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NCFM FUNDAMENTAL ANALYSIS MODULE - Download as PDF File .pdf), Text File .txt) or read online. FUNDAMENTAL ANALYSIS INVESTMENTS. Yumpu PDF Downloader. F NSE NCFM - Fundamental Analysis Module. indd. F NSE NCFM - Fundamental Analysis Print as pdf. Fundamental Analysis Module. By-. Aishwarya Pant (), Nikita Agrawal ( ), Rohan Garg (), Romil Bhardwaj () and Sanchit.

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Fundamental Analysis Course a one month programme specially designed for all students and professionals who wish to specialize in the stock market. The. Fundamental Analysis is the art of evaluating the intrinsic value of a stock to find long-term investing opportunities. Learn stock analysis in this module. Fundamental Analysis is the backbone of investing. The program statement analysis, earnings quality, security analysis and valuation classes relating to the.

The ability to stay current with interest payment obligations is absolutely critical for a company as a going concern. XYZ would go to the head of the class. XYZ had earnings before interest and taxes operating income of 7. In the case of XYZ. We prefer to focus on the former because. In this section. Simply put. In this instance. These ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales into cash.

Instead of using fixed assets. It is important to investigate the larger factor behind a low ratio. XYZ had net sales. To do this. A more conservative total debt figure would include. Under more typical circumstances. For most companies. Tracking this figure historically and comparing it to peer-group companies will make this quantitative amount more meaningful in an analytical sense. Industry and product-line characteristics will influence this indicator of employee productivity.

Fixed assets vary greatly among companies.

The sales. Before putting too much faith into this ratio. XYZ had generated Here again. The higher the figure the better. There is no exact number that determines whether a company is doing a good job of generating revenue from its investment in fixed assets.

ROE is. A company can be very profitable. Profitability is based upon accounting measures of sales revenue and costs. Net Profit Margin Profitability ratios measure the rate at which either sales or capital is converted into profits at different levels of the operation. The DuPont ratio is calculated as follows: The ratio provides measures in three of the four key areas of analysis. The net profitability for XYZ Technologies in is: Of the three.

A for-profit business exists to create wealth for its owner s. While profitability is important. The cross sectional comparison can be drawn from a variety of sources. As we have seen. The three components of the DuPont ratio. Such measures are generated using the matching principle of accounting.

The leverage multiplier employed in the DuPont ratio is directly related to the proportion of The goods sold may be entirely different from the goods produced during that same period.

Financial ratio bias is commonly present when combining items from both the balance sheet and income statement. A firm with abnormally large inventory balances is not performing effectively.

The cost of debt is lower than the cost of equity. It is important to use average assets in the denominator to eliminate bias in the ratio calculation. The limiting assumption is that the change in the balance sheet occurred evenly over the course of the year.

Taking a simple average for balance sheet items i. The total asset turnover TAT ratio measures the degree to which a firm generates sales with its total asset base. In cases where the firm has been involved in major change. Income statement items are flow variables measured over a time interval.

If debt proceeds are invested in projects which return more than the cost of debt. Adding debt creates a fixed payment required of the firm whether or not it is earning an operating profit. TAT uses income statement sales in its numerator and balance sheet assets in the denominator.

Debt is both beneficial and costly to a firm. The Leverage Multiplier Leverage ratios measure the extent to which a company relies on debt financing in its capital structure. The measure of total asset turnover for XYZ is: Goods produced but not sold will show up as inventory assets at the end of the year. While additional measures for prior years would provide the basis for a necessary trend analysis. Once again.


The DuPont ratio. The company appears to be significant in profitability. A quick analysis of profitability yields the following result: Sound financial statement analysis is an integral part of the management process for any organization. The measure. The leverage multiplier for XYZ is: DIO is computed by 1. Dividing the average inventory figure by the cost of sales per day figure. Dividing the cost of sales income statement by to get a cost of sales per day figure.

Without looking at the two detailed measures. The shorter this cycle. Some caveats. A DuPont study is not a replacement for detailed. The DuPont ratio consists of very general measures. Dividing the average accounts payable figure by the cost of sales per day figure.

