Security Analysis &

Portfolio Management
Unit 3 Fundamental Analysis

What is Fundamental Analysis

Analyzing
Economic Influences
Industry Factors and
Company Information
Estimating future Dividends and Stock Price
The framework used is the E-I-C Framework also
refered to as a top-down method of analysis
Arrive at an investment decision based on the
estimated value and current market price

Fundamental Analysis Hierarchy

Economic Analysis
Industry
Analysis
Company
Analysis

Economic
Analysis

Economic Analysis
GDP represents the aggregate value of the goods and services
Gross Domestic
produced in the economy. A higher growth rate is more favorable
Product (GDP)
to the stock market.
Savings and
Investment

The saving and investment patterns of the public affect the stock
to a great extent.

Inflation

If there is a mild inflation, it is good for the stock market but high
rate of inflation is harmful.

Interest Rates

Interest rate affects the cost of financing to the firms. Availability

of cheap funds encourages speculation and rise in the prices of
shares.

Budget

A balanced budget (neither Surplus nor Deficit) is highly

favorable to the stock market.

Economic Analysis... Contd.

Tax Structure

The type of tax exemption has impact on the profitability of the

industries.

Balance of
Payment

A favorable BoP renders a positive effect on the stock market.

Monsoon and
Agriculture

Agricultural produce is input raw material for many industries.

Infrastructure
Facilities

Communication, roads, power, banking services are all essential

for a vibrant industrial growth.

Demographic
Factors

The demographic data provides details about the population by

age, occupation, literacy and geographic location. This data is
needed to forecast demand for various goods and services.

Economic Analysis
GDP represents the aggregate value of the goods and services
Gross Domestic
produced in the economy. A higher growth rate is more favorable
Product (GDP)
to the stock market.
Savings and
Investment

The saving and investment patterns of the public affect the stock
to a great extent.

Inflation

If there is a mild inflation, it is good for the stock market but high
rate of inflation is harmful.

Interest Rates

Interest rate affects the cost of financing to the firms. Availability

of cheap funds encourages speculation and rise in the prices of
shares.

Budget

A balanced budget (neither Surplus nor Deficit) is highly

favorable to the stock market.

Economic Analysis... Contd.

Tax Structure

The type of tax exemption has impact on the profitability of the

industries.

Balance of
Payment

A favorable BoP renders a positive effect on the stock market.

Monsoon and
Agriculture

Agricultural produce is input raw material for many industries.

Infrastructure
Facilities

Communication, roads, power, banking services are all essential

for a vibrant industrial growth.

Demographic
Factors

The demographic data provides details about the population by

age, occupation, literacy and geographic location. This data is
needed to forecast demand for various goods and services.

Economic Forecasting
Investment is future oriented Activity.
Forecasting the future performance of economy is
important
Forecasting GNP
Short term up to 3years
Medium term 3 to 5 years
Long term more than 5 years

10

Forecasting Techniques
Anticipatory survey a survey of intentions of
govt., Business and trade, Industry it terms of
construction, Plan and machinery expenditure etc

11

Barometric or Indicator Approach

Study of economic indicators to forecast future
performance of the economy
Leading Indicators
Weekly hours of manufacturing production workers
Weekly unemployment claims
Orders for plant and Machinery
New building permits issued
Stock market indices
Money supply
Change in material prices
Index of consumer expectations

 Coincidental indicators
Employees on non agri pay rolls
Personal income
Index of industrial production
Manufacturing and trade sales

Lagging indicators
avg,. Duration of unemployment
Outstanding industrial and commercial loans
Change in consumer price index

12

13

Econometric Modeling - use of econometric and

statistical tools to analyse economic variables to
forecast economic performance

14

Opportunistic model building GNP Model

building forecasting GNP buy taking into various
variables
Initial estimate tax rates, interest rates, economic &
fiscal policies
Next Forecast based on consumption, domestic
investment, Govt spending and net exports.

15

Industry Analysis

16

Industry Analysis
Various sectors do not necessarily respond to the
same degree to economic changes
Recession or expansions in economic activity result
in different relative price changes among industry
groups
Investing is a business of relative changes

Industry Classification
Sl. No.

Industry Classification

Food products

Beverages, tobacco and tobacco products

Textiles

Wood and wood products

Leather and leather products

Rubber and plastic products

Chemical and chemical products

Non-metallic mineral products

Basic metals, alloys and metal products

10

Machinery and machine tools

11

Transport equipment and parts

12

Other miscellaneous manufacturing industries

17

18

Industry Classification According to

Business Cycle
Growth Industries
Abnormally high expansion in earnings. Ex: Mobile
phones, Waste management, Bio-technology, etc.

