Session 08

NSE Certified Capital Market Professional (NCCMP)

Fundamental Analysis Part 2

Years 0 1 2 3 4 5 6 7 8 9 10

A GNP projections a0 a1 a2 a3 a4 a5 a6 a7 a8 a9 a10 B Business cycle / Growth rate cycle

C Macro-economic policy changes

D Population projections

E Demographic profile

F Income distribution

G Industry life cycle

H Technological changes

I Industry related policy changes

J Industry sales estimates j0 j1 j2 j3 j4 j5 j6 j7 j8 j9 j10 K Quality of management

L Quality of technology

M Market share of the company

N Company sales estimates n0 n1 n2 n3 n4 n5 n6 n7 n8 n9 n10 O Net profit margin

P Net profit p0 p1 p2 p3 p4 p5 p6 p7 p8 p9 p10 Q Number of equity shares

Q EPS q0 q1 q2 q3 q4 q5 q6 q7 q8 q9 q10

Adjust O for 1. Increasing costs of scarce/non-renewable

resources. 2. Increasing cost of energy. 3. Increasing costs of environmental

conservation.

E-I-C Analysis Working Sheet

A GNP projections

J Industry sales estimates

Input Output Relations

Consumption Patterns

Industry Demand-Supply Gap

Industry Life Cycle

The relation between the change in GNP and industry sales may be influenced by

Input-Output Relations GNP denotes the total output of goods and services in the economy. Part of this output will be directly consumed; part of it will be used as input for another output.

Looking at this fact from the other side of the relation, it means that every output will require some other input. Change in the output of a given product would therefore call for a change in output of certain other products which are required by that product as inputs. This is what we call the Input-Output Relations.

Therefore, the effect of a given change in GNP on the sales of a given industry will depend on the input output relations between the products constituting the GNP.

GNP

Product 1 20%

Input 1 20%

Input 1 30%

Input 2 40%

Input 2 30%

Input 1 60%

Input 2 20%

Product 2 30%

Input 1 10%

Input 1 70%

Input 2 20%

Input 2 60%

Input 1 10%

Input 2 30%

Consumption Patterns

Consumption patterns change

as the household incomes change;

as the pattern of income distribution changes;

as the geographical distribution of income changes;

as the rural-urban distribution of population changes;

as a result of education and occupational changes;

as a result of media impact.

Industry Life Cycle

Introduction stage In this stage of the industry life cycle, the industry is in its infancy. Often, a new product has been developed or patented. During this phase, the firm that developed the product may be alone in the industry, focusing on “early adopter” customers. There is significant risk to investors during the introduction stage as the companies will need a significant amount of cash to promote and differentiate their products.

Growth Stage

In the growth stage, there are multiple companies in the industry seeking to differentiate themselves and earn market share. Like the introduction stage, the growth stage requires a significant cash outlay from the companies, but the funding is used toward more focused marketing efforts and expansion. It is during this phase that companies may start to benefit from economies of scale in production. This stage of industry growth, while still presenting risk to investors, demonstrates the viability of the industry.

Maturity Stage

This is the stage where the industry will start to see slowed growth with the rate of sales growth often slowing to the rate of overall economic growth. Late entrants appear in this stage seeking to capture market share through lower-cost offerings, thus requiring the existing companies to continue their marketing efforts. For investors, maturity of an industry can mean relatively stable stock investments with the possibility of income through dividends.

Decline stage A decline is inevitable in any industry as technological innovations and changing consumer tastes adversely affect sales. At this stage, some companies may exit the industry or merge and consolidate. An investor should approach stocks in declining industries with caution.

Dem

and

- Sup

ply

Gap

O Net profit margin

Dependence on Scarce Resources

Input Costs & Taxes

Environmental Impact of Industrial Processes

Energy Intensity of Industrial Processes

Company Key raw materials Raw material costto sales ratio Last 1 year Last 3 months

a b c d eMaruti Suzuki Metals, rubber, plastic 77.9 (8.1) (15.5)Reliance Industries Crude oil 77.1 (8.7) (5.3)ABB Metals and other components 74.2 (8.0) (17.8)Ashok Leyland Metals, rubber, plastic 73.1 13.4 (18.5)Bajaj Auto Metals, rubber, plastic 72.7 50.3 (18.5)Hero Honda Metals, rubber, plastic 70.4 11.8 (2.5)MRF Rubber 67.3 9.4 (28.4)Tata Motors Metals, rubber, plastic 65.1 57.4 5.1Cummins India Metals and other components 64.4 68.8 (0.5)Jain Irrigation Chemicals, PVC Resin & Vegetables 57.5 32.1 (2.7)Sintex Industries PVC Resin & Fibre 56.8 24.3 (20.7)Asian Paints Crude oil derivatives & chemicals 56.4 45.6 2.0Hind Unilever Chemicals, Tea, Coffe, Oil & Fats 50.6 14.7 (0.1)Nestle India Milk, Wheat, Sugar & Cofee 49.1 52.1 14.5

26% 30%

Percentage change in stock prices

Source : ET, January 17, 2011.

To what extent the RMC : Sales ratio explains the stock price variations

Impact of Input Costs on Stock Prices

Cost factor measures the percentage change in profit margin resulting from an expected one percent change in the price of a given input.

For instance, a 5% change in price of Coke can be expected to cause [0.05 X -2.60] = 2.55% fall in profit margin of a steel making company.

A similar method can be used to measure impact of expected changes in taxes or customs tariffs on profit margin. Dependence on scarce resources introduces an inherent tendency for rising input costs, and therefore falling profit margins. The same is true of energy intensity of production - higher the energy intensity, higher the tendency for squeeze on profit margins. The same is also true of environmental impact - higher the impact , higher the tendency, because environmental costs tend to get internalised over a long period of time.

The extent of squeeze on profit margin due to rising costs of scarce resources, energy or environmental protection, will depend upon the elasticity of demand for the output – that is, the possibility of passing on the increased costs to the consumer.

Higher the elasticity of demand, lower is the possibility of passing on the costs, and therefore higher is the squeeze on profits; and vice versa.

Session 09