CCC computed: Dividing net sales income statement by to get a net sales per day figure. DSO is computed by 1. DPO is computed by 1. Dividing the average accounts receivable figure by the net sales per day figure. An often-overlooked metric. It does this by looking at how quickly the company turns its inventory into sales. Decreasing DSO could indicate an increasingly competitive product. The CCC The obvious limitations of the current ratio as an indicator of true liquidity clearly establish a strong case for greater recognition.

The longer the duration of inventory on hand and of the collection of receivables. As a whole. If this circumstance becomes a trend. What this entire episode brings to the fore. The government was quick to act. Ramalinga Raju. The Satyam fracas is one more fraud in the long history of misappropriation of resources given in trust to individuals and institutions. Fingers were pointed. Cash Conversion cycle for XYZ over five years: In this context.

In the interest of organizations and numerous investors who have direct stake in the financial well-being of the organizations. The integration of accounting. There is a growing need among analysts. In the top-down approach. The leading indicators predict what is likely to happen to an economy. It is an integral part of the whole economy of a country.

Chapter 4: Valuation Methodologies One of the approaches on valuation discussed in the previous NCFM module5 was the so-called top-down valuation. Economic Indicators can have one of three different relationships to the economy: A procyclic or procyclical economic indicator is one that moves in the same direction as the economy. One can seldom find flourishing industries in an otherwise stagnant economy. To gain an insight into the complexities of the stock market one needs to develop a sound economic understanding and be able to interpret the impact of important economic indicators.

The search for the best security then trickles down to the analysis of total sales. Economic indicators include various indices. In the bottom-up approach. Perfect examples of leading indicators are the unemployment position.

Gross Domestic Product. An overall growing or a contracting economy affects every industry in the country positively or negatively. Economic Indicators An economic indicator or business indicator is a statistic about the economy.

Economic indicators allow analysis of economic performance and predictions of future performance. A coincident index may be used to identify. An acyclic economic indicator is one that is not related to the health of the economy and is generally of little use. Many different groups collect and publish economic indicators in different countries.

Baltic Dry Index. Coincident indicators are those which change at approximately the same time and in the same direction as the whole economy.

A counter-cyclic or countercyclical economic indicator is one that moves in the opposite direction as the economy. Inflation is procyclical as it tends to rise during booms and falls during periods of economic weakness. Their Economic Indicators are published monthly and are available for download in PDF and text formats. The Implicit Price Deflator is a measure of inflation.

Measures of inflation are also coincident indicators. Leading economic indicators are the most important type for investors as they help predict what the economy will be like in the future.

Personal income. A lagging economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate gets larger as the economy gets worse so it is a counter-cyclic economic indicator. Economic indicators fall into three categories: Stock market returns are a leading indicator.

Leading economic indicators are indicators which change before the economy changes. Each of the statistics in these categories helps create a picture of the performance of the economy and how the economy is likely to do in the future.

They have little or no correlation to the business cycle: Consumption and consumer spending are also procyclical and coincident. The indicators fall into seven broad categories.

In the U. The unemployment rate is a lagged economic indicator as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve. Unlike the unemployment rate it is a coincident economic indicator. Stock market returns are also procyclical but they are a leading indicator of economic performance. New construction including new home construction is another procyclical leading indicator which is watched closely by investors.

The level of civilian employment measures how many people are working so it is procyclic. A slowdown in the housing market during a boom often indicates that a recession is coming. Changes in business inventories is an important leading economic indicator as they indicate changes in consumer demand.

What does one look at when analysing a company? There is no point or issue too small to be ignored. While we cannot predict the future perfectly.

They tend to be coincident to the business cycle.

Everything matters. The level of exports tends not to change much during the business cycle. This analysis has two thrusts: This causes both government spending and government debt to rise during a recession. We look at the product lifecycle phase and competitive outlook in a particular industry to gauge the overall growth and competitive rivalry amongst the players in the industry.

The purpose of industry analysis is to identify those industries with a potential for future growth and to invest in equity shares of companies selected from such industries.


