Stocks 101

Understanding the Fundamental Analysis – 1

You have learned everything about the stock market from understanding the importance of investing to understanding the ecosystem of the stock market. Now it is time to understand the most important aspect of the stock market i.e., knowing how to pick the best stocks for investing. And the fundamental analysis helps you with that. Any study about the stock market is incomplete without learning the fundamental analysis.

Some people toss a coin and if it’s heads they buy the stock else they sell the stock. They take the stock market as a game of gamble. That is the biggest mistake they make while investing in stocks. For stock selection, you need to do a proper fundamental analysis of stocks.

What is Fundamental Analysis?

Fundamental Analysis (FA) is a thorough process of assessing the value of a business. When an investor wishes to invest in a business for the long term (say 5 to 10 years) it becomes extremely essential to understand the business from various perspectives. Over the long term, the stock prices of a fundamentally strong company tend to appreciate, thereby creating wealth for its investors.

In simple terms, fundamental analysis helps you to shortlist the best stocks out of over 6000 stocks in the country.

We have many examples in the Indian market such as Infosys Limited, TCS Limited, Page Industries, Eicher Motors, Bosch India, Nestle India, TTK Prestige, etc. Each of these companies has delivered on an average over 20% compounded annual growth return (CAGR) year on year for over 10 years. Some companies such as Bosch India Limited have delivered close to 30% CAGR.

Read: 10 Ways To Save Money While Traveling in 2020

A simple fundamental analysis would have helped you pick these kinds of stocks. Therefore, you can imagine the magnitude and the speed at which wealth is created if one would invest in fundamentally strong companies.

Look at the following charts:

Bosch share price has increased from Rs.370 in 2003 to Rs.13450 in 2020
Eicher Motor share price has increased from Rs.8 in 2003 to Rs.2145 in 2020

These companies have delivered close to 30% CAGR. But how do you conduct fundamental analysis? Well, there are tons of parameters that can help you with fundamental analysis.

Can’t wait? Let us continue.

Important parameters of Fundamental Analysis:

There are so many fundamental analysis parameters that can be used to ascertain the financial health of a company. Understanding these key indicators can help you make more informed buy or sell decisions.

In this post and in the following post we shall have a look at every indicator that helps in giving you an idea of the value of a company.

Let us get started right away.

1. Earning Per Share (EPS)

Earnings per share can be defined as the profits generated on a per-share basis. In a nutshell, it is nothing but the company’s profit distributed among the shareholders.

EPS is calculated as follows:

EPS = Net profit of a company / No.of outstanding shares

Here the number of outstanding shares refers to all the shares of a company that have been authorized, issued, and purchased by investors and are held by them.

For instance, a company, XYZ, is left with a net profit of Rs.10 lakh. The number of outstanding shares of the company is 1 Lakh. Therefore, the EPS of XYZ Company as per earnings per share formula would be:

=> Rs.10,00,000 / 1,00,000 shares = Rs.10 per share

It does not mean that you receive this amount. It is just a parameter that helps in analyzing the financial health of a company. Stocks with EPS growth rates of at least 25% compared with year-ago levels suggest a company has products or services in strong demand. Clearly, the higher the EPS, the better it is for its shareholders.

2. Price to Earnings ratio (P/E)

P/E Ratio or Price to Earnings Ratio is the ratio of the current price of a company’s share in relation to its earnings per share (EPS). The Price to Earnings ratio is perhaps the most popular financial parameter in fundamental analysis. This is a measure of valuation.

P/E is calculated as follows:

P/E = Current Market Price / Earnings Per Share(EPS)

The P/E ratio is a measure of valuation. That means it measures the willingness of the investor to pay for the stock, for every rupee of profit that the company generates. For example, if the P/E of a certain firm is 15, then it simply means that for every rupee of profit the company earns, the investor is willing to pay 15 rupees. Higher the P/E, the more expensive is the stock.

