Question

In 300 words or more, define Fundamental Analysis and the three-step valuation process, economic forecasting, and macroeconomic analysis.

Please stick to the word limit

Answer 1

There are two methods for valuing or analyzing equities - Fundamental analysis and Technical analysis. Fundamental analysis is an approach to identify an equity's intrinsic value on the basis of qualitative and quantitative factors. Quantitative factors involve analyzing a company's historical financial statements - its revenues, EBITDA, earnings, balance sheet metrics and the cash flow generation ability. These factors are used to determine the future cash inflows for an investor, which are then discounted to present value to arrive at a business's intrinsic value. Qualitative factors involve analyzing the quality of management, presence of headwinds/tailwinds within the industry and future sector potential. It is very crucial to consider the qualitative factors while analyzing the quantitative factors, for instance - a company that generates incremental positive operating cash flow each year and operates in an industry that is currently exhibiting tailwinds may have the potential to be a market leader in future.

The three-step valuation process is also referred to as EIC framework and involves analyzing the economy, industry and the company. This is also referred to as top-down approach. Few analysts even follow bottom-up approach, wherein they start their analysis from company level and finally move to the economic level.

Economic analysis: In the economic analysis, one must analyze the overall growth of the economy and the future economic potential. Key economic indicators that should be analyzed includes, but are not limited to, GDP growth rate, inflation, Gross capital formation, Govt. debt to GDP ratio and the National income of the economy. By interpreting the historical trend, following key circulars of the central bank (monetary measures) and fiscal policy initiatives, one can estimate the overall economic direction in the coming years.

Industry analysis: Industry analysis involves understanding about other players within the industry, the industry or market structure, industry supply chain, headwinds/tailwinds in the industry and the future industry potential. To understand the peers - it is essential to compare them on the basis of margins and the ratios such as Debt to Equity ratio, Operating cash as % of sales and cash ratio. We can even look at the product portfolios of different players within different industries. Analyzing the market structure will help you determine whether the market is monopoly or monopolistic or oligopoly or any other market form. This can be determined using Concentration ratio and Herfindahl-Hirschman Index. The objective is to select an industry that will exhibit tailwinds in future and has significant potential to grow in future.

Company analysis: This is the last and the most crucial step of analysis. During this process, one must identify companies that have performed well historically and have a sustainable business model. Key focus should be identifying company that has a potential to become future market leader.