Fundamental Analysis of Stocks

Fundamental Analysis – A Powerful Tool for Making Profit

You cannot invest in stock market blindly. Before investing your hard earned money to the stock market you should study the fundamental strength of those companies.

What is fundamental analysis?

Fundamental Analysis is a method, with this method you can evaluate the value of the underlying company. Basically, we do a fundamental analysis to understand the economic conditions and the industry along with the company’s financial condition and management performance. You can understand this by reading the balance sheet, the profit and loss statement, financial ratios and other data that could be used to forecast the future of a company. Generally, we use the real data to analysis a stock’s value. This method uses revenues, earnings, future growth, return on equity, profit margins and other data to define a company's underlying value and prospective for future growth.  The thinking behind the fundamental analysis is that as the company grows so will the value of the shares increase.

Fundamental Analysis Tools

Earnings Per Share

Earnings are profits. The most investors want to know about the earnings of the company before investing money in the company. Increasing earnings normally leads to a higher stock price and, in some cases, a regular dividend. Companies generally report about their earnings on a quarterly basis to their shareholders. Increasing earnings leads to a higher stock price and decreasing earnings leads to price fall of the shares. It works as an alarm. Factors defining earnings of the company are such as sales, costs, assets and liabilities. A basic view of the earnings is EPS (earnings per share). This figure of the earnings signifies the amount of earnings for each outstanding share.

Price to Earnings Ratio (PE Ratio)

Ratio analysis tool is the most commonly used tool in fundamental analysis. It is an indicator of the underlying value of a company in relation to the current share price and the reported earnings per share. It is calculated by dividing the current market price of an ordinary share by earnings per share.

The formula for calculating PE ratio:

PE Ratio =   Market Price per Equity Share                         

                         Earnings per Share

Example: The market price of XYZ Company’s share is Rs.500. And the earning per share is Rs.50. Then the PE ratio of that company will be 10. It refers the earnings per share of the company is covered 10 times by the market price of its share. Alternatively, you can say Rs.1 of earnings has a market value of Rs.10.

Now let’s understand how we can use PE ratio to analysis a stock

Suppose the market price of XYZ Ltd is Rs.600 and the earning per share is Rs.10. And the PE ratio of similar companies in the same industry is 8. It means the market value of XYZ limited should be Rs.800 (i.e., Rs.8 x Rs. 100). The market value of XYZ Limited is, therefore, undervalued by Rs.200. If the P/E ratio of similar companies is Rs.4, the market value of a share of XYZ Limited should have been Rs.400 (Rs.4 × Rs.100), thus the share is overvalued by Rs.200.

Price to Sales Ratio (PS Ratio)

Price to Sales ratio is another most popular fundamental analyzing tool.  Values below 1.0 often signal an undervalued company. A high PS ratio implies a high future revenue growth curve. Many stocks with high PS ratio have at least a few of quarters of demonstrated high revenue growth.

 

The formula for calculating PS Ratio

P/S Ratio = Price Per Share / Annual Net Sales Per Share

Let's assume company XYZ Ltd. reports net sales of 5,000,000 and it currently has 50,000 shares outstanding. The stock is currently trading at Rs.200.

Sales per share = 5,000,000/50,000 = 100

Price-to-Sales Ratio = 200/100 = 2

Now compare with company MNO Ltd.

MNO Ltd. reports net sales of Rs.5,000,000 and it also has 500,000 shares outstanding. The stock is trading at Rs.100.

Sales per share = 5,000,000/50,0000 = 10

Price-to-Sales Ratio = 100/10 = 10

Investors in MNO Ltd are willing to pay Rs.10 for Rs.1 in sales, while investors in XYZ Ltd are willing to only pay Rs.2 for Rs.1 in sales. MNO stocks are much more appealing here.

P/S ratio is suitable to use when valuing most types of stock. But note that P/S should never be the individual metric used when valuing a company.

Dividend Payout Ratio:

It works as an indicator of how the company is performing financially. The main motto of the companies is to maximize the wealth of the shareholders. When a company makes a profit then it becomes the duty of that company to pay dividends to their shareholders. When the profit is shared with their shareholders it is called dividend. And the percentage of the profit the company pays to their shareholders know as “dividend payout ratio”. 

Dividend Payout Ratio Calculation

Dividend Payout Ratio = Total Annual Dividends Per Share / Diluted Earnings Per Share

Let’s assume that Company X distributed four regular quarterly dividend payments of Rs.0.25 each, for a total annual dividend payment of Rs.1.00 per share. Over the same period, XYZ reported net earnings of Rs.10 per share. Company X dividend payout ratio is:

Rs.1 / Rs.10 = 10%

That means company X distributed 10% to the shareholders out of 100% as dividend and retains rest 90% as operating needs.

Dividend payout ratios offer valuable insight into a company's dividend policy.

Book Value:

Book Value is a key factor for measuring stock’s valuation. Book value means the total value of the company asset minus company's outstanding liabilities. Investors often look for the company’s book value. Investors find an opportunity to buy the shares when the shares traded below the book value.

Return on Equity:

It refers to how a company uses its valuable assets to produce earnings. This helps to evaluate the stocks.

ROE = Net Income / Book Value

A healthy company produces an ROE in the 14 to 15 percent range. You should not rely on this alone. Because a company might raise funds through borrowing fund rather than issuing stocks to the public. You need to consider at the ROE over a period of the past five years rather than just one year.

Always consider above all main fundamental tools for making investments in shares and get a healthy return on your investment.