Cyclical Industries
Moves in tandem with economic cycles. Ex:
Consumer durables

19

Industry Classification According to

Business Cycle.
Defensive Industries
Those that defy the movement of the business cycle.
Ex: Food industry. At times even counter-cyclical.

Cyclical-growth Industry
New type that is cyclical and at the same time
growing. Ex: Automotive.

In
/ Maturity
growth stabilizes.
Inthe
theStagnation
Pioneering
Stage,/ Stabilization
Technologystage,
& Product
are yet to 20
Investor
exit. Ex:called
Black &
White television
industry
80s.
becometoperfect;
sunrise
industries.
Ex: in
Mobile

Computing,
Nanotechnology,
etc.
Industry Life
Cycle

Decay Stage occurs when the products of the industry are

no longer in demand. Ex: Manual Typewriter.
Companies in Expansion Stage are attractive for
investment purposes due to higher returns at low risk. Also
called as Rapid Growth stage.

21
Industry Characteristics
and Structure

Demand Supply Gap

Competitive Conditions in the Industry
Growth Rate
Permanence
Government Policy
Labor
Other Factors : Cost structure, raw material
availability & quality, Investment in R&D, pollution
standards in the industry, etc.

22

Company Analysis

23

Company Analysis
Company analysis is the final stage of fundamental
analysis
Calls for information available from the company
(ex: annual reports) as well as external agency (ex:
press, analysts)
Here the analyst tries to forecast the future
earnings of the company and its share price

Factors Affecting Share Value

24

Factors Affecting Present and Future Values

Competitive edge
Earnings

Historic price of stock

P/E ratio

Capital structure
Management

Economic condition
Stock market condition

Operating efficiency
Financial performance

Future Price

Present Price

25

Measuring Earnings and

Financial Soundness

Comparative financial statements (CFS)

Trend analysis
Common size statements
Fund flow analysis
Cash flow analysis
Ratio analysis

26

Measuring Earnings and

Financial Soundness. Contd.
Liquidity Ratios
Leverage Ratios
Profitability Ratios
Activity or Efficiency or Turnover Ratios
Growth in Earnings
Assessment of Risk

27

Applied Valuation Techniques

Correlation and Regression Analysis
Trend Analysis
Decision Trees
Intrinsic Value Analysis

28

Intrinsic Value Analysis

The expected P/E ratio can be found out by
The numerator is:
Payout ratio = Cash dividend per share / Expected
earnings per share = D/E (EPS)

To forecast the P/E, the analyst should have the

following details:
Stocks risk-adjusted discount rate (K)
Growth (in earnings) rate (g) (= Retention rate X RoE)
Cash dividend per share (D)

29

Intrinsic Value Analysis

A simpler technique adopted by the analyst is as
follows:

OR

30

For a one year holding period present

Projecting value
Dividends
of share One Year
Where
D1 = Dividend to be received at the end of year 1
r = Investors required rate of return or discount
rate
P1 = Selling price at the end of year 1
P0 = Selling price today

Example Yield Calculation

Suppose we buy one share of XYZ Company
at the beginning of the year for Rs 25. We
hold the stock for one year. One rupee in
dividends is collected at year-end, and the
share is sold for Rs 26.50. The rate of return
achieved is the composite of dividend yield
and change in price (capital gains yield).
Thus we get:
Dividend yield = D/P = 1/25 = 0.04
CGains Yield = (26.50)/(25) = 1.06
Total (1+r) = (0.04+1.06) = 1.10
Rate of return (r) = 1.10 1 = 0.10 = 10%

31

Example: Present Value Calculation

32

Suppose you know the dividend and selling

price of the share and want to calculate the
price you can pay (present value) if the
required rate of return is 10% you can use
the formula:
Substituting the values we get

P0 = (1.00/1.1)+(26.50/1.1)
0.909 + 24.091 = Rs 25

Example: Present Value Calculation

33

To achieve a rate of return of 15% the value

of the stock at the beginning of the year
would have to be:

P0 = (1.00/1.15) + (26.50/1.15)
0.87 + 23.04 = Rs 23.91

Example: Calculating Sale Price

34

At what price must we be able to sell the

stock at the end of one year in order to attain
a rate of return of 15 percent?

