11/12/2015

Qualitative Analysis
(Fundamental)
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Prepared By:
Amit Gupta MS Finance, MMS Finance,

Dip TD, BE

Mobile: +91-9967813782/9004459173
Founder: iVidya Learning and Financial Solutions
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Skype: ANALYSTAMIT

LEARNING OBJECTIVE STATEMENTS (LOS)

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Definition
Qualitative Analysis
Analysis of the Economy
Analysis of the Industry
Analysis of the Company

Portor 5 force model

Barriers to entry (Low/medium/High)
Bargaining Power of Buyers (Low/medium/High)
Bargaining Power of Suppliers (Low/medium/High)
Threat of Substitutes (Low/medium/High)
Inter-Firm Rivalry (Low/medium/High)

SWOT Analysis

Key Economic Factors

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DEFINITION

Fundamental analysis is the examination of the underlying forces that affect

the well being of the Economy, Industry groups and Companies .

Fundamental Analysis determines the worth of a business by its future

expected earning potential which in turn depends on quality of companys
management, business outlook for the company, outlook for the industry in
which the company operates and the overall economic backdrop.

Stock Investment Decision:

We should invest in stocks that are fundamentally sound, run by good
management and are trading at attractive valuations.

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Country Analysis: Expected real economic growth has the most significant
influence on the risk and returns in national equity markets.
In the short run, the focus is on forecasting the stage in the business cycle
and, therefore, expected short-term economic growth.
In the long run, the focus shifts to expectations of sustainable economic
growth as measured by growth in per capita gross domestic product (GDP).
Industry Analysis: Return elements
Demand analysis, industry life cycle analysis, competition structure,
competitive advantage, competitive strategies, competition, and sector
rotation.
Industry Analysis: Risk elements
Market competition, value chain competition, rivalry intensity, substitutes,
buyer power, supplier power, new entrants, government participation, risks,
and covariance.

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QUALITATIVE ANALYSIS
The qualitative analysis process must follow three basic steps:
1) Analysis of the Economy
2) Analysis of the Industry
3) Analysis of the Company
1)

Analysis of the Economy:

>> Economic Cycles

Economic cycles refer to the rise and fall of economic health that most
economies go through, every few years.
In an economic downturn, valuations tend to be negatively impacted as the
uncertainties get magnified.

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There are different ways in which an economic trough can affect the
valuation of a company.
o When there is a decrease in demand of products
o When export markets dry up
o When prices of raw materials are volatile
o When capex plans become high-cost sinks.
>> Macroeconomic Factors
Macroeconomic factors play a very important role in the fortunes of any
industry or company. Each company operates within the realms of the
broader economy.
Hence, it is very important to understand these factors and how they affect
the performance of a company, and its stock.
This is the first step in Equity Research.

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KEY ECONOMIC FACTORS:

GDP:
Gross Domestic Product (GDP) is a measure of the countrys overall output in
a given year. The output that is produced by each industry, including
agriculture and services, is added together. That gives the GDP of the country.
Industrial Production:
This measures the output of industries in the country and compares it to the
same period in the previous year.

Inflation:
Inflation is defined as the general rise in prices over a given period. Analysts
must look at CPI, as that is what affects consumer demand. WPI and CPI are
measured by the rise in price of a defined basket of goods and services.
Unemployment:
An increasing unemployment rate implies lesser jobs, and thus lesser output.
If more people are unemployed, then the overall spending power of the
consumers goes down. This also reduces production.
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Business & Consumer Confidence:

Business and consumer confidence indicate what businesses and the
consumers feel about the present state of the economy.
Oil Prices:
An increase in oil prices, affects the input costs of all the industries linked to
oil, and consequently the output prices.
FIIs:
FIIs bring in large amounts of money into the stock market, propelling the
market upwards. On the other hand, when FIIs withdraw from these markets,
they can also fall dramatically. Hence, the role of FIIs, especially in emerging
markets, is very significant.

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Stock Indices:
Given that global markets affect India as well, it is important to track the different
benchmark stock indices across the globe.

