Security Analysis and Portfolio Management Fundamental Analysis 5/23/2018 Dr.P.S DoMS

Fundamental Analysis Fundamental Analysis is to evaluate a lot information about the past performance and the expected future performance of companies, industries and the economy as a whole before taking the investment decision. Such evaluation or analysis is called fundamental analysis. 5/23/2018 Dr.P.S DoMS

Fundamental Analysis (con’t) Fundamental analysis is really a logical and systematic approach to estimating the future dividends and share price. Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives: To conduct a company stock valuation and predict its probable price evolution, to make a projection on its business performance, to evaluate its management and make internal business decisions, to calculate its risk. 5/23/2018 Dr.P.S DoMS

Fundamental analysis includes: Economic analysis Industry analysis Company analysis 5/23/2018 Dr.P.S DoMS

Fundamental Analysis The Analysis of economy, industry and company constitute the main activity in the fundamental approach to security analysis. And can be viewed as different stages in investment decision making process. Three tier analysis depict that company performance dependent not only on its own effort but also on the general industry and economy factor. 5/23/2018 Dr.P.S DoMS

Economy Analysis 5/23/2018 Dr.P.S DoMS

Economy analysis (con’t) Growth rates of national income(GRNI) GRNI is an important variable can be calculated by GDP, NNP, and GDP to analysis the growth rate of economy. Four stages of economy or economic cycle i.e boom, depression, recession, recovery, of nation also impact on security performance. 5/23/2018 Dr.P.S DoMS

Depression: At this stage demand is low and declining inflation often high and so are interest rate, companies usually reduce activities and securities performance is poor. Recovery: Economy begin to revive after depression, demand pick up leading, production and activities increase. Boom: High demand with high investment and production, companies earn more profit Recession: Companies slowly begins downturn in demand, production and employment, profits are also decline. 5/23/2018 Dr.P.S DoMS

Inflation: Inflation prevailing significant impact on company performance. High inflation upset company plan. Demand goes down because purchasing power fall, high inflation impact company performance adversely. Inflation is measured both in WPI (Wholesale price index) CPI (Consumer price index) 5/23/2018 Dr.P.S DoMS

Interest Rate Interest rates determine the cost and availability of credit for companies operating in an economy. Low interest rate=> easily and cheaply available credit. => lower cost of finance => high profitability High interest rate => higher cost of production =>lower profitability =>Lower demand 5/23/2018 Dr.P.S DoMS

Government revenue, expenditure and deficit Government is the largest investor in economy of any country thus revenue, expenditure and deficit have significance impact on the performance of industries and companies. Expenditure stimulate demand and creates job. The excess of expenditure over revenue is deficit, (budget deficit), most expenditure are spent on infrastructure, and deficit financing fuel inflation. 5/23/2018 Dr.P.S DoMS

Exchange rate The balance of trade in import and export determine the rate of exchange rate. Depreciation of local currency improve the competitive position in foreign market the performance of exported product but it would also make the imported product more expensive. A foreign Exchange reserves is needed to meet several commitments such as payment for import and servicing of foreign depts. 5/23/2018 Dr.P.S DoMS

Infrastructure. Development of a economy depends very much on the infrastructure available. Industry needs electricity for its manufacturing activities road and railways to transport raw material and finished good. Communication channels help supplier and customers. Good infrastructure is symptoms of development. Bad infrastructure lead to inefficiencies, low productivity wastages and delay. Investors should analysis the infrastructure of any economy. 5/23/2018 Dr.P.S DoMS

Industry Analysis Classifying industries Cyclical industry - performance is positively related to economic activity Defensive industry - performance is insensitive to economic activity Growth industry - characterized by rapid growth in sales, independent of the business cycle 5/23/2018 Dr.P.S DoMS

Industry Analysis Industry Life Cycle Theory: Birth (heavy R&D, large losses - low revenues) Growth (building market share and economies of scale) Mature growth (maximum profitability) Stabilization (increase in unit sales may be achieved by decreasing prices) Decline (demand shifts lead to declining sales and profitability - losses) 5/23/2018 Dr.P.S DoMS

Industry Analysis Life Cycle of an Industry (Marketing view) Start-up stage: many new firms; grows rapidly (example: genetic engineering) Consolidation stage: shakeout period; growth slows (example: video games) Maturity stage: grows with economy (example: automobile industry) Decline stage: grows slower than economy (example: railroads) 5/23/2018 Dr.P.S DoMS

Industry Analysis Qualitative Issues Competitive Structure Permanence (probability of product obsolescence) Vulnerability to external shocks (foreign competition) Regulatory and tax conditions (adverse changes) Labor conditions (unionization) 5/23/2018 Dr.P.S DoMS

