Fundamental Analysis in Capital Markets -I
Introduction:
What is fundamental analysis?
Fundamental analysis is a stock valuation methodology that uses financial and economic analysis to envisage the movement of stock prices. The fundamental data that is analyzed could include a company’s financial reports and nonfinancial information such as estimates of its growth, demand for products sold by the company, industry comparisons, economy-wide changes, changes in government policies etc. The outcome of fundamental analysis is a value (or a range of values) of the stock of the company called its ‘intrinsic value’ (often called ‘price target’ in fundamental analysts’ parlance). To a fundamental investor, the market price of a stock tends to revert towards its intrinsic value. If the intrinsic value of a stock is above the current market price, the investor would purchase the stock because he believes that the stock price would rise and move towards its intrinsic value.
If the intrinsic value of a stock is below the market price, the investor would sell the stock because he believes that the stock price is going to fall and come closer to its intrinsic value. To find the intrinsic value of a company, the fundamental analyst initially takes a top-down view of the economic environment; the current and future overall health of the economy as a whole. After the analysis of the macro-economy, the next step is to analyze the industry environment which the firm is operating in. One should analyze all the factors that give the firm a competitive advantage in its sector, such as, management experience, history of performance, growth potential, low cost of production, brand name etc.
Some of the questions that should be asked while taking up fundamental analysis of a company would include:
What is the general economic environment in which the company is operating? Is it conducive or obstructive to the growth of the company and the industry in which the company is operating?
For companies operating in emerging markets like India, the economic environment is one of growth, growing incomes, high business confidence etc. As opposed to this a company may be operating in a developed but saturated market with stagnant incomes, high competition and lower relative expectations of incremental growth.
How is the political environment of the countries/markets in which the company is operating or based?
A stable political environment, supported by law and order in society leads to companies being able to operate without threats such as frequent changes to laws, political disturbances, terrorism, nationalization etc. 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.
Does the company have any core competency that puts it ahead of all the other competing firms?
Some companies have patented technologies or leadership position in a particular segment of the business that puts them ahead of the industry in general. For example, Reliance Industries’ core competency is its low-cost production model whereas Apple’s competency is its design and engineering capabilities adaptable to music players, mobile phones, tablets, computers etc.
What advantage do they have over their competing firms?
Some companies have strong brands; some have assured raw material supplies while others get government subsidies. All of these may help firms gain a competitive advantage over others by making their businesses more attractive in comparison to competitors. For example, a steel company that has its own captive mines (of iron ore, coal) is less dependent and affected by the raw material price fluctuations in the marketplace. Similarly, a power generation company that has entered into power purchase agreements is assured of the sale of the power that it produces and has the advantage of being perceived as a less risky business.
Does the company have a strong market presence and market share? Or does it constantly have to employ a large part of its profits and resources in marketing and finding new customers and fighting for market share?
Competition generally makes companies spend large amounts on advertising, engage in price wars by reducing prices to increase market shares which may in turn erode margins and profitability in general. The Indian telecom industry is an example of cut throat competition eating into companies’ profitability and a vigorous fight for market share. On the other hand there are very large, established companies which have a leadership position on account of established, large market share. Some of them have near-monopoly power which lets them set prices leading to constant profitability.
Why is fundamental analysis relevant for investing?
Let’s take a look at some reasons why fundamental analysis is used for stock-picking in the markets.
Efficient Market Hypothesis (EMH)
Market efficiency refers to a condition in which current prices reflect all the publicly available information about a security. The basic idea underlying market efficiency is that competition will drive all information into the stock price quickly. Thus EMH states that it is impossible to ‘beat the market’ because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always tend to trade at their fair value on stock exchanges, making it impossible for investors to either consistently purchase undervalued stocks or sell stocks at inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments. The EMH has three versions, depending on the level on information available:
Weak form EMH:
The weak form EMH stipulates that current asset prices reflect past price and volume information. The information contained in the past sequence of prices of a security is fully reflected in the current market price of that security. The weak form of the EMH implies that investors should not be able to outperform the market using something that “everybody else knows”. Yet, many financial researchers study past stock price series and trading volume (using a technique called technical analysis) data in an attempt to generate profits.
Semi-strong form EMH:
The semi-strong form of the EMH states that all publicly available information is similarly already incorporated into asset prices. In other words, all publicly available information is fully reflected in a security’s current market price. Public information here includes not only past prices but also data reported in a company’s financial statements, its announcements, economic factors and others. It also implies that no one should be able to outperform the market using something that “everybody else knows”. The semi-strong form of the EMH thus indicates that a company’s financial statements are of no help in forecasting future price movements and securing high investment returns in the long-term.
