Study of Fundamental Analysis

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STUDY OF FUNDAMENTAL ANALYSIS- A QUALITATIVE AND QUANTITATIVE

APPROCH

Research Report submitted to Entrepreneurship Development Institute

of India in partial fulfillment of the requirements for the award of

Post Graduate Diploma in Business Management

Submitted by

Dhananjay Kumar

Register No.: 10AJEPG1028

Under the guidance of

Balaji Rao

Faculty

SBM Jain College

Bangalore

Entrepreneurship Development Institute of India

Ahmadabad


2/15

2011

DECLARATION

I hereby declare that the research entitled STUDY OF FUNDAMENTAL ANALYSIS- A

QUALITATIVE AND QUANTITATIVE APPROCH submitted to Entrepreneurship

Development Institute of India in partial fulfillment of the requirements for the award of

the PGDBM, is a record of independent research work carried out by me under the

supervision and guidance of Balaji Rao, Faculty, SBM Jain College, Bangalore. This

work has not formed the basis for the award of any Degree and has not been submitted

previously to any other College/University.

Bangalore

August ___, 2011 DhananjayKumar


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Balaji Rao

Faculty

SBM Jain College

Bangalore

CERTIFICATE

I certify that this research entitled STUDY OF FUNDAMENTAL ANALYSIS- A

QUALITATIVE AND QUANTITATIVE APPROCH submitted to Entrepreneurship

Development Institute of India in partial fulfillment of the requirements for the award of

PGDBM, is a record of independent research work carried out by Mr. Dhananjay Kumar

under my supervision and guidance. This work has not formed the basis for the award

of any Degree and has not been submitted previously to any other College/University.

Bangalore Balaji Rao

August ___, 2011 Research

Mentor


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1. Fundamental Analysis

Fundamental analysis is the study of a companys financial strength, based on historical data;

sector and industry position; management; dividend history; capitalization; and potential for

future growth. It is a stock valuation method that uses financial and economic analysis to predict

the movement of stock prices. The analysis attempts to find the intrinsic value of a security that

helps investors to make decisions.

The fundamental information that is analyzed can include a company's financial reports, and

non-financial information such as estimates of the growth of demand for products sold by the

company, industry comparisons, and economy-wide changes, changes in government policies

etc.

The various steps involved in the fundamental analysis are:

1. Macroeconomic analysis, which involves considering the overall health of the

economy and its future.

2. Industry analysis, which involves the analysis of the industry in which the company is

operating.

3. Situational analysis of the company, studying their business model, management,

products and services, its current position, its future, etc.

4. Financial analysis of the company, which involves analyzing the financial statements

like balance sheets, income statements, cash flows and ratios.

5. Valuation, which attempts to find the intrinsic value of the securities of the company.

The approach to fundamental analysis is often referred to as E-I-C Approach. The E-I-C

denotes the three parts of the fundamental analysis. The three distinctive parts of fundamental

analysis are:

1. Economic Analysis

2. Industry Analysis and

3. Company Analysis


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I. ECONOMIC ANALYSIS:

Economic analysis is the analysis of forces operating the overall economy a country. It is a

process whereby strengths and weaknesses of an economy are analyzed and is important in order

to understand exact condition of an economy. The various factors considered are:

The Economic Cycle

Countries go through the business or economic cycle and the stage of the cycle at which a

country is in has a direct impact both on industry and individual companies. It affects investment

decisions, employment, demand and the profitability of companies. It is very important to

determine the stage of the cycle into which the economy is passing through. The four stages of

economic cycle are depression, recovery, boom and recession.

Investors should attempt to determine the stage of the economic cycle the country is in. They

should invest at the end of a depression when the economy begins to recover, and at the end of a

recession. Investors should disinvest either just before or during the boom, or at the worst, just

after the boom. Investment and disinvestments made at these times will earn the investor the

greatest benefits.

BOOM

RECOVERY RECESSION

DEPRESSION

INVEST

DISINVEST


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The Political Equation

A stable political environment is necessary for steady, balanced growth. If a country is

ruled by a stable government which takes decisions for the long-term development of the

country, industry and companies will prosper.

Foreign Exchange Reserves

A country needs foreign exchange reserves to meet its commitments, pay for its imports

and service foreign debts. If the reserves are not managed properly it may pose foreign exchange

risks.

Foreign Debt and the Balance of Trade

Foreign debt, especially if it is very large, can be a tremendous burden on an economy.

India pays around $ 5 billion a year in principal repayments and interest payments.

