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FUNDAMENTAL ANALYSIS

FUNDAMENTAL ANALYSIS. FUNDAMENTAL ANALYSIS. Top-down vs. Bottom-up Top-down approach: economy analysis and industry analysis Bottom-up approach: Technical analysis and security analysis Security analysis - Traditional fundamental analysis - Value based metrics analysis

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FUNDAMENTAL ANALYSIS

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  1. FUNDAMENTAL ANALYSIS • FUNDAMENTAL ANALYSIS www.pptmart.com

  2. Top-down vs. Bottom-up • Top-down approach: economy analysis and industry analysis • Bottom-up approach: Technical analysis and security analysis • Security analysis • - Traditional fundamental analysis • - Value based metrics analysis • - Quantitative fundamental analysis • Traditional fundamental analysis • - Sources of information • - COMPANY ANALYSIS • Financial ratio analysis • Fund flow statement analysis • Cash flow statement analysis • Break-even analysis and contribution analysis • Financial Analysis and measures of risk • Interviewing company representatives • Quality of management, brand image etc. • - Estimation of intrinsic value • Value based metric analysis • - EVA and selection of company www.pptmart.com

  3. Fundamental Analysis • Top down • Bottom up www.pptmart.com

  4. Top-down • Relies heavily on the analysis and forecasting of trends in the economy and industry • Evaluates the expected impact of changes in the world economy on the macro economy of the country. • Evaluates the expected influence of these changes on the domestic industry. • Identifies the stocks which are expected to outperform the market. • Thus, the expected market changes are the driving force behind this particular investment strategy. www.pptmart.com

  5. Bottom-up • Places greater emphasis on individual stock selection. • Picks up stock which are undervalued and have the potential to outperform. • Despite its weakness, this approach is very popular primarily because of their inability • - to forecast long-term economic and market trends or • - to undertake low-cost stock selection, as well as • their inherent tendency to speculate. www.pptmart.com

  6. Fundamental AnalysisTop-down approach • Economy Analysis • Industry Analysis www.pptmart.com

  7. Economy Analysis • Growth Rate of National Income (GDP Growth Rate): • Growth Rate in Industry • Growth Rate in Service • Growth Rate in Agriculture www.pptmart.com

  8. Economy Analysis • Inflation: • Higher rates of inflation upset business plans, lead to cost escalation and reduce profit margin. • It leads to erosion of purchasing power. www.pptmart.com

  9. Economy Analysis • Interest Rates: • High Interest Payment  Lower Profitability • Lower Interest rate stimulates Investment Activity www.pptmart.com

  10. Economy Analysis • Government Revenue, Expenditure, Deficit: • High Fiscal Deficit  High Inflation • High Growth Expenditure  • (i) To stimulate Economy; and • (ii) Expenditure to a particular sector i.e., infrastructure , cement , IT etc. www.pptmart.com

  11. Economy Analysis • Foreign Trade, BOP and Exchange Rate: • BOT = Imports – Exports • Balance on Current account = BOT + Invisible Items • BOP Deficit • = Balance on Current A/C + Loan Receipt /Repaid • High BOP Deficit Rupee will depreciate  Improves the competitive position of Indian product. www.pptmart.com

  12. Economy Analysis • Demographic Data (Monsoon) • Economic and political stability www.pptmart.com

  13. Industry Analysis • Profit • 1 2 3 4 • Industry Life Cycle www.pptmart.com

  14. Industry Analysis • Industry Life Cycle: • Pioneering Stage (Sunrise industries) [Bio-con, Sulzon (wind energy)] •  Risky Investment • Expansion Stage (Tele communication, IT. Etc.)  High Return at low risk • Maturity Stage [FMCG, Leasing industry (during 80,s it was in pioneering stage )] • Decay Stage (Type writer, Jute Industry, B&W TV)  get out from the company before the onset of the decay stage www.pptmart.com

  15. Industry Analysis • INDUSTRY CHARACTERISTIC • Demand Supply Gap • Competitive Conditions in the Industry • Barriers to Entry: • Product Differentiate (Buyers Preference for • established firm) • Absolute Cost Advance • Economy of Scale www.pptmart.com

  16. Industry Analysis • Attitude of Government • - Alcoholic Drinks • Cost structure • Proportion of fixed cost to variable cost • Higher fixed cost, higher B/E point www.pptmart.com