Governments generally try to stimulate the economy during recessions and to do so they increase spending without raising taxes. So the balance of trade or net exports is countercyclical as imports outweigh exports during boom periods. Measures of international trade tend to be coincident economic indicators. All policy is determined by the controlling family and while some policies may be good.

The advantage of such companies is the loyalty family members would have to the company which they consider their own. Sunil Mittal of Bharti Airtel. In India. In many family managed companies. The different issues regarding a company that should be examined are: Professional Management Professionally managed companies are those that are managed by professionals who are employees of the company. Many such businesses are very successful. The professional manager is a career employee He is at the helm of affairs because of his ability and experience.

Azim Premji of Wipro. In such companies. Narayan Murthy of XYZ. The Chairman or the Chief Executive Officer is usually a member of the controlling family and the Board of Directors are peopled either by members of the family or their friends and associates.

Family Management Professional Management Family management Family managed companies are those that have at the helm a member of the owner or controlling family.

This is no longer true. There have been some changes in the way family controlled businesses are managed. A good. It is upon the quality. Indian corporate history has many examples where an able and visionary management has worked wonders for companies and their stock prices.

There are also badly managed companies in both categories. The company gets the services of a loyal competent employee. The employee builds his wealth. This must be beyond question. It is often stated that a determined employee can perpetrate a fraud. He tries to run his company as a lean. What to look for It would be unfair to state that one should invest only in professionally managed companies and overlook family managed companies.

Often too. There are well managed. The employee thus becomes a part owner and becomes interested in the sustainability and profitability of the enterprise. Tracking integrity may not be easy but over time managements distinguish themselves from others on issues of honesty and integrity. Hindustan Lever. It is a fact that in many professionally managed companies there is corporate politics.

This is because managers are constantly trying to climb up the corporate ladder. The end is often what matters. As a consequence professionally managed companies are usually well-organized. This does not always happen in family managed companies as one is aware that the mantle of leadership will always be worn by the son or daughter of the owner. Companies that come readily to mind are ITC.

It is a win-win situation for both. Many companies therefore promote or create long term commitment and loyalty by offering employees stock options i. This is a loss for the company especially if the person is a high performer. As a professional he is usually aware of the latest trends in management philosophy and tries to introduce these to maximise employee performance. What then are the factors one should look for? How has the management managed the affairs of the company during the last few years?

Has One disadvantage of professionally managed companies is that the professional managers may leave the company for better pay and perquisites offered by another company. He may not necessarily be tied to the company by loyalty but is focussed on performance on a consistent basis which improves shareholder value.

In good times everyone does well. During a time of recession or depression. Their strategy is usually a personal one. Only then can it progress and keep ahead. They do not want change and often stand in the way of change. It must essentially know where it is going and have a plan of how to get there. Did it streamline its operations? Did it close down its factories? Did it if it could get rid of employees? Was it able to sell its products? Did the company perform better than its competitors?

How did sales fare? A management that can steer its company in difficult days will normally always do well. This is a very telling factor. It should be remembered that the regard the industry has of the management of a company is usually impartial.

Often the management of a company that has enjoyed a preeminent position sits back thinking that it will always be the dominant company. Competitors are aware of nearly all the strengths and weaknesses of management of their rivals and if they hold the management in high esteem it is truly worthy of respect.

The inherent strength of a management is tested at times of adversity. A company that has many layers of management and is top heavy tends to be very bureaucratic and ponderous.

The reality sinks in only when it is too late. The management must be in touch with the industry and customers at all times and be aware of the latest techniques and innovations. Has it become more profitable? Has it grown more impressively than others in the same industry? It is always wise to be a little wary of new management and new companies. In doing so. It must be receptive to ideas and be dynamic. Wait until the company shows signs of success and the management proves its competence.

The basic principle behind the DCF models is that every asset has an intrinsic value that can be estimated. The estimate of cash flow could be divided as. In such companies the most competent are not given the positions of power. The information required in order to find out the intrinsic value of any asset using DCF is: The cash flow could be either the dividend which is actually paid out to shareholders or free cash flow which is accrued to the firm or to the shareholders.

There may be nepotism with the nephews. Please refer to earlier section on Opportunity cost The discount rate used to deduce the present value should reflect the uncertainty risk of the cash flows and opportunity cost of capital.

