Having a basic knowledge of fundamental analysis will give
you a better foundation for your investment decisions. Learn five core elements
in Fundamental Analysis and understand why you should use it when investing.
You will learn how to find relevant information in earning reports from the
listed companies.
This article provides a guideline on where to start when
doing fundamental analysis. It covers the following aspects and elaborates on
the principles:
·
What is fundamental analysis?
·
Why use fundamental analysis?
·
The true value of a stock?
·
Five key factors to look for
·
Buying at the right price
Fundamental analysis is critical component in stock
analysis. It is quite accessible, extremely valuable and you actually don't
need a finance degree to get a basic understanding of it. The problem of
fundamental analysis is however that it can very easily get quite complicated,
but it doesn't have to be.
What
is a Fundamental Analysis?
A fundamental analysis is all about getting an understanding
of a company, the health of its business and its future prospects. It includes
reading and analyzing annual reports and financial statements to get an
understanding of the company's comparative advantages, competitors and its
market environment.
Why use fundamental analysis?
Fundamental analysis is built on the idea that the stock market may price a
company wrong from time to time. Profits can be made by finding underpriced
stocks and waiting for the market to adjust the valuation of the company. By
analyzing the financial reports from companies you will get an understanding of
the value of different companies and understand the pricing in the stock
market.
After analyzing these factors you have a better
understanding of whether the price of the stock is undervalued or overvalued at
the current market price. Fundamental analysis can also be performed on a
sectors basis and in the economy as a whole.
The
true value of a stock?
For a fundamental analyst, the market price of a stock tends
to move towards its 'intrinsic value', which is the 'true value' of a company
as calculated by its fundamentals. If the market value does not match the true
value of the company, there is an investment opportunity.
Example of this is that if the current market price of a
stock is lower than the intrinsic price, the investor should purchase the stock
because he expects the stock price to rise and move towards its true value.
Alternatively, if the current market price is above the intrinsic price, the
stock is considered overbought and the investor sells the stock because he
knows that the stock price will fall and move closer to its intrinsic value. To
determine the true price of the company's stock, the following factors need to
be considered.
Five key factors to look for
1. Earnings
The key element all investors look after is earnings.
Before investing in a company you want to know how much the company is making
in profits. Future earnings are a key factor as the future prospects of the
company's business and potential growth opportunities are determinants of the
stock price.
Factors determining earnings of the company are such as
sales, costs, assets and liabilities. A simplified view of the earnings
is earnings per share (EPS). This is a figure of the earnings which
denotes the amount of earnings for each outstanding share.
2. Profit Margins
Amount of earnings do not tell the full story, increasing earnings
are good but if the cost increases more than revenues then the profit margin is
not improving. The profit margin measures how much the company keeps
in earnings out of every dollar of their revenues. This measure is therefore
very useful for comparing similar companies, within the same industry.
Net Profit Margin = Net Profit
Revenue
Higher profit margin indicates that the company has better
control over its costs than its competitors. Profit margin is displayed in
percentages and a 10 percent profit margin denotes that the company has a net
income of 10 cents for each dollar of their revenues.
To get better understanding of profit margins it is good to compare two companies
with alternative margins, see table below.
|
Company
|
@Price (Rs.)
|
Revenue
|
Cost
|
Net Profit
|
Net profit Margin
|
|
A
|
100
@ 5
|
500
|
50
|
50
|
10%
|
|
B
|
100
@ 5
|
500
|
100
|
100
|
20%
|
3. Return on Equity
(ROE)
Return of equity (ROE) is a financial ratio that
does not account for the stock price. Since it ignores the price
entirely it is by many thought of as THE most important financial measure.
It can basically be thought of as the parent ratio that always needs to be
considered.
This ratio is a measure of how efficient a company is in
generating its profits. It is a ratio of revenue and profits to owners' equity
(shareholders are the owners). Specifically it is:
Return
on Equity = Net Income
Shareholder's Equity
An easy example of this is that if company A and company B
both generate net profits of Rs.10L but company A has equity of Rs.1cr but
company B has equity of Rs.10cr. Their ROE would be 10% and 1% respectively
meaning that company A is more efficient as it was able to produce the same
amount of earnings with 10 times less equity.
|
Company
|
Net Profit (Rs.)
|
Equity (Rs.)
|
ROE
|
|
A
|
10L
|
1cr
|
10%
|
|
B
|
10L
|
10cr
|
1%
|
The reason for why this measure is so important is because
it contains information about several factors, such as:
Leverage (which is the debt of the company)
Revenue, profits and margins
Returning values to shareholders
Good approximation is that ROE should be 10-40% greater than
its peer.
