Some ref for unit 2
What is fundamental analysis?
Fundamental analysis is a stock valuation methodology that uses financial and economic
analysis to envisage the movement of stock prices. The fundamental data that is analysed
could include a company’s financial reports and non-financial information such as estimates of
its growth, demand for products sold by the company, industry comparisons, economy-wide
changes, changes in government policies etc.
The outcome of fundamental analysis is a value (or a range of values) of the stock of the
company called its ‘intrinsic value’ (often called ‘price target’ in fundamental analysts’ parlance).
To a fundamental investor, the market price of a stock tends to revert towards its intrinsic
value. If the intrinsic value of a stock is above the current market price, the investor would
purchase the stock because he believes that the stock price would rise and move towards its
intrinsic value. If the intrinsic value of a stock is below the market price, the investor would
sell the stock because he believes that the stock price is going to fall and come closer to its
intrinsic value.
To find the intrinsic value of a company, the fundamental analyst initially takes a top-down
view of the economic environment; the current and future overall health of the economy as
a whole. After the analysis of the macro-economy, the next step is to analyse the industry
environment which the firm is operating in. One should analyse all the factors that give
the firm a competitive advantage in its sector, such as, management experience, history
of performance, growth potential, low cost of production, brand name etc. This step of the
analysis entails finding out as much as possible about the industry and the inter-relationships
of the companies operating in the industry as we have seen in the previous NCFM module 1.
The next step is to study the company and its products.
Some of the questions that should be asked while taking up fundamental analysis of a company
would include:
1. What is the general economic environment in which the company is operating?
Is it conducive or obstructive to the growth of the company and the industry in
which the company is operating?
For companies operating in emerging markets like India, the economic environment
is one of growth, growing incomes, high business confidence etc. As opposed to this a
company may be operating in a developed but saturated market with stagnant incomes,
high competition and lower relative expectations of incremental growth.
2. How is the political environment of the countries/markets in which the company
is operating or based?
A stable political environment, supported by law and order in society leads to companies
being able to operate without threats such as frequent changes to laws, political
disturbances, terrorism, nationalization etc. Stable political environment also means that
the government can carry on with progressive policies which would make doing business
in the country easy and profitable.
3. Does the company have any core competency that puts it ahead of all the other
competing firms?
Some companies have patented technologies or leadership position in a particular
segment of the business that puts them ahead of the industry in general. For example,
Reliance Industries’ core competency is its low-cost production model whereas Apple’s
competency is its design and engineering capabilities adaptable to music players, mobile
phones, tablets, computers etc.
4. What advantage do they have over their competing firms?
Some companies have strong brands; some have assured raw material supplies while
others get government subsidies. All of these may help firms gain a competitive advantage
over others by making their businesses more attractive in comparison to competitors.
For example, a steel company that has its own captive mines (of iron ore, coal) is
less dependent and affected by the raw material price fluctuations in the marketplace.
Similarly, a power generation company that has entered into power purchase agreements
is assured of the sale of the power that it produces and has the advantage of being
perceived as a less risky business.
5. Does the company have a strong market presence and market share? Or does it
constantly have to employ a large part of its profits and resources in marketing
and finding new customers and fighting for market share?
Competition generally makes companies spend large amounts on advertising, engage
in price wars by reducing prices to increase market shares which may in turn erode
margins and profitability in general. The Indian telecom industry is an example of cut
throat competition eating into companies’ profitability and a vigorous fight for market
share. On the other hand there are very large, established companies which have a
leadership position on account of established, large market share. Some of them have
near-monopoly power which lets them set prices leading to constant profitability.
Why is fundamental analysis relevant for investing?
There are numerous ways of taking investment decisions in the market such as fundamental
and technical analysis.