Strong form EMH:
The strong form of the EMH stipulates that private information or insider information too is quickly incorporated in market prices and therefore cannot be used to reap abnormal trading profits. Thus, all information, whether public or private, is fully reflected in a security’s current market price. This means no long-term gains are possible, even for the management of a company, with access to insider information. They are not able to take the advantage to profit from information such as a takeover decision which may have been made a few minutes ago.
The rationale to support this is that the market anticipates in an unbiased manner, future developments and therefore information has been incorporated and evaluated into market price in a much more objective and informative way than company insiders can take advantage of. Although it is a cornerstone of modern financial theory, the EMH is controversial and often disputed by market experts. In the years immediately following the hypothesis of market efficiency (EMH), tests of various forms of efficiency had suggested that the markets are reasonably efficient and beating them was not possible. Over time, this led to the gradual acceptance of the efficiency of markets. Academics later pointed out a number of instances of long-term deviations from the EMH in various asset markets which lead to arguments that markets are not always efficient.
Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias and various other predictable human errors in reasoning and information processing. Other empirical studies have shown that picking low P/E stocks can increase chances of beating the markets. Speculative economic bubbles are an anomaly when it comes to market efficiency. The market often appears to be driven by buyers operating on irrational exuberance, who take little notice of underlying value. These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices and profiting later by beating the markets. Sudden market crashes are mysterious from the perspective of efficient markets and throw market efficiency to the winds. Other examples are of investors, who have consistently beaten the market over long periods of time, which by definition should not be probable according to the EMH. Another example where EMH is purported to fail are anomalies like cheap stocks outperforming the markets in the long term.
Arguments against EMH
Alternative prescriptions about the behavior of markets are widely discussed these days. Most of these prescriptions are based on the irrationality of the markets in, either processing the information related to an event or based on biased investor preferences. The Behavioral Aspect Behavioral Finance is a field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.
In a market consisting of human beings, it seems logical that explanations rooted in human and social psychology would hold great promise in advancing our understanding of stock market behavior. More recent research has attempted to explain the persistence of anomalies by adopting a psychological perspective. Evidence in the psychology literature reveals that individuals have limited information processing capabilities, exhibit systematic bias in processing information, are prone to making mistakes, and often tend to rely on the opinion of others. The literature on cognitive psychology provides a promising framework for analyzing investors’ behavior in the stock market. By dropping the stringent assumption of rationality in conventional models, it might be possible to explain some of the persistent anomalous findings. For example, the observation of overreaction of the markets to news is consistent with the finding that people, in general, tend to overreact to new information. Also, people often allow their decision to be guided by irrelevant points of reference, a phenomenon called “anchoring and adjustment”. Experts propose an alternate model of stock prices that recognizes the influence of social psychology.
They attribute the movements in stock prices to social movements. Since there is no objective evidence on which to base their predictions of stock prices, it is suggested that the final opinion of individual investors may largely reflect the opinion of a larger group. Thus, excessive volatility in the stock market is often caused by social “fads” which may have very little rational or logical explanation. There have been many studies that have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. Behavioural finance attempts to fill that void. Regulatory Hindrances In the real world, many a times there are regulatory distortions on the trading activity of the stocks such as restrictions on short-selling or on the foreign ownership of a stock etc. causing inefficiencies in the fair price discovery mechanism. Such restrictions hinder the process of fair price discovery in the markets and thus represent deviation from the fair value of the stock. Then there may be some restrictions on the price movement itself (such as price bands and circuit filters which prevent prices of stocks moving more than a certain percentage during the day) that may prevent or delay the efficient price discovery mechanism. Also, many institutional investors and strategic investors hold stocks despite deviation from the fair value due to lack of trading interest in the stock in the short term and that may cause some inefficiencies in the price discovery mechanism of the market.
Does fundamental analysis work?
In the EMH, investors have a long-term perspective and return on investment is determined by a rational calculation based on changes in the long-run income flows. However, in the markets, investors may have shorter horizons and returns also represent changes in short-run price fluctuations. Recent years have witnessed a new wave of researchers who have provided thought provoking, theoretical arguments and provided supporting empirical evidence to show that security prices could deviate from their equilibrium values due to psychological factors, fads, and noise trading. That’s where investors through fundamental analysis and a sound investment objective can achieve excess returns and beat the market.