25 = (1.00/1.15)+(P1/1.15)
25

= 0.87 + (P1/1.15)

(P1/1.15) = 25 0.87 = 24.13

P1 = (24.13 X 1.15) = Rs 27.75 should be the
selling price at the end of one year.

35

For a multi-year holding period the

Projecting present
Dividends
valueofMulti-year
a share is given by:

%
%
%

36

If dividends
grow at a constant
Projecting
Dividends
Constant
Growth rate
in (g) into
indefinite future, the value of the stock
Dividends the
is given by:

Where N approaches infinity, this equation

collapses simply to:

Example: Constant Growth

ABC company would pay Rs 2.50 as

dividend per share for the next year and
expected to grow indefinitely at 12%.
What would be the equity value if the
investor requires 20% return?

P = [2.50/(0.20 - 0.12)] = Rs 31.25

37

38

The constant growth model can be

Projecting extended
Dividends
contd.growth model
to a two-stage
Here the growth stages are divided into
two, namely, a period of extraordinary
growth and a constant growth period of
infinite nature.
Present price =
PV of dividends during above-normal growth
period

+
value of stock price at end of above-normal
growth period discounted back to present

39

Projecting Dividends Two Stage

Example: 2 Stage Growth

40

Consider a company whose previous dividend

was Re 0.71, with the dividend expected to
increase by 15% a year for 10 years and
thereafter at 10 percent a year indefinitely. If a
stockholders RRR is 16%, what is the value of
the stock?
Given:
Ans: Rs 6.77 + Rs 11.94 = Rs 18.71
= Rs 0.71
= 0.15
= 0.10
= 0.16
= 10 years

41

6.7719

(0.71)*(1.15)^10
Example:1.2 0.7039
Stage Growth

2. 0.6978
3. 0.6918
4. 0.6858
5. 0.6799
6. 0.6741
7. 0.6682
8. 0.6625
9. 0.6568
10.0.6511

=2.872345
DN+1 = 2.872345*1.1
= 3.15958
II term = 3.15958/(0.16-0.1)
=52.6597
Discounting by 10 years we get

=11.94

Value of the Stock =

6.772+11.94 =
Rs 18.71

42

In this short-cut method the analyst

Capitalization
or Multiplier
Approach
estimates
EPS for the
year ahead
He divides the market price of the share
by the EPS
The result is the earnings multiplier
The term earnings multiplier and price
earnings ratio are the same
Thus Earnings multiplier =

43

Graham and Dodd method for valuing

Graham & Dodds
Investor
Ratio
stocks looks
for deeply
depressed prices
i.e. Low P/E, high dividend yield, price
below its book + net current asset value
Graham and Dodd believed that the
intrinsic value of a stock can be
determined based on the expected future
earnings and dividend an approach that
came to be known as fundamental
analysis

44

According to this model, also called as

Graham & Dodds
Ratio
traditionalInvestor
model, the
market price of
shares will increase when a company
declares a dividend rather than when it
does not
where:
P is the market price per share
m is multiplier that represents the Price Earnings
Ratio for the industry sector
D is the dividend per share
E is the earning per share.

45

Graham

They observed that there is a particular

& Dodds
relationshipInvestor
between earnings
Ratio
growth to price
earnings ratio (P/E)
They found that the average no-growth stock sold
at 8.5 times earnings and the price-to-earnings
ratio increased by twice the rate of earnings
growth
This lead to the earnings multiplier which can be
expressed as:

P/E = 8.5 + (2* Growth Rate)

where growth rate is the rate of earnings
growth

Problem Set 2
Fundamental Analysis

46

Discounting Process

At

PV
t 0

(1 r )
t

Where
PV is the present value of the sum to be
received in the future
At is the cash inflow for period t
n is the last period
r is the discount rate
47

Problem 1
Consider five annual cash flows (the first occurring one year
from today)
Year
1 2
3 4 5
Cash Flow (Rs) 5 8 12 15 16
Given a discount rate of 10 percent, what is the present value
of the stream of cash flows?