Let’s take a look at some reasons why fundamental analysis is used for stock-picking in the
markets
1.1.1 Efficient Market Hypothesis (EMH)
Market efficiency refers to a condition in which current prices reflect all the publicly available
information about a security. The basic idea underlying market efficiency is that competition
will drive all information into the stock price quickly. Thus EMH states that it is impossible
to ‘beat the market’ because stock market efficiency causes existing share prices to always
incorporate and reflect all relevant information. According to the EMH, stocks always tend
to trade at their fair value on stock exchanges, making it impossible for investors to either
consistently purchase undervalued stocks or sell stocks at inflated prices. As such, it should
be impossible to outperform the overall market through expert stock selection or market timing
and that the only way an investor can possibly obtain higher returns is by purchasing riskier
investments. The EMH has three versions, depending on the level on information available:
Weak form EMH
The weak form EMH stipulates that current asset prices reflect past price and volume
information. The information contained in the past sequence of prices of a security is fully
reflected in the current market price of that security. The weak form of the EMH implies that
investors should not be able to outperform the market using something that “everybody else
knows”. Yet, many financial researchers study past stock price series and trading volume
(using a technique called technical analysis) data in an attempt to generate profits.
Semi-strong form EMH
The semi-strong form of the EMH states that all publicly available information is similarly
already incorporated into asset prices. In other words, all publicly available information is fully
reflected in a security’s current market price. Public information here includes not only past
prices but also data reported in a company’s financial statements, its announcements,
economic factors and others. It also implies that no one should be able to outperform the
market using something that “everybody else knows”. The semi-strong form of the EMH thus
indicates that a company’s financial statements are of no help in forecasting future price
movements and securing high investment returns in the long-term.
Strong form EMH
The strong form of the EMH stipulates that private information or insider information too is
quickly incorporated in market prices and therefore cannot be used to reap abnormal trading
profits. Thus, all information, whether public or private, is fully reflected in a security’s current
market price. This means no long-term gains are possible, even for the management of a
company, with access to insider information. They are not able to take the advantage to profit
from information such as a takeover decision which may have been made a few minutes ago.
The rationale to support this is that the market anticipates in an unbiased manner, future
developments and therefore information has been incorporated and evaluated into market
price in a much more objective and informative way than company insiders can take advantage
of.
Although it is a cornerstone of modern financial theory, the EMH is controversial and often
disputed by market experts. In the years immediately following the hypothesis of market
efficiency (EMH), tests of various forms of efficiency had suggested that the markets are
reasonably efficient and beating them was not possible. Over time, this led to the gradual
acceptance of the efficiency of markets. Academics later pointed out a number of instances
of long-term deviations from the EMH in various asset markets which lead to arguments
that markets are not always efficient. Behavioral economists attribute the imperfections in
financial markets to a combination of cognitive biases such as overconfidence, overreaction,
representative bias, information bias and various other predictable human errors in reasoning
and information processing. Other empirical studies have shown that picking low P/E stocks
can increase chances of beating the markets. Speculative economic bubbles are an anomaly
when it comes to market efficiency. The market often appears to be driven by buyers
operating on irrational exuberance, who take little notice of underlying value. These bubbles
are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy
stocks at bargain prices and profiting later by beating the markets. Sudden market crashes
are mysterious from the perspective of efficient markets and throw market efficiency to the
winds. Other examples are of investors, who have consistently beaten the market over long
periods of time, which by definition should not be probable according to the EMH. Another
example where EMH is purported to fail are anomalies like cheap stocks outperforming the
markets in the long term.
Arguments against EMH
Alternative prescriptions about the behaviour of markets are widely discussed these days.
Most of these prescriptions are based on the irrationality of the markets in, either processing
the information related to an event or based on biased investor preferences.
The Behavioural Aspect
Behavioural Finance is a field of finance that proposes psychology-based theories to explain
stock market anomalies. Within behavioural finance, it is assumed that information structure
and the characteristics of market participants systematically influence individuals’ investment
decisions as well as market outcomes.
In a market consisting of human beings, it seems logical that explanations rooted in
human and social psychology would hold great promise in advancing our understanding of
stock market behaviour. More recent research has attempted to explain the persistence of
anomalies by adopting a psychological perspective. Evidence in the psychology literature
reveals that individuals have limited information processing capabilities, exhibit systematic
bias in processing information, are prone to making mistakes, and often tend to rely on the
opinion of others.
