FUNDAMENTAL ANALYSIS

( Understanding the Broad Picture )

PART-1

Prof. Seema Chakrabarti

 Economies and Markets

 A strong relationship exists between the economy

and the stock market

 Security markets reflect what is going on in an

economy because the value of an investment is
determined by
 its expected cash flows

 required rate of return

Economic Activity and
Security Markets
Stock Market As A Leading Indicator
 Stock prices reflect expectations of

earnings, dividends, and interest rates

 Stock market reacts to various leading

indicator series
 Stock prices consistently turn before the

economy does
 E - I - C FRAMEWORK
ERS HAVE FOUND THAT STOCK PRICE CHANGES CAN BE
ATTRIBUTED TO THE FOLLOWING FACTORS:

 ECONOMY-WIDE FACTORS : 30-35 PERCENT

 INDUSTRY FACTORS : 15-20 PERCENT
 COMPANY FACTORS : 30-35 PERCENT
 OTHERS FACTORS : 15-25 PERCENT

BASED ON THE ABOVE EVIDENCE, A COMMONLY ADVOCATED

PROCEDURE OF FUNDAMENTAL ANALYSIS INVOLVES A THREE-
STEP EXAMINATION, WHICH CALLS FOR:
 UNDERSTANDING OF THE MACRO-ECONOMIC
ENVIRONMENT
AND DEVELOPMENTS
 ANALYSING THE PROSPECTS OF THE INDUSTRY TO WHICH
THE FIRM BELONGS
 ASSESSING THE PROJECTED PERFORMANCE OF THE
COMPANY.
 THE GLOBAL ECONOMY

In a globalised business environment, the top down

analysis of the prospects of a firm must begin with the

global economy. The global economy has a bearing on the

export prospects of the firm, the competition it faces from

international competitors, and the profitability of its

overseas investors.
 THE GLOBAL ECONOMY

WHILE MONITORING THE GLOBAL ECONOMY BEAR IN

MIND THE FOLLOWING:
• Although the economies of most countries
are linked, economic performance varies
widely across countries at any time.
• From time to time countries may experience
turmoil due to a complex interplay between
political and economic factors.
• The exchange rate is a key factor
affecting the international competitiveness
of a country’s industries.
 Central Government Policies

• The Government employs two broad

classes of macroeconomic policies, viz.
demand side policies and supply side
policies.

• Traditionally, The Focus Was Mostly On

Fiscal And Monetary Policies, The Two
Major Tools Of Demand-side Economics.
From 1980s Onward, However, Supply-side
Economics Has Received A Lot Of
Attention.
 FISCAL POLICY

• Fiscal policy is concerned with the spending

and tax initiatives of the government. It is the
most direct tool to stimulate or dampen the
economy.

• An increase in government spending stimulates

the demand for goods and services, whereas a
decrease deflates the demand for goods and
services.

• By the same token, a decrease in tax rates

increases the consumption of goods and
services and an increase in tax rates decreases
the consumption of goods and services.
 MONETARY POLICY

Monetary policy is concerned with the manipulation of money

supply in the economy. Monetary policy affects the economy
mainly through its impact on interest rates.

THE MAIN TOOLS OF MONETARY POLICY ARE:

• Open Market Operation
• Bank Rate
• Reserve Requirements
• Direct Credit Controls
 Monetary Variables, the
Economy, and Stock Prices

 Money supply and the economy

 Money supply and stock prices

 Excess liquidity and stock prices

Money Supply and the Economy
 Declines in the rate of growth of the money
supply have preceded business contraction.

 Increases in the rate of growth of the

money supply have preceded economic
expansions.
Money Supply and Stock Prices
Excess Liquidity

 Excess liquidity causes interest rates to fall.

 Fall in the interest rates leads to encouraging

investment climate.

 Encouraging investment climate leads to

increased economic activity and capacity building
and restructuring.