  17. Bottom-Up Approaches • An investor who follows a bottom-up approach to investing focuses either on • (1) technical aspects of the market • or • (2) the economic and financial analysis of individual companies, • giving relatively less weight to the significance of economic and • market cycles. • The investor who pursues a bottom-up strategy based on certain technical aspects of the market is said to be basing stock selection on technical analysis. • The primary research tool used for investing based on economic and financial analysis of companies is called security analysis. www.pptmart.com

  18. Three types of security analysis • Traditional fundamental analysis • Value based metrics analysis • Quantitative fundamental analysis www.pptmart.com

  19. Traditional fundamental analysis • Traditional fundamental analysis begins with the financial statement analysis to evaluate the financial solvency and profitability of the firm. • The investor also looks at • - the firm’s product lines • - the economic outlook for the products (including • existing and potential competitors), and • - the industries in which the company operates. • - the quality of management, brand image etc. • Based on the growth prospects of earnings (or cash flows), the fundamental analysts attempts to determine the fair value or intrinsic value using P/E ratio (or DCF Technique). www.pptmart.com

  20. Value based metrics analysis • Based on Economic Value Added (EVA) method developed by Stern Stewart & Company during the early 80’s. • Fair market value should be equal to book value of assets plus present value of future EVA (MVA) i.e., • Fair market value • =Book value of assets + PV of future EVA (MVA) www.pptmart.com

  21. Quantitative fundamental analysis • Quantitative fundamental analysis seeks to assess the value of securities using a statistical model derived from historical information about security return. • The most commonly used model is the fundamental multifactor risk model which may be as follows; • E(R) = α + βM (market return) + β1(equity capitalisation) • + β2 (book-to-price ratio) + β3(dividend yield) • + β4(industrial) + β5(non-industrial) www.pptmart.com

  22. Traditional Fundamental Analysis:Sources of information • The basic information about a company can be gleaned from publication (both print and Internet), annual reports, sources such as the commercial financial information providers [CMIE, Prowess data base, Indian Quotation Systems Pvt. Ltd. (Moneyline Telerate), RBI bulletin]. www.pptmart.com

  23. The basic information about a company consists of the following • Type of business (e.g., manufacturer, retailer, service, utility) • Primary products • Strategic objectives • Financial condition and operating performance • Major competitors (domestic and foreign) • Competitiveness of the industry • Position of the company in the industry (e.g., market share) • Industry trend • Regulatory issues • Economic environment www.pptmart.com

  24. COMPANY ANALYSIS • Important Financial Statements • Income Statement (P&L Account) • Statement of Financial position (Balance Sheet) • Fund Flow Statement • Cash Flow Statement www.pptmart.com

  25. FINANCIAL RATIO ANALYSIS: • Liquidity Ratios • Leverage/Capital Structure Ratio • Turnover Ratio • Profitability Ratio (Net Profit, Operating Profit, Non-Operating Profit) • Common Stock Ratio (DPS, EPS, etc.) www.pptmart.com

  26. FINANCIAL RATIO ANALYSIS can not tell the whole story • So many assumptions. • Other areas of concern • - selection of an appropriate benchmark • firm or firms for comparison purposes • - interpretation of ratio. • - pitfalls in forecasting future operating • performance and financial condition • based on past trends www.pptmart.com

  27. ACCOUNTING POLICY AND NOTES • Depreciation Policy: WDM, SLM • Inventory Valuation: FIFO, LIFO, etc. • Before comparing two companies, you must recast their comparison on the basis of uniform accounting policy. www.pptmart.com

  28. FUND FLOW STATEMENT ANALYSIS www.pptmart.com

  29. Fund Flow ANALYSIS • What is the fund from operation (FFO)? • Whether acquisition is from FFO. • Whether the firm has used short term sources of funds to finance long-term investments. • Level of Increase/Decrease in Working Capital. Is it justified? • What is existing Current Ratio? • Excessive Liquidity is bad. www.pptmart.com

  30. CASH FLOW STATEMENT • 1. Cash Flow from Operating Activities is expected to be positive. • 2. Cash Flow from Investment Activities is expected to be negative. • 3. Cash Flow from Financial Activities is expected to be positive. www.pptmart.com

  31. CASH FLOW STATEMENT ANALYSIS • Checking the Power of Cash Flow Engine (CF from operating activity): • Whether it is increasing? • Is it increasing at the cost of Working Capital? • What is the qualities of Net Profit? • Correlation between net profit and cash flow from operation. • Whether cash flow from financing activity is now for investment activities or it is used to meet daily expense. • Whether CFOP Activity is negative? www.pptmart.com