In fact. The model is flexible enough to allow for time-varying discount rates. There are two basic inputs to the model.

To obtain the expected dividends. Since this expected price is itself determined by future dividends. The required rate of return on a stock is determined by its riskiness. While many analysts have turned away from the dividend discount model and viewed it as outmoded. The simplest model for valuing equity is the dividend discount model -.

The General Model When an investor buys stock. The Gordon growth model relates the value of a stock to its expected dividends in the next time period. While the Gordon growth model is a simple and powerful approach to valuing equity. Even in this case. The growth rate of a company may not be greater than that of the economy but it can be less.

Firms can becomes smaller over time relative to the economy. To see why. This does not. If the deviation becomes larger. This growth rate has to be less than or equal to the growth rate of the economy in which the firm operates.

Given the uncertainty associated with estimates of expected inflation and real growth in the economy. If the growth rate exceeds the cost of equity. Limitations of the model The Gordon growth model is a simple and convenient way of valuing stocks but it is extremely sensitive to the inputs for the growth rate. This issue is tied to the question of what comprises a stable growth rate. Used incorrectly. In summary. In particular.

The dividend pay-out of the firm has to be consistent with the assumption of stability. The value of this stock should be: Consider a stock. As the growth rate approaches the cost of equity. Extraordinary growth rate: High Growth period. Two-stage Dividend Discount Model The two-stage growth model allows for two stages of growth. The model is based upon two stages of growth. If the growth rate is expected to drop significantly after the initial growth phase.

A stable firm can pay out more of its earnings in dividends than a growing firm. The focus on dividends in this model can lead to skewed estimates of value for firms that are not paying out what they can afford in dividends.

Once the patent expires. While these sudden transformations in growth can happen. It is difficult in practice to convert these qualitative considerations into a specific time period.

Since the growth rate is expected to decline to a stable level after this period. The assumption that the growth rate drops precipitously from its level in the initial phase to a stable rate also implies that this model is more appropriate for firms with modest growth rates in the initial phase. One scenario. The two-stage model can also be extended to a multi-stage model that takes into consideration the gradual transition in the growth rates.

Limitations of the model There are three problems with the two-stage dividend discount model — the first two would apply to any two-stage model and the third is specific to the dividend discount model. Since the two-stage dividend discount model is based upon two clearly delineated growth stages. Another scenario where it may be reasonable to make this assumption about growth is when a firm is in an industry which is enjoying supernormal growth because there are significant barriers to entry either legal or as a consequence of infra-structure requirements.

The first practical problem is in defining the length of the extraordinary growth period. The second problem with this model lies in the assumption that the growth rate is high during the initial period and is transformed overnight to a lower stable rate at the end of the period.

The FCFE approach on the other hand can be used to directly find out the fair value of the equity of the firm by valuing free cash flows available to equity shareholders discounted at cost of capital. Free cash flow to firm is the cash available to bond holders and stock holders after all expenses and investments have taken place. CFO adds back depreciation and takes account of change in WC. So it is the money before paying the interest. In that instance. EBIT is pre interest charges.

A negative value. A positive value would indicate that the firm has cash left after expenses. FCFE is the cash available to stock holders after all expense.

The value of equity can be found by discounting FCFE at the required rate of return on equity r: We need to subtract the interest expense now because FCFE is all the cash available to stock holders.

FCFE is the cash flow from operations minus capital expenditures minus payments to and plus receipts from debt holders.

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This approach would be appropriate if free cash flow for the firm tended to grow at a constant rate and if historical relationships between free cash flow and fundamental factors were expected to be maintained. Dividing the total value of equity by the number of outstanding shares gives the value per share.

In this case. Since FCFE is the cash flow remaining for equity holders after all other claims have been satisfied. This equation is pretty common. On other occasions. If the firm finances a fixed percentage of its capital spending and investments in working capital with debt.

One approach is to compute historical free cash flow and apply some constant growth rate. Let DR be the debt ratio. If we assume that at some time in the future the company will grow at a constant growth rate g forever.