4.55 + 6.61 + 9.02 + 10.25 + 9.93 = 40.36

PV = Rs. 40.36

48

Problem 2
A share is currently selling for Rs. 65. The company is expected to
pay a dividend of Rs. 2.50 on the share at the end of the year. It is
reliably estimated that the share will sell for Rs. 78 at the end of the
year.
1. Would you buy the share to hold it for one year, if your RRR
were 12 percent?
2. What would the price have to be at the end of one year to
justify purchase of the share today, if your RRR were 15%?
=(2.5/1.12)+(78/1.12) = 2.23+69.64 = 71.87
IV = Rs. 71.87. Since the current market price (Rs. 65) is less
than the IV of the share the share is underpriced and can be bought
=(2.5/1.15)+(P1/1.15) = 65 ; P1 = (65*1.15)-2.5 = 72.25

A selling price of Rs. 72.25 at the end of the year would justify the
purchase of the share at the current price of Rs. 65 for an RRR of
15%
49

Problem 3
You have decided to buy 500 shares of an IT company with the
intention of selling out at the end of five years. You estimate the
company will pay Rs 3.50 per share as dividends for the first two
years and Rs. 4.50 per share for the next three years. You further
estimate that, at the end of the five year holding period, the shares
can be sold for Rs. 85. What would you be willing to pay today for
these shares if your RRR is 12%?
=3.125+2.790+3.203+2.859+2.553+48.23 = 62.76
Any price less than Rs. 62.76 per share can be paid for the
shares.

50

Problem 4
A company paid a cash dividend of Rs. 4 per share on its stock
during the current year. The earnings and dividends of the company
are expected to grow at an annual rate of 8 % indefinitely. Investors
expect a rate of return of 14 % on the companys shares. What is a
fair price for this companys shares?
=(4)(1.08)/(0.14-0.08) = (4.32)/(0.06) = 72
The fair price of the companys shares would be Rs. 72.

51

Problem 5

Cement Products Ltd., currently pays a dividend of Rs. 4 per share on its
equity shares.
1. If the company plans to increase its dividend at the rate of 8% per
year indefinitely, what will be the dividend per share in 10 years?
2. If the companys dividend per share is expected to be Rs 7.05 per
share at the end of five years, at what annual rate is the dividend expected
to grow?

D10 = (4)(1+0.08)^10 = Rs 8.64

D5 = (4)(1+r)^5 = 7.05
(1+r)^5 = 7.05/4 = 1.7625
(1+r) = (1.7625)^0.2 = 1.1200
R = 1.12 -1.00 = 0.12 = 12%
Dividend growth rate is 12 percent

52

Problem 6
A chemical company paid a dividend of Rs. 2.75 during the
current year. Forecasts suggest that earnings and dividends of
the company are likely to grow at the rate of 8% over the next
five years and at the rate of 5% thereafter. Investors have
traditionally required a rate of return of 20% on these shares.
What is the present value of the stock?

2.475 + 2.228 + 2.005 + 1.804 + 1.624 = 10.136

11.367
10.136 + 11.367 = 21.50
Present Value of the Stock is Rs 21.50

53

Bond Returns
A financial instrument that calls for a stated
amount of money to be paid to the investor
either at a single future date (zero coupon),
maturity, or at a series of future dates,
including final maturity (coupon bonds)
Pure discount (zero coupon) bonds
Coupon bonds

54

Pure Discount (Zero Coupon) Bonds

Make a single payment at a specified date
100
Payment = Face value
P
r 2n
PV of a zero coupon bond
(1 )
2
P is the present market price
r is the yield to maturity
n is the maturity
Use semiannual compounding
Face value = $100
55

Zero Coupon Bonds - Calculation

Suppose a company issued a zero coupon
bond with a face value of Rs 100 and a
maturity of 10 years and that the yield to
maturity is 12 %. Then Present Value is:
100
P
0.12 20
i.e.
100
(1
)
P
2
20
(1.06)
= Rs 31.18
56

Coupon Bonds
Pay interest payments
Final principal payment = Face value
Yield to maturity
P

C/2

r
1

C/2
r
1

...

C/2

2n

FV

r
1

2n

P is the present market price

C is the annual coupon payment
n is the number of years to maturity
(or) length of time to that payment
FV is the face value
57

Four Factors
Coupon rate

Final Maturity

Market price

Yield to maturity

58

Relationship Between Price and Yield

Market price = Face value
Yield = Coupon rate
Market price < Face value Discount
Yield > Coupon rate
Market price > Face value Premium
Yield < Coupon rate

59

Holding-Period Return
If a security is sold prior to maturity, then
the yield to maturity may not be relevant.
We need to calculate the Holding-Period
Return
The rate of discount that equates the PV of
interest payments plus the PV of terminal
value at the end of the holding period with
the price paid for the bond
60

Problem 7
A. An investor A purchased a bond at a price of Rs 900 with Rs 100 as
coupon payment and sold it at Rs. 1000. What is his holding
return?

