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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.xlsx8/13/2019 NCCMP Fundamental Analysis
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