Inflation

Inflation has an enormous effect in the economy. Within the country it erodes purchasing

power. As a consequence, demand falls. If the rate of inflation in the country from which a

company imports is high then the cost of production in that country will automatically go up.

Interest Rates

A low interest rate stimulates investment and industry. Conversely, high interest rates result

in higher cost of production and lower consumption.

Taxation

The level of taxation in a country has a direct effect on the economy. If tax rates are low,

people have more disposable income.

Government Policy

Government policy has a direct impact on the economy. A government that is perceived to

be pro-industry will attract investment.


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II. INDUSTRY ANALYSIS:

The importance of industry analysis is now dawning on the Indian investor as never before. It

is very important to analyze the health of an industry because no company is operating in

isolation. Analysis of an industry can be performed using the tools like:

Industry Life Cycle

The first step in industry is to determine the cycle it is in, or the stage of maturity of the

industry. All industries evolve through the following stages:

1. Introduction

2. Growth

3. Maturity

4. Decline

Porters Five Forces Model

There are competitive forces and it is these competitive forces that determine the extent of

the inflow of funds, the return on investment and the ability of companies to sustain these

returns. Porter has identified five competitive forces that shape every industry and every market.

The five forces identified by Porter are:

1. Threat of new entrants

2. Threat fo substitutes

3. Baggaining power of the customers

4. Bargaining power of the suppliers

5. Rivalry among competitors


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III. COMPANY ANALYSIS:

Company analysis is the final stage of fundamental analysis. The economy analysis provides

the investor a broad outline of the prospects of growth in the economy. The industry analysis

helps the investor to select the industry in which investment would be rewarding. Now he has to

decide in which company he has to invest. Company analysis provides the answer to this

question.

In company analysis the investor tries to predict the future earnings of the company because

there is strong evidence that the earnings have a strong effect on the share prices. The level, trend

and safety of earnings of a company, however depend upon a number of factors concerning the

operations of the company.

The different issues regarding a company that should be examined are:

The Management

The Company

The Annual Report

Ratios

Cash flow

The Management:

Management is the most important factor that should be first looked into in a company. The

performance of a company is primarily dependant on the effectiveness of the management.

Investors must check on the integrity of the managers, proven competence, rating among its

peers, its performance at the time of adversity, its depth of knowledge, innovation and

professionalism.


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The Company:

It is most important to understand the company because ultimately the profitability depends

on the business it is into. Many factors are considered here including the products and services,

its competitors, competitive advantage, market position, policies, etc.

The Annual Report:

The annual report is the primary and most important source of information on a company.

By law, this is prepared every year and distributed to the shareholders. It contains very important

information relating to the performance of a company over a period of time.

The Annual Report is broken down into the following specific parts:

A) The Director's Report,

B) The Auditor's Report,

C) The Financial Statements, and

D) The Schedules and Notes to the Accounts.

A. The Directors Report

The Directors Report is a report submitted by the directors of a company to its shareholders,

advising them of the performance of the company under their stewardship. A Directors Report

is valuable and it gives information relating to the workings of a company, the problems it faces,

the direction it intends taking, and its future prospects.

B. The Auditor's Report

The auditor represents the shareholders and it is his duty to report to the shareholders and the

general public on the stewardship of the company by its directors. Auditors are required to report

whether the financial statements presented do, in fact, present a true and fair view of the state of

the company. The auditors are their representatives and that they are required by law to point out

if the financial statements are not true and fair. They are also required to report any change, such

as a change in accounting principles or the non provision of charges that result in an increase or

decrease in profits.


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C. Financial Statements

The published financial statements of a company in an Annual Report consist of its

Balance Sheet as at the end of the accounting period detailing the financing condition of the

company at that date, and the Profit and Loss Account or Income Statement summarizing theactivities of the company for the accounting period.

Balance Sheet

The Balance Sheet details the financial position of a company on a particular date; of the

company's assets (that which the company owns), and liabilities (that which the company owes),

grouped logically under specific heads. It must however, be noted that the Balance Sheet details

the financial position on a particular day.

Profit & Loss Account

The Profit and Loss account summarizes the activities of a company during an

accounting period which may be a month, a quarter, six months, a year or longer, and the result

achieved by the company. It details the income earned by the company, its cost and the resulting

profit or loss. It is, in effect, the performance appraisal not only of the company but also of its

management- its competence, foresight and ability to lead.