Let us calculate the P/E for XYZ. Let us assume that:

  • Net Profit of the company = Rs.1 Crore
  • Total Number of Shares = 10 Lakh
  • Current Market Price of the company = Rs.250

As we know that EPS => Net profit / Total Number of shares

=> Rs.1,00,00,000 / Rs.10,00,000= Rs.10

Hence P/E => Market price / EPS = 250/10

= 25

This means the investors are contributing Rs.30.76 for every rupee of profit generated by XYL. Never buy stocks that are trading at high valuations i.e., do not buy stocks that are trading beyond 25 or at the most 30, irrespective of the company and the sector it belongs to.

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3. Price to Book Value ratio (P/BV or P/B)

Before understanding the Price to Book Value ratio, we shall understand what the term ‘Book Value’ means.

The “Book Value” of a firm is simply the amount of money left on the table after the company pays off its obligations. Let’s say that the value of a company is Rs.1000. It decides to shut down the company and receives Rs.1000. Out of this, it has to pay Rs.400 as loan repayment. Also, the company has some assets that fetch it Rs.200. Therefore, the total book value of the company = 1000 – 400 + 200 = Rs.800

Next, let’s say that the total number of shares in the company is 100. Therefore, the book value of the company per share = 800/100 = Rs.8. that means Rs.80 per share is what the shareholder can get in case the company decides to liquidate. Hence, the ‘Book Value per share’ can be calculated as follows:

Book value = (Total assets − Total liabilities) / Total number of outstanding shares

Now, if we divide the current market price of the stock by the book value per share, we will get the price to the book value ratio (P/BV) of the firm. It is calculated as follows:

P/BV = Market price of a share/Book value per share

Let’s say that the market price of the above-mentioned company is Rs.80. Therefore, P/B ratio = 80/8 = 10

If a company has a low P/B ratio, then it is said to be undervalued and a high P/B ratio is overvalued. It is always advisable to invest in undervalued stocks. However, you should not make a decision about the strength of a company by looking at its P/B ratio alone.

4. Debt to Equity ratio (D/E)

As the name suggests, this ratio gives you an overview of the debts and equity of the company. It is calculated by dividing the company’s total debt (liabilities) by its total shareholder equity (also known as net worth). The D/E ratio can help you determine if the company has a lot of debt or not.

The formula to calculate the Debt to Equity ratio is: Total Debt/Total Equity

There is no ideal D/E ratio as it can vary with industries and sectors.

Usually, if a company has a lot of debt, then it is assumed that the company will find it difficult to pay it back. So prefer stocks with relatively lower D/E ratio.

5. Return on Equity Ratio (RoE)

The RoE Ratio is a measure of the rate of return on the share of a company. In other words, it tells investors how good the company is in generating returns on stock investments. It is expressed in terms of percentage.

Mathematically, Return on equity = Net Income of the company / Shareholder’s equity (Net worth of the company)

Let’s say that you are the investor of a company and have contributed Rs.100 in equity and the total equity of the company is Rs.100.

Using this equity if the company generates an income of Rs.20, then the RoE is 20%. Imagine another company with the same total equity but generating an income of Rs.40 – its RoE ratio will be 40%. The company that generates better RoE is considered better.

Hence, this is an important ratio because it shows the company’s ability to turn equity investments into profits. 

6. Dividend yield

If you have read our article on Common Share Market Terms That You Should Know, you would what dividend means.

The Dividend Yield measures the annual value of dividends received relative to the market value per share of security. In other words, the dividend yield formula tells what percentage of a company’s share price is paid to shareholders in the form of dividends. It is expressed in terms of percentage.

The dividend yield formula is: Dividend per share / Market value per share

For example, Company XYZ’s share price of Rs.100. Over the course of one year, the company paid consistent dividends of Rs.5 per share for 3 quarters. The dividend yield ratio for Company XYZ is calculated as follows:

Dividend Yield Ratio =  Rs.5 + Rs.5 + Rs.5 / Rs.100 = 0.02666 = 15%

Therefore, an investor would earn 15% on shares of Company XYZ in the form of dividends.

That is all for this post. We shall continue learning more about the fundamental analysis in the next post.

Read the next post here. If you are a new reader, begin your journey here.

Disclaimer: The views expressed here are for educational purposes only. We don’t recommend to pick stocks based on the views presented here.

Thank you for reading. Stay safe.

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