If you are looking to invest in the stock market, you surely have tried your hand at determining stock prices and trends. Various factors, both microeconomic and macroeconomic, can affect the value of a security. However, the fundamental analysis uses some quantitative and qualitative metrics to do this with some accuracy.
Let us understand what these metrics, called stock fundamentals, are and how to analyse them.
What are stock fundamentals?
Stock fundamentals are the key metrics that are used to analyze the performance of a company. These include cash flow, balance of debt and equity, return on assets (ROA), accounting ratios, and other quantitative data. Not just this, but qualitative measures– such as the business environment and the company model– are also considered. The way capital is managed is taken into account. Overall efficient management is a prerequisite to the maximization of shareholders’ wealth.
What is fundamental analysis?
Fundamental analysis is the procedure of analyzing the key fundamentals with an aim of proper stock valuation. It is carried out by certified analysts who have the required expertise and knowledge.
Technical analysis is done when investing for the long term. In contrast, the fundamental analysis provides insights when you wish to profit from your investments in the long or medium term. The process starts by analyzing the financial statements of the company. The factors in the economic and financial environment are taken note of, instead of historical trends as used in the technical analysis.
In fundamental analysis, the intrinsic value– which is the value independent of the market price– of security is found. It is then measured in relation to the current stock price of the security. The primary reason behind this is to find the actual value of a stock. Going against the efficient market hypothesis, many analysts believe that the market price of a security is not always accurate. This increases the need to carefully analyze stock fundamentals even more.
Apart from this, there are many other reasons to carry out this analysis. Let us dig into those.
Why is it important to analyze stock fundamentals?
It is important to analyze stock fundamentals as investment decisions are taken on the basis of the value and the potential of stocks. As mentioned above, under this analysis, it is assumed that the markets do not give accurate information regarding the same. By closely looking at any data which is expected to affect the price of a stock, the correct decisions can be made.
Furthermore, fundamental analysis helps you determine whether a security is undervalued or overvalued. This is done by studying the balance sheet of a company and determining its financial stability.
There are various techniques that can be used to undertake the fundamental analysis. Let us understand some of them.
How to analyze stock fundamentals?
First and foremost, you need to understand the company you want to invest in. Look into its performance, decisions, and growth potential. Next, you must study the financial reports of the company. Analyze the balance sheet and the profit and loss statement. Check the operating costs, expenses, revenue, and cash flows. Find out the net profits in the last five years as well as the total sales of the company.
The next step is to check the liabilities of the company. Analyze the debt-to-equity ratio. It is a safe bet if it is less than one. You must also look into the future prospects of the company. Find out if their business idea (the product or service) will stay relevant in the long run. If not, what changes will be required to stay up to date? As a quantitative measure, you can also study the compounded annual growth rate (CAGR) of the company.
You must also check out the competitors of the firm. You never know, you may come across another company with better upcoming projects and future prospects. Always invest in the best. Lastly, remember to review these various aspects from time to time. Markets are subject to fluctuations. The impact of a single decision can be manifold.
Moving on to the quantitative analysis, you can measure your stock fundamentals using the following metrics:
EPS is an absolute measure that shows how much a company has earned per unit of stock. It can be calculated as follows:
EPS = (Net income – Preferred dividend) / Number of outstanding shares
The resultant value indicates the earnings that each shareholder shall receive over a specific time period. The higher the EPS, the better. It is a great tool to compare the performance of two companies and the return you would get on investing.
Let us take an example.
Company A has a net income of Rs. 50 lakhs. It has raised capital via 10 lakh shares, which are all equity. It has not issued any preference shares. Company B also has a net income of Rs. 50 lakh. Its capital is raised via 10 lakh shares, of which 8 lakh are equity shares and 2 lakh are preference shares. The company is liable to pay Rs. 5 lakh as a preference dividend. Let us calculate the EPS for the two companies.
EPS = (50,00,000 – 0) / 10,00,000 = Rs. 5 per share
EPS = (50,00,000 – 5,00,000) / 8,00,000 = Rs. 5.625 per share
Careful employment of both equity and preference shares has allowed company B to give a higher return to its equity shareholders.
The price-to-earnings ratio is used to measure the market value of the share against the earnings per share. It can be calculated as:
P/E Ratio = Market price of the share / Earnings per share
Let us see how to calculate this with an example.
The market price of X Ltd’s share is Rs. 100. The earnings on each share is Rs. 5. It’s P/E ratio is calculated as:
P/E ratio = 100/5 = 20
This indicates that X Ltd’s share is trading at 20 times its earnings.
A high P/E ratio may indicate two things. The first is that the share may be overvalued in the market. This means that the price at which the share is being traded is way more than what the earnings are on it. On the other hand, a high ratio because of the high price can indicate growth. Investors who see growth prospects for the company may be willingly pay more for its stock, hiking the ratio. A low P/E ratio shows undervaluation. It is good to invest in such stocks because you will get higher returns on your investment whenever the market realizes the true worth of such companies.