S&P 500

Dow Jones Industrial Average (US)

Nikkei 225 (Japan) Hang Seng (Hong Kong)

Sensex (India)

NASDAQ (US)
FTSE 100 (UK)

Nifty India

How do share prices and stock indices move?

The price of a share at a given point in the market is determined by the price at
which people are willing to buy and sell the stock.
How are stock markets interlinked?
All stock indices are interlinked to each other, in differing degrees. When the Dow
Jones moves, it is moving to reflect some event in the US economy.
Most large cap companies in India have clients or business in the US. The U.S
being the largest economy in the world, it is bound to have a ripple affect on
Indian companies as well, consequently affecting the Sensex and the Nifty. Hence,
a movement in Dow Jones affects the Sensex as well.
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2) Industry Analysis
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Companies producing similar products are subset (form a part) of an

Industry/Sector. For example, National Hydroelectric Power Company
(NHPC) Ltd., National Thermal Power Company (NTPC) Ltd., Tata Power
Company (TPC) Ltd. etc. belong to the Power Sector/Industry of India.
It is very important to see how the industry to which the company belongs
is faring. Specifics like effect of Government policy, future demand of its
products etc. need to be checked.
At times prospects of an industry may change drastically by any alterations
in business environment. For instance, devaluation of rupee may brighten
prospects of all export oriented companies. Investment analysts call this as
Industry Analysis.

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The elements that need to be covered in a thorough industry

analysis.
Evaluate the relationships between macroeconomic variables and industry
trends.
Estimate industry variables using different approaches and scenarios.
Check estimates against those from other analysts.
Compare the valuation for different industries.
Compare the valuation for industries across time to determine risk and
rotation strategies.
Analyze industry prospects based on strategic groups.
Classify industries by their life-cycle stage.
Position the industry on the experience curve.
Consider demographic, macroeconomic, governmental, social, and
technological influences.
Examine the forces that determine industry competition.

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A thorough industry analysis should:

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Broad questions one needs to ask about an industry are:

What are the sub-sectors of a particular industry?

What are the key revenue drivers in the industry?
What are the key concerns affecting the industry?

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Other Factors

How many players are there in the industry?

What are the prospects of the particular industry in the overall economy?
How dynamic and volatile is the industry?

How do we define the industry a company belongs to?

We need to understand, where a companys revenues primarily come from. In
case of Infosys, 95% of revenue comes from IT services, then the company
belongs to IT services sector.

What are the key revenue drivers in the industry?

Revenue drivers are important as any impact on them will have a direct impact
on the revenue and hence the valuation of the company. For example, day rate is
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one such element which affects the revenues of companies in the oil exploration
industry.

What are the key concerns affecting the industry?

This question addresses the biggest concerns that distort the profitability of an
industry.

How many players are there in the industry?

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For example, the biggest concern in the oil and gas industry is that it is policy driven,
and hence political considerations could distort the profitability of this industry.
This determines the:
Competition and
The nature of operating margins that the industry works with.
A classic example is the telecom industry. With new players coming in, the operating
margins have been decreasing year after year.

What are the prospects of the particular industry in the overall economy?

We need to know how a particular industry has developed over the years, and the
future trends in the industry.

How dynamic and volatile is the industry?

The nature of an industry is defined by how often developments take place in the
industry that influences movements in stocks of the companies. An industry where
products change often, changing the dynamics of the market tends to have volatile 13
stock movements.

Industry analysis looks at all those factors that potentially change the
fortunes of the company.

Past sales and earnings performance.

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Key Characteristics- In An Industry Analysis

Permanence of the industry.

The attitude of the government towards the industry.
Labour conditions within the industry.
The competitive conditions as reflected by the existence of the entry
barriers and
The stock prices of the firms in the industry relative to their earnings.
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Past Sales and Earnings Performance:

For an analyst, the past sales and earnings performance of the firm form
a crucial input in forecasting future trends. This is not to say that the firm
is going to repeat the same performance again. Rather, the analyst is
more interested in examining the contribution of the various factors in
the past so that the relevance of these factors individually and relatively
can be properly evaluated under present conditions.

