Notes Compiled by Prof.V.S.

Gopal

FUNDAMENTAL ANALYSIS
Fundamental analysis is examination of the underlying forces that affect the well being of
examination of the economy, industry groups, and companies. As with most analysis, the
goal is to derive a forecast and profit from future price movements.

INTERPRETATION
Most fundamental information focuses on economic, industry, and company statistics.
The typical approach to analyzing a company
involves three basic steps:

1. Determine the condition of the general

economy.
2. Determine the condition of the industry.
3. Determine the condition of the company.

ECONOMIC ANALYSIS
The economy is studied to determine if overall conditions are good for the stock
market. Is inflation a concern? Are interest rates likely to rise or fall? Are consumers
spending? Is the trade balance favorable? Is the money supply expanding or contracting?
These are just some of the questions that the fundamental analyst would ask to determine
if economic conditions are right for the stock market.

INDUSTRY ANALYSIS
It is the study of industries which are on the upswing. The ideal investment is the
investment in the growing industries. It is often said that a weak stock in a strong industry
is preferable to a strong stock in a weak industry. In order to make productive
investments the investor should know the industry classification used in the economy. It
is also enviable to know the characteristics, problems and practices in different industries.

COMAPNY ANALYSIS
 Notes Compiled by Prof.V.S.Gopal

After determining the economic and industry conditions, the company itself is
analyzed to determine its financial health. This is usually done by studying the company's
financial statements. From these statements a number of useful ratios can be calculated.
The ratios fall under five main categories: profitability, price, liquidity, leverage, and
efficiency. While performing ratio analysis of a company, the ratios should be compared
to other companies within the same or similar industry to get a feel for what is considered
"normal."
Phase Fundamental Analysis: -

Phase Nature of Purpose Tools & Techniques

analysis
First Economic To assess the general Economic indicators – lead,
Analysis economic situation both lag and coincidental
within the country and indicators
internationally
Second Industry To review prevailing Performance indicators –
Analysis conditions within a specific aggregate demand & supply
industry and its segments position, internal & external
competition, government
policies
Third Company To analyze the financial & Non-financial aspects
Analysis non-finance aspects of a analysis like promoters,
company to determine management, vital product
whether to buy, sell, or hold quality, corporate image,
onto the shares of a company etc. financial aspects like
EPS, sales, profitability,
dividend record, asset
growth
Notes Compiled by Prof.V.S.Gopal

BENEFITS OF FUNDAMENTAL ANALYSIS

Long-term trends: Fundamental analysis is good for long-term investments based

on long-term trends.

Value Spotting: Sound Fundamental Analysis will help identify companies that
represent good value. It can help discover companies with valuable assets, a strong
balance sheet, stable earnings and staying power.

Business Expertise: Fundamental Analysis helps to develop a thorough

understanding of the business. The investor becomes familiar with the key revenue and
profit drivers behind a company.

Categorization: Stocks move as a group, by understanding a company’s business,

investors can better position themselves to categorize stocks within their relevant industry
groups. Knowing a company’s business and being able to place it in a group can make a
huge difference in relative valuations.

The stock market does not operate in a vacuum. Similarly no industry or company can
exist in isolation. It is an integral part of the whole economy of a country, more so in a
free economy like that of US and to some extent in a mixed economy like that of ours.

The importance of Economic Analysis:

• To gain an insight into the complexities of the stock market, one needs to develop
a sound economic understanding and be able to interpret the important economic
indicators on stock markets.
• The economy is like the tide and the various industry groups and individual
companies are like boats. When the economy expands, most industry groups and
companies benefit and grow. When the economy declines, most sectors and
companies usually suffer.
• Investment decisions depend on the state of the economy existing at that
particular point of time. E.g. if the economy is expanding then, an aggressive
Notes Compiled by Prof.V.S.Gopal

growth-oriented strategy might be advisable. A growth strategy might involve the

purchase of technology, biotech, semiconductor and cyclical stocks. If the
economy is forecast to contract, an investor may opt for a more conservative
strategy and seek out stable income-oriented companies.

