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Fundamental Analysis
Fundamental Analysis
 Fundamental Analysis
Chapter Contents:
Concept of Security Analysis; Fundamental analysis: EICFramework; ’ Financial Ratios;
Summary; ’ Self Assessment.

Learning Objectives
After reading the chapter, students should be able to understand
Security analysis and inmportance of fundamental analysis in the same
Top-Down and Bottom-up approaches of fundamental analysis
Different financial ratios that can help in the fundamental analysis
Non-quantitative factors that help in the fundamental analysis

3.1 Security Analysis Meaning

Investors invest their funds in securities with the primary objective of earning a profit that can be
because of capital appreciation and/or intermittent monetary flows in the form of a dividend. A field
of study that deals with the analysis of stocks is known as 'Security Analysis.' Investors have always
been curious to identify the intrinsic worth of astock to determine whether it is worth buying or not, as
the fair value of a stock depends on the company's future earning potential to which the stock belongs.
There are two main methods of analysing a security - Fundamental and Technical analysis.
"I's far better to buy a wonderful company at afair price, than afair company at a wonderful
price, " -Warren Buffett
3.4 || Investing in Stock Markets

The above quote higlhlights the importance ofthe fair price ofa stock. Fundamental analysis deals with
Identifying the intrinsic value of an asset, which is based upon three parameters or stages: Economie
Industry, and Company. In fundamental analysis, investors can adopt either the Top-Down approach
or 'Bottom Up' Investment strategy.
Fundamental Analysis is thus the study of theforces that impact the economy, industry, and companies:
well-being to forecast the future stock prices and their fair value. It also helps in identifying whether
the stock is undervalued or overvalued by making acomparison between the stock's fair value and its
existing market price.
The most significant advantage of the fundamental analysis is that the investors can make a rational
decision that gives them a long-term perspective about an asset.

3.2 Top Down Approach

Investors who use a top-down approach focus on the overall macroeconomic condition before selecting
a particular stock for investment. Thus, top-down approach can be called macroeconomic in nature as it
starts at a broader level (Economic analysis) before narrowing it down to a specific company. The above
framework is also known as the E-1-C approach and is a"Top Down" method of analysis. Analysis of
the Economy, Industry and Company attributes are the main components of fundamental analysis. The
three components are interlinked as the analysis of the company is incomplete without the analysis of
the industry and the economicconditions.

Economy Analysis

Industry Analysis

Company Ananysis

EIC Analysis
A top-down approach is also known as the EIC analysis.
 Fundamental Analysis || 3.5

EconomicAnalysis
Who can forget
drastic fall in the stock market in 2008 due to the Global financial crisis and 2020
the
because ofthe COVID Pandemic. The fall highlighted how even the best companies could be hit really
hard becaus of a lousy economy. It taught investors how companies are subject to the vagaries of the
economny as a whole and the overall functioning of the economy can significantly impact the company's
prospects. Astudy of the broad economic variables (Macroeconomic as well as Microcconomic) helps
the Overall market situation that has the
theinvestor analyze power to impact all the stocks. Different
variables that are covered under the economic analysis are:
Growth Rate ofGDP - It is one ofthe most critical measure that tells about the health of an
economy.GDP has agreater value and meaning for everyone. But in relation to investors, they
are concermed about GDP growth as it determines the growth opportunity for companies to make
more profit.A rising GDP indicates a robust and growing economy that is considered suitable for
the overall stock market. It is also imperative to identify the stage of the economic cycle that the
country is going through to make some forecasts about future growth.
Infation Rate - It refers to the change in the level of price and has a direct impact on the
purchasing power. An increase in the inflation rate would reduce the impact of the enhanced GDP
as the real rate of interest would be low if inflation is too high. Inflation and stock markets have a
close association as increased inflation leads to reduced profits and fewer savings for making an
investment in the stock markets.
Interest Rates - Liquidity is considered essential for the functioning of any economy and a
measure that has a considerable impact on liquidity is the interest rate. An increase in the interest
rates makes the equity investment less preferable until and unless a higher return is provided
to the investors. Also, an increase in the interest rate leads to a higher borrOwing cost for the
companies that reduces their profits and hence the share prices.
Exchange Rate- As the companies cross their national boundaries they become more vulnerable
to the change in the exchange rate as it affects its raw material prices and the final product cost
and hence the profîits. Thus exchange rate has an impact on the firms that have an international
presence and also the smallfirms that are directly or indirectly related to them. Change in the
exchange rate also has an impact on the balance of payment situation that determines whether
acountry is atradesurplus or tradedeficit. BOP thus provides an idea about the strength of the
domestic currency which has an impact on its financial markets too.
FiscalPolicies - Fiscal policy refers to how the government manages its expenditure and tax rates
in order to keep the economy stable. The policies adopted by the government tovwards tax and
subsidies have an impact on the industrialisation, cost of manufacturing, product cost, etc that has
an impact on the profitability of the firm and hence the share prices.
Political situation of the economy - Political stability is very important for the growth of
any economy and its diflerent sectors specifically the industrial sector. A stable and eficient
government not only boosts the confidence of domestic investors but also helps in attracting
foreign investment.
Demographic factors - It includes details about the population like their age, gender, occupation,
literacy level etc.The demographic factors have an impact on the type and price of the product
and the firm's profitability. It thus has an impact on the demand for expansion and growth of the
industries which ultimately affects the stock market.
3.6 || Investing in Stock Markets
if the economy has g00d prospects in terns
So the first step in the top-down approach is to identify conducive economic reforms, ease of doino
of GDP growth, low inflation, good interest rate situation,
business, political stability etc. The current economic situation can beused to make a forecast about the
future economic condition that can be used in taking a rational investmernt decision.

