UNIT III: FUNDAMENTAL ANALYSIS:

ECONOMIC ANALYSIS:
Economic Analysis refers to evaluating costs and benefits to check the viability of a project, investment
opportunity, event, or any other matter. In other words, it involves identifying, evaluating ,and comparing
costs and benefits

Economic Forecasting and stock Investment Decisions:

Economic forecasting is the process of attempting to predict future conditions of the economy using a
combination of indicators.
Forecasting involves the building of statistical models with inputs of several key variables, typically in
an attempt to come up with a future gross domestic product (GDP) growth rate. Primary economic
indicators include inflation, interest rates, industrial production, consumer confidence, worker
productivity, retail sales, and unemployment rates.

 Economic forecasting is the process of attempting to predict future conditions of the economy using a
combination of widely followed indicators.
 Government officials and business managers use economic forecasts to determine fiscal and monetary
policies and plan future operating activities, respectively.
 Since politics are highly partisan, many rational people regard economic forecasts produced by
governments with healthy doses of skepticism.
 The challenges and subjective human behavioral aspects of economic forecasting also lead private-sector
economists to regularly get predictions wrong.
Forecasting Techniques:
There are basically five economic forecasting techniques:
1.Survey
3.Diffusion Indexes.
4.Economic Model Building.
Surveys One of the methods of Short term forecasting is to make a survey of the type of business that one
is interested in. The method to forecast through surveys is either through:
*Personal Contact:
It is to meet the people and to record conversation about their intention to invest money by type of
product, and by type of industry in future and make an anlysis of it.
*Detailed Questionnaire:
The basic use of this method is to have an insight of the kind of activity in the economy. For example ,
if an idea was to be received about the infrastructure activity of a country, then surveys may be made of
contractors concerning.
2.Indicators:
This project is a method of getting indications of the future relating to business depressions and business
prosperity. This method helps in finding out the leading , lagging, lagging and coincidental indicators of
economic activity.
3.Diffussion Indexes:
This is a complex statistical method and the combination of various factors in this technique makes it
extremely difficult to draw out a proper understanding of the forecasting methods.
4.Econometric Model Bulilding:
This technic can be used only by trained technicians and it is used to draw out relationships between two
or more variables. The technique is to take one independent variable and dependent variable and to
draw out a relationship between these variables.
Oppourtunity Model Building:
This method is the most widely used economic forecasting method. This is also called sectoral analysis of
the Gross National Product. ( GDP) Model Building. This method uses national accounting data to be
able forecast for a future short term period. When an investor has made an analysis of the domestic
economic factors taking into considerstion the leading lagging and the coincidental indicators including
the monetary, fiscal policies of the country together with the demographic factors to find out the change
of direction through indicators This may also known as (GNP).
INDUSTRY ANALYSIS:
Industry analysis is a market assessment tool used by businesses and analysts to understand the
competitive dynamics of an industry. It helps them get a sense of what is happening in an industry,
e.g., demand-supply statistics, degree of competition within the industry, state of competition of the
industry with other emerging industries, future prospects of the industry taking into account technological
changes, credit system within the industry, and the influence of external factors on the industry.
Industry Classification:
An industry can be classified as a group of companies that produce similar goods or services. Industrial
growth is a crucial factor as it determines the economy’s health. Understanding different types of
industries is essential as it helps entrepreneurs determine the viability of their business ideas. It enables
investors to make informed decisions, knowing which types of industries can bring in better returns.
Primary Industries
They are the first step towards the creation of the goods and services that we use every day. Industries,
including including agriculture, fishing, and mining are directly involved in the extraction of raw
materials from nature. In simple words, primary industries are the ones use the natural resources of the
environment and provide the raw material for secondary industries.

