Page 132 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 4: Fundamental Analysis

4.2.5 Conditions and Profitability Notes

The worth of a share depends on its return, which in turn depends on the profitability of the
company. It is interesting that growth is an essential variable but its mere presence does not
guarantee profitability. Profitability depends upon the state of competition prevalent in the
industry. Cost control measures adopted by its units and the growth in demand for its products.
While conducting an analysis from the point of view of profitability, some relevant aspects to be
investigated are:
1. How is the cost allocation done among various heads like raw materials, wages and
overheads? Knowledge about the distribution of costs under various heads is very essential
as this gives an idea to investors about the controllability of costs. Some industries have
much higher overhead costs than others. Labour cost is another area that requires close
scrutiny. This is because finally whether labour is cheap or expensive depends on the
wage level and labour productivity. Labour that apparently look cheaper may turn out to
be when its productivity is taken into account.
2. Price of the product of the industry
3. Capacity of production-installed, used, unused etc.
4. Level of capital expenditure required to maintain or increase the productive efficiency of
the industry.
Profitability is another area that calls for a thorough analysis on the part of investors.
No industry can survive in the long run if it is not making profits. This requires thorough
investigation into various aspects of profitability. However, such an analysis can begin by
having a bird's eye view of the situation. In this context, ratio analysis has been found quite
useful. Some of the important often used are:
1. Gross Profit Margin ratio
2. Operating Profit Margin ratio

3. Rate of Return on Equity
4. Rate of Return on Total Capital
Ratios are not an end in themselves. But they do indicate possible areas for further investigation.

Technology and Research

Due to increasing competition in general, technology and research play a crucial part in the
growth and survival of a particular industry. However, technology itself is subject to change;
sometimes, very fast, and can lead obsolescence. Thus only those industries, which update
themselves in the field of technology, can attain competitive advantage over others in terms of
the quality, pricing of products etc.

The relevant questions to be probed further by the analyst in this respect could include the
following:
1. What is the nature and type of technology used in the industry?

2. Are there any expected changes in the technology in terms of offering new products in the
market to increase in sales?
3. What has been the relationship of capital expenditure and the sales over time?

4. Whether more capital expenditure has led to increase in sales or not.

LOVELY PROFESSIONAL UNIVERSITY 127