Industry Analysis
Analysis of theprospects, growth potential, performance ofa particular sector/industry is called industry
productservice. Many
analysis. The industry refers to a group of fims that produce the same type of
websites and stock markets infact classify the companies based on the industry they belong to.Rational
Investors vouch for the strategy of identifying the industries/sectors that have the potential to grow in
the near future and then narrowing down their search by identification of the most promising company
belonging to that particular industry.
For Example - Electric Vehicle industry and green energy sector have high potential in India.
So, after analysing the economic situation,an investor needs to identify a specific sector to make
Industries can be
an investment as different sectors have their distinct risk and return profile levels.
classified mainly into 4 types that are:
Cyclical-The industries which produce goods that are in sync with the business cycle is called
cyclical industry. That is when there is a boom in the market the demand for such goods increase
and it reduces during the recession as they don't fall under the criteria of necessary goods.
Growth - The industries that are bound to grow irespective of the business cycle are called
growth industries. These industries basically can go against the recession and provide a high rate
of earnings.
Defensive - Itincludes industries that cover the necessary goods and hence they are not affected
by the business cycles and are relatively immune to economic fluctuations.
Cylical Growth - It covers industries that belong to both cyclical as well as the growth
industries wherein they see adip in the demand during the recession but because of technological
improvements, product development or other strategies soon experience the growth in eamings.
Different variables that are covered under the Industry analysis are:
Industry Life Cycle An investor needs to identify the stage at which a particular industry is
operating to forecast its prospects and growth potential. An industry passes through the following
4 stages:
(i) Pioneering StageThe initial stage when a company starts its business and the competition
being ferce there is uncertainty about the future potential. The investor therefore needs to be
cautious of selecting the industry and specifically acompany that is still in its nascent stage.
(ii) Rapid Growth Stage- The firns that are able to survive the initial pioneering stage then
enter the rapid growth stage where the earnings and market share increase drastically.
Investors need to identify such industries and also amongst the industries should try to
identify the particular company whose growth rate and earnings potential are greater than
that of the industry and the peer group.
 Fundamental Analysis || 3.7
i) Maturily Stage- The stage where the earnings and growth potential are stabilised is thc
maturity stage. Investors need to be aware of this stage as it can turn into the decline stae
if innovations are not brought in.
i ) Declining Stage- he stage is marked with a decrease in the earmings and hence it is not
advisable to invest in such an industry as it might lead to capital
erosion.
, Growth rate of the Industry-Analysis of the historical data in terms of the industry s
nerfomance is important for an investor as it might help him in the identification of any particular
Irend that might be exhibited in the future too. Though the investor needs to be aware that the
past performance may not repeat itself but still it gives an insight that is based on some reliable
parameters.
. Nature of Product -ldentification of the type of product being
manufactured by a particular
industry is also very important as it determines the growth potential and sustainability of the
carnings. An industry may be producing an intermediate good wherein it becomes imperative for
the investor to identify the demand and growth potential of the final goods
industry.
. Level of competition-It is one of the most important factors as it helps in the determination of
the sector's profitability as wellthe ability to create a durable competitive advantage. While doing
the analysis an investor needs to identify the level of competition being faced by the particular
industry and in that also should try to identify the top market shareholders.
Taxation and government Policies-There have been various industries that have become less
profitable because of government regulations and taxes being imposed while there are few that
have seen good times because of the liberalised government policies and subsidies. An investor
thus needs to find out the Government's outlook towards a particular industry.
This is the second step wherein investor analyses if the industry/sector has growth potential and
enough demand to persist in the long term. An investor also needs tofocus on the stage through which
a particular industry is going - is it the start-up stage like electric vehicles, online education, or the
sector is expericncing a maturity stage. Also,the nature of the industry also plays a pivotal role in the
investment decision along with the attitude of the government towards the promotion of that particular
sector. After doing an in-depth analysis of the economy and industry-level factors the next and the last
step in the equity research is to go for the analysis of an individual company.

