Fundamental analysis or How to Analyze the fundamentals of the company? It is a popular question asked by many investors. As an investor, we invest in company shares without knowing anything about the company. Investor needs to know the fundamentals of the company before making an investment. It involves assessing various aspects such as financial health, management team, competitive positioning, and growth prospects.
In this comprehensive guide, we will delve into the intricacies of fundamental analysis and explore the steps involved in analyzing the fundamentals of a company.
What is Fundamental Analysis?
Fundamental analysis is a method of evaluating a company’s intrinsic value. It is done by assessing a company’s true worth by analyzing its financial records, leadership, market patterns, and broader economic environment. In contrast to technical analysis, which looks at past price trends, fundamental analysis examines the key factors influencing a company’s success.
The investor needs to know all these details before investing in any company. Investment without knowledge is very risky.
How do we analyze the fundamentals of the Company?
Knowing About Company
You should know and understand the business of the company. What are the core products of the company or what type of services are provided by the company? How is the management of the company, Who are the customers of the company? What is the current demand for their products and how the demand will be in the future like in the next 3 to 5 years? If possible take the help of a professional for this.
Analyzing Financial Statements
Financial statements give a quick overview of a company’s financial well-being and success. The Balance Sheet, Income Statement, and Cash Flow Statement are the main financial statements.
The Balance Sheet gives an overview of a company’s assets, debts, and shareholders’ equity at a certain moment. It aids investors in evaluating a company’s ability to meet financial obligations.
The Income Statement, also called the Profit and Loss Statement, shows a company’s revenues, expenses, and profits during a specific time frame. It provides information on how profitable a company is and how efficiently it operates.
The Cash Flow Statement monitors the cash coming in and going out from operational, investment, and financing undertakings. It aids investors in assessing a company’s capacity to produce cash and handle its financial fluidity.
Earnings
This is the most important point one should consider before investing in any company. One should analyze at least 3 years of earnings to know if the company is posting profit or loss. Ultimately as an investor, one should know how much money the company is making and how much it is going to make in the future.
To find the earning status ratios used are
- EPS – Earning per share
- Trailing EPS
- Current EPS
- Forward EPS
Earning per share
EPS plays major role in investment decision. EPS is calculated by taking the net earnings of the company and dividing it by the outstanding shares.
EPS = Net Earnings / Outstanding Shares
(This ratio are available mostly on many websites no need to do calculation).
For example –
If Company X had earnings of RS 2000 crores and 100 shares outstanding, then its EPS
becomes 20 (RS 2000 / 100 = 20).
Higher the EPS better is the stock.
Note – If you are comparing EPS than you should compare the EPS of the company in same sector/industry. Please do not compare stock of Bajaj (Auto Industry) to Stock of Infosys (IT Industry).
Trailing EPS
Trailing EPS means last year’s EPS which is considered as actual and for ongoing current year.
Current EPS
Current EPS means which is still under projections and going to come on current financial year end.
Forward EPS
Forward EPS which is again under projections and going to come on next financial year end.
You can not make any prediction about company only by knowing EPS, we need to look at some more ratios as following.
Importance of Earnings –
Earnings are profits. Quarterly or yearly company’s increasing earnings generally makes its stock price move up and in some cases some companies pay out a regular dividend. This is Bullish sign and indicates that the company’s is healthy and growing in pace.
If company declares low earnings then stock price may correct (reduce) & will continue to correct further if the company doesn’t provide any sufficient justification for low earnings.
Every quarter, companies report its earnings. There are 4 quarters.
Quarter 1 – (April to June and earnings will be declared in July)
Quarter 2 – (July to Sept and earnings will be declared in Oct)
Quarter 3 – (Oct to Dec and earnings will be declared in Jan)
Quarter 4 – (Jan to Mar and earnings will be declared in April)
Posted earning are important in order to move stock up or down but earning are not only thing that one should consider for investment or trading. One should look for other details about company and ratio’s which are described below.
How to Pick Stocks: Fundamental Analysis vs. Technical Analysis
Current valuation –
This is another very important factor which most of the investor forgets while doing their investments.
One must know that stock available at current price are fair enough or not, some investor invest in to stock at very high price (higher valuations) and when share prices start coming down then they will be tens, so this should not happen. Please remember that every stock that moves up will come down at certain levels.
One should do analysis and invest in to stock at right price & see that he/she is not investing in over price stock.
This is what happened in year 2008. Most of the people invested at very high valuations considering that stock price will move up only and suddenly market crashed and some stock has not come to that level again till date. One of such example is Reliance Industries or Reliance Communications.
To find the current valuation of the stock the ratios used are
- PE ratio – Price to earnings ratio
- PB ratio – Price to book value ratio
PE ratio – Price to earning ratio –
The PE ratio is calculated by taking the share price and dividing it by the companies EPS.
PE = Stock Price / EPS
PE ratio is again one of the most important ratio on which most of the traders and investors keep watch.
Important – The PE ratio tells you whether the stock’s price is high or low compared to its forward earnings.
The high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.
This generally happen in bull in market where all people are keep on purchasing and due to which share price keeps on increasing. In this type of market investor/trader do not look for current valuation and once they start realizing that stock is now highly priced they start selling stock. This is very dangerous situation.
Generally the P/E ratios are compared of one company to other companies in the same sector/industry and not in other industry before selecting any particular share.
