Term Paper

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Chapter- 4 and 5 Fundamental Analysis: Economy, Industry and Company Analysis

Submitted to: Dr. Md. Rafiqul Islam Professor Department of Banking University of Dhaka Submitted by: Khodeza Kashem (50815003) Shakera Afroz (50815057) Rushmila Andalib (50916013) Course code: CB-605 Course name: Bank Investment Analysis

Submission date: 6th April, 2010

Table of Contents
Index Chapter Four
1. Fundamental Analysis: Introduction 2. Fundamental Analysis: What Is It? 3. EIC Frame Work- The Economy Analysis

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03 04 05

Chapter Five
4. 5. 6. 7.

EIC Frame Work- The Industry Analysis EIC Frame Work- The Company Analysis Financial Statement- The Ratio Analysis Strengths and Weaknesses of Fundamental Analysis Conclusion

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Chapter Four
Fundamental Analysis: Introduction
Fundamental Analysis is the process of determining the value of a company by analyzing and interpreting such key factors as economy, industry, and company. Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements. At the company level, fundamental analysis may involve examination of financial data, management, business concept and competition. At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy. To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock's current fair value and forecast future value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued and the market price will ultimately gravitate towards fair value. Fundamentalists do not heed the advice of the random walkers and believe that markets are weak-form efficient. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies.

The EIC valuation process, it is necessary to being with Economic Analysis. If we can envision a concentric circle with three sections; the first circle holds economic variables used to measure the health of the economy. The circle in the middle holds industry variables. The center circle of the diagram holds valuation variables of the individual firm. Fundamental analysis thus involves three steps: Economic Analysis: Business Cycles, Monetary & Fiscal Policy, Economic Indicators, World Events & Foreign Trade, Inflation, Public Sentiment, GDP Growth, Unemployment, Productivity, Capacity Utilization, etc. Industry Analysis: Industry Structure, Competition, Supply-Demand Relationships, Product Quality, Cost Elements, Government Regulation, Business Cycle Exposure, etc. Analysis of the Individual Firm: Forecasts of Earnings, Dividends and discount rates, Balance Sheet/Income Statement Analysis, Management, Research, Return, Risk, etc

Fundamental Analysis: What Is It?

The Very Basics When talking about stocks, fundamental analysis is a technique that attempts to determine a securitys value by focusing on underlying factors that affect a company's actual business and its future prospects. On a broader scope, we can perform fundamental analysis on industries or the economy as a whole. The term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements. Fundamental analysis serves to answer questions, such as:

Is the companys revenue growing? Is it actually making a profit? Is it in a strong-enough position to beat out its competitors in the future? Is it able to repay its debts? Is management trying to "cook the books"?

Fundamentals: Quantitative and Qualitative The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial meaning of these terms isnt all that different from their regular definitions. Here is how the MSN Encarta dictionary defines the terms:

Quantitative capable of being measured or expressed in numerical terms. Qualitative related to or based on the quality or character of something, often as opposed to its size or quantity.

In our context, quantitative fundamentals are numeric, measurable characteristics about a business. Its easy to see how the biggest source of quantitative data is the financial statements. You can measure revenue, profit, assets and more with great precision. Turning to qualitative fundamentals, these are the less tangible factors surrounding a business things such as the quality of a companys board members and key executives, its brand-name recognition, patents or proprietary technology.

EIC Frame Work- The Economy Analysis

Economy analysis is one of most important art of fundamental analysis. Companies are a part of the industrial and business sector, which in turn is a part of the overall economy. Thus the performance of a company depends on the performance of the economy in the first place.

If the economy is in recession or stagnation, the performance of companies will be bad in general, with some exceptions however. On the other hand, if the economy is booming, incomes are rising and the demand is good, then the industries and the companies in general may be prosperous, with some exception however.

Most Important Economic indicators are:

National Output: GDP Output, the most important concept of macroeconomics, refers to the total amount of goods and services a country produces, commonly known as the gross domestic product. The figure is like a snapshot of the economy at a certain point in time. When referring to GDP, macroeconomists tend to use real GDP, which takes inflation into account, as opposed to nominal GDP, which reflects only changes in prices. The nominal GDP figure will be higher if inflation goes up from year to year, so it is not necessarily indicative of higher output levels, only of higher prices. Unemployment The unemployment rate tells macroeconomists how many people from the available pool of labor (the labor force) are unable to find work. (For more about employment, Macroeconomists have come to agree that when the economy has witnessed growth from period to period, which is

indicated in the GDP growth rate, unemployment levels tend to be low. This is because with rising (real) GDP levels, we know that output is higher, and, hence, more laborers are needed to keep up with the greater levels of production . Inflation The third main factor that macroeconomists look at is the inflation rate, or the rate at which prices rise. Inflation is primarily measured in two ways: through the Consumer Price Index (CPI) and the GDP deflator. The CPI gives the current price of a selected basket of goods and services that is updated periodically. The GDP deflator is the ratio of nominal GDP to real GDP. If nominal GDP is higher than real GDP, we can assume that the prices of goods and services has been rising. Both the CPI and GDP deflator tend to move in the same direction and differ by less than 1%.