D. The Schedule and Notes to the Accounts:

Schedules and notes to the accounts are found after the financial statements in the annual

report. The schedules detail pertinent information about the items of the balance sheet and profit

and loss account. The notes are even more important as they give very important information

such as the accounting policies that the company has followed; the contingent liabilities of the

companies, etc. It is imperative that the schedules and notes to the accounts be read for a clearer

understanding of the companys financial condition.

Cash Flows:

A statement of sources and uses begins with the profit for the year to which are added the

increases in liability accounts (sources) and from which are reduced the increases in asset

accounts (uses). The net result shows whether there has been an excess or deficit of funds and

how this was financed. Investors must examine a company's cash flow as it reveals exactly


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where the money came from how it was utilized. Investors must be concerned if a company is

financing either its inventories or paying dividends from borrowings without real growth as that

shows deterioration.

Ratios:

A ratio is an arithmetical expression of relationship between two variables of the financial

statements. It helps in easy comparison. The comparison may be intra firm or inter firm. A

glance at the ratios of the company gives the complete information about the company to an

investor.

There are many ratios one can calculate and no single ratio can tell the complete story.

Ratios are generally classified as:

(A)Liquidity Ratios:

Liquidity ratios are the ratios which are used to measure the short term liquidity

position of a firm. Some of the commonly used liquidity ratios are Current Ratio, Acid

Test Ratio, Absolute Liquidity Ratio, etc.

(B)Solvency Ratios:

These are the ratios that are used to measure the long term solvency position of a

firm. These ratios are generally looked into by creditors of the companies. The common

solvency ratios are Debt Equity Ratio, Proprietory Ratio, Interest Coverage Ratio, Fixed

Charge Coverage Ratio, etc.

(C)Profitability Ratios:

The profitability ratios measure the overall profitability of a firm. Some of the

common profitability ratios are Gross Profit Ratio, Net Profit Ratio, Operating Profit

Ratio, Return on Equity, Return on Assets, Return on Investments, Return on CapitalEmployed, etc.

(D)Activity Based Ratios: Activity Ratios measures the efficiency of a firm. These ratios

are also called as performance ratios. Some of the commonly used ratios are Inventory

Turnover ratio, Debtors Turnover Ratio, Fixed Assets Turnover Ratio, etc.


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(E)Market Based Ratios:

These ratios are usually calculated using the values in the financial statements and the

market value of the share. Some of the commonly used ratios are: Price Earnings Ratio,

Dividend Yield Ratio, Market Price to Book value Ratio, etc.

Some important ratios that are considered in this project are:

Net Profit Margin:- The Net Profit Margin measures the relationship between Net Profits and

Sales of a firm. This ratio is indicative of managements ability to operate the business

successfully and expresses the cost effectiveness of the organization.

A high net profit margin would ensure adequate return to the owners as well as enable the firm to

withstand adverse economic conditions like falling demand, rising costs, etc. while a low net profit

margin has the opposite implications.

Debt-Equity Ratio:- This ratio is used to find out the long term solvency position of the firm.

This ratio serves of primary use to the creditors of the company. This ratio is also used by the

investors to know their claim in the company.

Return on Equity:- This ratio expresses the profitability of a firm in relation to the equity

shareholders funds.

This is the single most important ratio to judge whether the firm has earned satisfactory return to

the equity shareholders or not.


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Earnings Per Share (EPS):- This ratio measures the profit available to the equity shareholders on

a per share basis, that is the amount they can get on every share held. It is the most widely used

ratio by investors.

This ratio only shows the profits earned per share but the same amount is not received by the

shareholders.

Price Earnings (P/E) Ratio:- The P/E Ratio reflects the price currently paid by the investor for

each rupee of the reported EPS.

It measures the investors confidence in the firms future. The higher the ratio, the larger is the

investors confidence in the firms future.

Dividend Per Share (DPS):- This ratio shows the profits that are paid to equity shareholders on a

per share basis

The DPS is a better indicator than EPS as the former shows exactly what amount is received by the

shareholders.

Dividend Payout Ratio:- This ratio measures the relationship between the earnings belonging tothe equity shareholders and the dividends paid to them.

If the Dividend Payout Ratio is subtracted from 100 it shows the Earnings Retention Ratio, which

shows the profits retained in the business.


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Dividend Yield Ratio:- This ratio reflects the price paid by the investor for each rupee of the

dividend paid.

This ratio is very significant from the point of view of those investors who are interested in

dividend income.

Book Value Per Share:- Book value per share represents the claim of the shareholders on a per

share basis. This ratio is sometimes used as a benchmark for comparison with the Market price per

share.


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Tata Steel

Study of Fundamental Analysis

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