Types of Primary Industries

The two types of primary industries are extractive and genetic.
Extractive Industries
These involve the extraction of natural resources. Examples include mining, fishing, forestry, and
agriculture.
Genetic Industries
These are involved in the reproduction and breeding of plants and animals. Examples of genetic industries
include agriculture and animal husbandry.
Both these types of primary industries play a crucial role in providing the raw materials needed for the
manufacturing of goods and the provision of services in other sectors.
 Why is Primary Industry Important?
They are the backbone of any economy as they provide employment to a significant part of the population
and contribute towards the economic growth of a country. A booming primary industry sector has a direct
correlation with the overall growth of the economy.
Their importance cannot be underrated as it is responsible for the livelihood of many people, especially
those who live in rural areas. It also provides the raw material required for secondary industries to
function and, thus, plays a crucial role in the overall development of the country.
Especially, in India, which is an agrarian economy with 54.6% of the population involved in agriculture
and allied sectors (niti.gov.in). The Hindu states, this sector contributes to 17.5 to 18% of the nation’s
GDP.
Common Roles in the Primary Industry
These are the workforce working in the primary industry.
1. Farmers cultivate crops and raise livestock.
2. Fishermen catch fish and other aquatic species.
3. Forestry workers harvest timber and manage forest areas.
4. Miners extract minerals and ores from the earth.
5. Oil rig workers drill for oil and gas.
6. Agricultural engineers provide support and expertise in the agriculture industry.
Secondary Industry
These industries use products and resources of the primary sector to create finished products that are
ready for sale to consumers. Automobile manufacturing, textile manufacturing, and oil refining are some
major examples that are involved in processing raw materials. Workers in this industry are referred to as
blue-collar workers.
Two Types of Secondary Industry
Light Industry
Light industry creates products that are relatively small, easy to use, and often found in our daily lives.
These products can include things like clothing, smartphones, and kitchen appliances.
This subcategory usually doesn’t require massive machines or extensive raw materials. It’s the kind of
industry that makes things we use at home or wear, like clothes and household items.
Heavy Industry
Heavy industry, on the other hand, deals with making heavy and large products. These products are often
used by other industries to build even bigger things. Examples include steel, heavy machinery, and
chemicals.
Unlike the light industry, this one needs significant machines and a lot of resources because it deals with
making large and intricate items. It plays a crucial role in creating the foundation for other industries to
work with.
Industry Life Cycle:
While different versions of the framework have different components, the life cycle can be broadly
divided into five main stages. These are:
Launch
The launch stage is when an industry is just starting; perhaps a new technology has been developed or a
new service offering has been created.
During the launch stage, players may still be exploring what the unit economics will look like while
concurrently seeking a broader product market fit. It’s primarily a pre-revenue stage and capital that’s
invested goes towards R&D early, then into marketing and sales a little later.
Regulation tends to be low during the launch phase; it’s common for governments and regulators to not
yet understand the landscape and therefore not really understand how to regulate it.
Growth
Once an industry hits its growth phase, a product-market fit has been established and there’s viable
commercial potential for this new product, service, or technology.
Some versions of the framework, including the one we’ve presented here, break the growth stage into
distinct “sub phases.” We’ve presented these as early growth and growth.
Early growth and growth are best characterized by the size of the market and the slope of the revenue
trajectory. There is often considerable competition during the growth stage, as many new entrants jump
into the mix to try and secure a small slice of the growing pie.
Shake-out
Shake-out is where the breakneck growth slows considerably.
It tends to be that regulation starts to catch up around the shake out phase, as people understand the
industry more and regulators can wrap their heads around what’s going on.
