Learning Objectives

 Elements of Top-Down Fundamental Analysis

 Macroeconomic Factors
 Classification of Industries
 Techniques for industry analysis
 Techniques for company analysis
THE ROLE OF THE SECURITY
ANALYST
 Analysts issue reports, forecast earnings and returns
for specific companies and provide inputs to the
valuation process.
 Present buy, hold or sell decisions.

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APPROACHES TO SHARE
SELECTION
 Technical analysis  an approach that is
designed to forecast fluctuations in share
prices.
 Fundamental analysis  an approach which
relies on the assumption that every security has
an intrinsic value which can be estimated and
compared to the current market price.

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Fundamental Analysis

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 Fundamental Analysis
 Fundamental analysts attempt to study everything that can
affect the security's value, including macroeconomic factors
(like the overall economy and industry conditions) and
individually specific factors (like the financial condition and
management of companies).
 Fundamental analysis is premised on the belief that markets
are not efficient and that superior research can uncover stocks
whose intrinsic values differ from their market values
 The end goal of performing fundamental analysis is to produce
a value that an investor can compare with the security's current
price in hopes of figuring out what sort of position to take with
that security (underpriced = buy, overpriced = sell or short).

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Fundamental Analysis
Fundamental analysis serves to answer questions, such
as:
 Is the company’s revenue growing? Will it continue to
grow in future?
 Is it actually making a profit? Will it continue in
future?
 Is it in a strong-enough position to beat out its
competitors in the future?
 Is it able to repay its debts?
 Is management trying to "cook the books"?

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 The Concept of Intrinsic Value
 One of the primary assumptions of fundamental analysis is that the
price on the stock market does not fully reflect a stock’s “real” value
 Let’s say that a company’s stock was trading at $20. After doing
extensive research on the company, you determine that it really is
worth $25. In other words, you determine the intrinsic value of the firm
to be $25. This is clearly relevant because an investor wants to buy
stocks that are trading at prices significantly below their estimated
intrinsic value.
 This leads us to one of the second major assumptions of fundamental
analysis: in the long run, the stock market will reflect the
fundamentals.
 By focusing on a particular business, an investor can estimate the
intrinsic value of a firm and thus find opportunities where he or she
can buy at a discount. If all goes well, the investment will pay off over
time as the market catches up to the fundamentals
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Framework of Fundamental Analysis
Why use the top-down sequence?
• it ensures that an investor includes all
relevant information in a consistent
manner;
• no company operates in a vacuum, and
macroeconomic and industry conditions are
important inputs into its performance

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Framework of Fundamental Analysis
The analysis to determine values of firms, by predicting
earnings and dividends with economic and accounting
information open to the public
 Macroeconomic analysis: evaluates current economic
(global and domestic) environment and its effect on
industry and company fundamentals
 Industry analysis: evaluates outlook for particular
industries
 Company analysis: evaluates company’s strengths and
weaknesses within industry
MACROECONOMIC ANALYSIS

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 The Global Economy
 Stock markets around the world
responded in unison to the financial crisis
of 2008.
 Performance in countries and regions can
be highly variable.
 It is harder for businesses to succeed in a
contracting economy than in an
expanding one.
 The Global Economy
 Political risk:
 The global environment may present
much greater risks than normally
found in local investments.
 Exchange rate risk:
 Changes the prices of imports and
exports.
The Domestic Macroeconomy:
Key Variables
 Gross domestic product
 Unemployment rates
 Inflation
 Interest rates
 Budget deficit
 Consumer sentiment
 Demand and Supply Shocks
Demand shock - an
event that affects
demand for goods and
services in the economy
 Reduction in tax rates
 Increases in the money supply
 Increases in government spending
 Increases in foreign export
demand
Supply shock - an event
that influences production
capacity or production
costs
 Changes in the price of imported oil
 Freezes
 Floods
 Droughts
 Changes in the wage rates
Demand-side Policy
Fiscal policy – the government’s spending and taxing actions
 Most direct way to stimulate or slow the economy
 Deficit stimulates the economy because:
 it increases the demand for goods (via spending) by
more than it reduces the demand for goods (via taxes)

Monetary policy – Manipulation of the money supply to

influence economic activity.
 Increasing the money supply lowers interest rates and
stimulates the economy.
 Less immediate effect than fiscal policy
 Tools of monetary policy include open market operations,
discount rate, reserve requirements.
Impediments to Effective Policy
 Time lags between [stimulus] and [desired effect]
 Unintended consequences
 “irrational” expectations on part of policy makers
 Adverse influence of speculators
 Adverse global responses
 Consumer behavior (rational expectations)
 Incorrect analysis, actions, or timing by policy makers
Business Cycles - Four Phases