The literature on cognitive psychology provides a promising framework for analysing
investors’ behaviour in the stock market. By dropping the stringent assumption of rationality
in conventional models, it might be possible to explain some of the persistent anomalous
findings. For example, the observation of overreaction of the markets to news is consistent
with the finding that people, in general, tend to overreact to new information. Also, people
often allow their decision to be guided by irrelevant points of reference, a phenomenon called
“anchoring and adjustment”. Experts propose an alternate model of stock prices that
recognizes the influence of social psychology. They attribute the movements in stock prices
to social movements. Since there is no objective evidence on which to base their predictions
of stock prices, it is suggested that the final opinion of individual investors may largely reflect
the opinion of a larger group. Thus, excessive volatility in the stock market is often caused by
social “fads” which may have very little rational or logical explanation.
There have been many studies that have documented long-term historical phenomena in
securities markets that contradict the efficient market hypothesis and cannot be captured
plausibly in models based on perfect investor rationality. Behavioural finance attempts to fill
that void.
Regulatory Hindrances
In the real world, many a times there are regulatory distortions on the trading activity of the
stocks such as restrictions on short-selling or on the foreign ownership of a stock etc. causing
inefficiencies in the fair price discovery mechanism. Such restrictions hinder the process of
fair price discovery in the markets and thus represent deviation from the fair value of the
stock. Then there may be some restrictions on the price movement itself (such as price bands
and circuit filters which prevent prices of stocks moving more than a certain percentage during
the day) that may prevent or delay the efficient price discovery mechanism. Also,
many institutional investors and strategic investors hold stocks despite deviation from the fair
value due to lack of trading interest in the stock in the short term and that may cause some
inefficiencies in the price discovery mechanism of the market.
So, does fundamental analysis work?
In the EMH, investors have a long-term perspective and return on investment is determined
by a rational calculation based on changes in the long-run income flows. However, in the
markets, investors may have shorter horizons and returns also represent changes in short-run
price fluctuations. Recent years have witnessed a new wave of researchers who have provided
thought provoking, theoretical arguments and provided supporting empirical evidence to show
that security prices could deviate from their equilibrium values due to psychological factors,
fads, and noise trading. That’s where investors through fundamental analysis and a sound
investment objective can achieve excess returns and beat the market.
Steps in Fundamental Analysis
Fundamental analysis is the cornerstone of investing. In fact all types of investing comprise
studying some fundamentals. The subject of fundamental analysis is also very vast. However,
the most important part of fundamental analysis involves delving into the financial statements.
This involves looking at revenue, expenses, assets, liabilities and all the other financial aspects
of a company. Fundamental analysts look at these information to gain an insight into a
company’s future performance.
Fundamental analysis consists of a systematic series of steps to examine the investment
environment of a company and then identify opportunities. Some of these are:
• Macroeconomic analysis - which involves analysing capital flows, interest rate cycles,
currencies, commodities, indices etc.
• Industry analysis - which involves the analysis of industry and the companies that are
a part of the sector
• Situational analysis of a company
• Financial analysis of the company
• Valuation
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Concept of “Time value of Money”
The concept of time value of money arises from the relative importance of an asset now vs.
in future. Assets provide returns and ownership of assets provides access to these returns.
For example, Rs. 100 of today’s money invested for one year and earning 5% interest will
be worth Rs. 105 after one year. Hence, Rs. 100 now ought to be worth more than Rs. 100
a year from now. Therefore, any wise person would chose to own Rs. 100 now than Rs. 100
in future. In the first option he can earn interest on on Rs. 100 while in the second option he
loses interest. This explains the ‘time value’ of money. Also, Rs. 100 paid now or Rs. 105 paid
exactly one year from now both have the same value to the recipient who assumes 5% as the
rate of interest. Using time value of money terminology, Rs. 100 invested for one year at 5%
interest has a future value of Rs. 105. The method also allows the valuation of a likely stream
of income in the future, in such a way that the annual incomes are discounted and then added
together, thus providing a lump-sum “present value” of the entire income stream. For eg. If
you earn Rs. 5 each for the next two years (at 5% p.a. simple interest) on Rs. 100, you would
receive Rs. 110 after two years. The Rs. 110 you earn, can be discounted at 5% for two years
to arrive at the present value of Rs. 110, i.e. Rs. 100.
