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Equity Research- An Investment Advisory Service

Sandeep SHARMA 
on 15 January 2014

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(Fundamental Analysis Approach)

Investment in securities is - not buying a lottery ticket, but a piece of ownership in a company. Therefore, Investment in the securities requires scientific and analytical knowledge as well as artistic skill. Security Analysis involves a systematic analysis of the risk-return characteristics of various securities which is to help a rational investor to identify underpriced and overpriced securities. Investment decision depends on securities to be bought, held or sold. The role of research is to provide information and to improve market efficiency. Thus analysis of the security on a continuous basis is a must.

EQUITY RESEARCH is the systematic study of the performance of companies in stock market with help of fundamental analysis and technical analysis. The purpose of the research is to evaluate investment worthiness of the equity share and find out the appropriate timing of investment in such shares.

VOGUE APPROACHES TO EQUITY RESEARCH:-

1. Fundamental Analysis: - Analysis the RISK-RETURN characteristic of the securities.

2. Technical Analysis: - Examine the DEMAND-SUPPLY position of the securities.

3. Efficient Market Hypothesis: - Assumption the share price movements are RANDOM and not systematic.

FUNDAMENTAL ANALYSIS APPROACH – Researching the Fundamentals

Fundamental Analysis is the cornerstone of investing. It forces you to focus on investing in businesses, not stocks. Fundamental Analysis is a disciplinary study (base on facts) of financial health of the company. The analysis helps to identify fundamentally strong companies whose shares are worthy to be included in the investor’s portfolio. Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts.

In nutshell, Fundamental Analysis is a technique that attempt to determine a future stock price by understanding and measuring the objective ‘value’ of equity.

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 credit risk.

ASSUMPTION: - Fundamental analysis is based on the assumption that the share prices depend upon the present value of future dividends (i.e. discounted cash flows) which is also known as ‘intrinsic value of share’ (often called ‘price target’ in fundamental analysts’ parlance) expected by the shareholders. In other words it is premised on the belief that market is not efficient and that superior research can uncover stock whose intrinsic value differ from their market value. A share that is priced below the intrinsic value must be bought, while a share quoting above the intrinsic value must be sold.

Thus, PRICE OF SHARE = Present Value of dividend + Expected Closing value

(Price is what you pay. Value is what you got.….. WARREN BUFFETT)

The fortunes of each industry are closely tied to those of other industries and to the performance of the economy as a whole. Therefore, Fundamental analysis is a method of evaluating a security by attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors.

KEY VARIABLES OF FUNDAMENTAL ANALYSIS

1. Economic Analysis: - With respect to the information on the economy, the analyst must evaluate how company perform in different economic environment. Macro-economic factors to be assessed while analyzing the overall economy are: -

2. Growth Rates of National Income and Related Measures: - A primary indicator of an economy’s health is the growth in real gross domestic product (GDP).

3. Growth Rates of Industrial Sector: - The growth rates in various industries are estimated based on the estimated demand for its products.

4. < >: - Inflation is measured in terms of either wholesale prices (the Wholesale Price Index or WPI) or retail prices (Consumer Price Index or CPI).< >: - Indian Budget is a gamble of monsoon. Therefore, monsoon is of great concern to investors in the stock market too.

5. Anticipatory Survey: - They help investors to form an opinion about the future state of the economy. It incorporates expert opinion all having a definite bearing on economic activities.

6. Barometer/Indicator Approach: - Various indicators are used to find out how the economy shall perform in the future. The indicators have been classified as under:

7. Leading Indicators: - They relate to the time series data of the variables that reach high/low points in advance of economic activity.

8. Roughly Coincidental Indicators: - They reach their peaks and troughs at approximately the same in the economy.

9. Lagging Indicators: - They reach their turning points after the economy has reached its own already.

All these indicators suggest direction of change in the aggregate economic activity but nothing about its magnitude.

1. Economic Model Building Approach: - In this approach, a precise and clear relationship between dependent and independent variables is determined.

2. Industry Analysis: - Since the basic profitability of any company depends upon the economic prospects of the industry to which it belongs, therefore an appraisal of the particular industry's prospects is essential. Learning about how the industry works will give an investor a deeper understanding of company’s financial health. Factors affecting Industry Analysis are:-

3. < >: - In today information technology scenario customer is the King of game. For this reason, customer trend of a business define the business.