In any firm, sales and the earnings play an important role. These
variables will exhibit a degree of consistency only when the firm has
weathered a variety of economic conditions. The analyst from the
observation of these variables will be able to judge the stability of the
performance in terms of sales and earnings as well as the growth rates.

Another crucial factor is that of the relationship between the sales and
the fixed costs. The more the fixed costs, the higher will be the break
even point and higher will be the sales volume to be achieved.

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Permanence:
By permanence, we understand the products and the technology of a
particular industry not becoming obsolete in a short span of time.

If the industry is not permanent, then investing in that industry

altogether becomes a losing proportion. In some of the cases a product
with additional features manufactured by employing superior technology
makes the existing product totally irrelevant or at least results in the
manufacturing process becoming a commercially enviable proposition.

In this age of rapid technological developments, this factor plays a crucial

role in Industry Analysis.

The Government's role is also an important factor affecting the

permanence of the industry.
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The Attitude of the Government towards the Industry:

It is imperative for an Analyst that he should be well aware of the various
Government policies and regulations with reference to an industry in which he is
going to invest.

The government policies like deregulating an industry by allowing foreign

investment, imposing high tariffs on imports and restrictive legislation have a
bearing on their performance. Some of the legal restrictions result in the profits
being very low for a particular industry.

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Labor Conditions:

This is an important factor to be considered in industries which are labor

intensive.

An analyst should examine the various provisions of the labor laws and also go
into the possible reasons that may halt the production process and its fallout on
the profits of the industry.

In case of a prolonged strike, a labor intensive firm will not only lose its
customers and goodwill but also may not be able to cover its fixed costs in certain
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Competitive Conditions:

While analyzing this situation, the three general types of barriers that an analyst
should concentrate on, are
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Existence of product differentiation

The existence of the first barrier assures that a new entrant will not be able
to charge as much as the existing firms. Also he has to spend large amounts
of money on advertising to capture an acceptable share of the market as
this situation is usually found in cases where the customers exhibit a high
degree of brand loyalty.
1.

2. Absolute cost advantages and

An existing firms are capable of producing and distributing the products at
lower costs than the new entrants irrespective of the volume produced. As a
result, they enjoy wider profit margins. This may be due to the fact that the
existing firms may have exclusive patents, own the resources or superior
management skills that are not available to the new entrants.
3. Advantages rising from economies of scale.

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Economies of scale are usually realized when the production levels are
quite high. A new entrant in this case also has to garner a significant market
share so that he can avail the benefits from economies of scale. If he fails to
do so, he will not be able to compete with the prices offered by the existing
players.
Industry Share Prices Relative to its Earnings:
An analyst also has to look at the present share prices. In this case under
priced share would be the best bet. Also he should examine the fact that the
share prices are not high due to the overzealous nature of the investors to
acquire the shares of the firms in a new industry. Usually the shares of these
companies experience high fluctuations depending on the crowd behavior.
The major sources of exit barriers are as follows:
1.
Specialized assets
2.
Fixed costs of exit
3.
Strategic relationships
4.
Emotional barriers
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5.
Government and social restrictions.

3) Company Analysis

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To begin, we need to ask ourselves the following:

From where do we get all the information about the company?
What are the questions that need to be answered, to understand a company
well?
How has the company been faring over the past few years? Seek information on
its current operations, managerial capabilities, growth plans, its past
performance vis--vis its competitors etc. This is known as Corporate Analysis.
From where do we get all the information about the company?
The best resource for information about a company is its website.
Here, you can learn about:
a)
b)
c)
d)

The business
The financials
The management team
The clients, etc.