Valuing future cash flows, that may arise from an asset such as stocks, is one of the cornerstones
of fundamental analysis. Cash flows from assets make them more valuable now than in the
future and to understand the relative difference we use the concepts of interest and discount
rates. Interest rates provide the rate of return of an asset over a period of time, i.e., in future
and discount rates help us determine what a future value of asset, value that would come to
us in future, is currently worth.
The present value of an asset could be shown to be:
where, PV = Present value
FV = Future value
r = Discount rate
t = time
Interest Rates and Discount Factors
So, what interest rate should we use while discounting the future cash flows? Understanding
what is called as Opportunity cost is very important here.
Opportunity Cost
Opportunity cost is the cost of any activity measured in terms of the value of the other
alternative that is not chosen (that is foregone). Put another way, it is the benefit you could
have received by taking an alternative action; the difference in return between a chosen
investment and one that is not taken. Say you invest in a stock and it returns 6% over a year.
In placing your money in the stock, you gave up the opportunity of another investment - say,
a fixed deposit yielding 8%. In this situation, your opportunity costs are 2% (8% - 6%).
But do you expect only fixed deposit returns from stocks? Certainly not. You expect to earn
more than the return from fixed deposit when you invest in stocks. Otherwise you are better
off with fixed deposits. The reason you expect higher returns from stocks is because the stocks
are much riskier as compared to fixed deposits. This extra risk that you assume when you
invest in stocks calls for additional return that you assume over other risk-free (or near risk-
free) return.
The discount rate of cost of capital to be used in case of discounting future cash flows to
come up with their present value is termed as Weighted Average Cost of Capital (WACC).
Where
D = Debt portion of the Total Capital Employed by the firm
TC = Total Capital Employed by the frim (D+E+P)
Kd = Cost of Debt of the Company.
t = Effective tax rate of the firm
E = Equity portion of the Total Capital employed by the firm
P = Preferred Equity portion of the Total Capital employed by the firm
Kp = Cost of Preferred Equity of the firm
The Cost of equity of the firm, Ke (or any other risky asset) is given by the Capital Asset
Pricing Model (CAPM)
Or
where Rf = Risk-free rate
β = Beta, the factor signifying risk of the firm
Rm = Implied required rate of return for the market.
So what discount factors do we use in order to come up with the present value of the future
cash flows from a company’s stock?
Risk-free Rate
The risk-free interest rate is the theoretical rate of return of an investment with zero risk,
including default risk. Default risk is the risk that an individual or company would be unable
to pay its debt obligations. The risk-free rate represents the interest an investor would expect
from an absolutely risk-free investment over a given period of time.
Though a truly risk-free asset exists only in theory, in practice most professionals and academics
use short-dated government bonds of the currency in question. For US Dollar investments,
US Treasury bills are used, while a common choice for EURO investments are the German
government bonds or Euribor rates. The risk-free interest rate for the Indian Rupee for Indian
investors would be the yield on Indian government bonds denominated in Indian Rupee of
appropriate maturity. These securities are considered to be risk-free because the likelihood of
governments defaulting is extremely low and because the short maturity of the bills protect
investors from interest-rate risk that is present in all fixed rate bonds (if interest rates go up
soon after a bond is purchased, the investor misses out on the this amount of interest, till the
bond matures and the amount received on maturity can be reinvested at the new interestrate).
Though Indian government bond is a riskless security per se, a foreign investor may look at
the India’s sovereign risk which would represent some risk. As India’s sovereign rating is not
the highest (please search the internet for sovereign ratings of India and other countries)
a foreign investor may consider investing in Indian government bonds as not a risk free
investment.