For example
A company with a share price of RS 40 and an EPS of 8 would have a PE ratio of 5 (RS 40 / 8 = 5).
Importance – The PE ratio gives you an idea of what the market is willing to pay for the companies earning.
The higher the P/E the more the market is willing to pay for the companies earning. it indicates that market has high hopes for such company’s future growth and due to which market is ready to pay high price for stock.
Low P/E ratio for high growth stock is one should look for in market which will provide high returns in future.
Price to Book Ratio – PB ratio
PB ratio = Share Price / Book Value per Share.
Basically PB ratio is utilized by smart investors to find real wealth in shares, so investing in stocks having low PB ratio is to identify potential shares for future growth.
A lower P/B ratio could mean that the stock is available at low cost. Like the PE, the lower the PB, the better the value of the stock for future growth.
Some of the investors become quite wealthy by holding stocks for the long term whose growth is based on their businesses instead of market and one day when every one notices this stock the value investor’s pockets are full of profit.
Generally, if the ratio comes below 1 then it is considered as value investing because share price is same as that of book value.
Future earnings growth –
Future earnings growth is most important which will provide details that how the company is going to do in future. How will be its returns or its profits etc?
To find the future growth of the stock the ratios used are
- PEG ratio – Projected to earnings growth ratio
- Current EPS and Forward EPS
- Price to sales ratio
Projected Earnings Growth ratio – PEG ratio
Because the market is usually more concerned about the future than the present, it is always looking for companies projected plans, financial ratios, and other future announcements.
The use of PEG ratio will help you look at future earnings growth of the company. PEG is a widely used indicator of a stock’s potential value.
Similar to the P/E ratio, a lower PEG means that the stock is more undervalued.
To calculate the PEG the P/E is divided by the projected growth in earnings.
PEG = P/E / (projected growth in earnings)
For example –
A stock with a P/E of 50 and projected earnings growth for next year is 25% then that
stock would have a PEG of 2
(50 / 25 = 2).
Lower the PEG ratio the less you pay for each unit in future earnings growth. So the conclusion is you can invest in high P/E stocks but the projected earnings growth should be high so that companies can provide good returns.
Price to Sales Ratio
P/S = Market Cap / Revenues
or
P/S = Stock Price / Sales Price per Share
Some of company which are new have no current earnings in order to do analysis of such company one must take precaution.
The Price to Sales (P/S) ratio looks at the current stock price relative to the total sales per share.
Debit status –
It is very important for investor to know how much money has been borrowed by the company from the market which is known as the debit status of the company. It is better to invest in a company that is debt-free or has taken fewer loans/borrowing from the market because the company needs to pay back this loan so its profit will be going in paying this loan.
This loan may be for expansion plan for new business or for other financial needs. The company that has few debit has more cash in hand and can survive and do business well.
Debt Ratio
Debt Ratio = Total Liabilities / Total Assets
The debt ratio compares a company’s total debt to its total assets, which is used to gain a general idea as to the amount of leverage being used by a company.
This ratio should be low as low is ratio company is less loaded by debt. In general, the higher the ratio, the more risk that company is considered to have taken on.
Dividend Yield
Many investors invest in stock by considering the dividend payout by the company. The dividend yield will tell you how the company has paid to shareholders in terms of dividends.
One can refer to dividend history to know more about the dividend payout given by the company.
Dividend Yield = Annual dividend per share / Stock’s price per share
If a company’s annual dividend is RS 15 and the stock trades at RS 1225, the Dividend
Yield is 1.2%. (RS 15 / RS 1225 = 0.012).
Management’s Role in Company Success
Skilled management teams excel at making strategic decisions, efficiently allocating resources, and effectively overcoming challenges. Investors need to evaluate the past performance, knowledge, and alignment with shareholders’ interests of the management team.
Efficiency ratios like Return on Assets (ROA) and Return on Equity (ROE) assess how well a company can make profits compared to its assets and shareholders’ equity.
Things to Remember before investing in any Stock:-
- Understand the Business of the company.
- The higher is the EPS, the better is the Stock.
- The higher the P/E the more the market is willing to pay for the company’s earnings.
- The lower the PB, the better the value of the stock for future growth.
- The PEG of the company should be High.
- The debt ratio of the company should be low.
FAQs
Why is fundamental analysis important for investors?
- Fundamental analysis helps investors assess a company’s intrinsic value and growth potential, enabling them to make informed investment decisions.
What are some common financial ratios used in fundamental analysis?
- Common financial ratios include the Price-to-Earnings (P/E) ratio, Debt-to-Equity ratio, and Return on Equity (ROE), among others.
How can investors mitigate investment risks?
- Investors can mitigate risks through diversification, asset allocation, and staying informed about market developments.
What role does qualitative analysis play in fundamental analysis?
- Qualitative analysis considers factors such as brand reputation, industry leadership, and corporate governance, providing a holistic view of a company’s prospects.
What are the drawbacks of fundamental analysis?
- Drawbacks include the complexity of analysis, reliance on historical data, and the potential for overlooking market sentiments and macroeconomic factors.
Conclusion
In conclusion, analyzing the fundamentals of a company is essential for making informed investment decisions. By understanding a company’s financial health, growth potential, and competitive position, investors can identify high-quality investment opportunities and mitigate risks. Through a thorough evaluation of financial statements, key metrics, industry trends, and qualitative factors, investors can build a robust investment strategy that aligns with their financial goals.
