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L 2 Fundamental Analysis
L 2 Fundamental Analysis
Prepared by
Prof. Rahul Mailcontractor
Assistant Professor,
Jain College of MCA and MBA,
Belgaum
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
company.
• 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
prices.
The various Macro economic factors are as follows.
Maturity
Introduction
Decline
Growth
Total Industry Revenue
Time
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
stages
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
industries.
• 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.
PORTER’S FIVE FORCES MODEL
Potential
entrants
Threat of new entrants
Threat of substitutes
Substitutes
Five forces shaping competition & determining profitability in industry
PORTER’S FIVE FORCES MODEL
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.
The DuPont System suggests that ROE (which drives stock price) is a
function
of cost control, asset management, and debt management.
Growth in Earnings
• Growth Rate= Retention ratio X ROE
• Retention Ratio= Retained earnings /Net
Income;