What is Fundamental Analysis?
Fundamental analysis is the study of the various factors that affect a company’s earnings and dividends. Fundamental analysis studies the relationship between a company’s share price and the various elements of its financial position and performance.
Fundamental analysis is forward-looking even though the data used is by and large historical. The objective of fundamental analysis is to determine a company’s intrinsic value or its growth prospects. This intrinsic value can be compared to the current value of the company as measured by the share price. If the shares are trading at less than the intrinsic value then the shares may be seen as good value.
Table of Contents
In simple words, fundamental analysis gives the answer to “which security to buy”. It studies how lucrative that security is and hence decision of holding or buying of security is made.
Foundation of Fundamental Analysis – Intrinsic Value
Before understanding the three elements of fundamental analysis, it is of paramount importance to understand the concept of intrinsic value. The whole process of fundamental analysis is based on intrinsic value.
The intrinsic value is the actual economic value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.
Criteria for investment decision
- If intrinsic value > Market price, Buy the security
- If intrinsic value < Market price, Sell the security
- If intrinsic value = Market price, No Action
Process of Fundamental Analysis
Elements of fundamental analysis are:
Regardless of the qualities or capabilities of a firm, the economy and industry environment will have a major influence on the success of a firm and a realized rate of return on a stock. For this, factors affecting these three elements are studied and analyzed to take the investment decision.
The three phase examination of fundamental analysis is also called as an EIC (Economy- Industry-Company analysis) framework or a top-down approach.
Here the financial analyst first makes forecasts for the economy, then for industries and finally for companies. The industry forecasts are based on the forecasts for the economy and in turn, the company forecasts are based on the forecasts for both the industry and the economy. Also in this approach, industry groups are compared against other industry groups and companies against other companies. Usually, companies are compared with others in the same group.
For example, a telecom operator (Spice) would be compared to another telecom operator not to an oil company.
These phases of Fundament analysis can be tabulated as follow:
| PHASE | NATURE | PURPOSE | INDICATORS |
|---|---|---|---|
| FIRST | Economic Analysis | To access the general economic situation of the nation | Economic indicators |
| SECOND | Industry Analysis | To assess the prospects of Various industry groupings. | Industry life cycle analysis, Competitive analysis of industries etc. |
| THIRD | Company Analysis | To analyse the Financial and Non-financial aspects of a company to determine whether to buy, sell or hold the shares of a company. | Analysis of Financial Aspects: Sales, Profitability, EPS etc. Analysis of Non- financial aspects: management, corporate image, product, quality etc. |
Economic Analysis
First and foremost step in the top-down approach of top down approach is evaluation of general economic conditions. Economic indicators are taken into the account to analyze overall attractiveness of the economy. These factors help analysts to develop a sound understanding of the overall economic conditions.
While doing economic analysis, investors need to analyze these factors in three scenarios: Past, Current and Future. Key factors to be considered by investors while analyzing the economy are given following:
- Gross Domestic Product
- Inflation
- Interest Rates
- Saving and Investment
- Industrial Production
- Fiscal and Monetary Policies
- Infrastructural Facilities
- Economic and Political Stability
- Exchange Rate
Gross Domestic Product
GDP is the total value of goods produced and services provided in a country during one year. It is the broadest quantitative measure of a country’s economic activity. It acts as a basis on which investment climate of the country can be gauged. Components of GDP are as follow:
- Consumption spending: Represents those goods and services which are consumed by the people.
- Investment Spending: Represents the capital expenditure incurred for future production purposes.
- Government expenditure: Represents the spending done by Government on goods and services like infrastructure, school, roads, etc.
- Exports: Represents the goods and services purchased by foreign companies in exchange of the foreign currency.
All these components help investors to calculate the GDP of that economy and thus make a decision as to how strong or weak that economy is.
Inflation
It is a sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. Inflation impacts the capital market in numerous ways:
- It reduces the value of fixed income securities
- Increases the uncertainty in economy
- Cost of production increases and thus profits can also shrink for the businesses.
All these factors can impact the stock market and future investment patterns in the country.