4. Price-to-Earnings
(P/E)
When taking the current market price into consideration, the
most popular ratio is the Price-to-Earnings (P/E) ratio. As the name suggest it
is the current market price divided by its earnings per share (EPS). It is an
easy way to get a quick look of a stock's value.
A high P/E indicates that the stock is priced relatively
high to its earnings, and companies with higher P/E therefore seem more
expensive. However, this measure, as well as other financial ratios, needs to
be compared to similar companies within the same sector or to its own
historical P/E. This is due to different characteristics in different sectors
and changing markets conditions.
This ratio does not tell the full story since it does not
account for growth. Normally, companies with high earnings growth are traded at
higher P/E values than companies with more moderate growth rate. Accordingly,
if the company is growing rapidly and is expected to maintain its growth in the
future this current market price might not seem so expensive. This is
the reasoning for the existence of different investment styles; Value vs.
Growth Stocks.
Example:
While some sectors normally have low P/E measures, other sectors commonly have
higher ratios. For example, utilities commonly have P/E ranging from 5 to
10 while technology companies commonly have a P/E ratio ranging from 15 to 20
or above. This is due to expectations in the market about the sector and
its earnings-growth possibilities. The utility sector has stable earnings and
is not expected to grow rapidly while technology companies are expected to grow
faster and tend to need less capital for its growth.
In order to simplify, the following table illustrates
four companies in two sectors with alternative figures.
|
Company
|
Sector
|
Current stock Price (rs)
|
EPS
|
P/E
|
Growth Rate
|
|
A
|
Technology
|
420
|
27
|
16
|
66%
|
|
B
|
Technology
|
580
|
26
|
22
|
25%
|
|
C
|
Utilities
|
16
|
3,5
|
5
|
13%
|
|
D
|
Utilities
|
20
|
2,5
|
8
|
6%
|
It is not very appropriate to compare A with D as A has a growth
rate of 11 times more than D. It is
more appropriate to compare A with B. In that relation, A seems cheaper than B by the look of the P/E. Now you
should ask why that could be? -is this bargain or are some other reason why A
is priced lower than B. One
suggestion might be that the market expects B to have more earnings-growth in the coming future and A's previous earnings growth is not
expected to grow much further.
In order to account for growth, the P/E ratio can be
modified into the Price/Earnings to
Growth (PEG) ratio. A PEG ratio
is calculated by dividing the stock's P/E ratio by its expected 12 month growth
rate. A common rule of thumb is that the growth rate ought to be roughly equal
to the P/E ratio and thus the PEG ratio should be around 1. A relatively low
PEG ratio indicates an undervalued stock and a PEG ratio much greater than 1
indicates an overvalued stock.
The PEG ratio can be very informative figure, especially for
fast growing and cyclical companies. In this one ratio you get an understanding
of the company's earnings, growth expectations and whether it is trading at a
reasonable price relative to its fundamentals.
5. Price-to-Book
(P/B)
A price-to-book (P/B) ratio is used to compare a stock's
market value to its book value. It can be calculated as the current share price
divided to the book value per share, according to previous financial statement.
In a broader sense, it can also be calculated as the total market
capitalization of the company divided by all the shareholders equity.
This ratio gives certain idea of whether you are paying too
high price for the stock as it denotes what would be the residual value if the
company went bankrupt today.
A higher P/B ratio than 1 denotes that the share price is
higher than what the company's assed would be sold for. The difference
indicates what investors think about the future growth potential of the
company.
Buying at the right price?
In the long run the stock price should reflect its
fundamental true value. However in the short run a stock might have great
fundamentals but still be moving in wrong direction. This can be due to other
factors, such as news releases and changes in future outlook, which also have
effect on the price. Trends in the market and investors emotions also effect
the short-term fluctuation in stock prices resulting in the current market
price deviating from its true value.
One question that is important to consider is: "What
is the difference between a great business and a great investment?"
-the answer is "price". If you pay too high price for even the best
stock in the world, you will never make a good return on your investment.
Therefore, a great investment does not likely have a high price. The point of
this question is that the price you pay for a stock does matter enormously; it
is the most important factor in your return. Accordingly, doing your
fundamental analysis (thoroughly) is of a great importance when making your
investments.