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.
While some industries such as shipping or consumer durable goods are greatly affected
by the business cycle, others such as the food or health industry are not affected to the
same extent. This is because in regard to certain products consumers can postpone their
purchase decisions, whereas in certain others they cannot.

Fig.: Economic Cycle

BOOM

DISINVEST

RECOVERY RECESSION

INVEST

DEPRESSION

THE INVESTMENT DECISION

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
Notes Compiled by Prof.V.S.Gopal

at the worst, just after the boom. Investment and disinvestments made at these times will
earn the investor the greatest benefits.

Key Economic Indicators:

There are certain economic indicators, which may be studied to assess the national
economy as a whole.

Leading Indicators: These indicators predict what is likely to happen to the

economy. Perfect examples of leading indicators are the unemployment position, rainfall
and agricultural production, fixed capital investment, corporate profits, money supply,
credit position and index of equity share prices.

Coincidental Indicators: These indicators highlight the current position. Some

examples are Gross National Product, Index of Industrial Production, money market
rates, interest rates and reserve funds with commercial banks.

Lagging Indicators: These explain what has already taken place. Some examples are
large-scale unemployment, piled up inventories, outstanding debt, interest rates of
commercial loans, etc.

Though useful, these indicators must be used with caution. These can only help in
understanding economic trends and outlining your investment strategy intelligently.

Political Equation
A stable political environment is necessary for steady, balanced growth. A stable
government is able to take decisions regarding long-term development of the country,
which leads to prosperity of industries and companies. On the other hand, instability
causes insecurity. India has been going through a fairly difficult period. There had been
terrible political instability since the late eighties. Various elections with no majority
power to any one party, religious and ethnic issues, the Pakistan issue etc. lead to
instability in the Government.
Notes Compiled by Prof.V.S.Gopal

Industrial Production:
An upswing in industrial production is good for the economy and a downswing
rings an alarm. The decline in agricultural growth and the steep hike in petroleum prices
would affect industrial growth.

Inflation:
Inflation has an enormous effect on the economy. Within the country it erodes
purchasing power considerably. As a result, demand falls. A low rate of inflation
indicates stability and healthy economic conditions and industries prosper at such times.
The USA and Europe have fairly low inflation rates.

Interest Rates:
A low rate of interest rate is must for economic development. It stimulates
investment and industry. On the contrary, high interest rates result in high cost of
production, low consumption and decrease in company’s competitiveness.

Infrastructure:
The development of an economy is dependent on its infrastructure. Public
infrastructure services like banking, telecom, coal and power etc play a crucial role in
deciding the fate of an economy. Investments into these sectors have accounted for a
major share of public spending for most of the last fifty years. A key constraint facing
the Indian economy is the country's seriously inadequate infrastructure. Uncertainties
over the policy, legal, and regulatory frameworks in key infrastructure sectors continue to
act as a constraint to increasing private sector involvement.

Rainfall and Agricultural Production:

Notes Compiled by Prof.V.S.Gopal

Foreign Exchange Reserves:

A country needs foreign exchange reserves to meet its commitments, pay for its
imports and service foreign debts. Without foreign exchange, a country would not be able
to import materials or goods for its development and there is also a loss of international
confidence in such a country.

Budgetary Deficit:
A budgetary deficit occurs when governmental expenditure exceeds its income.
Expenditure stimulates the economy by creating jobs and stimulating demand. However,
this can also lead to deficit financing and inflation. All developing economies including
India suffer from budget deficits. The performance of India's economy in recent years has
been overwhelmingly encouraging, but that doesn't reduce the magnitude of the problem
posed by its fiscal deficits.

Domestic Savings and Capital Output Ratio:

Employment
High employment is required to achieve a good growth in national income. As the
population growth is faster than the economic growth unemployment is increasing. This
is not good for the economy.

