Equity Fundamental Analysis
The Basics of Fundamental Analysis
Fundamental Analysis Definition:-
Fundamental analysis is a stock valuation method that uses financial and economic analysis to predict the movement of stock prices.
The fundamental information that is analyzed can include a company's financial reports, and non-financial information such as estimates of the growth of demand for products sold by the company, industry comparisons, and economy-wide changes, changes in government policies, etc..
General Strategy
To a fundamentalist, the market price of a stock tends to move towards its “real value” or “intrinsic value”. If the “intrinsic/real value” of a stock is above the current market price, the investor would purchase the stock because he knows that the stock price would rise and move towards its “intrinsic or real value”
If the intrinsic value of a stock was below the market price, the investor would sell the stock because he knows that the stock price is going to fall and come closer to its intrinsic value.
All this seems simple. Now the next obvious question is how do you find out what the intrinsic value of a company is? Once you know this, you will be able to compare this price to the market price of the company and decide whether you want to buy it (or sell it if you already own that stock).
To start finding out the intrinsic value, the fundamentalist analyzer makes an examination of the current and future overall health of the economy as a whole.
After you analyzed the overall economy, you have to analyze the firm you are interested in. You should analyze factors that give the firm a competitive advantage in its sector such as management experience, history of performance, growth potential, low-cost producer, brand name, etc. Find out as much as possible about the company and its products.
Do they have any “core competency” or “fundamental strength” that puts them ahead of all the other competing firms?
What advantages do they have over their competing firms?
Do they have a strong market presence and market share?
Or do they constantly have to employ a large part of their profits and resources in marketing and finding new customers and fighting for market share?
After you understand the company & what they do, how they relate to the market, and their customers, you will be in a much better position to decide whether the price of the companies stock is going to go up or down.
Having understood the basics of fundamental analysis, let us go into some more details.
When investing in stocks, we want the price of our stock to rise. Not only do we want our stock price to rise, but we also want it to rise FAST! So the challenge is to figure out: which stock prices are going to rise fast?
Some stocks are cheap and some are costly. Some are worth Rs.500 and some are even worth 50paise. But the price of the stock is not important. The price of the stock does not make a stock good to buy. What is important is how much the price of the stock is likely to rise.
If you invest Rs.500 in one stock of Rs.500 and the price goes up to Rs.540 you will make Rs.40. However, if you invest Rs.500 in a 50paise stock, you will have 1000 stocks. If the price of the stock goes up from 50paise to Rs.1, then the Rs.500 you invested is now Rs.1000. You made a profit of Rs.500.
If you understand this, you can see that the price of the stock is not important. What is important is the rise in the stock price. More specifically the “percentage” rise in the stock price is important.
If the Rs.500 stock becomes worth Rs.540, then that is an 8% rise. This 8% rise only makes us Rs.40. On the other hand, when we invest the same Rs.500 in the 50paise stock and the stock price goes up to Rs.1, it is a 100% rise as the stock price has doubled. This 100% rise makes us Rs.500.
The point is that when picking a company, we are interested in a company whose stock price will rise by a large percentage.
Please note: Looking at the above paragraphs, it may seem like a good idea to buy all the really cheap 50paise and Rs.1 stocks hoping that their price will rise by 100% or more. This sounds good, but it can also be really really bad sometimes! These really small stocks are very volatile and unless you know what you are doing, do NOT get into them.
However, the point to be noted is that we are interested in stocks that will have the highest % rise in the stock price. Now the question is, how do you compare stocks. How do you compare a stock worth Rs.500 to a stock worth 50paise and figure out which one will have a higher percentage rise?
How do you compare two companies that are in different fields and different industries? How do you know which one is fundamentally strong and which one is a week?
If you try to compare two companies in different industries and different customers it is like comparing apples and elephants. There is no way to compare them!
So fundamental analysts use different tools and ratios to compare all sorts of companies no matter what business they are in or what they do!
