Chapter 6 – Fundamental Analysis

Pravin : “ If I wish to invest in the stock market, What are the things I need to
concentrate upon?”

Gopal : “ You need to analyse The economy ( the big picture), The industry( the
components) and ultimately The company( the best in the selected
component).This is known as top-down approach of investment. An investor who
feels that a particular company can really do the best in almost any situation of
the economy and industry, can follow the reverse approach known as bottom up
approach. For ex. say HUL”

The fundamental analysis of a security investigates and analyses the fundamental factors
which affect the price of security and thus the returns. Thus the basic objective of
fundamental analysis is to find out the intrinsic/fair value of a security. This enables the investor to
know whether the security is undervalued (current market price is less than the intrinsic value) or
overpriced (current market price is more than the intrinsic value). And this ultimately helps the
investor to make trading decisions – to buy undervalued securities and to sell overpriced
securities.

What is Intrinsic value? How does it help to make trading decisions?

Intrinsic value is nothing but the present value of future cash flows (say interest, dividend,
redemption value or say liquidation proceeds) of a security. This value for basically equity share
may vary from investor to investor due to variation in expected future cash flow as well as
discount rates. Thus the investor X who desires to buy a security as he finds it an undervalued
security, another investor say Y may desire to sell it being overvalued.

This can be clarified with the help of an example.

“NTPC, a power generation company has a pattern of trading at 5 times its book value. Present
rate of NTPC’s shares is 95 ( present book value is 19 Rs.). After one year it is expected that the
book value would move up by 2 Rs. and thus the share price would reach to 105 Rs. “ A report by
Mangal Keshav Securities.

1) Mr. Nagendra wants to put his savings account money into this stock. He expects to gain
at least 5% from this stock.
So intrinsic value for Nagendra = F.V./ 100+ Expe.Return ( %) * 100
=105/105 * 100
= Rs.100
This intrinsic value is more than the current market price of Rs. 95. So being undervalued stock,
Nagendra may wish to buy the stock

2) Suppose Nagendra doesn’t believe in Mangal Keshav Security’s Report and believes the
the book value and rate after one year will be Rs.19.5 and Rs 97.5 respectively.

In this case intrinsic value will be = 97.5/105 * 100

= Rs. 92.85
This value is less than current market price of the stock (overpriced), So he wouldn’t like to
buy the stock.
3) Consider another investor Mr. Vishwas, who wants to have 25% return from the stock
and expects that company would pay the dividend of Rs. 3 during the year and its book
value and price at the end of the year would be Rs.29.4 and Rs 147 respectively.

Intrinsic value of NTPC for Vishwas = 147+3/125 *100

= Rs. 120
This value is much more than its market price of Rs. 95 ( undervalued stock ). So he may
strongly wish to buy this stock.

Thus intrinsic value is based upon the expected rate of return / cost of capital/discount rate
and expected future cash flows. So it differs from person to person even for the same stock.

To find out intrinsic value, an investor has to correctly predict the future cash flows in the form
of earnings and dividends. This totally depends upon economic and industrial environment. It
also depends upon the financial strengths, the management, the policies and strategies of the
company. Thus it is a must to analyse all the factors related to economy, industry and the
company.

Hence the fundamental analysis procedure involves a three step examination

 Understanding of the macro-economic environment and developments

 Analysing the prospects of the industry to which the firm belongs

 Assessing the projected performance of the company and the intrinsic value of its
shares

1) Understanding of the macro-economic environment and developments :

This includes the following factors.

A) The Global Economy: In a globalised business environment, the top down

analysis of the prospects of a firm must begin with the global economy. The
global economy has a bearing on the export prospects of the firm, the
competition it faces from international competitors, and the profitability of its
overseas investments. It is necessary to analyse the global economy because

 Although the economies of most countries are linked, economic

performance varies widely across countries at any time.
 From time to time countries may experience turmoil due to a complex
interplay between political and economic factors.
 The exchange rate is a key factor affecting the international
competitiveness of a country’s industries

B) The Central Govt. Policy : The government employs two broad classes of
macroeconomic policies, viz. demand side policies and supply side policies.
Traditionally, the focus was mostly on fiscal and monetary policies, the two major
tools of demand-side economics. From 1980s onward, however, supply-side
economics has received a lot of attention.