Taxation

EXIM Policy

International Developments

US Factor
Notes Compiled by Prof.V.S.Gopal

INDUSTRY ANALYSIS
The second phase of fundamental analysis consists of a detailed analysis of a
specific industry; its characteristics, past record, present state and future prospects. The
purpose of industry analysis is to identify those industries with a potential for future
growth, and to invest in equity shares of companies selected from such industries.
Industry analysis has become very important after the opening of the economy, new
entrants and intense competition.
To assess an industry groups’ potential, an investor should consider the overall growth
rate, market size, and importance to the economy. While the individual company is still
important, its industry group is likely to exert just as much, or more, influence on the
stock price. When stocks move, they usually move as groups; there are very few lone
guns out there. Many times it is more important to be in the right industry than in the
right stock!

Every industry, and company with in a particular industry, undergoes a life cycle with
four distinct phases as shown in the diagram below:

Figure: Industry Life cycle

1 2 3 4

Profits

Years
Notes Compiled by Prof.V.S.Gopal

1. Entrepreneurial or nascent stage

2. Expansion or growth stage
3. Stagnation stage
4. Decay or sunset stage

Entrepreneurial Stage:
This is the first stage of the industrial life cycle of a new industry where the
technology as well as the product are relatively new and have not reached a stage of
perfection. The pioneering stage is characterized by rapid growth in demand for the
output of the industry. As a result there is great opportunity for profit. As a large number
of companies attempt to capture their share of the market, there arises a high business
mortality rate. Weak firma are eliminated and a lesser number of firms survive the
pioneering stage.
It is difficult for the analyst to identify those companies that are in the likely to
survive and come out strong later on. Therefore, investment in a company in an
industry which is in the pioneering stage is highly risky. Industries in the
entrepreneurial stage are also called as sunrise or nascent industries.
Telecommunications, computer software, information technology are the examples
of the sunrise industries in India.

Expansion or Growth Stage:

The second stage of expansion includes only those companies that have survived
the pioneering stage. These companies continue to become stronger. Each company finds
a market for itself and develops its own strategies to sell and maintain its position in the
market. The competition among the surviving companies brings about improved products
at lower prices.
Companies in the expansion stage of an industry are quite attractive for
investment purposes. Investors can get high returns at lower risk because demand
exceeds supply in this stage. Companies will earn increasing amounts of profits and pay
attractive dividends.
Notes Compiled by Prof.V.S.Gopal

Stagnation Stage:
This is the third stage in the industry life cycle. In this stage, the growth of the
industry stabilizes. The ability of the industry to grow appears to be lost. Sales may be
increasing but at a lower rate than that experienced by the competitive industries or the
overall economy. The industry begins to stagnate. The transition of the industry from
expansion to stagnation stage is often very slow. Two important reasons for this transition
are change in social habits and development of new technology.
Sometimes an industry may stagnate only for a short period. By the introduction
of a technological innovation or a new product, it may resume a process of growth,
thereby starting a new cycle. Therefore an investor or analyst has to monitor the industry
developments constantly and with diligence.

Decay Stage:
From the stagnation stage the industry passes to the decay stage. This occurs
when the products of the industry are no longer in demand. New products and
technologies have come to the market. Customers have changed their habits style and
liking. As a result the industry becomes obsolete and gradually ceases to exist. Thus,
changes in social habits, technology and declining demand are the causes of decay of any
industry. An investor should get out of the industry before the decay stage.. The profits
associated with the different stages in the life of an industry can be illustrated in the form
of an inverted ‘S’ curve as shown in the figure.
It is not always easy to detect which stage of development an industry is in at any
point in time. The transition form one stage to the next is slow and unclear. It can be
detected only by careful analysis. Further, the classification of industries under this
approach is the general pattern. There can be exceptions to the general pattern. The life of
industry may, for instance, be extended after the stagnation and decay stage through
appropriate adaptation to changes in the environment. Careful analysis is needed to detect
such exceptions.
Notes Compiled by Prof.V.S.Gopal