Interest Rates
Interest rates keep on changing in an economy due to various reasons and can have an effect on the stock market. Higher interest rates mean that money becomes more expensive to borrow. To compensate for the higher interest costs, companies may have to cut back spending or lay off workers.
Higher interest rates also mean that a company cannot borrow as much as it used to, and this has an adverse affect on company earnings. All of this adds up to a drop in the stock market. Falling interest rate on the other hand leads to growing stock market.
Saving and Investment
Investors shall know the portion of GDP being saved and invested in an economy. They shall be aware of what are the investment patterns of that economy, i.e, in which alternatives public is investing their money saved. Higher saving and investment, other things being equal, is more favorable for stock markets.
Industrial Production
overall growth in industrial production also affects the economy and hence put an impact on the stock market of the country. If industrial sector is booming, it benefits stock market as well. Higher the growth rate of the industrial production, other things being equal, more favorable is the stock market for the investment.
Fiscal and Monetary Policies
Collection of revenue and payment of expenditure by Government is called fiscal policies. Policy incorporating the actions of a central bank to control money supply in the economy is called monetary policy.
There are various elements of fiscal and monetary policy may have favorable or unfavorable impact on the economy. These elements can be: Nature of budget, Balance of payment position, Tax structure, money supply, etc.
Infrastructural Facilities
Infrastructural facilities are regarded as the backbone of an economy. Well established connectivity through robust transportation facilities is of paramount importance for any economy to develop. Good network of a communication system in the form of telecommunication facility is also required to enhance the overall growth of an economy.
Proper infrastructural facilities along with communication network also attract foreign direct investments. Therefore, good infrastructural facilities are the indicator of economic growth.
Economic and Political Stability
Political environment of a country have an impact on the economic environment of the economy. A stable political scenario boosts up the investor’s confidence and on the other hand, destabilized political system creates an atmosphere of uncertainties in the mind of investors.
The investor thus shall keep in the mind the current state of economic-political environment of the economy.
Agriculture
In country like India monsoon and agriculture play a vital role in determining the economic condition of the country. This is because almost 70% of Indian population is dependent upon the agriculture. Also, good monsoon gives impetus to agricultural income, which in turn gives boost to the industrial sector.
Many industries are dependent upon agriculture for the raw material being used by them. Thus monsoon and agriculture are the main indicators of economic growth and stock market growth.
Business Cycle: In an economy there are many ups and downs known as growth and recession. This phenomenon of recurring ups and downs is known as business cycle. A typical business cycle has four stages:
- Peak
- Recession
- Trough
- Recovery
The period and intensity of these stages may vary from one economy to another, but certainly exist in all economies. On the basis of these stages investors make the decision regarding investment in that particular economy.
Exchange Rate
It is the rate at which one currency can be exchanged for another currency. Exchange rate if often considered to the barometer of economy. If exchange rate changes, it will impact the export and import of that particular economy as well. This will in turn have an impact on the stock market
Industry Analysis
Once an investor has made an analysis of the economic factors of the country taking into consideration the leading, lagging and coincidental indicators and also taking into consideration the monetary, fiscal policies of the country together with the demographic factors to find out the change of direction through indicators, the next step is to analyses the industry and more firmly the company in which he wishes to invest.
Need For Industry Analysis
Investors perform industry analysis because they believe it helps them isolate investment opportunities that have favorable risk-return characteristics. Following are the major reasons we go through industry analysis to make the investment decisions.
- Cross sectional performances: Different industries show different rates of returns for specific time period.
- Industry performance over time: For each different time period, different analysis has to be done. Industry performing well today might not be giving the same results in the future as well.
- Differences in industry risk: different industries have different kind of risks attached to them in accordance to their nature.
- Performance of companies within industry: Even all companies of a particular industry might not show similar returns.