 Economic activity leads to improvement in the

stock prices.
 Money Supply and Stock Prices
Tight liquidity

 Tight liquidity leads to less money being available

for the industry

 Causes increase in the interest rates

 Discourages investment climate and affects

economic activity

 Leads to negative sentiments in the market

 Also….
 Increase in money supply puts more money in
the hands of consumers

 Stimulates increased spending

 Businesses increase production

 Raises demand for labor and capital goods

 Capital markets improve

 And…
 If output growth reaches capacity limits prices
begin to rise

 Expect inflation

 Lenders increase the lending rates

 Interest rates rises

 Stock market turns negative

 Inflation, Interest Rates, and
Security Prices
 Inflation and interest rates
 generally move together

 investors are not good at predicting inflation

 Inflation rates and bond prices

 negative relationship

 more effect on longer term bonds

 Interest rates and stock prices

 not direct and not consistent

 effect varies over time

 Cyclical Indicator Approach to
understand the Economy
 This approach contends that the aggregate
economy expands and contracts in
discernable periods

 Cyclical indicator categories:

 leading indicators

 coincident indicators

 lagging indicators
 Cyclical Indicator Categories
 Leading indicators – Economic series that
usually reach peaks or troughs before
corresponding peaks or troughs in aggregate
economy activity

 Coincident indicators – Economic series that

have peaks and troughs that roughly coincide with
the peaks and troughs in the business cycle
 Cyclical Indicator Categories
 Lagging indicators – Economic series that
experience their peaks and troughs after those of
the aggregate economy

 Other series – Economic series that do not fall

into one of the three main groups
 Lead Indicators
 Manufacturers order book
 Capital goods order book
 Index of stocks
 Money Supply
 Interest Rate Spreads
 Consumers Business Confidence Index
 Unemployment rate
 Coincident Indicators
 IIP
 Corporate earnings
 Employees payrolls
 Inflation
 Lag indicators
 Credit expansion
 Bank PLR
 Inventories to sales
 MACRO ECONOMIC ANALYSIS
THE MACROECONOMY IS THE OVERALL ECONOMIC
ENVIRONMENT IN WHICH ALL FIRMS OPERATE. THE KEY
VARIABLES COMMONLY USED TO DESCRIBE THE STATE OF THE
MACROECONOMY ARE :

 GROWTH RATE OF GROSS DOMESTIC PRODUCT

 INDUSTRIAL GROWTH RATE
 AGRICULTURE AND MONSOONS
 SAVINGS AND INVESTMENTS
 GOVERNMENT BUDGET AND DEFICIT
 PRICE LEVEL AND INFLATION
 INTEREST RATES
 BALANCE OF PAYMENT, FOREX RESERVES, AND EXCHANGE
RATE
 INFRASTRUCTURAL FACILITIES AND ARRANGEMENTS
 SENTIMENTS
 Industry Analysis
Approaches to industry analysis:

 Sensitivity to business cycle

 Study of structure & characteristics of the industry

 Industry Life cycle

 Profit potential of industries : Porter model

 Industry Analysis
 SENSITIVITY TO BUSINESS CYCLE
is determined by:
• Sensitivity of Sales
• Operating Leverages
• Financial Leverage

 Study of structure & characteristics of the

industry
• Structure of the industry & nature of competition
• Nature & prospects of demand
• Cost, Efficiency & Profitability
• Technology & Research
 INDUSTRY ANALYSIS
 INDUSTRY LIFE CYCLE ANALYSIS
• PIONEERING STAGE
• RAPID GROWTH STAGE
• MATURITY & STABILIZ’N STAGE
• DECLINE STAGE
 PROFIT POTENTIAL OF INDUSTRIES
• FORCES DRIVING COMPETITION PORTER MODEL

POTENTIAL
ENTRANTS
TREAT OF NEW ENTRANTS
BARGAINING INDUSTRY BARGAINING
SUPPLIERS RIVALRY BUYERS
POWER OF AMONG POWER OF
SUPPLIERS FIRMS BUYERS

THREAT OF
SUBSTITUTE
PRODUCTS
SUBSTITUTES
 INDUSTRY ANALYSIS
 INDUSTRY LIFE CYCLE ANALYSIS
• PIONEERING STAGE
• RAPID GROWTH STAGE
• MATURITY & STABILIZ’N STAGE
• DECLINE STAGE
 PROFIT POTENTIAL OF INDUSTRIES
• FORCES DRIVING COMPETITION PORTER MODEL

POTENTIAL
ENTRANTS
TREAT OF NEW ENTRANTS
BARGAINING INDUSTRY BARGAINING
SUPPLIERS RIVALRY BUYERS
POWER OF AMONG POWER OF
SUPPLIERS FIRMS BUYERS

THREAT OF
SUBSTITUTE
PRODUCTS
SUBSTITUTES