Between increased regulation and the fact that the winners have effectively differentiated themselves by
now, Everyone else “shakes out” of the market, either by failing outright or by merging with competitors.
Maturity
During the maturity stage total revenue flattens out and may even start to decline.
Businesses operating in mature industries tend to have stable margins and growing cash flow (since
management teams aren’t aggressively re-investing in growth).
Industry concentration tends to increase during the maturity phase. Competition whittles away at margins
but the surplus cash flow means that management teams can look at optimizing capital structure and
returning capital to shareholders via dividends or stock buybacks.
Decline
As the name suggests, total industry revenue starts to really decline in this stage. As a result, the main
engine for growth is merger and acquisition activity, which creates even higher levels of industry revenue
concentration.
Management teams of firms in declining industries are usually faced with two choices — reinvent the
business or enjoy what’s left of the ride. In the latter case, the principal motivation becomes returning as
much capital to shareholders as possible.
Firms in declining industries tend to have high dividend yields and low earnings growth. In fact, any EPS
growth that does occur usually comes from accretive acquisitions or financial engineering (like reducing
share count).
Industry Life Cycle:
There are great opportunities to deploy capital into businesses operating at all stages of an industry’s life
cycle. However, the nature of opportunities depend largely on the risk/return profile of the investor (or
creditor).
 For example, a senior lender (like a commercial banker) will be most comfortable with later growth and
mature industries. Venture capital investors, on the other hand, will invest only in businesses in the
launch or early growth stages.
Understanding where a firm fits into its industry, and how that industry’s life cycle may create risks or
opportunities for that management team is paramount in really understanding a business.
Company analysis:
Company analysis is a study of the variables that influence the future of a firm both qualitatively and
quantitatively. It is the method of assessing the competitive position of a firm, it’s earning and
profitability.
Company analysis contains an evaluation & examination of a company, its financial health & prospects,
management strategy or marketing activities & its strengths & weaknesses. There are several types of
company analysis:
Financial Reports: examples include SWOT analysis, SEC filing sections (Management Discussion and
Analysis) as well as company overview information (often called Tearsheets).
Marketing/Management Reports:
 Market Research: typically cover industries and product categories including coverage of individual
competitors (which may also include privately held companies) if they are major industry players. While
the focus of these reports will be on the company's market strategy, expect to find sales and other
financial data.
 Management Reports will cover aspects of the company's operations including sustainability,
organizational philosophy, initiatives, core values and mission statements, goals and objectives and much
more.
Articles: Articles can be extensive treatments of a company including case histories. Look for in-depth
articles in:
 Scholarly Journals: There are scholarly journals for most business disciplines (e.g., marketing,
management, finance, etc.). Articles submitted for publication undergo a rigorous peer review process.
Business databases such as ABI/Inform Global and Business Search Complete let you limit a search to
the scholarly literature.
 Trade Journals: There are numerous trade journals for each industry. Trade journals provide continuous
coverage of corporate developments. Articles include company coverage that may not be found in the
national business press.
Earnings Transcripts: Conference call presentations by top management to analysts, investors and
shareholders. Management discuss current corporate financial health, outcomes of various strategic
initiatives and financial outlook.
Analyst Reports: Analysis for buy, sell, hold recommendations with detailed company analysis to
support the recommendations.
Understanding where a firm fits into its industry, and how that industry’s life cycle may create risks or
opportunities for that management team is paramount in really understanding a business.
APPLIED VALUATION TECHNIQUES:
1. Earnings per Share EPS
2. Price to Earnings Ratio P/E
3. Projected Earnings Growth PEG
4. Price to Sales P/S
5. Price to Book P/B
6. Dividend Payout Ratio
7. Dividend Yield
8. Book Value per share
9. Return on Equity