Industry Analysis End use analysis Ratio analysis Regression analysis identify demand for industry’s products estimates of future demand identification of substitutes Ratio analysis examining data over time identifying favorable/unfavorable trends Regression analysis determining the relationship between variables 5/23/2018 Dr.P.S DoMS

Company Analysis: Qualitative Issues Sales Revenue (growth) Profitability (trend) Product line (turnover, age) Output rate of new products Product innovation strategies R&D budgets Pricing Strategy Patents and technology 5/23/2018 Dr.P.S DoMS

Company Analysis: Qualitative Issues Organizational performance Effective application of company resources Efficient accomplishment of company goals Management functions Planning - setting goals/resources Organizing - assigning tasks/resources Leading - motivating achievement Controlling - monitoring performance 5/23/2018 Dr.P.S DoMS

Company Analysis: Qualitative Issues Evaluating Management Quality Age and experience of management Strategic planning Understanding of the global environment Adaptability to external changes Marketing strategy Track record of the competitive position Sustainable growth Public image Finance Strategy - adequate and appropriate Employee/union relations Effectiveness of board of directors 5/23/2018 Dr.P.S DoMS

Company Analysis: Quantitative Issues Operating efficiency Productivity Production function Importance of Q.A. Understanding a company’s risks Financial, operating, and business risks Financial Ratio Analysis Past financial ratios With industry, competitors, and Regression analysis Forecast Revenues, Expenses, Net Income Forecast Assets, Liabilities, External Capital Requirements 5/23/2018 Dr.P.S DoMS

Company Analysis: Quantitative Issues Balance Sheet Snapshot of company’s Assets, Liabilities and Equity. Income statement Sales, expenses, and taxes incurred to operate Earnings per share Cash flow statement Sources and Uses of funds Are financial statements reliable? G.A.A.P. vs Cleverly Rigged Accounting Ploys 5/23/2018 Dr.P.S DoMS

Company Analysis: Quantitative Issues Financial Ratio Analysis Liquidity (ability to pay bills) Debt (financial leverage) Profitability (cost controls) Efficiency (asset management) DuPont Analysis Top-down analysis of company operations Objective: increase ROE 5/23/2018 Dr.P.S DoMS

Liquidity Ratios Measure ability to pay maturing obligations Current ratio Current assets / current liabilities Quick ratio (Current assets less inventories) / current liabilities 5/23/2018 Dr.P.S DoMS

Debt Ratios Measure extent to which firm uses debt to finance asset investment (risk attribute) Debt-equity ratio Total long-term debt / total equity Total debt - total assets ratio (Current liabilities + long-term debt) / total assets Times interest earned EBIT / interest charges Fixed charge coverage ratio (EBIT + Lease Exp.) / (Int. Exp. + Lease Exp.) 5/23/2018 Dr.P.S DoMS

Profitability Ratios Measure profits relative to sales Gross profit margin ( % ) = Gross profit / sales Operating Profit Margin = Operating profits / sales Net profit margin = Net profit after taxes / sales ROA = Net Profit / Total Assets ROE = Net Profit / Stockholder Equity* * Excludes preferred stock balances 5/23/2018 Dr.P.S DoMS

Efficiency Ratios Measure effectiveness of asset management Average collection period (in days) Average receivables / Sales per day Inventory turnover (times per year) Cost of Goods Sold / average inventory Total asset turnover Sales / average total assets Fixed asset turnover Sales / average net fixed assets 5/23/2018 Dr.P.S DoMS

Other Ratios Earnings per share (EPS): (Net income after taxes – preferred dividends)/ number of shares Price-earnings (P/E): Price per share/expected EPS Dividend yield: Indicated annual dividend/price per share Dividend payout: Dividends per share/EPS Cash flow per share: (After-tax profits + depreciation and other noncash expenses)/number of shares Book value per share: Net worth attributable to common shareholders/number of shares 5/23/2018 Dr.P.S DoMS

DuPont Analysis of ROE Ratio 1 = NPM Ratio 2 = TATO Ratio 3 = Equity Kicker The DuPont System suggests that ROE (which drives stock price) is a function of cost control, asset management, and debt management. 5/23/2018 Dr.P.S DoMS

Estimating Earnings and Fair Market Value for Equity Five Steps 1. Estimate next year’s sales revenues 2. Estimate next year’s expenses 3. Earnings = Revenue - Expenses 4. Estimate next year’s dividend per share = Earnings Per Share * dividend payout ratio 5. Estimate the fair market value of stock given next years earnings, dividend, ROE, and growth rate for dividends. Using Gordon Growth model or P/E Model 5/23/2018 Dr.P.S DoMS