INDUSTRY CHARECTERISTICS:
In an industry analysis, there are a number of key characteristics that are to be
considered by the analyst. These features broadly relate to the operational and structural
aspects of the industry. They have a bearing on the prospects of the industry. Some of
these are discussed below:

Demand Supply Gap:

The demand for a product usually tends to change at a steady rate, whereas the
capacity to produce the product tends to change at irregular intervals, depending on the
installation of additional production capacity. As a result an industry is likely to
experience under-supply and over-supply of capacity at different times. Excess supply
educes the profitability of the industry through a decrease in the unit price realization. On
the contrary, insufficient supply tends to improve the profitability through higher unit
price realization. Therefore, the gap between the demand and supply in an industry is a
fairly good indicator of its short term or medium-term prospects. As part of industry
analysis, an investor should estimate the demand supply gap in the industry.

Competitive Conditions in the Industry:

Another significant factor to be considered in industry analysis is the competitive
conditions in the industry. The level of competition among various companies in an
industry is determined by certain competitive forces. These competitive prices are:
barriers to entry, threat of substitution, bargaining power of the buyers, bargaining power
of the suppliers and the rivalry among competitors.
New entrants to an industry increase the capacity in the industry. But these new
entrants may face certain barriers to their entry. The barriers to their entry may arise
because of product differentiation, absolute cost advantage or economy of scale. Product
differentiation refers to the preference the buyers have to the products of the already
established players. Their products enjoy a premium in the market. Absolute cost
Notes Compiled by Prof.V.S.Gopal

advantage refers to the ability of established firms to produce their products at a lower
cost than any new entrant.
Economy of scale refers to a situation in which it is necessary to attain a fairly high level
of production in order to obtain economically feasible levels of cost. In some industries it
may not be economical to set up small capacities. An industry that is well protected from
the inroads of new firms would be ideal for investment.

Permanence:
In this age of rapid technological change, the degree of permanence of an industry
is an important consideration in industry analysis. Permanence is a phenomenon related
to the products and technology used by the industry. If an analyst feels that the need for a
particular industry will vanish in a short period, it would be foolish to invest in such an
industry.

Labor Conditions:
The state of labor conditions in the industry under analysis is an important
consideration in an economy such as ours where the unions are very powerful. If the
labor in a particular industry is rebellious and is inclined to strikes frequently, the
prospects of that industry cannot become bright.

Attitude of Government:
The attitude of the government towards an industry has a significant impact on its
prospects. The government may encourage the growth of certain industries and can assist
such industries through favorable legislations.
On the contrary, the government will look with disfavor on certain other
industries. In India, this has been the experience of alcoholic drinks and cigarette
industries. The government may place different kinds of legal restrictions on its
development. A prospective investor must therefore consider the role the government is
likely to play.
Notes Compiled by Prof.V.S.Gopal

Supply of Raw Materials:

The availability of raw materials is an important factor determining the
profitability of an industry. Some industries may have no difficulty in obtaining the raw
materials while the others have to depend on limited resources. Industry analysis must
take into consideration the availability of raw materials and its impact on the industry
prospects.

COMPANYANALYSIS:

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.

FINANCIAL STATEMENTS
The prosperity of a company will depend upon its profitability and financial
health. The financial statement published by a company periodically helps us to access
the profitability and financial health of the company. The two basic financial statements
provided by the companies are the balance sheet and the P&L A/C. The first gives us a
picture of the company’s assets and liabilities while the second gives us a picture of its
earnings.
The balance sheet gives us the list of assets and liabilities of a company on a
specific date. The major categories of assets are fixed and current. The P&L A/C, also
Notes Compiled by Prof.V.S.Gopal

called as the income statement, reveals the revenue earned, the cost incurred and the
resulting profit or loss of the company for one accounting year. The profit after tax
(PAT) divided by the number of shares gives the Earnings per Share (EPS), which is a
figure which most investors are interested. The P&L A/C summarizes the activities of a
company during an accounting year.