Steps in Fundamental Analysis
Fundamental analysis is the cornerstone of investing. In fact all types of investing comprise studying some fundamentals. The subject of fundamental analysis is also very vast. However, the most important part of fundamental analysis involves delving into the financial statements. This involves looking at revenue, expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain an insight into a company’s future performance. Fundamental analysis consists of a systematic series of steps to examine the investment environment of a company and then identify opportunities. Some of these are:
- Macroeconomic analysis - which involves analyzing capital flows, interest rate cycles, currencies, commodities, indices etc.
- Industry analysis - which involves the analysis of industry and the companies that are a part of the sector
- Situational analysis of a company
- Financial analysis of the company
- Valuation
Brushing up the Basics
Concept of “Time value of Money”
The concept of time value of money arises from the relative importance of an asset now vs. in future. Assets provide returns and ownership of assets provides access to these returns. For example, Rs. 100 of today’s money invested for one year and earning 5% interest will be worth Rs. 105 after one year. Hence, Rs. 100 now ought to be worth more than Rs. 100 a year from now. Therefore, any wise person would chose to own Rs. 100 now than Rs. 100 in future. In the first option he can earn interest on Rs. 100 while in the second option he loses interest. This explains the ‘time value’ of money. Also, Rs. 100 paid now or Rs. 105 paid exactly one year from now both have the same value to the recipient who assumes 5% as the rate of interest. Using time value of money terminology, Rs. 100 invested for one year at 5% interest has a future value of Rs. 105. 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.
Example:
If the investor earn Rs. 5 each for the next two years (at 5% p.a. simple interest) on Rs. 100, the investor would receive Rs. 110 after two years. The Rs. 110 the investor earn can be discounted at 5% for two years to arrive at the present value of Rs. 110, i.e. Rs. 100.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.e., in future and discount rates help us determine what a future value of asset, value that would come to us in future, is currently worth.
The present value of an asset could be shown to be:
PV = FV/(1+r)^t
FV = PV * (1+r)^t
Where
PV = Present Value
FV = Future Value
r = Discount Rate
t = Time
Interest Rates and Discount Factors
So, what interest rate should we use while discounting the future cash flows? Understanding what is called as Opportunity cost is very important here.
Opportunity Cost
Opportunity cost is the cost of any activity measured in terms of the value of the other alternative that is not chosen (that is foregone). Put another way, it is the benefit the investor could have received by taking an alternative action; the difference in return between a chosen investment and one that is not taken. Say the investor invests in a stock and it returns 6% over a year. In placing their money in the stock, the investor gave up the opportunity of another investment - say, a fixed deposit yielding 8%. In this situation, the the opportunity costs are 2% (8% - 6%).
But does the investor expect only fixed deposit returns from stocks? Certainly not! One can expect to earn more than the return from fixed deposit when the investor invests in stocks. Otherwise investor is better off with fixed deposits. The reason one can expect higher returns from stocks is because the stocks are much riskier as compared to fixed deposits. This extra risk that the investor assume when the investor invest in stocks calls for additional return that the investor 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)
WACC = D/TC * Kd * (1-t) + E/TC * Ke + P/TC * Kp
Where
D = Debt portion of the Total Capital Employed by the firm
TC = Total Capital Employed by the frim (D+E+P)
Kd = Cost of Debt of the Company.
t = Effective tax rate of the firm
E = Equity portion of the Total Capital employed by the firm
P = Preferred Equity portion of the Total Capital employed by the firm
Kp = Cost of Preferred Equity of the firm
The Cost of equity of the firm, Ke (or any other risky asset) is given by the Capital Asset Pricing model (CAPM)
Ke = Rf + β * (Rm – Rf)
(or)
Ke = Rf + β * (Equity Risk Premium)
Where
Rf = Risk-free rate
β = Beta, the factor signifying risk of the firm
Rm = Implied required rate of return for the market. So what discount factors do we use in order to come up with the present value of the future cash flows from a company’s stock?
Risk-free Rate
The risk-free interest rate is the theoretical rate of return of an investment with zero risk, including default risk. 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. For US Dollar investments, US Treasury bills are used, while a common choice for EURO investments are the German government bonds or EURIBOR rates. 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 India’s sovereign risk which would represent some risk. As India’s 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 10-Yr Government Bond as risk-free interest rate. (5.95%).
Equity Risk Premium
The notion that risk matters and those riskier investments should have higher expected returns than safer investments, to be considered good investments, are both central to modern finance. 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. The equity risk premium reflects fundamental judgments we make about how much risk we see in an economy/market and what price we attach to that 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. The Beta: The Beta is a measure of the systematic risk of a security that cannot be avoided through diversification. 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 stock’s 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.