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The Business Cycle
• Recurring patterns of recession and recovery
are called business cycles
• Industry relationship to business cycles
(cyclical vs. defensive industries)
– Cyclical industries
• Industries with above average sensitivity to the state of the
economy
• For example, the producers of durable goods (e.g., cars) or
capital goods (that are used by other firms to produce their
own products)
• Firms in cyclical industries tend to have high betas

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The Business Cycle
– Defensive industries
• Industries with below-average sensitivity to the state of the
economy
• For example, food producers, pharmaceutical firms, and
public utilities
– The demand of food, drugs, electricity, and gas is consistent
regardless of the business cycle
• Firms in defensive industries tend to have low betas
– The trading strategy based on the business cycle
• Optimistic about the economy, hold cyclical stocks
• Pessimistic about the economy, hold defensive (or counter-
cyclical) stocks

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Economic Indicators
• Leading Indicators – economic series tend to rise
and fall in advance of the economy, for example,
– Stock prices
• Stock prices are forward-looking estimates for future profitability
and thus able to be a leading indicator
• Since the stock prices themselves are leading indicators, the
information of other leading indicators contributes less for stock
investment – by the time they predict an upturn, the stock
market has already made its move
• Stock prices can be a leading indicator for the business cycle, but
there is no leading indictor for stock prices
– Money supply growth rate
• Due to the indirect and lag influence of the monetary policy on
the economy

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Economic Indicators
• Coincident Indicators – indicators that tend to
change at the same time with the economy, e.g.,
– Industrial production
– Manufacturing and trade sales
• Lagging Indicators – indicators that tend to
follow the lag economic performance, e.g.,
– Ratio of inventories to sales
– Ratio of consumer installment credit outstanding to
personal income

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Indexes of Economic Indicators

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INDUSTRY ANALYSIS

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Industry Analysis
 unusual for a firm in a troubled industry to
perform well
 Performance can vary widely across industries
 Performance of firms in the same industry
varies substantially
Industry groups:
- Grouping firm for statistical analysis

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Industry Analysis
Determinants of competition:
- Threat of entry
- Rivalry between existing competitors
- Pressure from Substitute Products
- Bargaining power of buyers
- Bargaining power of sellers

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Sensitivity to Business Cycle
 Three factors affecting sensitivity of earnings to
business cycles
 Sensitivity of sales
 Sales of necessities will show little sensitivity to business
conditions, e.g., food, drugs, medical services
 Sales of luxuries or discretionary goods are more sensitive
to business conditions, e.g., jewelry, autos, recreational
services

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The Stock Market and
the Business Cycle

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Sector Rotation
To select industries in different phases of the business
cycle.
- Portfolio is adjusted by selecting companies that should perform well for
the stage of the business cycle
– Peak – natural resource extraction firms
• The economy might be overheated with high inflation
• Invest in natural resource firms to against the inflation
– Contraction – defensive firms, e.g., food, drugs, or other
necessities
• These firms are less affected by the contraction
• Lower inflation and IR rates favor financial firms
– Trough – equipment, transportation and construction firms
(capital goods industry)
• Firms might purchase new equipment to meet anticipated increases
in demand in the following expansion
– Expansion – cyclical industries, e.g., consumer durables and
luxury items
• These firms are the most profitable in this phase

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Sector Rotation

※ The typical sector rotation across different states of the business cycle is
shown; Each sector historically had their “day in the sun” during a
typical economic cycle

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Life Cycles of an Industry
Stage Sales Growth
Start-up Rapid & Increasing
Consolidation Stable
Maturity Slowing
Relative Decline Minimal or Negative

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Life Cycles of an Industry
• The logic behind the progression from one stage of the
industry life cycle to another
– High growth and fat profits bring new competitors and thus
generate new sources of supply to reduce prices, profits, and
growth finally
• Are high-growth industries good investment targets?
– The historical records tells us they are, as long as they offer
high enough expected return to compensate the risks you
bear
– But if the security prices already reflect the likelihood for
high growth, then it is too late to make money from this
strategy