ANALYSIS OF FINANCIAL STATEMENTS

The financial statement of a company can be used to evaluate the financial
position f the company. Financial ratios are most extensively used for this purpose. Ratio
analysis helps an investor to determine the strengths and weakness of the company. It
also helps him to analyze whether the financial performance and financial strengths are
improving or deteriorating. Ratios can be used for comparative analysis either with other
firms in the industry through a cross sectional analysis or with past data through a time
series analysis.
Different ratios measure different aspects of a company’s performance or health.
Four groups of ratios may be used for analyzing the performance of a company.

Liquidity Ratios: These measure the company’s ability to fulfill its short-term
obligations and reflect its short-term financial strength or liquidity. The commonly used
ratios are

Current Ratio = Current Assets / Current Liabilities.

Quick Ratio = Current Assets- Inventory – Prepaid Expenses

Current Liabilities
A higher current ratio would enable a company to meet its short-term obligations even if
the value of current assets decline. The quick ratio represents the ratio between quick
assets and current liabilities. It is a more rigorous measure of liquidity. However, both
these ratios are to be used together to analyze the liquidity of the company.
Notes Compiled by Prof.V.S.Gopal

Leverage Ratios: These ratios are also known as capital structure ratios. They measure
the ability of the company to meet its long-term debt obligations. They throw light
on the long-term solvency of a company. The commonly used leverage ratios are:

Long-term Debt
Debt-Equity Ratio = Shareholder’s Equity

Debt to Total = Total Debt

Asset Ratio Total Assets

Proprietary Ratio = Shareholders Equity

Total Assets

Interest Coverage Ratio = EBIT

Interest

The first three ratios indicate the relative contribution of owners and creditors in
financing the assets of the company. These ratios reflect the safety margin available to
the long-term creditors. The coverage ratios measures the ability if the company to meet
its interest payments arising from the debt.

Profitability Ratios: The profitability of a company can be the profitability ratios. These
ratios are calculated be relating the profits either to sales, or to investment, or t the equity
shares. Thus we have three groups of profitability ratios. These are listed below.

A. Profitability related to Sales

Gross Profit Ratio = Gross Profit (Sales – Cost of Goods Sold)
Sales

Operating Profit Ratio = EBIT / Sales

Net Profit Ratio = EAT

Sales
Notes Compiled by Prof.V.S.Gopal

Administrative Expenses Ratio = Administrative Expenses

Sales

Selling Expenses Ratio = Selling Expenses

Sales

Operating Expenses Ratio = Administrative Expenses + Selling Expenses

Sales

Operating Ratio = COGS + Operating Expenses

Sales

B. Profitability related to Investment.

Return on Assets = EAT
Total Assets

Return on Capital Employed = EBIT

Total Capital Employed

Return on Equity = EAT

Shareholders Equity

C. Profitability related to Equity Shares.

Earnings Per Share = Net Profit available to Eq.Sh.Holders

Number of Equity Shares

Earnings Yield = EPS

Market Price per Share
Notes Compiled by Prof.V.S.Gopal

Dividend Yield = DPS (Dividend per Share)

Market Price per Share

Dividend Payout Ratio = DPS

EPS

Price Earning Ratio (P/E Ratio) = Market Price per Share

EPS

D. Overall Profitability (Earning Power)

Return on Investment (ROI) = EAT
Total Assets

The overall profitability is measured by the ROI, which is the product of the net profit
ratio and the investment turnover. It is a central measure of the earning power or
operating efficiency of a company.

Activity or Efficiency Ratios:

These are also known as turnover ratios. These ratios measure the efficiency in
asset management. They express the relation between the sales and the different types of
assets, showing the speed with which these assets generate sales. Important activity ratios
are enumerated below.
Current Asset Turnover = Sales / Current Assets

Fixed Assets Turnover = Sales / Fixed Assets

Total Assets Turnover = Sales / Total Assets