  32. BREAK-EVEN ANALYSIS AND CONTRIBUTION ANALYSIS • EBIT = TR – TC = PQ – (Va + F) • = Q (p – v) – F • At Break-even point EBIT = 0, • Or QB/E = [F/(p – v)] • = Fixed Cost/Contribution www.pptmart.com

  33. Margin of Safety • Margin of Safety • = Actual Sale – Break-even sale • Suppose B/E sale is 80% of actual sale. • Margin of safety is 20%. • Its sales can drop by 20% before it shows loss. www.pptmart.com

  34. Contribution Margin • Contribution Margin = contribution / sale • Suppose sale = Rs50 per unit • Variable cost =Rs20 per unit • Contribution margin = (50 -20) / 50 = 60 i.e., 60%. • This means that every rupee of additional sales will increase the pretax profit by 60 paise. • The traditional financial ratio does not provide this information at all. • Suppose we have got PBT to sales = 20%. • Will profit increase by 20 paise for every rupee increase in sales? www.pptmart.com

  35. Limitation of contribution margin analysis • Since an investor is interested only on the profit of the firm, the forecasted sale or growth in sale can be translated into earnings growth with the help of contribution analysis. • Two notes of caution are, however, in order. • First, the contribution analysis is valid only as long as the existing capacity is adequate to meet the forecasted demand growth. • Second, the traditional accounting statements do not provide adequate information about variable and fixed costs. www.pptmart.com

  36. FINANCIAL ANALYSIS AND MEASURES OF RISK www.pptmart.com

  37. FINANCIAL ANALYSIS AND MEASURES OF RISK www.pptmart.com

  38. FINANCIAL ANALYSIS AND MEASURES OF RISK www.pptmart.com

  39. Interviewing company representatives • Interviewing representatives of company may produce additional information and insight into the company’s business. • Because the analyst comes armed with knowledge of the company’s financial statements, the questions should focus on taking a closer look at the information provided by these disclosures: • - Extraordinary or unusual revenues and expenses • - Large differences between earnings and Cash Flows from • operating activities. • - Changes in accounting policy • - How the company values itself versus the market’s valuation www.pptmart.com

  40. Other company specific factors • Age of Plant • Quality of Management • Brand Image • Labour-Management relation www.pptmart.com

  41. ESTIMATION OF INTRINSIC VALUEEarning Analysis, dividend and dividend discount models Value of a firm =expected value of a future cash flow of the firm As an alternative, what is typically done is to examine the historical and current relation between stock prices and some fundamental values, such as earnings, dividends, using this relation to estimate the value of a share. www.pptmart.com

  42. ESTIMATION OF INTRINSIC VALUE • Estimate the expected earnings per share (EPS). • Establish a P/E Ratio. • Develop a value anchor and a value range. www.pptmart.com

  43. 1. Estimate the expected earnings per share. www.pptmart.com

  44. Can earnings be managed? • There is a possibility that reported financial information may be managed or manipulated by the judicious choice of accounting methods and timing. • Earnings can be manipulated using a number of devices • including the selection of Depreciation Policy: • WDM, SLM • Inventory Valuation: FIFO, LIFO, etc. www.pptmart.com

  45. There are many pressures that a company may face that affect the likelihood of manipulation. These pressures include: • - Reporting ever-increasing earnings, especially when • the business is subject to variations in the business • cycle • - Meeting or beating analyst forecasts • - Executive compensation based on earnings targets www.pptmart.com

  46. Earnings Per Share • EPS = EAT / Number of common shares outstanding • What is there to interpret? • EAT is the net income available to shareholders. It is pretty clear. • What about the number of common shares outstanding? • Can that change during the period of time under consideration? • Diluted shares. • Basic EPS vs. Diluted EPS www.pptmart.com

  47. Establish a P/E Ratio. • The P/E ratio may be derived from • 1. The constant growth dividend model, or • 2. Historical analysis www.pptmart.com

  48. 1. DIVIDEND GROWTH MODEL www.pptmart.com

  49. Calculate P/E ratio on the basis of above formula. ……(1) • Historical P/E ratio for 5 year (average) ..(2) • Weighted Average P/E ratio • = (1+2)/2 www.pptmart.com

  50. DETERMINE A VALUE ANCHOR AND A VALUE RANGE • Projected EPS x Appropriate P/E Ratio • Suppose it is = 5 x 6.8 = Rs.34 • Intrinsic Value Range = Rs.32 – Rs.36 www.pptmart.com

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