on equity = (Net profit to owners/value of the specific owner's contribution to the business) x 100

The return on equity, mentioned above, could be categorically computed for different types of owners' capital, namely common shareholders' return and preference shareholders' return. Accordingly, the denominator will change in the above equation. Equity often implies common equity shareholders' funds and their specific reserves. Return on preference equity will have the denominator of preference shareholders' funds and any reserves that are due to preference shareholders' alone.

Earnings Per Share (EPS)

This ratio determines what the company is earning for every share. For many investors, earnings is the most important tool. EPS is calculated by dividing the earnings (net profit) by the total number of equity shares. The computation of EPS is as follows:

Earnings per share = Net profit/Number of shares outstanding

Net profit implies profit that is available to the shareholders. When there are different types of owners, earnings per share must be computed in terms of specific ownership type for better interpretation.

Thus, if AB Limited has 2 crore shares and has earned Rs 4 crore in the past 12 months, it has an EPS of Rs 2. Apart from EPS, the actual growth in EPS is a better measure for the investors to shortlist the companies. The companies in the top list ranked according to growth in EPS would be good investment avenues for the investors.

Dividend Per Share (DPS)

The extent of payment of dividend to the shareholders is measured in the form of dividend per share. The dividend per share gives the amount of cash flow from the company to the owners and is calculated as follows:

Dividend per share = Total dividend payment/Number of shares outstanding

The payment of dividend can have several interpretations to the shareholder. The distribution of dividend could be thought of as the distribution of excess profits/abnormal profits by the company. On the other hand, it could also be negatively interpreted as lack of investment opportunities. In all, dividend payout gives the extent of inflows to the shareholders from the company.

Payout Ratio

From the profits of each company a cash flow called dividend is distributed among its shareholders. This is the continuous stream of cash flow to the owners of shares, apart from the price differentials (capital gains) in the market. The return to the shareholders, in the form of dividend, out of the company's profit is measured through the payout ratio. The payout ratio is computed as follows:

Payout Ratio = (Dividend per share/Earnings per share) * 100

The percentage of payout ratio can also be used to compute the percentage of retained earnings. The profits available for distribution are either paid as dividends or retained internally for business growth opportunities. Hence,

when dividends are not declared, the entire profit is ploughed back into the business for its future investments.

The computation of retained earnings ratio (Retention Rate) is as follows:Retention Rate = 1 - Payout ratio

For example, if the company has an EPS of Rs. 15 and declares a DPS of Rs 5, the payout ratio is computed as (5/15) * 100 = 33.33 per cent. The retention rate is hence (10/15)*100 or 1-33.33, per cent ie, 66.67 per cent.

Dividend Yield

Dividend yield is computed by relating the dividend per share to the market price of the share. The market place provides opportunities for the investor to buy the company's share at any point of time. The price at which the share has been bought from the market is the actual cost of the investment to the shareholder. The market price is to be taken as the cum-dividend price. Dividend yield relates the actual cost to the cash flows received from the company. The computation of dividend yield is as follows

Dividend yield - (Dividend per share/Market price per share) * 100

High dividend yield ratios are usually interpreted as undervalued companies in the market. The market price is a measure of future discounted values, while the dividend per share is the present return from the investment.

Hence, a high dividend yield implies that the share has been underpriced in the market. On the other hand a low dividend yield need not be interpreted as overvaluation of shares. A company that does not pay out dividends will not have a dividend yield and the real measure of the market price will be in terms of earnings per share and not through the dividend payments.

Price/Earnings Ratio (P/E)

The P/E multiplier or the price earnings ratio relates the current market price of the share to the earnings per share. This is computed as follows:

Price/earnings ratio = Current market price/Earnings per share

The current market price is expected to reflect the value of shares at present and when compared to the earnings per share, a low P/E multiplier has the implication that the current market price is too low for the earnings declared by the company. Many investors prefer to buy the company's shares at a low P/E ratio since the general interpretation is that the market is undervaluing the share and there will be a correction in the market price sooner or later.

A very high P/E ratio on the other hand implies that the company's shares are overvalued and the investor can benefit by selling the shares at this high market price. However, P/E multiplier alone will not accurately predict the future price movements of the share.

P/E ration alone does not give a complete and true picture about the company. If AB limited is currently trading at Rs 20 a share with Rs 4 of earnings per share (EPS), it would have a P/E of 5. When a share's P/ E ratio is high, the majority of investors consider it as expensive or overvalued. Shares with low P/E's are typically considered better investment options.

Book Value Per Share

The book value per share is computed as per the balance sheet of the company. The book value per share gives a historical valuation of the company and sometimes book value indicates the exact amount that the shareholders' hold as their stake in the company. The computation of book value per share is as follows:

Book value per share = (Total Assets-Intangible Assets)/Number of Shares

The book value per share is sometimes referred to as the cost of assets held in the business as on a specific day. It is a more realistic measure of the under valuation/over valuation of a company in the market. The company's shares are expected to have at least the book value as a starting point. However, this measure is subject to a lot of criticism since book value is a historical accounting measure and need not necessarily reflect the true worth of the company. It is more subject to accounting policies and procedures rather than the liquidation value or the true worth of the company.

Current Ratio

The testing of liquidity of the business is through the current ratio. A company that manages its current obligations through its current holdings will be able to match its asset-liability structure profitably. The computation of the current ratio is given below:Current Ratio - Current Assets/Current liabilitiesCurrent assets and current liabilities are classified on the basis of the time duration that these assets are expected to be in the books of a company. Current assets are rotated in the business quiet often and they do not retain the same form for more than twelve months. Hence they are termed as current asset

Debt-to-Equity Ratio

This measures how much debt a company has compared to its equity. The debt-to-equity ratio is computed by dividing the total debt of the company with the equity capital. If it is 1, then the company still has the equity backup to borrow further. A D/E ratio of more than 2 is considered risky. It means that the company has a high interest burden, which could eventually affect the bottom line. If interest payments are using only a small portion of the company's revenues, then the company is better off by employing debt to increase growth. Also capital intensive industries tend to have a higher debt/equity ratio, hence the interpretation of D/E ratio must be through a comparison of industry average

Conclusion

Fundamental analysis is the study of economic factors, industrial environment and the factors related to the company. The job of fundamental security analysis is to short out the temporary disequilibrium from the true shifts in the national economy and the accounting gimmicks from true changes in the firms income in order to arrive at an unbiased estimate of the intrusive value

Decision rules for buying and selling individual security result from depends on comparison of relative value .The degree of sophistication of these fundamental approach to investments range from the classic, qualitative, discussion of investment values to highly refined, technically complex valuation.

Understandably, fundamental analysis is the most widely used method of estimating security prices. But even under ideal condition fundamental analysis can suggest only a range of prices rather than a specific value.

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.

BIBLIOGRAPHY

Books

1. Investment management….written by V.K.bhalla

2. Investment analysis and portfolio management… Written by M. Ranganatham and R.Madhumathi

3 Security Analysis and Portfolio ManagementWritten by Punvathy Pandian

4. Investment analysis and portfolio management

Written by Prasanna Chandra

5. Portfolio Management…..written by S.Kevin