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Fundamental Analysis

Prepared by
Prof. Rahul Mailcontractor
Assistant Professor,
KLS’s Institute of Management Education and Research,
Belgaum, Karnataka
Fundamental Analysis
• Fundamental analysis involves determining the
intrinsic value of an equity share. To determine the
intrinsic value, the analyst must forecast the earnings
and expected dividends from the stock and choose a
discount rate which reflects the risk of the stock.
• It is the examination of various factors such as
earnings of the company, growth rate and risk
exposure that affects the value of shares of a
• Fundamental analysis consists of:
 Economic analysis: Impact 30-35 %
 Industry analysis : Impact 15- 20 %
 Company analysis: Impact 30-35 %
Economic Analysis
• Economic analysis is the analysis of various macro economic
factors that have a significant bearing on the value of various
securities. When the level of economic activity is low security
prices are low and when the economic activity is high security
prices are high. An analysis of the macro economic
environment is essential to understand the behavior of stock
The various Macro economic factors are as follows.

 Global Economic Factors  Tax structure

 Fiscal Policy  Balance of payments, Forex

reserves and exchange rates
 Monetary Policy  Foreign Direct Investment
 Gross Domestic Product  Investment by FII's
 Savings and Investment  Business cycles
 Inflation  Monsoon and Agriculture

 Interest rates  Infrastructure Facilities

 Budget  Demographic Factors

Economic Forecasting
• To estimate stock price changes, an analyst must look at the macro economic environment
and the factors peculiar to the industry. Economic activities affect corporate profits,
investment attitudes and share price. For economic analysis an analyst should be familiar
with forecasting techniques. Economic indicators, diffusion index, surveys and
econometric model building are some forecasting methods are used for analyzing the state
of the economy:
 Economic indicators: Any economic variable that predicts the future of financial or
economic trends is called an economic indicator. The purpose of using indicators is to
make an early diagnosis of the cyclical movements in the economy. It Indicates the
present status, progress or slow down of the economy. Indicators are classified as
leading, coincidental and lagging.
a. Leading indicators: Indicate what is going to happen in the economy. Popular
leading indicators are fiscal policy, monetary policy, productivity, rainfall, capital
investment and stock indices.
b. Coincidental indicators: Indicate what the economy is i.e., state of economy. The
coincidental indicators are GDP, industrial production, interest rates and reserve
c. Lagging indicators: Changes occurring in leading and coincidental indicators are
reflected in lagging indicators. Unemployment rate, consumer price index and flow of
foreign funds are examples of such indicators.
The leading. Coincidental and lagging indicators provide an insight into the
economy’s current and future position.
 Diffusion and Composite index: The diffusion index indicates the current business
cycle phase. It measures the breadth of a business cycle movement (Contraction or
Expansion).It provides an overview of the economic activity of the country. It is a
consensus index consisting of leading, coincidental and lagging indicators and has
been constructed by the National Bureau of Economic Research in USA. It is
complex and difficult to calculate.
The best of leading, coincidental and lagging indicators are selected and
combined into the composite index. It highlights the cyclical patterns in the data
and reduces the volatility of individual indicators. A composite index reveals
common turning point patterns in a set of economic data more clearly than any
individual component.
 Econometric Models: An analysis of economic factors provides direction for
investment in the stock market. Economist have developed many economic models
to forecast endogenous variables. To make forecast the model depends on certain
other variables called exogenous variables. The model can be deterministic or
stochastic. When an exact relationship is assumed in the model it is deterministic.
In stochastic model, one or more variables are random.
 Creating macro economic models involves the following steps
a. Selection of the variables
b. Categorization of variables
c. Specification of the model.
d. Collection of data
e. Estimation of the parameters.
Industry Analysis
• Industry Analysis: An analysis of the performance, prospects and problems
of an industry is known as industry analysis. Industry analysis is required
because the return and risk of various industries are different. The
performance of the industry reflects the performance of the companies it
consists. Industry analysis is used to analyze the performance of the
industries over the years.
• An industry is a group of firms that have a similar technological structure of
production and produce similar goods and services.
• Industries can be classified into:
 Growth industry: Has high rate of earnings and growth is independent
of business cycle. The expansion depends on technological change. Ex.
IT, Pharma.
 Cyclical industry: Growth and profitability of the industry move along
with the business cycle. During boom, industry enjoys growth and during
depression they suffer a setback. Ex. Real Estate, Capital Goods.
 Defensive industry: It is an industry which defies the business cycle.
The stocks of defensive industries can be held as they pay dividends on a
regular basis. The expand and earn income in depression also. They are
counter cyclical in nature. Ex. FMCG
 Cyclical growth industry: It is an industry that is cyclical and at the
same time growing. Changes in technology and introduction of new
models can help the industry resume its growth path. Ex. Automobile.
The Industry Life Cycle