(ompony Analysis
Company analysis is the process of evaluatinga company's performance based on a variety of qualitative
and quantitative indicators.
An investor when deciding on aparticular company needs to identify a company's ability to generate
profits,repay the debts, having the ability to increase the revenue and possessing a significant advantage
over and above its competitors/peer. So, the different variables that are covered under the Company
analysis can be broadlyclassified into the following:
" Competitive Advantage Whenever an investor starts with the equity research, the first thing
that he tries to identify is the companies with a "moat - durable competitive advantage that is
difficult to surpass". Competitive advantage is the factor that can ensure not only great earnings
but also a higher market share and goodwill. So the first step in the company analysis is to identify
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arises analysis:
Analysis uses to first
of determine
a both operating
profit,
company make when
isthe
investors a
qualitative
carried thorough its -Warren Buffett
intrinsic
out try efficiency
analysis
for and worth to
the the dive
 Determination of the
Fundamental Analysis || 3.25
1. Intrinsic worth of a
analysingthe fair value ofa company's stockcompany's stock - Fundamental
Analysis helps in
valuation whether the stock is wherein also
it helps in the determination of its
Analysis ofthe,
undervalued or overvalued.
2. financial strength and the
analysis involves the study of the financial competitive position of a company -Fundamental
financial
of its
reports ofa
health. An in-depth analysis also company that helps in the determination
durable competitive advantage (Moat) as helps the investor in the identification of the
forlong-term investing. described by Warren Bufett as an
essential element
Dediction the future price of a Stock -
of
Economic, inndustry, and various Fundamental analysts broadly make use of the
future priIce movement of a stock. company-specific parameters that help in
determining the
Summary

Fundamental.Analysis is thus the study of the forces

that
well-being to forecast the future stock prices and theirimpact the economy, industry, and
fair value. Fundamental companies
eatifving the intrinsic value oI an asset, Which 1s based upon three analysis deals with
and Company. In fundamental analysis, parameters or stages: Economic,
investors
Dottom- Up' Investment strategy. The three financial can adopt either the Top-Down approach'
statements that help in the
Loss Account and the Balancesheet. Thesefundamental
eis are the Cash Flow Statement, Profit and
ide the information for the computation of various statements
nakt equity ratio, Interest coverage ratio, dividend yieldfinancial ratios like the P/E, PEG, Current ratio,
mation to make a rational decision. Apart from the ratio, etc that belp in the analysis of the vast
quantitative analysis, there are various other
aalitative factors like the quality of the management, corporate
governance, shareholding pattern, etc
that also go a long way in establishing the intrinsic value of a company's stock.

Self Assesment
1. What do you mean by security analysis. What are its two
conponents? Explain in detail
2. Fundamental analysis is for long-term investors. Comment on this
statement along with highlighting
the importance of the fundamental analysis.
3. What are the two approaches that are used in the fundamental analysis?
two.
Distinguish between the
4. What are the important financial ratios that are used in the fundamental
analysis? Explain any four
in detail.
J. PEG ratio is an advancement over and above the P/E ratio. Diflerentiate between the two.
. What do you mean by shareholding pattern and why is it important to understand the changes that
arise in the shareholding pattern.