Chapter 12

Fundamental Analysis
 Chapter Objectives
 To understand fundamental analysis

 To know economic analysis

 To explain industry analysis

 To learn about company analysis

 Concept of
Fundamental Analysis
 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
 Industry analysis
 Company analysis
 Economic Analysis
 It is the analysis of various macro economic factors
that have a significant bearing on the stock market.
 The various macro economic factors are:
 Gross Domestic Product (GDP)
 Savings and investment

 Inflation

 Interest rates

 Budget

 Tax structure
 Economic Forecasting
 Forecasting the future state of the economy is needed for
decision making.
 The following forecasting methods are used for analyzing the
state of the economy:
 Economic indicators: Indicate the present status, progress or slow
down of the economy.
 Leading indicators: Indicate what is going to happen in the
economy. Popular leading indicators are fiscal policy, monetary
policy, rainfall and capital investment.
 Coincidental indicators: Indicate what the economy is — GDP,
industrial production, interest rates and so on.
 Lagging indicators: Changes occurring in leading and coincidental
indicators are reflected in lagging indicators. Unemployment rate,
consumer price index and flow of foreign funds are examples of such
indicators.
 Diffusion index: It is a consensus index, which has been constructed
by the National Bureau of Economic Research in USA.
 Industry Analysis
 It is used to analyze the performance of the industries over the
years.
 An industry is a group of firms that are engaged in the
production of similar goods and services.
 Industries can be classified into:
 Growth industry: Has high rate of earnings and growth is
independent of business cycle.
 Cyclical industry: Growth and profitability of the industry move
along with the business cycle.
 Defensive industry: It is an industry which defies the business cycle.
 Cyclical growth industry: It is an industry that is cyclical and at the
same time growing.
 An investor must analyze the following factors:
 Growth of the industry  Cost structure and profitability
 Nature of the product  Nature of the competition
 Government policy
 Company Analysis
 In company analysis, the growth of the company is
analyzed by the investor so that the present and future
value of the shares can be known.
 The present and future value of shares is affected by a
following number of factors such as:
 Competitive edge of the company
 Market share

 Growth of sales

 Stability of the sales

 Financial Analysis
 It involves analyzing the financial statements of the
company.
 The financial statements of the company include:
 Balance sheet: It shows the status of a company’s financial
position at the end of the year.
 Profit and loss account: It shows the profit and loss made
by the company during a period.
 Ratio Analysis
1. Liquidity – the ability of the firm to pay its way
2. Activity /Gearing – information on the relationship between the
exposure of the business to loans as opposed to share capital
3. Investment or shareholders: EPS, P/E, ROE
4. Profitability ratios– how effective the firm is at generating profits given
sales and or its capital assets
5. Financial / turnover ratios – the rate at which the company sells its
stock and the efficiency with which it uses its assets
 Fixed sources of funds- debentures , bonds –
debts/ bank borrowing
 Debt/equity
 Equity -
Liquidity
 Acid Test
 Also referred to as the ‘Quick ratio’
 (Current assets – stock) : liabilities
 1:1 seen as ideal
 The omission of stock gives an indication of the cash the firm has in
relation to its liabilities (what it owes)
 A ratio of 3:1 therefore would suggest the firm has 3 times as much
cash as it owes – very healthy!
 A ratio of 0.5:1 would suggest the firm has twice as many liabilities as
it has cash to pay for those liabilities. This might put the firm under
pressure but is not in itself the end of the world!
 Current Ratio
 Looks at the ratio between Current Assets and Current Liabilities
 Current Ratio = Current Assets : Current Liabilities
 Ideal level? – 1.5 : 1 or 1:1
 A ratio of 5 : 1 would imply the firm has Rs5 of assets to cover every
rs 1 in liabilities
 A ratio of 0.75 : 1 would suggest the firm has only 75p in assets
available to cover every Rs1 it owes
 Too high – Might suggest that too much of its assets are tied up in
unproductive activities – too much stock, for example?
 Too low - risk of not being able to pay your way
Investment/Shareholders
 Investment/Shareholders
 Earnings per share – profit after tax / number of shares
 Price earnings ratio – market price / earnings per share – the
higher the better generally for company. Comparison with other
firms helps to identify value placed on the market of the business.
 EV / EBITDA Ratio - Enterprise Value / EBITDA ratio - the
higher the better generally for company . It measures the
operational performance of the firm.
 Dividend yield – ordinary share dividend / market price x 100 –
higher the better. Relates the return on the investment to the share
price.
Gearing
 Gearing
 Gearing Ratio = Long term loans / Capital
employed x 100
 The higher the ratio the more the business is

exposed to interest rate fluctuations and to

having to pay back interest and loans before
being able to re-invest earnings
 Debt/equity- Debts are cheaper source of

finance
2:1;
Profitability
 Profitability
 Profitability measures look at how much profit the
firm generates from sales or from its capital assets
 Different measures of profit – gross and net
 Gross profit – effectively total revenue (turnover) –
variable costs (cost of sales)
 Net Profit – effectively total revenue (turnover) – variable
costs and fixed costs (overheads)
 Profitability
 Gross Profit Margin = Gross profit / turnover x
100
 The higher the better
 Enables the firm to assess the impact of its sales and
how much it cost to generate (produce) those sales
 A gross profit margin of 45% means that for every
Rs1 of sales, the firm makes 45p in gross profit
 Profitability
 Net Profit Margin = Net Profit / Turnover x 100
 Net profit takes into account the fixed costs involved in
production – the overheads
 Keeping control over fixed costs is important – could be
easy to overlook for example the amount of waste - paper,
stationery, lighting, heating, water, etc.
 e.g. – leaving a photocopier on overnight uses enough electricity to make
5,300 A4 copies. (1,934,500 per year)
 1 ream = 500 copies. 1 ream = £5.00 (on average)
 Total cost therefore = £19,345 per year – or 1 person’s salary
 Profitability
 Return on Capital Employed (ROCE) =
Profit / capital employed x 100
 Profitability
 The higher the better
 Shows how effective the firm is in using its
capital to generate profit
 A ROCE of 25% means that it uses every £1
of capital to generate 25p in profit
 Partly a measure of efficiency in organisation
and use of capital
Financial
 Asset Turnover
 Asset Turnover = Sales turnover / assets employed
 Using assets to generate profit
 Asset turnover x net profit margin = ROCE
 Stock Turnover
 Stock turnover = Cost of goods sold / stock expressed as times per
year
 The rate at which a company’s stock is turned over
 A high stock turnover might mean increased efficiency?
 But: dependent on the type of business – supermarkets might have

high stock turnover ratios whereas a shop selling high value

musical instruments might have low stock turnover ratio
 Low stock turnover could mean poor customer satisfaction if

people are not buying the goods (Marks and Spencer?)

 Debtor Days
 Debtor Days = Debtors / sales turnover x 365
 Shorter the better
 Gives a measure of how long it takes the business to
recover debts
 Can be skewed by the degree of credit facility a firm offers
Before looking at the ratios there are a number of cautionary points concerning
their use that need to be identified :

a.The dates and duration of the financial statements being compared should be
the same. If not, the effects of seasonality may cause erroneous conclusions to be
drawn.

b.The accounts to be compared should have been prepared on the same bases.
Different treatment of stocks or depreciations or asset valuations will distort the
results.

c.In order to judge the overall performance of the firm a group of ratios, as
opposed to just one or two should be used. In order to identify trends at least three
years of ratios are normally required.
 Chapter Summary
By now, you should have:

 Understood the concept of fundamental analysis

 Understood the concept of industry analysis

 Learnt about company analysis