a) Fiscal Policy - It is concerned with the spending and tax

initiatives of the government. It is the most direct tool to stimulate
or dampen the economy. An increase in government spending
 stimulates the demand for goods and services, whereas a
decrease deflates the demand for goods and services. By the
same token, a decrease in tax rates increases the consumption
of goods and services and an increase in tax rates decreases
the consumption of goods and services.

b) Monetary Policy :Monetary policy is concerned with the

manipulation of money supply in the economy. Monetary policy
affects the economy mainly through its impact on interest rates.
The main tools of monetary policy are:
 open market operation
 Bank rate
 Reserve requirements
 Direct credit controls

C) The Macroeconomic Analysis : It is the overall economic environment in which

all firms operate. The key variables commonly used to describe the state of the
macroeconomy are :

 Growth rate of gross domestic product

 Industrial growth rate
 Agriculture and monsoons
 Savings and investments
 Government budget and deficit
 Price level and inflation
 Interest rates
 Balance of payment, forex reserves, and exchange rate
 Infrastructural facilities and arrangements
 Sentiments ( The sentiments of consumers and businessmen)

2) Analysing the prospects of the industry to which the firm belongs : This can
be divided into four parts
A) Sensitivity to the Business Cycle : Some industries are very sensitive to the
business cycle and some are not.
For ex. During expansion phase of the economy, the demand for automobiles
tends to rise sharply and vice versa. By contrast, the cigarette industry is more or
less independent of the business cycle.

B) Industry Life Cycle Analysis: Every industry has to go through four well defined
stages. They are

• Pioneering Stage
• Rapid Growth Stage
• Maturity & Stabiliz’n Stage
• Decline Stage

C) Study of the Structure and Characteristics of an industry – This helps to

know the basic structure and characteristics of an industry. It focuses on
following points.

 Structure of Industry and nature of competition

 Nature and Prospects of demand
  Cost, efficiency and profitability
 Technology and research

D) Profit potential of industries – Porter Model : As per Michel Porter, the profit
potential of an industry depends upon five basic competitive forces- They are

 Threat of new Entrants

 Rivalry among the existing firms
 Pressure from substitute products
 Bargaining power of Buyers
 Bargaining power of Sellers

POTENTIAL
ENTRANTS

TREAT OF NEW ENTRANTS

Bargaining Power of Suppliers INDUSTRY BARGAINING POWER OF BUYER BUYER

SUPPLIERS RIVALRY
AMONG THE
EXISTING FIRMS

THREAT OF
SUBSTITUTE
PRODUCTS

SUBSTITUTES

Diagrammatic presentation of forces that drive competition and determine

industry profit potential

3) Assessing the projected performance of the company and the intrinsic

value of its shares: This includes the following factors

A) Study of Financials --- This helps to know and analyse the historical
performance of the company and also helps to judge the future performance.
Ratio Analysis is the important tool for the same. The following example
 explains the important ratios which help to know present financial position
of the company and also help to predict future earnings of the company
and thus the intrinsic value of the firm.

FINANCIALS OF X-PRO INDIA LTD

(Amount in Rs.)

20X3 20X4 20X5 20X6 20X7 20X8 20X9

• Net Sales 475 542 605 623 701 771 840
• Cost of goods sold 352 380 444 475 552 580 638
• Gross profit 123 162 161 148 149 191 202
• Operating expenses 35 41 44 49 60 60 74
• Operating profit 88 121 117 99 89 131 128
• Non-operating surplus/deficit 4 7 9 6 - -7 2
• Profit before interest and tax 92 128 126 105 89 124 130
(PBIT)
• Interest 20 21 25 22 21 24 25
• Profit before tax 72 107 101 83 68 100 105
• Tax 30 44 42 41 34 40 35
• Profit after tax 42 63 59 42 34 60 70
• Dividend 20 23 23 27 28 30 30
• Retained earnings 22 40 36 15 6 30 40
• Equity share capital 100 100 150 150 150 150 150
• Reserves and surplus 65 105 91 106 112 142 182
• Shareholders’ funds 165 205 241 256 262 292 332
• Loan funds 150 161 157 156 212 228 221
• Capital employed 315 366 398 412 474 520 553
• Net fixed assets 252 283 304 322 330 390 408
• Investments 18 17 16 15 15 20 25
• Net current assets 45 66 78 75 129 110 120
• Total assets 315 366 398 412 474 520 553
• Earnings per share 2.8 2.27 4.00 4.67
• Market price per share 21.00 26.50 29.10 31.5
(End of the year)
* Face value of the share is Rs. 10