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COMPANY ANALYSIS

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 Quantitative and Qualitative
 Quantitative – capable of being measured or expressed in
numerical terms. The biggest source of quantitative data is the
financial statements. You can measure revenue, profit, assets and
more with great precision.
 Qualitative – related to or based on the quality or character of
something, often as opposed to its size or quantity. These are the
less tangible factors surrounding a business - things such as the
quality of a company’s board members and key executives, its
brand-name recognition, patents or proprietary technology.
Neither qualitative nor quantitative analysis is
inherently better than the other. Instead, many analysts
consider qualitative factors in conjunction with the
hard, quantitative factors
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 Qualitative
Business Model - What exactly does the company do? This is
referred to as a company's business model – it's how a company
makes money. Unless you understand a company's business
model, you don't know what the drivers are for future growth, and
you leave yourself vulnerable to being blindsided
Competitive Advantage – A company's long-term success is
driven largely by its ability to maintain a competitive advantage -
and keep it. Powerful competitive advantages, such as Coca Cola's
brand name and Microsoft's domination of the personal computer
operating system, create a moat around a business allowing it to
keep competitors at bay and enjoy growth and profits. When a
company can achieve competitive advantage, its shareholders can
be well rewarded for decades.

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 Qualitative
Management - a company relies upon management to steer it
towards financial success. Some believe that management is the
most important aspect for investing in a company. It makes sense
- even the best business model is doomed if the leaders of the
company fail to properly execute the plan.
 Here are a few ways for you to get a feel for management:
1. Conference Calls
2. Management Discussion and Analysis (MD&A)
3. Ownership and Insider Sales
4. Past Performance

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 Qualitative
Corporate Governance
1. Financial and Information Transparency
2. Stakeholder Rights
3. Structure of the Board of Directors

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Company Analysis
 The base for the company analysis in fundamental
analyses are the publicly disclosed and audited
financial statements of the company:
 Balance Sheet
 Profit/ loss Statement
 Cash Flow Statement
 Statement of Profit Distribution

 Analysis could use the period not less than 3 years.

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 Company Analysis
Ratio analysis
 1. Profitability ratios, which measure the earning power
of the firm.
 2. Liquidity ratios, which measure the ability of the firm
to pay its immediate liabilities.
 3. Debt ratios, which measure the firm’s ability to pay the
debt obligations over the time.
 4. Asset – utilization ratios, which measure the firm’s
ability to use its assets efficiently.
 5. Market value ratios are an additional group of ratios
which reflect the market value of the stock and the firm.

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Profitability ratios
Gross profit margin Gross profit/ Sales

Operating profit margin Operating profit / Sales

Net profit margin Net income/ Sales

Return on assets (ROA) Net income / Total assets

Return on equity (ROE) Net income / Stockholders’ equity

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Liquidity ratios
Current ratio Current assets / Current liabilities

Quick ratio (Current assets – Inventory) /

Current liabilities
Net working capital Current assets Current liabilities

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Debt ratios
Debt to assets Total liabilities / Total assets

Debt to equity Total Debt / Equity

Times interest Income before interest and taxes

earned / Interest

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Asset utilization ratios
Inventory turnover Cost of goods sold / Inventory

Receivables turnover Sales (credit) / Receivables

Fixed asset turnover Sales/ Fixed assets

Total assets turnover Sales/ Total assets

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 Market Value Ratios
Capitalization Number of common stock * Market price of
the common stock
Earnings per share (EPS) (Net Income – Cash Dividends of Preferred
stock) / Number of Common Stocks
Price/Earnings ratio Market price of the stock/ Earnings per share
(PER)
Book value of the stock (Equity–Preferred stock - Preferred stock
dividends) / Number of Common Stock
Market price to Book Market price of the stock / Book value of the
value stock
Dividends per share (Dividends Preferred stock dividends)/
Number of Common Stock
Payout Ratio Dividends per share / Earnings per share
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 Limitations Of
Financial Analysis
 Horizontal, vertical, and ratio analysis are frequently
used in making significant business decisions.
 One should be aware of the limitations of these tools
and the financial statements.

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 Estimates
 Financial statements are based on estimates.
 allowance for uncollectible accounts
 depreciation
 costs of warranties
 contingent losses

To the extent that these estimates are inaccurate, the financial

ratios and percentages are also inaccurate.

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 Price Earnings Ratio

The P/E ratio reflects the investors’

assessment of a company’s future
earnings.