Also, one document that details everything about a public company is the
Annual Report.
The annual report of a company talks about:
a)
b)
c)

The management team

The companys business, its performance in the previous year and expectations for
the future
Detailed financial statements of the previous year
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Some of the important information we need for equity research is;

1. The Companys Business and product range: For example Maruti
Suzuki is in the business of passenger car manufacturing. Its product range
includes passenger cars, both at entry and mid level. It also provides
services for car financing and car leasing.
2. Revenue Drivers: For example Bajaj Hindusthan Ltd. which is one of the
largest sugar producers in the country, has its revenues impacted by
government policies regarding pricing of both sugar and sugarcane. Other
factors like price elasticity also impacts the revenues, and hence, valuation
of the company.
3. Markets, Competitors, Entry Barriers:
o What is the nature of the market in which the company operates?

This will define: How much it can grow are the entry barriers high or low?
and how flexible is the pricing how competitive is the market?
o What are the dynamics of the market? Is it fast changing?

For example: If a company is operating in an oligopoly (few sellers, many

buyers), it would have different dynamics, than if it is operating in a perfect
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competition (many buyers, many sellers). of clients?

4. Clients and Suppliers:

Clients:
a)

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b)

Who are the major clients of the company?

What industries is the company exposed to, in terms of clients?

How are these industries faring in the present economy?

d) Does the company have a dependency on a small number of
customers?
Suppliers:
A vendor or supplier can impact a companys ability to quickly scale up
its operations.
5. Management Team:
The competency of the management is one of the most important factors
affecting the companys performance.
c)

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Company Analysis - Detailed

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In the following situations, the company profits are inflated:

a. Switching form the accrual basis of accounting for gratuity to cash basis
during lean years to save on the provision for gratuity will show higher
profit figure.

b. Under inflationary circumstances, a company may switch over from the

LIFO method to FIFO method and increase its profits and switching from
FIFO to LIFO during decreasing prices result in increased profits. During
decreasing prices, under FIFO method of inventory valuation, the value
of stock consumed will be high and profits will be low whereas under
LIFO, the stock consumed will be low and profits will be high. Hence,
switching from FIFO to LIFO the profits will be increased.
c. Capitalizing the patent rights which were previously written off will also
lead to higher profit figures.
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a.

c.
d.

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b.

Management evaluation:
Organization profile, adequacy and quality of organizational set-up,
extent and effectiveness of delegation.
Policies and practices regarding recruitment, training, motivation and
career planning of employees.
Shareholding pattern and controlling interest.
Management information and monitoring system.

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Portors 5 force model

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Two central questions provide the basis for the firms choice of a competitive
strategy:
1. Industry attractiveness: Is the industry attractive in terms of long-term
profitability potential?
2. Competitive advantage: What determines a firms relative competitive
position within an industry?
These can be analyzed through Porters Five Forces:
Environmental AnalysisPorters Model (For a Telecom Company)
a. Barriers to entry (Low/medium/High)
b. Bargaining Power of Buyers (Low/medium/High)
c. Bargaining Power of Suppliers (Low/medium/High)
d. Threat of Substitutes (Low/medium/High)
e. Inter-Firm Rivalry (Low/medium/High)
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a. Barriers to Entry /Threat of New Entrants:

Will new industry entrants compete away the value-added component of
price? The greater the threat of entry, the more pricing pressure there is
on current competitors and the lower industry profits are.
High barriers to entry prevent new competitors from taking away market
share, but they do not guarantee pricing power or high return on capital,
especially if the products are undifferentiated or barriers to exit result in
overcapacity. Barriers to entry may change over time.
While market fragmentation usually results in strong competition and
low return on capital, high industry concentration may not guarantee
pricing power. If industry products are undifferentiated, consumers will
switch to the cheapest producer. Overcapacity may result in price wars.
In theory, any firm should be able to enter and exit a market, and if free
entry and exit exists, then profits always should be nominal. But in reality
industries possess characteristics that protect the high profit levels of the
firms in the market and inhibit additional rivals from entering the
market. These are barriers to entry.

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For Capital intensive and long gestation period to start up business is the
barrier of entry.
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Product differentiation is highly desired

In this industry the customers can easily switch from one service
provider to another service provider. Because of this capturing and
maintaining the market share is difficult which the new entrant should
keep in mind.