Total Industry Revenue


Industries evolve over time, both structurally and in terms of overall size. The industry life cycle is measured in total
industry sales and the growth in total industry sales. The industry structure and competitive forces that shape the
environment in which businesses operate change throughout the life cycle. Therefore a business's strategy must adapt
accordingly. It is useful to consider the evolution of the industry life cycle in the context of Porter’s 5 Forces.
Industry Life cycle
• The life cycle of an industry is separated into four well defined
a. Pioneering stage: In this stage the prospective demand for the
product is promising and the technology used to manufacture the
product is low. The demand for the product encourages many
entrants and there is severe competition among rivals. The
entrants try to develop a brand name, differentiate the product and
create product image. The severe competition leads to change in
market share and position of the firm and variation in profits. It is
very difficult to invest in companies at the pioneering stage.
Ex. E-commerce
b. Rapid Growth stage: After the pioneering stage the companies
that have withstood the competition improve their market share
and financial performance. The technology improves resulting in
lower cost of production and good quality products. The
companies have stable growth. It is advisable to invest in these
companies. Ex. Pharma. IT
c. Maturity and stabilization stage: In the stabilization stage
the growth rate of the industry tends to moderate and the rate
of growth stabilizes. Symptoms of obsolescence may appear in
the technology. Technological innovations in the production
process and product have to be introduced. The industry will
start to consolidate, possibly through mergers and acquisitions.
Mature industries are settled , risks are low and cash is
generated. However, rivalry among competitors is fierce and
falling prices pose a serious threat to profitability.
d. Declining stage: In this stage, demand for the product and the
earnings of the company decline. Innovation and change in
consumer preference lead to this stage. The specific features of
the declining stage is that even in boom, the growth of the
industry is low and declines at a higher rate during a recession.
It is better avoiding investment in such industries.
Study of structure and characteristics of an industry
An investor must analyze the following factors:
• Growth of the industry: The historical performance of the
industry in terms of growth and profitability must be analyzed.
The past variability in returns and growth in reaction to
macroeconomic factors must be analyzed and future estimates of
growth must be forecasted.
• Cost structure and profitability: The cost structure affects the
cost of production and profitability of the firm. Cost structure of
the industry in terms of fixed and variable cots must be
analyzed. Factors like inventory turnover and asset turnover
must be analyzed which is an indication of capacity utilization
of an industry. Analyzing Profitability ratios helps us
understand the profitability of the industry.
• Nature of the product and demand: The products produced by
industries are demanded by consumers and other industries. An
investor must analyze the condition of the feeder industry as
well as the end user industry to assess the demand for industrial
goods. In case of consumer goods industry, a change in
consumer preference, technological innovations and substitute
products affect the demand.
• Nature of the competition: The number of firms in the industry
and the market share of top firms must be analyzed. Factors like
Entry Barriers and Exit Barriers, Degree of homogeneity and
differentiation of products practiced by various players, Pricing
policies, Competition from foreign players etc must be analyzed.
• Government policy: Government polices affect the industries
directly. Factors like tax subsidies and tax holidays, regulations
and pricing policy , Entry and exit barriers set by government and
liberalization of licensing must be analyzed. Government policies
on environment and pollution control standards affect various
• Labor: Labor scenario in a particular industry is very important.
The number of trade unions and their operating mode have an
impact on labor productivity. Frequent strikes and lockouts result
in loss of production and high fixed capital loss. Availability of
Skilled and unskilled labor must be analyzed.
• Research and Development: For any industry to survive
competition in national and international market, the product and
production process must be competitive. This depends on R&D.
The expenditure on R&D should be studied before making any
investment in industry.

Threat of new entrants

Bargaining power Bargaining power of buyers

of suppliers
Industry competitors
Rivalry among existing Buyers

Threat of substitutes

Five forces shaping competition & determining profitability in industry
1. Threat of new entrants: The entry of new companies in the
market increases the competition and reduces profitability. The entry
and exit barriers for a particular industry decide the number of new
entrants. Government rules and regulation for starting a company is a
major factor for new entrants. The capital required to start new
companies, economies of scale, customer switching costs, resistance
of existing players are main barriers for entrants.