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Earnings Per Share and Price
Earnings Ratio

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 Company Valuation
 Market value ratios provide an investor with a shortest way
to understand how attractive the stock in the market is.
 But looking for long-term investment decisions investor
must analyze not only the current market results but to
assess the potential of the firm to generate earnings in the
future.
 Thus, only using the other groups of financial ratios
investor can receive “a full picture” of the financial
condition of the firm and when continue with stock
valuation.

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Company Valuation
 After calculating the ratios, the investor must compare the
ratios of the firm with the ratios of a relevant benchmark.
The selection of the appropriate benchmark is a difficult
decision. For this reason firms are frequently
benchmarked against other firms with similar size and in
the same home country and industry.
 However, such comparisons do not always reveal whether
the company is buy-worthy, because the whole size
category, country or industry may under perform.
 When using these ratios for analysis of the firm investors
compare them also with industry average.

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 Stock Picking Principles
 Changes in perceptions of company and industry
fundamentals are the catalyst for a stock’s movement
 Anticipate these changes before others do
 The most important factor in anticipating change is to
understand the competitive position of a company and its
industry
 The qualitative is more important than the quantitative
 Decisions must be made using limited and conflicting
information. Do not wait until you have all the facts to
buy a stock. It will then be too late

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Stock Picking Principles
 The more complex the reasoning, the more likely it is to
be wrong. The basis for buying a stock should be simple
and explainable in less than a minute
 Know the sign (+ or -) of a company or industry’s key
operating indicators.The best investments are anti-
consensus. If consensus is correct on a stock, abnormal
returns cannot be achieved
 Earnings disappointments and positive surprises are
usually multiple quarter events

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ECONOMIC, INDUSTRY, & STRUCTURAL LINKS TO COMPANY ANALYSIS
Economic and Industry Influence
 If economic trends are favorable for an industry, the company
analysis should focus on firms in that industry that will benefit
from these economic trends
 Research analysts should become familiar with the cash flow and
risk attributes of the firms
 The most attractive firms in the industry will typically have high
levels of operating and financial leverage wherein a modest
percentage increase in revenue results in a must larger
percentage rise in earnings and cash flow
 Firms in an industry will have varying sensitivities to economic
variables, such as economic growth, interest rates, input costs,
and exchange rates

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ECONOMIC, INDUSTRY, & STRUCTURAL LINKS TO COMPANY ANALYSIS
Structural influences
 Social trends, technology, and political and regulatory
influences, can have a major effect on some firms in an industry
 Some firms in the industry are able to take advantage of
demographic changes or shifts in consumer tastes and lifestyle,
or they can invest in technology to lower costs and better serve
their customers.
 However, although the economy plays a major role in
determining overall market trends, and industry groups display
sensitivity to economic variables, other structural changes may
counterbalance the economic effects, or company management
may be able to minimize the impact of economic or industry
events on a company. Analysts who are familiar with industry
trends and company strategies can issue well-reasoned buy- and
sell- recommendations irrespective of the economic forecast.
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TECHNICAL ANALYSIS

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Technical analysis
 A method of evaluating securities by analyzing statistics
generated by market activity, such as past prices and volume.
 Technical analysts do not attempt to measure a security's
intrinsic value, but instead use charts and other tools to identify
patterns that can suggest future activity.

The field of technical analysis is based on three assumptions:

1. The market discounts everything.

2. Price moves in trends.
3. History tends to repeat itself.

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Technical analysis
 A method of evaluating securities by analyzing statistics
generated by market activity, such as past prices and volume.
 Technical analysts do not attempt to measure a security's
intrinsic value, but instead use charts and other tools to identify
patterns that can suggest future activity.

The field of technical analysis is based on three assumptions:

1. The market discounts everything.

2. Price moves in trends.
3. History tends to repeat itself.

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Technical analysis
 Trends
 Support And Resistance
 Volume
 Chart Types and Patterns
 Moving Averages
 Indicators And Oscillators

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Technical vs Fundamental Analysis
 Although technical analysis and fundamental analysis are seen by
many as polar opposites - many market participants have
experienced great success by combining the two. For example,
some fundamental analysts use technical analysis techniques to
figure out the best time to enter into an undervalued security.
Oftentimes, this situation occurs when the security is severely
oversold. By timing entry into a security, the gains on the
investment can be greatly improved.
 Alternatively, some technical traders might look at fundamentals
to add strength to a technical signal. For example, if a sell signal is
given through technical patterns and indicators, a technical
trader might look to reaffirm his or her decision by looking at
some key fundamental data. Oftentimes, having both the
fundamentals and technicals on your side can provide the best-
case scenario for a trade.
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The end

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