Fundamental Analysis is the method of evaluating securities by attempting to measure the intrinsic value of a stock and comparing it with the prevailing market price for the purpose of decision making.
- Top down approach
- Focuses on examining the fundamentals of the security in order to make an investment decision.
- Involves examining the economic, financial and other qualitative and quantitative factors related to a security in order to determine its intrinsic value.
- It attempts 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)
- Also known as quantitative analysis involves delving into a company’s financial statements such as profit and loss account and balance sheet.
- Fundamental analysis is the examination of the underlying forces that affect the wellbeing of the economy, industry groups and companies.
- The fundamental analyst works out the true worth or intrinsic value of a security based on its fundamentals; then compares this intrinsic value with the current market market price. If the current market price is higher than the intrinsic value, the share is said to be overpriced and vice versa.
- The mispricing of securities provides an opportunity to the investor to acquire the share or dispose of the share profitably.
- An investor would buy those securities which are underpriced and sell those securities which are overpriced.
- It is believed that notable cases of mispricing will be corrected by the market in the future.
Factors considered while doing Fundamental Analysis
- Economy wide factors
- Industry wide factors
- Company wide factors
1. Economy wide factors
- 50% change in share prices are attributable to economy wide factors
- Domestic and global factors to be taken into account for economic analysis.
- Domestic factors include: GDP, price level and inflation, consumer sentiment, agriculture and monsoon, interest rates, infrastructure facilities etc.
- Global factors include: exchange rates, balance of payments, foreign exchange reserves etc.
- Economic analysis is essential to understand the behavior of stock prices.
- If the economy grows rapidly, the industry can also be expected to grow rapidly and vice versa.
- When the level of economic activity is low, the stock prices are low and when the level of economic activity is high, stock prices are high.
- Leads to erosion of purchasing power of consumers – lower the demand for products.
- Higher rate of inflation will upset business plans.
- Determine the cost and availability of credit to the companies.
- Low interest rates stimulate investment.
- Higher interest rates result in higher cost of production which may lead to lower profitability and lower demand.
Government revenue, expenditure and deficits
- Largest investor and spender
- Expenditure by the government stimulates the economy by creating jobs and generating demand.
- Performance and profitability of industries and companies that are major importers or exporters are considerably affected by the exchange rates.
- Depreciation improves the competitive position of products in foreign market by stimulating exports, but it would also make imports more expensive.
- Development of an economy depends on the availability of infrastructure.
- Power, transportation, communication systems etc.
- Performance of agriculture depends on the monson.
Economic and political stability
- Stable economic policies
2. Industry wide factors
- Industry is a group of companies having similar ways of production or the companies have similar output.
- 13% of change in share price is due to industrial influence.
- We do industrial analysis to identify those industries which are performing well enough and have chances of growth.
Industrial analysis can be done in 4 parts:
- Sensitivity of the industry to the business cycle
- Industry life cycle analysis
- Structure and characteristics of the industry
- Profit potential of industries – Porter’s 5 force model
1. Demand supply gap
- Excess supply reduces the profitability
- Insufficient supply improve the profitability (unit price increase)
2. Competitive conditions in the industry
- Barriers to entry
- Threat of substitution
- Bargaining power of suppliers
- Rivalry among competitors
3. Labor conditions
- Labor unions
4. Attitude of government
- Encouragement through legislation, subsidies etc.
5. Supply of raw materials
6. Cost structure
- Related to products and technology used
3. Company Wide Factors
- Finding the company that seems most lucrative in terms of returns and risk
- 27% of the change in share price is attributable to the company’s performance.
- Analysts try to forecast future earnings of the company because there is strong evidence that future earnings have a direct and powerful impact on share prices.
The level, trend and stability of earnings of a company depending on a number of factors:
- Financial statements
- Helps to assess profitability and financial health
- Balance sheet and profit and loss account
- Financial ratio analysis
- Company’s market share
- Capacity utilisation
- Modernisation and expansion plans
- Order book position
- Availability of raw materials
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April 14, 2022
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