Greasing the Engine of the Economy - What the Government Can Do

Monetary Policy A simple example of monetary policy is the central bank's open-market operations. When there is a need to increase cash in the economy, the central bank will buy government bonds (monetary expansion). These securities allow the central bank to inject the economy with an immediate supply of cash. On the other hand, when the central bank needs to absorb extra money in the economy, and push inflation levels down, it will sell its T-bills. This will result in higher interest rates (less borrowing, less spending and investment) and less demand, which will ultimately push down price level (inflation) but will also result in less real output. Fiscal Policy The government can also increase taxes or lower government spending in order to conduct a fiscal contraction. What this will do is lower real output because less government spending means less disposable income for consumers. And, because more of consumers' wages will go to taxes, demand as well as output will decrease. A fiscal expansion by the government would mean that taxes are decreased or government spending is increased. Ether way, the result will be growth in real output because the government will stir demand with increased spending. In the meantime, a consumer with more disposable income will be willing to buy more.

Forecasting Techniques
Anticipatory Surveys
Statistical surveys are used to collect quantitative information about items in a population. Surveys of human populations and institutions are common in political polling and government,
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health, social science and marketing research. A survey may focus on opinions or factual information depending on its purpose, and many surveys involve administering questions to individuals. When the questions are administered by a researcher, the survey is called a structured interview or a researcher-administered survey. When the questions are administered by the respondent, the survey is referred to as a questionnaire or a self-administered survey.

Barometric Forecasting Techniques

Barometric techniques examine the relationships between causal or coincident events to predict future events. This approach is based on the logic that key current developments can serve as a barometer of the future. This approach assumes the key developments can be identified, measured and recorded as a statistical time series.

Leading indicators
An economic indicator that changes before the economy has changed. Examples of leading indicators include production workweek, building permits, unemployment insurance claims, money supply, inventory changes, and stock prices. The Fed watches many of these indicators as it decides what to do about interest rates. There are also coincident indicators, which change about the same time as the overall economy, and lagging indicators, which change after the overall economy, but these are of minimal use as predictive tools.

Chapter Five
EIC Frame Work- The Industry Analysis
Each industry has differences in terms of its customer base, market share among firms, industrywide growth, competition, regulation and business cycles. Learning about how the industry works will give an investor a deeper understanding of a company's financial health. This section is divided into four parts:
The Business Cycle

Industry Life Cycle Analysis Study of the Structure and Characteristics of an Industry Profit Potential of Industries: Porter Model

The Business Cycle

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The economy recurrently experiences periods of expansion and contraction, although the length and depth of those cycles can be irregular. This recurring pattern of recession and recovery is called the Business Cycle. Stages in Business Cycle:
Expansion Peak Contraction Trough

Industry Life Cycle

Where is the industry in its life cycle? The best returns and most risk tend to occur early in the cycle. The possible phases are: Introduction Phase/Birth Phase / Pioneering Stage / Start-up Growth Phase / Expansion Stage / Consolidation Mature Growth Phase / Maturity Decline Phase / Relative Decline

Study of the Structure and characteristics of an Industry

Customers Some companies serve only a handful of customers, while others serve millions. In general, it's a red flag (a negative) if a business relies on a small number of customers for a large portion of its sales because the loss of each customer could dramatically affect revenues. Market Share Understanding a company's present market share can tell volumes about the company's business. The fact that a company possesses an 85% market share tells you that it is the largest player in its
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market by far. Furthermore, this could also suggest that the company possesses some sort of "economic moat," in other words, a competitive barrier serving to protect its current and future earnings, along with its market share. Industry Growth One way of examining a company's growth potential is to first examine whether the amount of customers in the overall market will grow. This is crucial because without new customers, a company has to steal market share in order to grow Competition Simply looking at the number of competitors goes a long way in understanding the competitive landscape for a company. Industries that have limited barriers to entry and a large number of competing firms create a difficult operating environment for firms. Regulation Certain industries are heavily regulated due to the importance or severity of the industry's products and/or services. As important as some of these regulations are to the public, they can drastically affect the attractiveness of a company for investment purposes.

Profit Potential of Industries: Porter Model

The profit potential of an industry depends on the combined strength of the following 5 basic competitive forces: Five factors are:
1. 2. 3. 4. 5. Threat of new entrants Rivalry among the existing firms Pressure from substitute products Bargaining power of buyers Bargaining power of sellers

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EIC Frame Work- The Company Analysis

Fundamental analysis seeks to determine the intrinsic value of a company's stock. But since qualitative factors, by definition, represent aspects of a company's business that are difficult or impossible to quantify, incorporating that kind of information into a pricing evaluation can be quite difficult. On the flip side, as we've demonstrated, you can't ignore the less tangible characteristics of a company.

