Fundamental analysis

A share is part ownership of a company. Over the long run, the workbook argues, its value has to be driven by the profits and cash flows that company earns on its investments. Short-term prices wander away from that value, and when they wander far enough a profit-making opportunity appears.

So the fundamental analyst does two things in order. First, work out the fair price of the equity from the expected performance of the business. Second, compare it with the market price. Below intrinsic value, it is an attractive opportunity; above it, sell or avoid.

The workbook groups the whole exercise into three baskets, and every chapter of the syllabus after Chapter 4 fills one of them:

1. Economic analysis — is the macro trend, cyclical and secular, going to help this industry grow or shrink?
2. Industry analysis — how intense is the competition, and is the structure conducive to the existing players thriving?
3. Company analysis — how is the company positioned against competitors, what is its cost structure, how strong is its financial position, how capable is the management, and is the governance structure sound?

It also separates two jobs that are usually run together. Research is obtaining the information; analysis is drawing the conclusion from it. The workbook is blunt that research is the harder half: an annual report is published once a year and starts going stale immediately, and it says nothing in depth about industry conditions or the economy. So the analyst reads market research, speaks to industry experts, and conducts primary research — visiting facilities, speaking to customers, suppliers and employees.

One boundary is absolute. Collating insider information is not research. Assembling individually insignificant pieces into an insight — mosaic analysis — is acceptable.

Fair value = f( expected profits, cash flows, risk )

Market price < fair value  → attractive investment
Market price > fair value  → sell or avoid

Run the three baskets on a cement company.

Economy. Nominal GDP growing at 10%, infrastructure spending rising — cement demand tracks both.

Industry. National capacity 620 million tonnes against demand of 440 million tonnes: utilisation of 71%. Below roughly 80%, nobody has pricing power.

Company. Capacity 12 million tonnes, sales 9.1 million tonnes (76% utilisation), realisation Rs 4,650 a tonne, EBITDA Rs 950 a tonne.

Revenue  = 9.1 mn t × Rs 4,650 = Rs 4,232 crore
EBITDA   = 9.1 mn t × Rs 950   = Rs 864 crore
Less depreciation 260, interest 190 → PBT = Rs 414 crore
Tax 25%                             → PAT = Rs 311 crore
On 20 crore shares                  → EPS = Rs 15.55
At 14× earnings                     → Rs 218 per share

The share trades at Rs 176 — a 19% discount to the estimate. On the workbook's test, that is an attractive opportunity.

Now test the industry basket. Cut realisation by Rs 200 a tonne — a 4.3% price cut, which 71% utilisation makes entirely plausible. EBITDA per tonne falls to Rs 750:

EBITDA = Rs 682 crore → PBT 232 → PAT Rs 174 crore
EPS    = Rs 8.72 → at 14× → Rs 122 per share

A 4.3% move in one industry variable took 44% off the valuation. That is why the economy and industry baskets exist, and why company analysis alone is not fundamental analysis.

Chapter 4 (Fundamentals of Research, section 4.4) defines fundamental analysis, lists the seven questions it asks and sorts them into the three baskets. Chapter 15.1 then tabulates it against technical analysis on focus, data source, time horizon, tools, assumptions, objectives and who uses it — that table is heavily examined.

• Fundamental analysis is for long-term investing. Chapter 15.1's table is explicit: short and medium-term trading belongs to technical analysis. A correct valuation can be wrong for years.
• It contradicts the Efficient Market Hypothesis by construction (Chapter 4.4). If prices already reflected all relevant information there would be no divergence to exploit.
• A good company is not the same as a good investment. The test is price against intrinsic value, not the quality of the business on its own.
• The three baskets run economy, industry, company. An answer that reduces fundamental analysis to reading financial statements has dropped two-thirds of it.
• Research and analysis are different jobs (Chapter 4.2). Getting information the market does not have is the harder half, and the annual report goes stale from the day it is filed.
• Primary research is legitimate; insider information is not. Mosaic analysis — individually insignificant pieces assembled into an insight — is acceptable, and the analyst must be able to tell which side of the line an insight came from.