Industry analysis can be studied under five parts:
Business Cycle
Business Cycle and Industry sector
There are mainly four phases of economic cycle:
- Full Recession
- Early Recovery
- Late Recovery
- Early Recession
Different industries are preferred during these four phases, depending upon their sensitivity to the business cycle
Full Recession
This is not a good time for businesses. GDP has been retracting, quarter-over-quarter, interest rates are falling, consumer expectations have bottomed and the yield curve is normal. Sectors that have historically profited most in this stage include:
- Transports (near the beginning)
- Technology
- Industrials (near the end)
Early Recovery
This is when things start to pick up. Consumer expectations are rising, industrial production is growing, interest rates have bottomed and the yield curve is beginning to get steeper. Historically, successful sectors at this stage include:
- Industrials (near the beginning)
- Basic materials
- Energy (near the end)
Late Recovery
In this stage, interest rates can be rising rapidly, with a flattening yield curve. Consumer expectations are beginning to decline, and industrial production is flat.
Historically profitable sectors in this stage include:
- Energy (near the beginning) of Staples
- Services (near the end)
Early Recession
This is where things start to go bad for the overall economy. Consumer expectations are at their worst, industrial production is falling, interest rates are at their highest, and the yield curve is flat or even inverted.
Historically, the following sectors have found favor during these rough times:
- Services (near the beginning)
- Utilities
- Transports (near the end)
The investor shall make the investment decision keeping in mind the current phase of business cycle and its impact on the prospective industry.
Industry Competitiveness
In order to assess the level of competition in an industry Porter’s Five forces model is applied. Michael Porter (1985) provided a framework for analyzing the competitive conditions, prevailing in an industry and its relation with the industry’s profitability.
In his model Porter has identified five competitive forces those altogether can drive competition or determine the profit potential or strength of an industry.
The forces identified by Porter in his study include:
- Threat of New Entrants
- Rivalry among the existing players
- Pressure from substitute products
- Bargaining power of buyers
- Bargaining power of supplier
Life Cycle Analysis
Every industry passes through different stages in its life cycle. Many industrial economics believe that the development of almost every industry may be analysed in terms of its life cycle.
The life of an industry can be separated into:
- Pioneering stage
- Expansion stage
- Stagnation stage
- Decline stage.
SWOT Analysis
SWOT analysis is a strategic planning method used to evaluate the Strengths, Weaknesses, Opportunities and Threats of a particular industry. It involves specifying and identifying the internal and external factors that are favorable and unfavorable to a particular industry.
Every Industry has its own strengths and weaknesses which shall be analyzed by the investor before making its decision to invest.
Company Analysis
Once an investor determines the economy and industry to invest in, next step in fundamental analysis is to perform company analysis. Company analysis assesses the competitive position of a firm, its earnings and profitability, the operating efficiency, its financial position and the future prospect in regards to the earnings to the shareholder.
Within an industry, different companies might be performing differently. This makes it necessary to analyze the companies within the selected industry or industries.
Need of company analysis
- Industry factors alone cannot explain all the price movements of a common stock. Even if all indications are that the industry has very favorable future prospects, this does not necessarily imply that funds should be committed to it immediately.
- Although all the firms in most industries tend to be somewhat similar, they are not homogeneous. Differences in the factors can result in significant variations among firms which are all competing in an industry to manufacture a similar product.
Company analysis can be studied under two heads:
Financial Indicators
The investor shall conduct a in depth analysis of the financial health of the selected company (s). A financially strong company can indicate the good future returns. Financial analysis can be done through various tools. These can be:
- Ratio Analysis
- Income Statement Analysis
- Balance Sheet Analysis
- Cash Flow Statement Analysis
Non Financial Indicators
Apart from financial indicators, Company analysis shall also take into consideration various non financial indicators. Some of these indicators are:
- Nature of business
- Competitive Advantage
- Management
- Corporate Governance
Advantages of Fundamental Analysis
Following are the advantages of fundamental analysis:
Long Term Trends
Fundamental analysis is good for long-term investments based on very long-term trends. 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. 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.
Knowing Who’s Who
Stocks move as a group. By understanding a company’s business, investors can better position themselves to categorize stocks within their relevant industry group. Knowing a company’s business and being able to place it in a group can make a huge difference in relative valuations.
Disadvantages of Fundamental Analysis
Following are the disadvantages of fundamental analysis:
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 in the stock market.
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.
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.
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