Next, let us get into the tools and ratios that tell us about the companies and their comparison...
Earnings per share (EPS) ratio & what it means!
Even comparing the earnings of one company to another really doesn’t make any sense, if you think about it. Earnings will tell you nothing about how many shares the company has. Because you do not know how many shares a company has, you do not know how many parts that companies' earnings have to be divided into. If the company has more shares, the earnings will be divided into more parts.
For example, companies A and B both earn Rs.100, but company A has 10 shares outstanding, so each shareholder has in effect earned Rs.10.
On the other hand, if company B has 50 shares outstanding and they too have earned Rs.100 then each shareholder has earned Rs.2. So you see it is important to know what is the total number of outstanding shares is as well as the earnings.
Thus it makes more sense to look at earnings per share (EPS), as a comparison tool. You calculate earnings per share by taking the net earnings and divide by the outstanding shares.
EPS = Net Earnings / Outstanding Shares
So looking at the EPS ratio, you should go buy Company A with an EPS of 10, right? EPS is not the only basis for comparing two companies, but it is one of the methods used.
Note that there are three types of EPS numbers:
Trailing EPS – last year’s numbers and the only actual EPS
Current EPS – this year’s numbers, which are still projections
Forward EPS – future numbers, which are obviously projections
EPS doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some other ratios next...
Price to earnings (P/E) ratio & what it means?
If there is one number that people look at than any other number, it is the “Price to Earnings Ratio (P/E)”. The P/E is a ratio that investors throw around with confidence as if it told the complete story. Of course, it doesn’t tell the whole story (if it did, we wouldn’t need all the other numbers.)
The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular stock analysis ratio, although it is not the only one you should consider.
You calculate the P/E by taking the share price and dividing it by the company’s EPS (Earnings Per Share that we saw above)
P/E = Stock Price / EPS
For example, A company with a share price of Rs.40 and an EPS of 8 would have a P/E of (40 / 8) = 5
What does P/E tell you?
Some investors read a high P/E as an “overpriced stock”.
However, it can also indicate the market has high hopes for this stock’s future and has bid up the price.
Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean that the market has just overlooked the stock. Many investors made their fortunes spotting these overlooked but fundamentally strong stocks before the rest of the market discovered their true worth.
In conclusion, the P/E tells you what the market thinks of a stock. It tells you whether the market likes or dislikes the stock. If things are vague and unclear to you, do not worry. The next ratio will make everything you read until now make sense.
PEG (Price to future growth ratio!) and what it tells you!
The market is usually more concerned about the future than the present, it is always looking for some way to figure out what is going to happen in the companies future.
A ratio that will help you look at future earnings growth is called the PEG ratio.
You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.
PEG = (P/E) / (projected growth in earnings)
For example, a stock with a P/E of 30 and projected earning growth next year of 15% would have a PEG of 30 / 15 = 2.
What does the “2” mean?
Technically speaking: The lower the PEG number, the less you pay for each unit of future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value.
So, to put it very simply, we are interested in stocks with a low PEG value.
Just for the sake of understanding, consider this situation, you have a stock with a low P/E. Since the stock is has a low P/E, you start to wonder why the stock has a low P/E. Is it that the stock market does not like the stock? Or is it that the stock market has overlooked a stock that is actually fundamentally very strong and of good value?
To figure this out, you look at the PEG ratio. Now, if the PEG ratio is big (or close to the P/E ratio), you can understand that this is probably because the “projected growth earnings” are low. This is the kind of stock that the stock market thinks is of not much value.
On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio, then you know that it is a valuable stock) you know that the projected earnings must be high. You know that this is the kind of fundamentally strong stock that the market has overlooked for some reason.
Important note: You must understand that the PEG ratio relies on the projected % earnings. These earnings are not always accurate and so the PEG ratio is not always accurate.
Having understood these basic three ratios, you probably have started to understand how these ratios help you understand stock and what is valuable and what is not.
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