1. Earnings per Share

The overall earnings of a company is not in itself a useful indicator of a stock's worth. Low earnings
coupled with low outstanding shares can be more valuable than high earnings with a high number of
outstanding shares. Earnings per share is much more useful information than earnings by itself. Earnings
per share (EPS) is calculated by dividing the net earnings by the number of outstanding shares.

EPS = Net Earnings / Outstanding Shares

For example: ABC company had net earnings of Rs.1000000 and 100,000 outstanding shares for an EPS
of 10 (1000000 / 100,000 = 10). This information is useful for comparing two companies in a certain
industry but should not be the deciding factor when choosing stocks.

2.Price to Earnings Ratio

The Price to Earnings Ratio (P/E) shows the relationship between stock price and company earnings. It is
calculated by dividing the share price by the Earnings per Share.

P/E = Stock Price / EPS

In our example above of ABC company the EPS is 10 so if it has a price per share of $50 the P/E is 5 (50
/ 10 = 5). The P/E tells you how many investors are willing to pay for that particular company's earnings.
P/E's can be read in a variety of ways. A high P/E could mean that the company is overpriced or it could
mean that investors expect the company to continue to grow and generate profits. A low P/E could mean
that investors are wary of the company or it could indicate a company that most investors have
overlooked.

Either way, further analysis is needed to determine the true value of a particular stock.

3. Projected Earnings Growth Rate-PEG Ratio

A ratio used to determine a stock's value while taking into account earnings growth. The calculation is as
follows:

PEG is a widely used indicator of a stock's potential value. It is favoured by many over the price/earnings
ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is
more undervalued.
4. Price to Sales Ratio
When a company has no earnings, there are other tools available to help investors judge its worth. New
companies in particular often have no earnings, but that does not mean they are bad investments. The
Price to Sales ratio (P/S) is a useful tool for judging new companies. It is calculated by dividing the
market cap (stock price times number of outstanding shares) by total revenues. An alternate method is to
divide current share price by sales per share. P/S indicates the value the market places on sales. The lower
the P/S the better the value.

5.Price to Book Ratio

Book value is determined by subtracting liabilities from assets. The value of a growing company will
always be more than book value because of the potential for future revenue. The price to book ratio (P/B)
is the value the market places on the book value of the company. It is calculated by dividing the current
price per share by the book value per share (book value / number of outstanding shares). It is also known
as the "price-equity ratio".

P/B = Share Price / Book Value per Share

6. Dividend Yield
Some investors are looking for stocks that can maximize dividend income. Dividend yield is useful for
determining the percentage return a company pays in the form of dividends. It is calculated by dividing
the annual dividend per share by the stock's price per share. Usually it is the older, well-established
companies that pay a higher percentage, and these companies also usually have a more consistent
dividend history than younger companies. Dividend yield is calculated as follows:

7. Dividend payout ratio

Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends:

The part of the earnings not paid to investors is left for investment to provide for future earnings growth.
Investors seeking high current income and limited capital growth prefer companies with high Dividend
payout ratio. However investors seeking capital growth may prefer lower payout ratio because capital
gains are taxed at a lower rate. High growth firms in early life generally have low or zero payout ratios.
As they mature, they tend to return more of the earnings back to investors. Note that dividend payout ratio
is calculated as EPS/DPS.

Calculated as:

The payout ratio provides an idea of how well earnings support the dividend payments. More mature
companies tend to have a higher payout ratio. In the U.K. there is a similar ratio, which is known as
dividend cover. It is calculated as earnings per share divided by dividends per share.

8. Return on Equity
Return on equity (ROE) is a measure of how much, in earnings a company generates in a time period
compared to its shareholders' equity. It is typically calculated on a full-year basis (either the last fiscal
year or the last four quarters).

Expanded Definition
When capital is tied up in a business, the owners of the capital want to see a good return on that capital.
Looking at profit by itself is meaningless. I mean, if a company earns $1 million in net income, that's
okay. But its great if the capital invested to earn that is only $2.5 million (40% return) and terrible if the
capital invested is $25 million (4% return).

Return on investment measures how profitable the company is for the owner of the investment. In this
case, return on equity measures how profitable the company is for the equity owners, a.k.a. the
shareholders.

The "average" is taken over the time period being calculated and is equal to "the sum of the beginning
equity balance and the ending equity balance, divided by two."

9.Book Value per Share

A measure used by owners of common shares in a firm to determine the level of safety associated with
each individual share after all debts are paid accordingly.

Sho
uld
the company decide to dissolve, the book value per common indicates the dollar value remaining for
common shareholders after all assets are liquidated and all debtors are paid. In simple terms it would be
the amount of money that a holder of a common share would get if a company were to liquidate.
Grahm and Dodds Investor ratios:
Eg., Earnings per share=
Earnings available for the common shares / Weighted average common shares outstanding