Roe : 3 Factors
PAT SALES ASSETS
ROE = x x
SALES ASSETS EQUITY

NET PROFIT ASSET EQUITY MULITIPLIER

MARGIN TURNOVER
The break-up of the return on equity in terms of its determinants for the period 20x7 –
20x9 for horizon limited is given below:

Return on equity = Net profit margin x Asset turnover x Equity multiplier

20X7 13.0 % = 4.85% x 1.48 x 1.81
20X8 20.5% = 7.78% x 1.48 x 1.78
20X9 21.1% = 8.33% x 1.52 x 1.67

ROE : 5 FACTORS

Investment analysts use one more formulation of the ROE wherein it is analysed in terms
of five factors :

PBIT SALES PROFIT BEFORE TAX PROFIT AFTER TAX ASSETS

ROE = X X X X
SALES ASSETS PBIT PROFIT BEFORE TAX EQUITY

ROE = PBIT efficiency x Asset Turnover x Interest Burden x Tax Burden x Leverage

The ROE break-up for X-PRO company is given below :

ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x Leverage

20X7 13.0% = 12.70% x 1.48 x 0.764 x 0.50 x 1.81

20X8 20.5% = 16.08% x 1.48 x 0.81 x 0.60 x 1.78
20X9 21.1% = 15.48% x 1.52 x 0.81 x 0.67 x 1.67

Book Value Per Share And Earnings Per Share

Book Value Per Share (BVPS) = Paid-up equity capital + Reserves and surplus
Number of equity shares

20 x 7 20 x 8 20 x 9
BVPS 262/15 = 17.47 292/15 = 19.47 332/15 = 22.13

Earnings Per Share (EPS) = Equity earnings

Number of equity shares
 20 x 7 20 x 8 20 x 9
EPS 34/15 = 2.27 60/15 = 4.00 70/15 = 4.67

Dividend Payout Ratio And Dividend Per Share

Dividend Payout Ratio = Equity dividends

Equity earnings

20 x 7 20 x 8 20 x 9
Dividend
Payout ratio 28/34 = 0.82 30/60 = 0.50 30/70 = 0.43

Dividend Per Share (DPS)

20 x 7 20 x8 20 x 9
DPS Rs 1.87 2.00 2.00

Growth Performance

• To measure the historical growth, the compound annual growth rate (CAGR) in variables
like sales, net profit, earnings per share and dividend per share is calculated.

• To get a handle over the kind of growth that can be maintained, the sustainable growth
rate is calculated.

Compound Annual Growth Rate (CAGR)

The compound annual growth rate (CAGR) of sales, earnings per share, and dividend per share
for a period of five years 20x4 – 20x9 for X- pro India Limited is calculated below:

Sales of 20 x 9 1/ 5 840 1/ 5
CAGR of Sales : –1= – 1 = 9.2%
Sales for 20 x 4 542

CAGR of earnings EPS for 20 x 9 1/ 5 4.671/ 5

per share (EPS) : EPS for 20 x 4 – 1 = 4.2 –1 = 2.1%

CAGR of dividend : DPS for 20 x 9 1/ 5 2 1/ 5

per share (DPS) DPS for 20 x 4 – 1 = 1.53 –1 = 5.5%
Sustainable Growth Rate

The sustainable growth rate is defined as :

Sustainable growth rate = Retention ratio x Return on equity

Based on the average retention ratio and the average return on equity of the three year period
(20x7 – 20x9) the sustainable growth rate of X- pro India Limited is:

Sustainable growth rate = 0.417 x 18.2% = 7.58%

B) Going Beyond The Numbers :

** Sizing Up The Present Situation And Prospects

 Availability and Cost of Inputs

 Order Position
 Regulatory Framework
 Technological and Production Capabilities
 Marketing and Distribution
 Finance and Accounting
 Human Resources and Personnel

** Evaluation Of Management

 Strategy
 Calibre, Integrity, Dynamism
 Organisational Structure
 Execution Capability
 Investor – friendliness

C) Intrinsic Value : The above mentioned analysis through valuation ratios helps to
determine the future outcome/value of the stock and thus instrumental to discover the
fair/intrinsic value of the stock