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b. Bargaining Power of Buyers (Low/medium/High)

Will buyers capture the value-added component of price? The more power
buyers have, the more pressure they can apply to lower industry prices and
profits
Buyers are powerful if:
a. Buyers are concentrated.
b. Buyer possess a credible backward intergration threat.
c. Buyers purchase a significant proportion of output
Buyers are weak if:
a. Producers threatens forward integration.
b. Significant buyer switching cost
c. Producers supply critical portion of buyers input.

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c. Bargaining Power of Suppliers (Low/medium/High)

Will suppliers capture the value-added component of price? The more
power suppliers have, the more pressure they can apply to raise industry
costs and lower profits.
Suppliers are powerful if:
a. Credible forward integration threat by suppliers.
b. Suppliers are concentrated
c. Significant cost to switch supplier
Suppliers are weak if:
a. Many competitive suppliers
b. Concentrated purchases

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d. Threat of substitutes.
Do alternative products or approaches put a ceiling on the price buyers are
willing to pay? The more cost-effective a substitute product is, the more
pricing pressure there is on industry competitors.

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e. Inter-Firm Rivalry (Low/medium/High) / Rivalry among existing

competitors
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Will existing firms compete away the value-added component through lower prices
or higher costs? The more rivalry there is among current competitors, the more
likely they are to engage in destructive price wars or to raise the cost of competing
by increasing marketing, enhancing product features and/or services, or other
product attributes.

Large number of firms

Market growth
High fixed costs
Low switching cost
Low level of product differentiation

Eliminating rivals is a risky strategy because the increased industry profits are likely
to attract new competitors. The entry of new competitors into the industry will
eventually cause an increase in rivalry among competitors in the industryone of
Porters Five Forcesand reduce industry attractiveness in the long term.
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For example, industry growth rate, technology and innovation, government, and
complementary products and services are transient factors that do not have a
clear cut impact on profitability. These should be evaluated in terms of their
influence on Porters Five Forces.
Managers should intentionally create changes in the five forces by reducing
customer power (increase service, bypass middlemen); supplier power (using
standardized parts, outsourcing labor); availability of substitutes (enhance
features, add distribution channels); threat of entry (raising fixed costs, lobbying
regulators); and reduce rivalry (avoid price wars, differentiate products).
Firms can capitalize on changes in the industry with forward/backward
integration and changes in external forces (e.g., the use of cell phones vs. land
lines). These opportunities can be taken by leaders, smaller competitors, or new
entrants depending upon the nature of the opportunity and the industry
structure.
A firm can create changes in the industry structure and improve industry
attractiveness by enhancing industry value added overall (e.g., eliminating
inefficiencies in the supply chain or distribution network), or by redistributing
the value added in favor of industry participants (e.g., improving pricing by
reducing customer power). Industry leaders are best positioned to reshape the
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industry.

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Not all factors that affect an industry are considered one of Porters
Five Forces:

SWOT Analysis

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Strengths:
1. International and domestic presence.
2. Government special status / award etc.
3. Significant Manufacturing/Production/Export capabilities.
4. Highly qualified and motivated employee base and proven management
team
5. Strong marketing and distribution network

Weaknesses:
1. The company experienced negative cash flows in the past
2. The company has high working capital requirements. If it experiences
insufficient cash flows to meet required payments on debt and working
capital requirements, there may be an adverse effect on its results of
operations.
3. The companys insurance may not be adequate to protect against all
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potential losses to which it may be subject.

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OPPORTUNITIES:
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1. Further increase in the companys market share.

2. Continue to maintain focus on international markets.
3. Continue to further develop particulars product lines.
4. Continue to expand retail operations.
5. Continue to expand product offerings and maintain high quality customer
service.
6. Pursue strategic acquisitions and alliances.

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THREATS:
A decrease in the availability or an increase in the price of raw material may
make it difficult for the company to procure enough product at competitive prices
to supply its customers.

The companys business is dependent on a continuing relationship with our

customers.

The company face significant competition in business from Indian and

international companies.

