Fundamental Analysis

Introduction to Fundamental Analysis:
Fundamental analysis is an approach to determine this ‘what ought to be price’. Its objective is to identify the underpriced and overpriced securities in the market place so that the investment decisions – buying and selling – can be made.

The fundamental analysts believe that due to temporary market disequilibrium, the current market price may be at variance with its intrinsic value, but in the long run the market price would get back to its intrinsic value.

Intrinsic Value:
Intrinsic value is a value that justifies the earnings, assets, the prospects and management of a company. In simple terms, it is the present value of the future benefits from an investment. A stock is said to be undervalued when its market price is less than the intrinsic value and a stock is said to be overvalued when its market price is above the intrinsic value. A rational investor would buy an underpriced stock and sell overpriced stock.

Company Analysis:
While, industry analysis assists an investor in choosing an industry, company analysis assists him in choosing a company based on certain fundamental factors. While analysing a company, an analysis of financials and management has to be done.
- Financial Parameters: The financial factors of a company can be analysed by analysing its financial statements. The most oftenly used tool for such an analysis is the ratio analysis. The most important ratios for analysis are the profitability ratios and leverage ratios. The profitability ratios will give an insight into the profit trends of the company in the past. The leverage ratios help one to analyse the capital structure of the company. The liquidity ratios provide scope for analysing the liquidity position of the company. As an investment is related to shares, the investor will have to apply market related measures. The Return on Equity is another important indicator regarding the performance of the company. It tells us how much profit a company has earned as compared to shareholder’s equity.
- Non – Financial Parameters: Though a company may have strong financials, an inefficient management, lack of R & D and less diversification will not help the company move forward. The financial indicators would also take a downturn. Therefore, an investor has to study the businesses a company is involved in and the product range and its scope of diversification. Further, it has to study the competence of the management team. The investor should analyse the shareholding pattern. A company with good R & D can implement and cope up with the technological developments in the industry. As such the R & D scope also has to be analysed.

Economic Forecasting Methods:
The economic forces have an affect on the share prices. Therefore, an analyst has to understand and analyse these forces to forecast the possible changes in the market using the information regarding economic variables.

- GNP Model Building Approach: Gross National Product or GNP is the total value of goods and services produced by a country in a given year after adding income earned by citizens abroad but after deducting income earned by foreigners from domestic production. This approach forecasts GNP in the short run by estimating the extent of the various components comprising GNP. After the various components of GNP are estimated, they are added to get an estimate of the GNP. The forecast is then tested for internal consistency as the GNP accounts are interrelated. As GNP forecast is adjusted for changes and tested for internal consistency, the model is likely reliable.
- Econometric Model Building Approach: An approach based on econometric methods has the advantage of providing a magnitude and direction to the dependent variable, like GNP for a short – term forecast. However, the accuracy of the forecast will eventually depend upon the quality of data input, the validity of the assumptions underlying the model, and above all upon the model builder’s understanding of the underlying economic theory. This model is significant for future projections only when the estimated co-efficient (like the intercept ‘a’ and slope ‘b’ in a linear regression model) are found to be good enough in respect of their stability over time.
- Diffusion Indices: A diffusion index gauges how widespread an occurrence is. A diffusion index can be set – up for leading indicators by counting the number of indicators that ascend during a specific period and stating it as a share of the total number of lead indicators and more desirably in a percentage form. The user must infer the diffusion index relative to the levels of the index in the past. For example, in case there are ten indicators, out of which 3 have risen then the diffusion index for the month is 30%. In case in the next month 5 (not necessarily the previous 3) rise then the diffusion index for the month is said to have risen to 50%. An interpretation of this index should be based on relative levels in the past.
- Lead Indicator Approach: This approach attempts to estimate the general economic conditions by identifying key economic indicators that run ahead of the change in the level of economic activity. Leading indicators provide signals of the turning points in the level of economic activity. An analyst must ensure that the lead indicator fulfils the following criteria as closely as possible when spotting a lead indicator for the purposes of forecasting.

1. It should move smoothly from one period to another as it rises or falls and should turn sharply at its peaks and trough. If there are a series of zigzags during its rise and fall, it becomes complex to recognise whether the ‘zig’ is a genuine turning point or a temporary reversal of trend.

2. An ideal lead indicator is one which always leads the turning points of general business activity by the same number of months with no ‘false’ leads. (The predictions of business turning points which do not materialise are known as False Leads).