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 analyse the industry environment which the firm is operating in. One should analyse 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. This step of the analysis entails finding out as much as possible about the industry and the inter-relationships of the companies operating in the industry as we have seen in the previous NCFM module1. The next step is to study the company and its products.
Some of the questions that should be asked while taking up fundamental analysis of a company would include:
1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
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