The massive amount of numbers in a company's financial statements can be bewildering and intimidating to many investors. On the other hand, if you know how to analyze them, the financial statements are a gold mine of information. Financial statements are the medium by which a company discloses information concerning its financial performance. Followers of fundamental analysis use the quantitative information gleaned from financial statements to make investment decisions. Before we jump into the specifics of the three most important financial statements - income statements, balance sheets and cash flow statements - we will briefly introduce each financial statement's specific function, along with where they can be found.

The Major Statements

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The Balance Sheet The balance sheet represents a record of a company's assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a business's financial structure balances in the following manner:

Assets = Liabilities + Shareholders' Equity Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business - including retained earnings, which is the profit made in previous years. The Income Statement While the balance sheet takes a snapshot approach in examining a business, the income statement measures a company's performance over a specific time frame. Technically, you could have a balance sheet for a month or even a day, but you'll only see public companies report quarterly and annually. The income statement presents information about revenues, expenses and profit that was generated as a result of the business' operations for that period. Statement of Cash Flows The statement of cash flows represents a record of a business' cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities:

Operating Cash Flow (OCF): Cash generated from day-to-day business operations Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds.

Financial Statement- The Ratio Analysis

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Financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Security analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios. Ratios may be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, such as earnings yield, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1, such as P/E ratio; these latter are also called multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1, the reciprocal will be below 1, and conversely. The reciprocal expresses the same information, but may be more understandable: for instance, the earnings yield can be compared with bond yields, while the P/E ratio cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

Purpose and types of ratios

Financial ratios quantify many aspects of a business and are an integral part of financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Liquidity ratios measure the availability of cash to pay debt. Activity ratios measure how quickly a firm converts non-cash assets to cash assets. Debt ratios measure the firm's ability to repay long-term debt. Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.

Financial ratios allow for comparisons between companies between industries between different time periods for one company between a single company and its industry average

Ratios generally hold no meaning unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition.

Profitability ratios
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Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return.

Gross margin, Gross profit margin or Gross Profit Rate

Operating margin, Operating Income Margin, Operating profit margin or Return on sales

Note: Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit. This is true if the firm has no non-operating income. (Earnings before interest and taxes / Sales) Profit margin, net margin or net profit margin

Return on equity (ROE)

Return on investment (ROI ratio or Du Pont Ratio)

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Return on assets (ROA)

Return on Equity Du Pont (ROE Du Pont)

Risk adjusted return on capital (RAROC)

Efficiency ratio

Liquidity ratios
Liquidity ratios measure the availability of cash to pay debt.

Current ratio

Acid-test ratio (Quick ratio)

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Operation cash flow ratio

Activity ratios (Efficiency Ratios)

Activity ratios measure the effectiveness of the firms use of resources.

Average collection period

Degree of Operating Leverage (DOL)

Asset turnover

Stock turnover ratio

Receivables Turnover Ratio

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Inventory conversion ratio

Inventory conversion period

Receivables conversion period

Debt ratios (leveraging ratios)

Debt ratios measure the firm's ability to repay long-term debt. Debt ratios measure financial leverage. Debt ratio

Debt to equity ratio

Long-term Debt to equity (LT Debt to Equity)

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Times interest-earned ratio / Interest Coverage Ratio

Debt service coverage ratio

Market ratios
Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.

Earnings per share (EPS)

Payout ratio

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Dividend cover (the inverse of Payout Ratio)

P/E ratio

Dividend yield

Price/sales ratio

PEG ratio

Strengths and Weakness of Fundamental Analysis

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Strengths
Long-term Trends Fundamental analysis is good for long-term investments based on long-term trends, very longterm. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies. Value Spotting Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power. Business Acumen One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry.

Weaknesses
Time Constraints Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it is quite brash to imply that the market price, and hence Wall Street, is wrong. Industry/Company Specific Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time-consuming, which can limit the amount of research that can be performed.

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Subjectivity Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, an average-case valuation and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so. Analyst Bias The majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, "there are lies, damn lies, and statistics."

Conclusions
Fundamental analysis can be valuable, but it should be approached with caution. If you are reading research written by a sell-side analyst, it is important to be familiar with the analyst behind the report. We all have personal biases, and every analyst has some sort of bias. There is nothing wrong with this, and the research can still be of great value. Learn what the ratings mean and the track record of an analyst before jumping off the deep end. Corporate statements and press releases offer good information, but they should be read with a healthy degree of skepticism to separate the facts from the spin. Press releases don't happen by accident; they are an important PR tool for companies. Investors should become skilled readers to weed out the important information and ignore the hype.

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