Fundamental and technical analysis are two ways of evaluating a stock for its potential to give returns in the future.
While technical analysis focuses on predicting a stock’s performance based on the trend in stock price, fundamental analysis focuses on intrinsic factors such as the company’s financial potential, growth prospects, competitive advantage over peers, management quality, etc.
One aspect of company analysis in fundamental analysis is to gather insights about the industry in general and the business in particular. This is known as Business and Industry analysis. In this article, I will explain, what is a company analysis, how to conduct BIA and fine-tune your stock selection strategy. Read On!
You can use two main approaches to conduct a BIA- The Top-Down or Bottom-Up approach. Let me quickly take you through them both. You can choose either one as your guiding light.
In a top-down approach, investors usually start by analyzing the economy, move to analyse the industry and then, finally, the company.
This allows them to narrow down the list of stocks by looking at the state of the economy and figuring out sectors that were expected to perform well. Subsequently, a company-level analysis would help the investor create a shortlist of stocks for investment.
As the name suggests, in the bottom-up approach, the investor tries to identify companies expected to grow without restricting the search to any specific sector or industry.
This involves finding companies with superior business strengths regardless of the state of the industry or the economy. Investors who follow this approach believe that companies with a distinct business advantage are good companies to invest in for the long term.
Companies | Type | Bidding Dates | |
Regular | Closes Today | ||
SME | Closes 26 Nov | ||
SME | Closes 26 Nov | ||
Regular | Closes 26 Nov | ||
SME | Opens 25 Nov |
If a company has a consistent history of year-on-year sales growth, it indicates that the company has a distinct business advantage. Typically, a company with a YoY growth of 10-20 per cent over the last 5/10 years indicates a company doing something right.
Let’s look at an example of two companies from the banking sector – IDBI Bank and HDFC Bank. Here is a table of the net sales turnover of both these banks over the last 5 years (in Rs. Crores):
Please Note: The companies mentioned below are not stock recommendations. They should only be used to understand the concept of the article. Please carry out independent research before investing.
Company | 2016 | 2017 | 2018 | 2019 | 2020 | CAGR |
HDFC Bank Ltd. | 60221 | 69306 | 80241 | 98972 | 114812 | 9.09% |
IDBI Bank Ltd. | 28043 | 27791 | 23027 | 22071 | 20825 | -5.78% |
As you can see above, there is a significant difference in the CAGR of the sales of HDFC and IDBI banks. If you look at the stock prices, HDFC Bank has generated more wealth for investors as compared to IDBI Bank.
If you had invested Rs.1 lakh in HDFC and IDBI in March 2016, then by March 2020, the invested amount would have grown to Rs.234233 in HDFC, whereas it would have reduced to Rs.46490 in IDBI Bank.
However, it is important to remember that an increase in a company's total sales cannot be the sole factor in determining the strength of its stock. While this can indicate a company with a distinct business advantage, you need to consider other aspects too.
While analyzing a stock, it is important to look at its immediate peers to assess its performance. While HDFC had a CAGR of around 9% in total income in the five years, how did its competitive banks perform?
This is where your industry knowledge comes in handy. Which banks can be considered direct competitors of HDFC? My guess would be ICICI Bank, State bank of India, Kotak Mahindra Bank, and Axis Bank. Let’s take a quick look at the comparative performance of net sales turnover (Rs. Crores) of all these banks:
Company | 2016 | 2017 | 2018 | 2019 | 2020 | CAGR |
HDFC Bank Ltd. | 60221 | 69306 | 80241 | 98972 | 114812 | 9.09% |
ICICI Bank Ltd. | 52739 | 54156 | 54966 | 63401 | 74798 | 7.24% |
Kotak Mahindra Bank Ltd. | 16384 | 17699 | 19748 | 23943 | 26930 | 10.45% |
Axis Bank Ltd. | 40988 | 44542 | 45780 | 54986 | 62635 | 8.85% |
State Bank of India | 163998 | 175518 | 220499 | 242867 | 257324 | 9.43% |
This table gives me a better picture of HDFC’s performance. While it has fared well when compared to IDBI, if we extend the comparison with other peers as well, then the growth in net sales turnover of HDFC is in sync with the industry’s average, and not other players have outperformed it.
When you are analyzing a company’s fundamentals and find that it has a good growth rate in sales compared to its peers, the next step is to ascertain if the company is converting these sales into profits effectively.
If the company has a distinct business advantage, then it will be able to generate increased profits as its sales increase. On the other hand, if the increase in profits is not proportional to the increase in sales, then the growth in sales is probably accompanied by an increase in expenses, too, bringing profits down.
Let’s look at how HDFC Bank fares on this parameter:
HDFC Bank | 2016 | 2017 | 2018 | 2019 | 2020 | CAGR |
Sales | 60221 | 69306 | 80241 | 98972 | 114812 | 9.09% |
Profit Before Tax (PAT) | 12296 | 14550 | 17487 | 21078 | 26257 | 16.38% |
Profit margin (PAT*100/Sales) | 20.42% | 20.99% | 21.79% | 21.30% | 22.87% |
*Amounts in rupees crore
Let’s also take a look at Axis Bank’s performance:
Axis Bank | 2016 | 2017 | 2018 | 2019 | 2020 | CAGR |
Sales | 40988 | 44542 | 45780 | 54986 | 62635 | 8.85% |
Profit Before Tax (PAT) | 8224 | 3679 | 276 | 4677 | 1627 | -27.68% |
Profit margin (PAT*100/Sales) | 20.06% | 8.26% | 0.60% | 8.51% | 2.60% |
*Amounts in rupees crore
As you can see, although Axis Bank had a sales CAGR of 8.85% over the last five years, it couldn’t convert it into sales and has a negative CAGR of PAT.
Look at it this way, HDFC and Axis Bank have similar CAGR of sales but a huge difference in PAT.
When a company generates profits, it can retain a certain part of it for reinvesting in the business for growth and/or expansion. Companies that have a distinct business advantage ensure that they generate better value for their shareholders.
If we follow Warren Buffett’s advice, a fundamentally strong company generates at least $1 of market value for every $1 that it retains.
The figures of HDFC Bank are as follows:
Therefore,
The value created per rupee = Increase in market capitalization / Profits retained
= 43.61/8.456 = 5.16
This means HDFC Bank has generated a value of Rs.5.16 for every rupee it retains for reinvestment in the business. Hence, it created value for shareholders due to a distinct business advantage.
As you can see, an individual investor can do a business and industry analysis of a company before investing to ensure that he picks fundamentally strong stocks with a distinct business advantage.
To summarize, investors must look at companies with good growth rates in sales, comparison with their peers, and profit and value-creating ability. Remember, while looking out for answers for how to do industry analysis, it is important to remember that glancing at individual factors alone can be misleading.
If a company fulfils the criteria mentioned above, it indicates a fundamentally strong company that can be considered for investment.