NCCMP Fundamental Analysis

8/13/2019 NCCMP Fundamental Analysis

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NSE Certified Capital Market Professional

(NCCMP)


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Fundamental Analysis


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Fundamental Analysis

Fundamental analysis is a technique thatuses financial and economic analysis to decide

about investment in the shares of a given

company.The information that is analyzed can

include the company's financial reports, non-

financial information such as estimates of thegrowth of demand for products sold by the

company, industry comparisons, economy-wide

changes, changes in government policies, etc.


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A fundamental analyst believes that the

market price of an equity share tends to move

towards it's real value or intrinsic value.If the intrinsic value of a share is above the

current market price, the investor would

purchase the share because he knows that themarket price is likely to rise and move towards

its intrinsic value.

If the intrinsic value of a share is below themarket price, the investor would sell the share

because he knows that the market price is likely

to fall and come closer to its intrinsic value.


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All this seems extremely simple. But the

obvious question is : How do you find out what

the intrinsic value of an equity share is ?That is what fundamental analysis is all

about.

Let us begin with the concept of

Intrinsic Value


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Intrinsic Value (I V) of a share is the

Present Value of the future earnings that

the share will yield to the investor. In this

sense the concept of I Vof a share is same

as the concept of P V of a bond that we

have seen earlier.

Present Value of a bond

= PV of Coupon for year 1+ PV of Coupon for year 2

+ PV of Coupon for year 3

+

+

+ PV of Coupon for year n

+ PV of Principal repayment.


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In a similar manner the Intrinsic

Valueof an equity share is given by


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Intrinsic Value of a share

= (Earnings in year 1) / (1+ k)1

+ (Earnings in year 2) / (1+ k)2

+ (Earnings inyear 3) / (1+ k)3

+

+ (Earnings inyear n) / (1+ k)n+

upto infinity

Unlike a bond, in case of an equity share,there is no fixed term for which the future

earnings will flow. So we sum the present

values till infinity.


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Again, unlike in the case of a bond, which has a

known coupon, in the case of an equity share, we do

not have a pre-determined value for earnings.

What constitutes the earning of an investor in

the shares of a company ?

The most commonly accepted variable for

earnings of an equity share investor is the Earnings

Per Share (EPS).

EPS = Net profit or loss during the period.Weighted average number of equity shares

outstanding during the period.

[ Accounting Standard (AS) 20 ]


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I V = (EPS for year 1) / (1+ k)1

+ (EPS for year 2) / (1+ k)2

+ (EPS for year 3) / (1+ k)3

+

+ (EPS for year n) / (1+ k)n

+

upto infinity

So the Intrinsic Value equation will

read as follows :


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I V = [ ( EPS0) x ( 1+g )1] / ( 1+ k )1

+ [ ( EPS0) x ( 1+g )2

] / ( 1+ k )2

+ [ ( EPS0) x ( 1+g )

3] / ( 1+ k )3

+

+ [ ( EPS0) x ( 1+g )n] / ( 1+ k )n

+

upto infinity

So the Intrinsic Value equation will now

read as :


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k is the rate at which we discount the

future earnings.

k is also called the Capitalisation Rate.

k is given by

k = rf + ( rm - rf)

Beta : level ofsystematic risk

Expected market

rate of return

Risk free rate

of return

Risk free rate

of return

Risk

Premium


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So, the Capitalisation Rate k varies with

the risk free rate of return rf the expected market rate of return rm

the level of systematic risk

In a depressed market (bear phase) both

rf (time preference) and[ rm - rf ] (risk

premium) increase; so kincreases.In a buoyant market (bull phase) both rf

(time preference) and [ rm - rf ] (risk

premium) decrease; so kdecreases.


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Now let us turn back to g, the critical

variable for calculation of the Intrinsic Value

of an equity share.

For this we use a comprehensive model called

the ECONOMY-INDUSTRY-COMPANY Framework

g

Growth in

national

output

Growth in

industry

sales.

Growth in

company

sales.

Net Profit

Margin

Companys

market

share

Input-output relations

&

Consumption patterns

Company Analysis Industry Analysis Economy Analysis


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g

Growth in

national

output

Growth in

industry

sales.

Growth in

company

sales.

Net Profit

Margin

Companys

market

share

Input-output

relations

&

Consumption

patterns

Company Analysis Industry Analysis Economy Analysis

Let us study the E-I-C Model in the next

session.


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Strengths of Fundamental Analysis

Long-term Trends

Fundamental analysis is good for long-

term investments based on long-term trends,very long-term.

The ability to identify and predict long-

term economic, demographic, technological orconsumer trends can benefit patient investors

who pick the right industry groups or

companies.


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Value Spotting

Sound fundamental analysis will help

identify companies that represent a good

value. Some of the most legendary investorsthink long-term and value. Fundamental

analysis can help uncover companies with

valuable assets, a strong balance sheet, stable

earnings and staying power.


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Business Acumen

One of the most obvious, but less

tangible, rewards of fundamental analysis is

the development of a thorough understanding

of the business. Earnings and earnings

expectations can be potent drivers of equity

prices. In addition to understanding the

business, fundamental analysis allowsinvestors to develop an understanding of the

key value drivers within an industry.


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Weaknesses of Fundamental

Analysis

Time Constraints

Fundamental analysis may offer excellent

insights, but it can be extraordinarily time-

consuming. Such elaborate models often produce

valuations that are contradictory to the current priceprevailing in the market.


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Industry/Company Specific

Valuation techniques vary depending on

the industry group and specifics of each

company. For this reason, a different technique

and model is required for different industries

and different companies.

Subjectivity

Fair value is based on assumptions. Anychanges to growth rate, capitalisation rate or

multiplier assumptions can greatly alter the

ultimate valuation.


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When market valuations extend beyond

historical norms, there is pressure to adjust

growth and multiplier assumptions tocompensate. If market values a stock at 50

times earnings and the current assumption is

30 times, the analyst would be pressured torevise this assumption higher. There is an old

stock market saying : The value of any asset

(stock) is only what someone is willing to pay

for it (current price).

Then the question comes : who is right,

the market or the analyst ?


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I V = [ ( EPS0) x ( 1+g )1] / ( 1+ k )1+ [ ( EPS0) x ( 1+g )

2] / ( 1+ k )2

+ [ ( EPS0) x ( 1+g )3] / ( 1+ k )3

+

+ [ ( EPS0) x ( 1+g )n] / ( 1+ k )n

+

up to infinity

Getting back to the Intrinsic Value

equation :

Let us now see how we can handle this

equation using Excel.


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Intrinsic Value is the

Present Value of the future flow

of earnings from the equity

share. Since the amountreceived every year is not

constant, we cannot use the PV

formula; instead we use the

NPVformula.

As seen earlier, NPV

formula requires that we

arrange the expected futureearnings in an array of values

on an Excel sheet, and then lift

the array into the NPVformula.


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We assume that EPS

grows ant an increasing rate

for the first eight years, thenat a declining rate for the next

seven years, and at a constant

rate thereafter. We create an

array for values of EPS for 25years. One can consider

values for any number of

years. But not for infinity. One

needs to take values forsufficiently long time to

arrive at a fair approximation

of Intrinsic Value.


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We assume that all earnings

come at the end of the year.

We assume k = 0.9.

The Intrinsic Value is `42/-.
http://intrinsic%20value.xlsx/http://c/Users/ACER/Documents/PPT%20links/Intrinsic%20value.xlsx


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