period

B. If the bond is sold for Rs. 750 after receiving Rs. 100 as coupon
payment, then what is the holding period return?

A. Holding Period Return = 22.22%

B. Holding Period Return = - 5.5%

61

Perpetuities
A perpetuity involves periodic cash inflows of an
equal amount forever. Example: Preferred
stock
*
Current Yield = Discount Rate = r A
A
0
where
A0 is the initial cash outflow at time 0 i.e. current
market price of the bond and
A* is the fixed cash inflow at the end of each year
i.e. annual coupon payment
Current Yield

Annual coupon payment

Current market price

62

Problem 8

A Rs. 100 par value bond bearing a coupon rate of 11% matures
after 5 years. The expected yield to maturity is 15%. The present
market price of Rs. 82. Can the investor buy it?

If coupon payments are assumed to be paid once a

year then the discounted values are:
9.565 + 8.318 + 7.233 + 6.289 + 5.469 + 49.72
PV=86.59
If coupon payments are once in 6 months then:
5.116 + 4.759 + 4.427 + 4.118 + 3.831 + 3.564 +
3.315 + 3.084 + 2.869 + 2.669 = 37.75 + 49.72
PV = 87.47
63

Problem 9

At an annual rate of compounding of 9%, how long does it take for

a given sum to become double and triple its original value?

A=P(1+r)^n ; 2P = P(1.09)^n ; OR (1.09)^n=2;

Expressing in logarithmic form : log (2) to the
base 1.09 = n
Base change rule in logarithm:
log x to the base b = log x / log b both to a
common base of 10 or e
Therefore, log 2 to the base 1.09 = log 2/log 1.09
= 8.04 years;
log 3/log 1.09 = 12.74 years
64

Problem 10

Of the following which amount is worth more at 10%; Rs. 1,000 today or
Rs. 2,100 after five years?

PV of Rs. 2,100 = Rs. 1,303.94; Hence Rs. 2,100 after 5 years is worthy.

65

Problem 11

A. Determine the price of Rs. 1,000 zero coupon bond with yield to
maturity of 18% and 10 years to maturity
B. What is YTM of this bond if its price is Rs. 220?
A. Price = Rs. 191.07
B. YTM = 16.3%

66

Problem 12

Arvind considers Rs. 1,000 par value bond bearing a coupon rate of
11% that matures after 5 years. He wants a minimum yield to
maturity of 15%. The bond is currently sold at Rs 870. Should he
buy the bond?

= 95.65+83.16+72.33+62.89+54.69+497.18
= 368.72+497.18
= 865.90
Since the market price is higher, he
should not buy.

67

Problem 13

A bond of Rs. 1,000 face value, bearing a coupon rate of 12% will mature
after 7 years. What is the value of the bond if the discount rates are 14%
and 12%?
PV @ 14% = Rs. 914.56;

PV @ 12% = Rs. 1,000

68

Problem 14

Prem is considering the purchase of a bond currently selling at Rs. 878.50.

The bond has four years to maturity, face value of Rs. 1,000 and 8%
coupon rate. The next annual interest payment is due after one year from
today. The required rate of return is 10%
a. Calculate the intrinsic value (Present value) of the bond. Should Prem
buy the bond?
b. Calculate the yield to maturity of the bond.
PV = 72.73 + 66.12 + 60.11 + 54.64 + 683.01 = Rs. 936.61; the bond is
underpriced and therefore, Prem should buy.

69

Problem 14

Prem is considering the purchase of a bond currently selling at Rs. 878.50.

The bond has four years to maturity, face value of Rs. 1,000 and 8%
coupon rate. The next annual interest payment is due after one year from
today. The required rate of return is 10%
a. Calculate the intrinsic value (Present value) of the bond. Should Prem
buy the bond?
b. Calculate the yield to maturity of the bond.
The yield to maturity is to be found by trial and error method for which the
following formula will be useful to guess the rate.

C (P or D / Years to Maturity)
Y
( P0 F ) / 2

Where,
Y = Yield to maturity; C = Coupon Interest in Rs.
P or D = Premium or Discount; P0 = Present Value; F = Face Value
Yield to Maturity is 12%
70

71

SAPM Unit 3 - Syllabus

Fundamental Analysis
Economic analysis
Economic forecasting and stock investment
decisions
Forecasting techniques
Industry Analysis : Industry classification, Industry
life cycle
Company analysis
Measuring earnings, Forecasting earnings
Applied valuation techniques, Graham & Dodds
investor ratios

Questions?

72

73

The End of
UNIT 3