2. Bargaining power of Buyers: Buyers are a competitive force.

They can bargain for price cut, superior and better service and induce
rivalry among competitors. If they are powerful. They can depress the
profitability of suppliers. Bargaining power of buyers is high when.
•Its purchasing power is relatively large to the seller
•Its switching costs are low
•It poses strong threat to backward integration
3. Bargaining Power of Suppliers: Suppliers can exert competitive force in
an industry as they can raise prices, lower quality and curtail the range of free
services they provide. Powerful suppliers can affect the profitability of the
buyer industry. Suppliers have strong bargaining power when
• A few suppliers dominate the industry and there are many buyers
• There are no substitutes for the product supplied.
• The switching cost of buyers is high
•If suppliers pose a threat of forward integration.
4. Rivalry Among Existing Players: Firms in an industry compete on the basis
of price, quality, promotions, services etc. A firms attempt to improve its
competitive position provokes retaliatory action from others. This can affect the
profitability of industry. Rivalry tends to be high when
•The number of competitors is large
•Few firms are capable of engaging in competitive battle
•Industry growth is sluggish forcing the firms to acquire a larger market share
•The level of fixed cost are high forcing the firms to achieve higher capacity
•The industry has high exit barriers
5. Threat from the Substitutes: All firms in an industry face
competition from industries producing substitutes products.
Substitute product may limit the profit potential of the industry. The
threat of substitute products is high when
• The price performance tradeoff offered by substitutes is attractive
• The switching costs for buyer is low
• The substitute products are produced by industry earnin superior
Company Analysis
• Evaluating the financial performance of the company on the
basis of qualitative factors and quantitative factors is company
• Qualitative Factors: The qualitative factors that affect the
value of a company are
1. Business Model: The way in which a company makes money.
It describes company’s operations, mode of revenue
generation, nature of expenses, organization structure and its
sales and marketing effort.
2. Management :Good and capable management teams generate
profits. Management should attain the stated objectives of the
company and create value for all the stake holders. The
criterion used for management analysis is management
discussion and analysis, management ownership of equity
3. Corporate governance : It refers to the set of systems and
practices put in place by the company to ensure
accountability, transparency and fairness in order to
safeguard the interest of the stake holders. Areas of corporate
governance are
a) Structure of board of directors
b) Financial and information transparency
c) Stake holders rights
4. Corporate culture : It refers to the collective beliefs, values,
systems and processes of the company. Every company has
set of values and goals that helps to define what the business
is about. The basis of corporate culture is expressed in terms
of the policies and procedures adopted in the company’s
• Quantitative Factors
1. Earnings of the company: Earnings decide its stock value in the
market. Growing earnings result in high valuation of the stock.
Earnings are operating profits. Earnings are generated from
operating sources and non operating sources. The following factors
have an effect on the earnings of a company.
 a. Change in sales b. Change in cost c. Depreciation method d.
Depletion of resources e. Inventory accounting method. f.
Replacement cost of inventory g. Wages, salaries h. Income tax and
other taxes.
 Measurement of earnings:
 Gross Profit= Sales – Cost of Goods Sold (COGS)
 EBITDA = Gross profit- Operating Expenses
 EBIT = EBITDA – (Depreciation and Amortization)
 EBT= EBIT – Interest
 EAT= EBT – Tax
• EPS(Earnings per share): EPS gives the overall picture of
the performance of the company.

• EPS = Net Income – Dividends on Preference Shares

Average Outstanding Shares
• P/E multiple (Price Earnings multiple) The price earnings
ratio reflects the price investors are willing to pay for every
rupee of earning per share. It is calculated in retrospective or
prospective manner. A high P/E ratio indicates high
Expectations of the market regarding the growth of the
company’s future earnings. Investors compare the P/E ratio of
company to that of the industry and market.
• P/E ratio = Market price per share
Earnings per share
2. Financial Leverage: The degree of utilization of Borrowed
money in a business is known as the financial leverage. It
involves the selection of appropriate financing mix ,
proportion of long term debt and equity capital (Net worth)
i.e., capital structure of a company . A high degree of financial
leverage results in high interest payments. This will affect the
net profits to equity holders.
• Financial Leverage = Total Debt
Share holder’s equity
Degree of Financial Leverage (DFL) = % change in EPS
% change in EBIT
Degree of Financial Leverage (DFL) = EBIT
EBIT – Interest(EBT)
3. Operating Leverage: The extent to which an organization uses
fixed costs in its cost structure is called operating leverage. The
operating leverage is greatest in firms with a large proportion of
fixed costs, low proportion of variable costs, and the resulting
high contribution-margin ratio. A high degree of operating
leverage implies other factors being constant, a relatively small
change in sales results in a large change in return on equity.
• Degree of Operating Leverage (DOL) = % Change in Operating Income
% Change in Sales