For valuing Indian equities, we will take 10-Yr Government Bond as risk-free interest rate.
(Roughly 7.8% - as of this writing).
Equity Risk Premium
The notion that risk matters and that riskier investments should have higher expected returns
than safer investments, to be considered good investments, is both central to modern finance.
Thus, the expected return on any investment can be written as the sum of the risk-free rate
and a risk premium to compensate for the risk. The equity risk premium reflects fundamental
judgments we make about how much risk we see in an economy/market and what price we
attach to that risk. In effect, the equity risk premium is the premium that investors demand for
the average risk investment and by extension, the discount that they apply to expected cash
flows with average risk. When equity risk premia rises, investors are charging a higher price
for risk and will therefore pay lower prices for the same set of risky expected cash flows.
Equity risk premia are a central component of every risk and return model in finance and is a
key input into estimating costs of equity and capital in both corporate finance and valuation.
2.1.1 The Beta
The Beta is a measure of the systematic risk of a security that cannot be avoided through
diversification. Therefore, Beta measures non-diversifiable risk. It is a relative measure of risk:
the risk of an individual stock relative to the market portfolio of all stocks. Beta is a statistical
measurement indicating the volatility of a stock’s price relative to the price movement of the
overall market. Higher-beta stocks mean greater volatility and are therefore considered to be
riskier but are in turn supposed to provide a potential for higher returns; low-beta stocks pose
less risk but also lower returns.
The market itself has a beta value of 1; in other words, its movement is exactly equal to itself
(a 1:1 ratio). Stocks may have a beta value of less than, equal to, or greater than one. An
asset with a beta of 0 means that its price is not at all correlated with the market; that asset
is independent. A positive beta means that the asset generally tracks the market. A negative
beta shows that the asset inversely follows the market; the asset generally decreases in value
if the market goes up.
where = Beta of security with market
= Covariance between security and market
= Variance of market returns
OR
Where = Coefficient of Correlation between security and market returns
Consider the stock of ABC Technologies Ltd. which has a beta of 0.8. This essentially points to
the fact that based on past trading data, ABC Technologies Ltd. as a whole has been relatively
less volatile as compared to the market as a whole. Its price moves less than the market
movement. Suppose Nifty index moves by 1% (up or down), ABC Technologies Ltd.’s price
would move 0.80% (up or down). If ABC Technologies Ltd. has a Beta of 1.2, it is theoretically
20% more volatile than the market.
Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for
higher returns. Lower-beta stocks pose less risk but generally offer lower returns. This idea
has been challenged by some, claiming that data shows little relation between beta and
potential returns, or even that lower-beta stocks are both less risky and more profitable.
Beta is an extremely useful tool to consider when building a portfolio. For example, if you are
concerned about the markets and want a more conservative portfolio of stocks to ride out the
expected market decline, you’ll want to focus on stocks with low betas. On the other hand, if
you are extremely bullish on the overall market, you’ll want to focus on high beta stocks in
order to leverage the expected strong market conditions. Beta can also considered to be an
indicator of expected return on investment. Given a risk-free rate of 2%, for example, if the
market (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 should
return 11% (= 2% + 1.5(8% - 2%)).
Problems with Beta
The Beta is just a tool and as is the case with any tool, is not infallible. While it may
seemto be a good measure of risk, there are some problems with relying on beta scores
alone fordetermining the risk of an investment.
• Beta is not a sure thing. For example, the view that a stock with a beta of less than
1 willdo better than the market during down periods may not always be true in
reality. Beta scores merely suggest how a stock, based on its historical price
movements will behaverelative to the market. Beta looks backward and history is
not always an accurate predictor of the future.
• Beta also doesn’t account for changes that are in the works, such as new lines of
business or industry shifts. Indeed, a stock’s beta may change over time though
usuallythis happens gradually.
As a fundamental analyst, you should never rely exclusively on beta when picking
stocks. Rather, beta is best used in conjunction with other stock-picking tools.