4. Market Share: - Understanding a company's present market share can tell volumes about the company's business.

5. Product Life Cycle

6. Demand Supply Gap

7. Barriers to Entry: - Some of these barriers are innate to the product and the technology of production, while other barriers are created by existing firms in the industry.

8. Government Attitude: - Investors should keep these regulatory costs in mind as they assess the potential risks and rewards of investing.

9. State of Competition in the industry: - Simply looking at the number of competitors goes a long way in understanding the competitive landscape for a company.

10. Cost Condition and Profitability: - the price of a share depends on its return and return depends on profitability of the firm.

11. Technology and research

Some of the techniques used for analyzing the industry wide factors are:

1. Regression & Correlation Analysis:- These are the statistical techniques through investor diagnoses the factors determining the demand for output of the industry through product demand analysis.

2. Input-Output Analysis:- It is a tool to evaluate how good a company is at turning raw material into profit. This is carried out to detect changing patterns/trends indicating growth/decline of industries.

3. Company Analysis:- This requires careful examination of the company's quantitative and qualitative fundamentals.

4. Business Model:- Business Model implies - What exactly does the company do i.e. how company makes money. Investor should understand the business model of any company you invest in. Unless you understand company’s business model, you do not know what the drivers are for future growth.

5. Competitive Advantage: - A company’s long term success is largely based on its competitive advantage and its durability. Investor should know that few companies are able to compete successful for long if they are doing the same thing as their competitors.  

6. Corporate Governance: - It describes the policies in place within an organization denoting the relationships and responsibilities between management, directors and stakeholders.

7. Net Worth and Book Value:- Net Worth is sum of equity share capital, preference share capital and free reserves less intangible assets and any carry forward of losses.

8. Sources and Uses of Funds: - The identification of sources and uses of funds is known as Funds Flow Analysis.

9. Cross-Sectional and Time Series Analysis: - The techniques that are used to do such proper comparative analysis are: common-sized statement, and financial ratio analysis.

10. Size and Ranking: - In this regard the net capital employed the net profits, the return on investment and the sales figures of the company under consideration may be compared with similar data of other companies in the same industry group. It may also be useful to assess the position of the company in terms of technical know-how, research and development activity and price leadership.

11. Growth Record: - The following three growth indicators may be particularly looked into: (a) Price earnings ratio, (b) Percentage growth rate of earnings per annum, and (c) Percentage growth rate of net block. Growth is the single most important factor in company analysis for the purpose of investment management.

12. Financial Analysis:- An analysis of its financial statements (include fundamental ratios) for the past few years would help the investment manager in understanding the financial solvency and liquidity, the efficiency with which the funds are used, the profitability, the operating efficiency and the financial and operating leverages of the company.

13. Quality Management: - This is an intangible factor. Quality of management has to be seen with reference to the experience, skills and integrity of the persons at the helm of affairs of the company. The good way to get a feel for management capabilities is to check and see how executives have done in the past.

14. Location and Labor-Management Relations:- The locations of the company's manufacturing facilities determines its economic viability which depends on the availability of crucial inputs like power, skilled labor and raw-materials, etc.

15. Pattern of Existing Stock Holding: - This would show the stake of various parties in the company.

16. Marketability of the Shares

Some of the techniques used in company analysis: Through the use of statistical techniques the company wide factors can be analyzed.

1. Correlation & Regression Analysis: - Here the inter relationship between variables belonging to economy, industry and company are found out.  The main advantage in such analysis is the determination of the forecasted values along with testing the reliability of the estimates.

2. Trend Analysis: - It gives an insight to the historical behavior of the variable.

3. Decision Tree Analysis: - In decision tree analysis, the decision is taken sequentially with probabilities attached to each sequence.

Apart from these, the Group Analysis has also become an important factor.

Thus, fundamental analysis is basically an examination of the economic and financial aspects of a company with the aim of estimating future earnings and dividend prospects. It includes an analysis of the macro-economic and political factors which will have an impact on the performance of the company.

CONCLUSIVE THOUGHT: - Market is rational neither fundamental analysis nor technical analysis is useful in outperforming the markets. Therefore, fundamental analysis would not tell you the exact best time and day to buy or sell, it can at least give you better understanding of things to look out for when it come to make decisions.

(If a Business does well, the stock eventually follows.  ….. WARREN BUFFETT)

Sandeep SHARMA

(CA Final)

sandeep.ca92@gmail.com


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