• DOL = Total Contribution ( Sales – Variable Cost) = Total Contribution

Operating Income Total Contribution - FC
4. Competitive Edge: The competitiveness of a company can be
assed by looking at the following aspects
• Market share: The market share of annual sales helps
determine a company’s relative position within the industry. If
market share is high the company will be able to meet the
competition successfully. While assessing the market share the
size of the company should also be considered.
• Growth of sales: A company with rapid growth in sales is
better for share holders than one with stagnant growth rate.
Investors prefer a large company because it is able to withstand
the business cycle. Growth in sales results in growth in profits.
• Stability of Sales: A company with stable sales revenue will
have more stable earnings. Wide variation in sales lead to
variation in capacity utilization. The fall in market share
indicates a declining trend for the company even if the sales are
stable. Stability of shares should be compared to market share.
• Production Efficiency: Production efficiency means producing
the maximum output at minimum cost per unit of output. This
measures how well the production process is performing.
Increasing efficiency boosts the capacity of the business without
any change in number of inputs employed. Production efficiency
enables the firm to produce goods at a lower cost than competitors
and generate more profits. Production efficiency results in
Increase in profitability, Low operational costs, Optimum use of
company resources, Enhanced competitiveness and market share
and superior return to the investor.
Financial Analysis
• It involves analyzing the financial statements of the company
from various view points. The financial statements give the
historical and current information of the company’s
operations. Historical financial statements helps to predict the
• The financial statements of the company include:
 Balance sheet: It shows the status of a company’s financial
position at the end of the year. It is snapshot of company’s
Assets, Liabilities and Equity
 Profit and loss account: It shows the profit and loss made
by the company during a period. It shows the Sales,
expenses, and taxes incurred to operate
 Fund flow and Cash Flow Statement: It shows the
sources and application of funds
Analysis of Financial Statements
• It helps the investor in determining the financial position and progress of
the company.
• The various simple analyses that are performed to ascertain the financial
position of the company are:
 Comparative financial statement: Here data from the current year’s
financial statements is compared with similar data from the previous
year’s financial statements.
 Trend analysis: It shows the growth and decline of sale or profit over
the years.
 Common size statement: Common size balance sheet shows each item
in balance sheet as a percentage of total assets for assets and each item
as a percentage of total liabilities. Common size income statement
shows each item of expense as a percentage of net sales. With common
size statements comparisons can be made between firms of different
 Fund flow analysis: It is a statement of the sources and application of
 Cash flow analysis: It shows cash inflow and outflow of a company
during the year.
 Ratio analysis: Ratios summarize the data for easy understanding,
comparisons and interpretations.
Financial Ratio Analysis
• Liquidity Ratios (ability to meet financial obligations)
• Leverage Ratios (use of debt)
• Turn over Ratios (asset management or efficiency ratios)
• Profitability Ratios (Reflect profitability)
Liquidity Ratios
• Measure ability to pay maturing obligations
• Current ratio = Current assets
current liabilities
• Quick ratio or
• Acid test ratio = Current assets - Inventories
current liabilities
Leverage or Debt Ratios
• Measure extent to which firm uses debt to finance asset
investment (risk attribute)
• Debt-equity ratio = Total debt
Equity( Net worth)
• Total debt to total assets ratio
• Debt to asset ratio = (Current liabilities + long-term debt)
Total assets
• Interest coverage ratio = EBIT
Turn over Ratios Efficiency Ratios
• Measure effectiveness of asset management
• Inventory turnover (times per year)= Net sales
Average inventory

• Total asset turnover = Sales

Average Total assets

• Fixed asset turnover = Sales

Average net fixed assets

• Debtor turn over = Net credit Sales

Average Debtors
Profitability Ratios
• Measures profits relative to sales (profit margin ratios)
• Gross profit margin = Gross profit (Sales – COGS)
• Operating Profit Margin =Operating profits(Gross Profit –
• Net profit margin = Net profit (PAT)
• Rate of return ratios
• Return on Assets (ROA) = Net Profit(PAT)
Total Assets
• Return on Equity (ROE) = Net Profit
Stockholder Equity
Excludes preferred stock balances
Valuation Ratios
• Earnings per share (EPS):
• EPS = Net Income – Dividends on Preference Shares
Average Outstanding Shares
• P/E ratio = Market price per share
Earnings per share
• Dividend yield = Annual dividend
price per share
• Dividend payout = Dividends per share (DPS)
Earnings per share (EPS)
• Book value per share = Net worth
Number of shares
• Market price to Book Value( P/B ratio) = Market price per share
Book value per share
DuPont Analysis
Net Profits Net Profits Sales Total Assets
ROE = = × ×
Equity Sales Total Assets Equity
Ratio 1 Ratio 2 Ratio 3

Ratio 1 = NPM Ratio 2 = TATO Ratio 3 = Equity


The DuPont System suggests that ROE (which drives stock price) is a
of cost control, asset management, and debt management.
Growth in Earnings
• Growth Rate= Retention ratio X ROE
• Retention Ratio= Retained earnings /Net Income;