Definition of Fundamental Security Analysis - Economic Analysis

Introduction

The intrinsic value of an equity share depends on a multitude of factors. The earnings of the company, the growth rate and the risk exposure of the company have a direct bearing on the price of the share. These factors in turn rely on the host of other factors like economic environment in which they function, the industry they belong to, and finally companies’ own performance.\

The fundamental school of thought appraised the intrinsic value of shares through

Economic Analysis

Industry Analysis

Company Analysis

Economy-Industry-Company Analysis Framework

The analysis of economy, industry and company fundamentals constitute the main activity in the fundamental approach to security analysis. In this era of globalization we may add one more circle to the diagram to represent the international economy.

The logic of this three tier analysis is that the company performance depends not only on its own efforts, but also on the general industry and economy factors. A company belongs to an industry and the industry operates within the economy. As such, industry and economy factors affect the performance of the company.

The multitude of factors affecting the performance of a company can be broadly classified as:

Economy-wide factors such as growth rate of the economy, inflation rate, foreign exchange rates, etc. which affect all companies.

Industry-wide factors such as demand-supply gap in the industry, the emergence of substitute products, changes in government policy relating to the industry, etc. these factors such as the age of its plant, the quality of management.

Company specific factors such as the age of its plant, the quality of management brand image of its products, its labour-management relations, etc. these factors are likely to make a company’s performance quite different from that of its competitors in the same industry.

Fundamental analysis thus involves three steps:

Economy Analysis

Industry Analysis

Company analysis

Let us see what each of these analyses implies.

Economy Analysis

The performance of a company depends on the performance of the economy. If the economy is booming, incomes rise, demand for goods increases, and hence the industries and companies in general tend to the prosperous. On the other hand, if the economy is in recession, the performance of companies will be generally bad.

Investors are concerned with those variables in the economy which affect the performance of the company in which they intend to invest. A study of these economic variables would give an idea about future corporate earnings and the payment of dividends and interest part of his fundamental analysis.

Growth Rates of National Income

The rate of growth of the national economy is an important variable to be considered by an investor. GNP (gross national product), NNP (net national product) and GDP (gross domestic product) are the different measures of the total income or total economic output of the country as a whole. The growth rates of these measures indicate the growth rate of the economy. The estimates of GNP, NNP and GDP and their rates are made available by the government from time to time.

The estimated growth rate of the economy would be a pointer towards the prosperity of the economy. An economy typically passes through different phases of prosperity known as the different stages of the economic or business cycle. The four stages of an economic cycle are depression, recovery, boom and recession. The stage of the economic cycle through which a country passes has a direct impact on the performance of industries and companies.

Depression is the worst of the four stages. During a depression, demand is low and declining. Inflation is often high and so are interest rates. Companies are forced to reduce production, shut down plant and lay off workers. During the recovery stage, the economy begins to revive after a depression. Demand picks up leading to more investments in the economy. Production, employment and profits are on the increase.

The boom phase of the economic cycle is characterized by high demand. Investments and production are maintained at a high level to satisfy the high demand. Companies generally post higher profits. The boom phase gradually slows down. The economy slowly begins to experience a downturn in demand, production, employment, etc. The profits of companies also start to decline. This is the recession stage of the business cycle.

While analyzing the growth rate of the economy, an investor would do well to determine the stage of the economic cycle through which the economy is passing and evaluate its impact on his investment decision.

Inflation

Inflation prevailing in the economy has considerable impact on the performance of companies. Higher rates of inflation upset business plans, lead to cost escalation and result in a squeeze on profit margins.

On the other hand, inflation leads to erosion of 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. Industries and companies prosper during times of low inflation.

Inflation is measured both in terms of wholesale prices through the wholesale price index (WPI) and in terms of retail prices through the consumer price index (CPI). These figures are available on weekly or monthly basis. As part of the fundamental analysis, an investor should evaluate the inflation rate prevailing in the economy currently as also the trend of inflation likely to prevail in the future.

Interest Rates

Interest rates determine the cost and availability of credit for companies operating in an economy. A low interest rate stimulates investment by making credit available easily and cheaply. Moreover, it implies lower cost of finance for companies and thereby assures higher profitability. On the contrary, higher interest rates result in higher cost of production which may lead to lower profitability and lower demand.

The interest rates in the organized financial sector of the economy are determined by the monetary policy of the government and the trends in money supply. These rates are thus controlled and vary within certain ranges.

But the interest rates in the unorganized financial sector are not controlled and may fluctuate widely depending upon the demand and supply of funds in the market. Further, long-term interest rates differ from short-term interest rates.