Given that we have a variety of ways in which to derive free cash flow on a historical basis. We describe these variables and how to estimate them in other screens. Some companies have substantial non-current investments in stocks and bonds that are not operating subsidiaries but financial investments.

Step 3—Calculate the Value of the Corporation: We describe how to do this using easily observable inputs in other screens. In many respects. These should be reflected at their current market value. Step 1—Forecast Expected Cash Flow: Step 4—Calculate Intrinsic Stock Value: Step 2—Estimate the Discount Rate: Based on accounting conventions.

SOTP is regarded as the best tool to value companies with diversified business interests. It evaluates each business or division of the company separately and assigns a value to its The sum of these parts makes up the total enterprise value EV of the company value of operations. This valuation also captures future potential of the new ventures which are not generating revenues right now. We then use either DCF or price multiples to come up with value of each business and thus come up with the EV and subsequently value of equity of the firm.

Relative Valuation In relative valuation. The terminal value in a significant number of discounted cashflow valuations is estimated using a multiple. Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation.

This can be an advantage when it is important that the price reflect these perceptions as is the case when. In turn we assume that each of these businesses has a different risk. Consider a company that has three business divisions — a power generation plant.

At the end. While there are more discounted cashflow valuations in consulting and corporate finance. If we can find ways to frame multiples right. The reciprocal of the PE ratio is known as the earnings yield. For example, Rs. Hence, Rs. Therefore, any wise person would chose to own Rs. In the first option he can earn interest on on Rs. This explains the time value of money. Also, Rs. Using time value of money terminology, Rs. 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. The Rs. 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. Understanding what is called as Opportunity cost is very important here. 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. 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. 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. 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 interest rate.

Though Indian government bond is a riskless security per se, a foreign investor may look at the Indias sovereign risk which would represent some risk. As Indias 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 Yr Government Bond as risk-free interest rate. Roughly 7. 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.

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.

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 stocks 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 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. Its price moves less than the market movement.

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, youll want to focus on stocks with low betas.

On the other hand, if you are extremely bullish on the overall market, youll 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.

Problems with Beta The Beta is just a tool and as is the case with any tool, is not infallible. While it may seem to be a good measure of risk, there are some problems with relying on beta scores alone for determining 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 will do 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 behave relative to the market.

Beta looks backward and history is not always an accurate predictor of the future. Here is how the MSN Encarta dictionary defines the terms: Quantitative — capable of being measured or expressed in numerical terms.


Qualitative — related to or based on the quality or character of something, often as opposed to its size or quantity. In our context, quantitative fundamentals are numeric, measurable characteristics about a business.

It's easy to see how the biggest source of quantitative data is the financial statements. You can measure revenue, profit, assets and more with great precision. Turning to qualitative fundamentals, these are the less tangible factors surrounding a business - things such as the quality of a company's board members and key executives, its brand-name recognition, patents or proprietary technology. Quantitative Meets Qualitative Neither qualitative nor quantitative analysis is inherently better than the other.

Instead, many analysts consider qualitative factors in conjunction with the hard, quantitative factors. Take the Coca-Cola Company, for example. However, no analysis of Coca-Cola would be complete without taking into account its brand recognition. Anybody can start a company that sells sugar and water, but few companies on earth are recognized by billions of people.

It's tough to put your finger on exactly what the Coke brand is worth, but you can be sure that it's an essential ingredient contributing to the company's ongoing success.

The Concept of Intrinsic Value Before we get any further, we have to address the subject of intrinsic value. One of the primary assumptions of fundamental analysis is that the price on the stock market does not fully reflect a stock's "real" value. After all, why would you be doing price analysis if the stock market were always correct?

In financial jargon, this true value is known as the intrinsic value. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value. This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market will reflect the fundamentals. There is no point in buying a stock based on intrinsic value if the price never reflected that value.

Nobody knows how long "the long run" really is. It could be days or years. This is what fundamental analysis is all about.So it is the money before paying the interest. For some private sector banks the ratio is negative on account of their large IT and network expansion spending.

Due to their new business models. Nothing stops a company from declaring a bonus and dividend together if it has large accumulated profits as well as cash. Measures of international trade tend to be coincident economic indicators.

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.

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