The price-to-book value ratio measures the market value of the stock against its book value. You can calculate the ratio as follows:
P/B Ratio = Market price per share / Book value per share
Here, the book value is calculated as:
Book value per share = (Current assets – Current liabilities) / Number of outstanding shares
Let us see how it is calculated:
X Ltd. has current assets worth Rs. 12,50,000 and current liabilities worth Rs. 10,00,000. The number of outstanding shares are 8,000. Its share is currently trading at Rs. 30 per share. The P/B Ratio will be calculated as:
Book value per share = (12,50,000 – 10,00,000) / 8,000 = 31.25
P/B Ratio = 30 / 31.25 = 0.96
A high P/B ratio means that the stocks are overvalued. Conversely, a lower P/B ratio may indicate undervaluation. As an investor, look for stocks whose P/B ratio is less than one.
In general, a high P/B ratio should be in conjunction with a high ROE. Let us see how that is employed to analyze stock fundamentals.
Return on Equity (ROE)
Return on equity is the metric used to measure how well a company is making profits. It can be calculated as:
ROE = Net income / Shareholder’s fund or equity
The resultant value is further converted into percentage terms to facilitate better comparison.
Let us see how to calculate this with an example.
Assume that the net income of a company is Rs. 1,50,000. The shareholder’s fund stands at Rs. 10,00,000. ROE will be calculated as:
ROE = 1,50,000 / 10,00,000 = 0.15 = 15%
A good ROE figure differs from one industry to another. What may be a good ratio for say the automobile industry may be different for the IT industry.
Employing this, you can also roughly estimate the growth potential of a company and the chances of earning dividends. However, this ratio is just a part of the estimation. You may require more information regarding the retained earnings, growth rate, and expansion opportunities available for the company.
The debt-to-equity ratio of a firm is also known as financial leverage. It is used to calculate how much a company is operating on debt compared to its own capital. It also indicates how much of the total debt of the company is covered by the shareholder’s fund. It can be calculated as follows:
D/E ratio = Total liabilities or debt / Shareholder’s fund
Let us understand this with an example.
The balance sheet of A Ltd. declares its total liabilities as Rs. 2,00,000 and its shareholder’s equity as Rs. 12,00,000. The D/E ratio would be:
D/E ratio = 2,00,000 / 12,00,000 = 0.1666 = 16.67%
A high D/E ratio means higher risk as the level of borrowings is higher. However, it is not always bad. If the earnings exceed the interest to be paid on the debt, shareholders benefit. This is because the interest is deductible before paying tax, reducing the tax liability, and increasing shareholders’ earnings. But a very high ratio is taken as a bad sign.
Current ratio measures the short-term liquidity of a company. It compares its current assets to its current liabilities. Current assets are those assets that can or are expected to turn into cash within a year. Similarly, current liabilities are those which are due within a year. It is calculated as:
Current ratio = Current assets / Current liabilities
Taking an example, the current ratio can be calculated as follows:
Assume that a company’s current assets are worth Rs. 50,000, whereas its current liabilities are worth Rs. 25,000. Then,
Current ratio = 50,000 / 25,000 = 2:1
Even though the ratio varies from sector to sector, the ideal current ratio is 2:1. It indicates how well-equipped a company is to meet the short-term obligations that may come up.
These are the various metrics that you can use to measure your stock fundamentals.
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Promoter’s holding refers to the number of shares held by the promoters of a company. Investors take note of this metric to gauge the future path of the company. A higher share of promoter’s holding in the total equity of a company indicates that the promoters are confident about their company’s growth. Similarly, an increase in the promoter’s holding may imply a favorable change in the company’s operations from which the shareholders stand to gain.
On the other hand, a decline in promoters holding may be a sign of worry. The promoters may reduce their shares to mitigate a loss that may arise, looking at the path the company is on. However, there are other reasons for this too. They may want to free up capital to expand operations. Thus, any decrease in the promoter’s holding that is backed by a valid explanation is not a bad sign. However, as an investor, you must be cautious if an unexplained decline takes place.
This is a useful method employed by investors to compare stocks within a specified industry. The focus is narrowed down to one sector or industry and the stocks that fall within that segment are analysed. For this, standard metrics are decided and stocks are compared based on those measures.
This makes the comparative analysis more accurate as the market conditions that affect the share prices remain largely the same within a sector. Investors may put their money in stocks that are performing better than their peers. This technique is also useful in establishing whether a stock is undervalued or overvalued. Uncovering undervalued stocks is a part of value investing that can help you earn high returns in the long term.
The results of the fundamental analysis will be different for separate industries. What may be a clear indicator of growth in the automobile industry may be irrelevant in pharmaceuticals. However, things such as good ethics, strong financial stability, and an inclination towards growth remain constant. While fundamentals may just be a part of the total variables that affect the stock price, they surely hold an important value.
That being said, calculating the metrics and understanding their implications is not a straightforward task. Experts at TejiMandi help you with the fundamental analysis and provide you with the latest market updates, making investing easy.