Fundamental analysts attempt to study everything that can affect the security's value, including macroeconomic factors (like the overall economy and industry conditions) and individually specific factors.
The fundamental approach is based on an in-depth and all-around study of the underlying forces of the economy, conducted to provide data that can be used to forecast future prices and market developments.
A combination of the data is used to establish the true current value of the underlying asset, to determine whether they are over- or under-valued and to predict the future value of the underlying asset based on this information.
It helps an investor obtain information about the overall state of the market, attractiveness and state of a specific security as compared to other securities, However, when and how to react to the information, derived through fundamental analysis, is determined using technical analysis.
Though the basic approach is the same while doing fundamental analysis, the various factors that affect the value of the underlying asset keep changing depending upon the class and nature of the asset under focus.
The end goal of performing fundamental analysis is to produce a value that an investor can compare with the underlying assets current price in hopes of figuring out what sort of position to take with that security(under priced = buy, overpriced = sell).
Fundamental analysis focuses on cause and effect — causes external to the trading markets that are likely to affect prices in the market.
These factors may include the weather, current inventory levels, government policies, economic indicators, trade balances and even how traders are likely to react to certain events.
Fundamental analysis maintains that markets may misprice a commodity in the short run but that the "correct" price will eventually be reached. Profits can be made by trading the mispriced commodity and then waiting for the market to recognize its "mistake" and correct it.
Market Demand: Market demand represents how much people are willing to purchase at various prices. Thus, demand is a relationship between price and quantity demanded, with all other factors remaining constant.
The performance of a company depends much on the performance of the economy if the economy is BOOM, the industries and companies in general said to be prosperous. On the other hand, if the economy is in RECESSION, the performance of companies will be generally poor.
Investors are interested in studying those economic varieties, which affect the performance of the company in which they proposed to invest. An analyzed of those economic variable would give an idea about future corporate earnings and the payment of dividends and interest to investors.
GNP represents the aggregate value of goods and services produced in the economy. It reflects the over all performance of the economy. The growth rate of GNP indicates the growth rate of the economy the higher the rate of growth of GNP, the more favorable is it for the stock market and vice versa
Savings and investment denote that position of GNP, which is saved and invested savings increases in India since eighties now the rate of savings is 25% from 21% in 80’s, which indicates the growth of capital market. The higher the level of savings interest, the more favorable is it for the stock marketed vice versa
Inflation has considerate impact on the performance of companies. Higher rates of inflation upset business plans and erode purchasing power in the hands of consumers. This will result in lower demand for products. Thus high rates of inflation in an economy are likely to affect the performance of companies adversely. However industries and companies prosper during periods of low inflation. Hence an investor has to evaluate the inflation rates prevailing in the economy currently as well as the trend of inflation likely to prevail in the future.
Agriculture forms a major part of the Indian economy. Some companies are using agricultural raw material as inputs and some others are supplying inputs to agriculture. Such companies are directly affected by changes in agricultural production. Hence, the increase/decrease in agricultural production has a significant bearing on the industrial production and corporate performance
The cost and availability of credit for companies are determined by the rates of interest prevalent in an economy. A low interest rate stimulates investment by making credit available easily and cheaply. As a result cost of finance for companies decreases which assures higher profitability. On the other hand, higher interest rates result in higher cost of production, which may lead to lower profitability and lower demand. Hence an investor has to consider the interest rates prevailing in the economy and evaluate their impact on the performance and profitability of the companies.
Government is the largest investor and spender of money. So the trends in government revenue expenditure deficits have a significant impact on the performance of industries and companies. So the investor has to evaluate these carefully to assess their impact on his investments.
The development of an economy very much on the availability of infrastructure. It includes electricity, roads and railways, communication channels etc. The availability of infrastructural facilities affects the performance of companies. Bas infrastructure leads to inefficiencies, lower productivity, wastage and delays and vice versa. Thus an investor should assess the status of infrastructural facilities available in the economy before finalizing his investment avenues.
The Indian economy is essentially an agrarian economy and agriculture forms a very important sector of the Indian economy. But the performance of agriculture to a very great extent depends upon the monsoon. The adequacy of the monsoon ensures the success of the agricultural activities in India and vice versa. Hence the progress and adequacy of the monsoon becomes a matter of great concern for an investor in India.
A stable political environment is necessary for steady and balanced growth. No industry or company can grow and prosper in the midst of political turmoil. Such long term economic policies are needed for industrial growth. Such stable policies can be framed only by stable political systems.
Relationship between Demand & supply: Excess supply reduces the profitability of the industry and insufficient supply tends to improve the profitability. Thus an investor should estimate the demand and supply gap in an industry.
(b) Period of life: Life of the industry depends on the products and the technology used by the industry. Technological changes leads to product obsolete. No investment should be made in such industries.
(c) State of labour: When there is labour revolution, industries cannot become bright.
(d) Governments attitude: The Government may encourage the growth and development of certain industries by giving much assistance to such industries.
(e) Availability of Raw Material: An industry may depend on internal / external country for raw material. Sometimes they depend on import of raw material.
(f) Cost structure: It refers to the proportion of fixed costs to variable costs. (Discuss about Marginal Cost)
(i) Threat new entrants: New entrants inflate cost, push down the prices and reduce profitability. An industry which is well protected from the entry of new firms would be ideal for investment.
(ii) Competitions among existing firms: The firm competes with each other on the basis of price, quality, promotion, service, warranties and so on. If the rivalry between the firms in an industry is strong average profitability of the industry may be discouraged. The rivalry in an industry is high when the following conditions prevail in the market:
(a) There is a sustained competitive battle
(b) The industry growth is dull
(c) The level of fixed cost is high
(d) There is over capacity in the industry continuing for a long time.
(e) The industry product is considered as a commodity, which
Pressure from substitute products: Each firm in an industry face competition from other firms in the same industry producing substitute products. Substitute products may affect the profit potential of the industry badly. The pressure from the substitute products is found to be high under the following circumstances:
(a) When the price of the products is attractive
(b) When the cost for the prospective buyers to switch over to a substitute product is minimum.
(c) When the substitute products are earning greater profits.
Bargaining power of sellers: Sellers also can exert a competitive force in an industry and bargain for rise in prices, lower quality, curtail some of the free services they offer etc. Powerful suppliers can affect the profitability of the buyer industry badly. Suppliers are said to be powerful under the following circumstances.
(a) Few suppliers dominate the entire market.
(b) There is no viable substitute for the products supplied.
(c) The switching poses a strong threat of forward integration.
(d) Suppliers also pose a strong threat of forward integration.