If the company is unable to accurately manage inventory of quality raw material,

its reputation and results of operations could suffer.

The company is subject to seasonal fluctuations in sales.

The Company is involved in certain tax related disputes that, if determined

against the Company, could have a material adverse impact on the Company.

There are certain legal proceedings against the Companys Directors, Promoters
and group companies.

Changes in the government policies have the higher dominance on the top line as
well as the bottom line of the company.

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Sensitivity of a Company/Industry to the Business Cycle

A Cyclical Firm has earnings that are highly dependent on the business cycle. Eg.
Housing and autos are examples of cyclical industries.

A Non-cyclical Firm has earnings that are less dependent on the business cycle.
Non-cyclical industries demand is not highly sensitive to business cycles, such as
utilities, health care, and food and beverages.

Industries can also be classified as cyclical or non-cyclical. Non-cyclical industries

or firms can be classified as defensive (demand for the product tends not to
fluctuate with the business cycle) or growth (demand is so strong that it is largely
unaffected by the business cycle).

Limitations of descriptors such as growth, defensive, and cyclical include the facts
that cyclical industries often include growth firms; even non-cyclical industries
can be affected by severe recessions; defensive industries are not always safe
investments; business cycle timing differs across countries and regions; and the
classification of firms is somewhat arbitrary.

A Defensive Industry is typically characterized by stable performance during

both expansions and contractions of the business cycle.

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A Growth Industry is typically characterized by above-normal expansion in sales

and profits independent of the business cycle. A growth industry has demand
that is strong enough that earnings remain relatively unaffected by the business
cycle.

Producers of luxury items tend to have Cyclical Earnings because consumers

typically decrease their purchases of these items during economic recessions.
The earnings of firms with high percentages of variable costs are not as likely to
be cyclical as those of firms with high percentages of fixed costs (i.e., high
operating leverage).

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The relation of "peer group," as used in equity valuation, to a company's

industry classification.
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A peer group should consist of companies with similar business activities, demand
drivers, cost structure drivers, and availability of capital. To form a peer group, the
analyst will often start by identifying companies in the same industry, but the
analyst should use other information to verify that the firms in an industry are
comparable.

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Phases of the industry life-cycle model

Phases of the industry life-cycle model are the embryonic, growth, shakeout,
maturity, and decline stages.
Embryonic stage: Slow growth; high prices; large investment required; high
risk of failure.
Growth stage: Rapid growth; little competition; falling prices; increasing
profitability.
Shakeout stage: Slowing growth; intense competition; industry overcapacity;
declining profitability; cost cutting; increased failures.
Mature stage: Slow growth; consolidation; high barriers to entry; stable
pricing; superior firms gain market share.
Decline stage: Negative growth; declining prices; consolidation.

A limitation of life-cycle analysis is that life-cycle stages may not be as long or

short as anticipated or might be skipped altogether due to technological change,
government regulation, societal change, or demographics. Firms in the same lifecycle stage will experience dissimilar growth and profits due to their competitive
positions.

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Prepared By:
Prof. Amit Gupta MS Finance(CFA, icfai), MMS Finance(NIT), CFPcm, CWM(USA), NCMP2, Dip TD (ISTD, New Delhi), B.E (Electrical,
MBM Govt. College, Jodhpur)

Founder: iVidya Learning & Financial Solutions; www.iVidyaFinancialSolutions.com

Visiting Faculty : NITIE (Mumbai), BSE, NMIMS, PUMBA, SIMS(Pune), SIOM (Nasik), SIU(Pune), ISB&M (Pune), Mumbai University,......etc
Mumbai, Maharashtra
Mobile: +91-9004459173/ 9967813782 (Whatsapp)
Email: analystamit@yahoo.com| analystamit@gmail.com
LinkedIn: http://in.linkedin.com/in/amitguptamsf
Face Book: https://www.facebook.com/analystamit

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Ex-Employee: ICICI Securities Ltd, ISEIL, Financial Technologies Ltd and Standard Chartered Securities Ltd;