An investor has to consider the interest rates prevailing in the different segments of the economy and evaluate their impact on the performance and profitability of companies.

Government Revenue, Expenditure and Deficits

As the government is the largest investor and spender of money, the trends in government revenue, expenditure and deficits have a significant impact on the performance of industries and companies. Expenditure by the government stimulates the economy by creating jobs and generating demand. Since a major portion of demand in the economy is generated by government spending, the nature of government spending is of great importance in determining the fortunes of many an industry.

However, when government expenditure exceeds its revenue, there occurs a deficit. This deficit is known as budget deficit. All developing countries suffer from budget deficits as government spend large amount of money to build up infrastructure. But budget deficit is an important determinant of inflation, as it leads to deficit financing which fuels inflation.

Exchange Rates

The performance and profitability of industries and companies that are major importers or exporters are considerably affected by the exchange rates of the rupee against major currencies of the world. A depreciation of the rupee improves the competitive position of Indian products in foreign markets, thereby stimulating exports. But it would also make imports more expensive. A company depending heavily on imports may find devaluation of the rupee affecting its profitability adversely.

The exchange rates of the rupee are influenced by the balance of trade deficit, the balance of payments deficit and also the foreign exchange reserves of the country. The excess of imports over exports is called balance of trade deficit. The balance of payments deficit represents the net difference payable on account of all transactions such as trade, services and capital transaction. If these deficits increase, there is a possibility that the rupee may depreciate in value.

A country needs foreign exchange reserves to meet several commitments such as payment for imports and servicing of foreign debts. Balance of payment deficit typically leads to decline in foreign exchange reserves as the deficit has to be met from the reserve. The size of the foreign exchange reserve is a measure of the strength of the rupee on external account. Large foreign exchange reserves help to increase the value of the rupee against other currencies.

The exchange rates of the rupee against the major currencies of the world are published daily in the financial press. An investor has to keep track of the trend in exchange rates of rupee. An analysis of the balance of trade deficit, balance of payments deficit and the foreign exchange reserves will help to project the future trends in exchange rates.

Infrastructure

The development of an economy depends very much on the infrastructure available. Industry needs electricity for its manufacturing activities, roads and railways to transport raw materials and finished goods, communication channels to keep in touch with suppliers and customers.

The availability of infrastructural facilities such as power, transportation and communication systems affects the performance of companies. Bad infrastructure leads to inefficiencies, lower productivity, wastage and delays. An investor should assess the status of the infrastructural facilities available in the economy before finalizing has investment plans.

Monsoon

The Indian economy is essentially an agrarian economy and agriculture forms a very important sector of the Indian economy. Because of the strong forward and back-ward linkages between agriculture and industry, performance of several industries and companies are dependent on the performance of agriculture. Moreover, as agricultural incomes rise, the demand for industrial products and services will be good and industry will prosper.

But the performance of agriculture to a very great extent depends on the monsoon. The adequacy of the monsoon determines the success or failure of the agricultural activities in India. Hence, the progress and adequacy of the monsoon becomes a matter of great concern for an investor in the Indian context.

Economic and Political Stability

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. Stable long-term economic policies are what are needed for industrial growth. Such stable policies can emanate only from stable political systems as economic and political factors are inter-linked. A stable government with clear cut long – term economic policies will be conducive to good performance of the economy.

Economic Forecasting

Economy analysis is the first stage of fundamental analysis and starts with an analysis of historical performance of the economy. But as investment is a future-oriented activity, the investor is more interested in the expected future performance of the overall economy and its various segments. For this, forecasting the future direction of the economy becomes necessary. Economic forecasting thus becomes a key activity in economy analysis.

The central theme in economic forecasting is to forecast the national income with its various components. Gross national product or GNP is a measure of the national income. It is the total value of the final output of goods and services produced in the economy. It is a measure of the total economic activities over a specified period of time and is an indicator of the level and rate of growth of economic activities. An investor would be particularly interested in forecasting the various components of the national income, especially those components that have a bearing on the particular industries and companies that he is analysing.

Forecasting Techniques

Economic forecasting may be carried out for short-term periods (up to three years), intermediate term periods (three to five years) and long-term periods (more than five years). An investor is more concerned about short-term economic forecasts for periods ranging from a quarter to three years. Some of the techniques of short-term economic forecasting are discussed below:

Anticipatory Surveys

Much of the activities in government, business, trade and industry are planned in advance and stated in the form of budgets. Consumers also plan for their major spending in advance. To the extent that institutions and people plan and budget for expenditures in advance, surveys of their intentions can provide valuable input to short-term economic forecasting.

Anticipatory surveys are the surveys of intentions of people in government, business, trade and industry regarding their construction activities, plant and machinery expenditures, level of inventory, etc. Such surveys may also include the future plans of consumers with regard to their spending on durables and non-durables. Based on the results of these surveys, the analyst can form his own forecast of the future state of the economy.

The greatest shortcoming of the anticipatory surveys is that there is no guarantee that the intentions surveyed will certainly materialise. The forecast based on anticipatory surveys or surveys of intentions will be valid only to the extent that the intentions are translated into action. Hence, the analyst cannot rely solely on these surveys.

Barometric or Indicator Approach

In this approach to economic forecasting, various types of indicators are studied to find out how the economy is likely to perform in the future. These indicators are time series data of certain economic variables. The indicators are classified into leading, coincidental and lagging indicators.

The leading indicators are those time series data that reach their high points (peaks) or their low points (troughs) in advance of the high points and low points of total economic activity. The coincidental indicators reach their peaks and troughs at approximately the same time as the economy, while the lagging indicators reach their turning points after the economy has already reached its own turning points. In this method, the indicators1 act as barometers to indicate the future level of economic activity. However, careful examination of historical data of economic series is necessary to ascertain which economic variables have led, lagged behind or moved together with the economy.

The US Department of Commerce, through its Bureau of Economic Analysis, has prepared a short list of the different indicators. Some of them are given below for illustrative purpose.

Leading Indicators

Average weekly hours of manufacturing production workers

Average weekly initial unemployment claims

Contracts and orders for plant and machinery

Number of new building permits issued

Index of S and P 500 stock prices

Money supply (M2)

Change in sensitive materials prices

Change in manufactures’ unfilled orders (durable goods industries)

Index of consumer expectations

Coincidental Indicators

Employees on non-agricultural pay rolls

Personal income less transfer payments

Index of industrial production

Manufacturing and trade sales

Lagging Indicators

Average duration of unemployment

Ratio of manufacturing and trade inventories to sales

Average prime rate

Commercial and industrial loans outstanding

Change in consumer price index for services

Of the three types of indicators, leading indicators are more useful for economic forecasting because they measure something that foreshadows a change in economic activity.

The indicator approach has its own limitations. It is useful in forecasting the direction of the change in aggregate economic activity, but it does not indicate the magnitude or duration of the change. Further, the leading indicators may give false signals. Moreover, different leading indicators may give conflicting signals. The indicator approach becomes useful for economic forecasting only if data collection and presentation are done quickly. Any delay in presentation of data defeats the purpose of the indicators.

Econometric Model Building

This is the most precise and scientific of the different forecasting techniques. This technique makes use of Econometrics, which is a discipline that applies mathematical and statistical techniques to economic theory.

In the economic field we find complex interrelationships between the different economic variables. The precise relationships between the dependent and independent variables are specified in a formal mathematical manner in the form of equations. The system of equations is then solved to yield a forecast that is quite precise.

In applying this technique, the analyst is forced to define learly and precisely the interrelationships between the economic variables. The accuracy of the forecast derived from this technique would depend on the validity of the assumptions made by the analyst regarding economic interrelationships and the quality of his input data.

Econometric models used for economic forecasting are generally complex. Vast amounts of data are required to be collected and processed for the solution of the model. This may cause delay in making the results available. Undue delay may render the results obsolete for purpose of forecasting.

Opportunistic Model Building

This is one of the most widely used forecasting techniques. It is also known as GNP model building or sectoral analysis.

Initially, an analyst estimates the total demand in the economy, and based on this he estimates the total income or GNP for the forecast period. This initial estimate takes into consideration the prevailing economic environment such as the existing tax rates, interest rates, rate of inflation and other economic and fiscal policies of the government.

After this initial forecast is arrived at, the analyst now begins building up a forecast of the GNP figure by estimating the levels of various components of GNP. For this, he collects the figures of consumption expenditure, gross private domestic investment, government purchase of goods and services and net exports. He adds these figures together to arrive at the GNP forecast.

The two GNP forecasts arrived at by two different methods will be compared and necessary adjustments will be made to bring the two forecasts into line with each other.

The opportunistic model building approach makes use of other forecasting techniques to build up the various components. A vast amount of judgement and ingenuity is also applied to make the overall forecast reliable.

Economic forecasting is an extremely complex and difficult process. No method is expected to give accurate results. The investor must evaluate all economic forecasts critically before making his investment decision.