With more technological access, a large number of people are investing in stocks. Investment in shares can be very profitable if you conduct proper due diligence of the security before investing. There are two types of analysis that you can do before trading in stocks. These are:
1. Technical stock analysis
2. Fundamental stock analysis
Technical stock analysis studies historical market data of price and volume and forecasts the direction in which prices will move. Fundamental analysis measures the stock’s intrinsic value by evaluating primary information both at the macroeconomic and microeconomic levels. While at the microeconomic level, it studies the performance of the company, at the macro level, it monitors the industry condition and economic policies affecting the sector.
Fundamental analysis tools help in analysing these financial and economic factors.
What is fundamental analysis?
Fundamental analysis studies the business at a basic fundamental level to judge its financial health. It examines the key ratios of a business to determine if the stock’s current price is undervalued or overvalued. It also projects the company’s health and growth prospects. For an investor, fundamental analysis is necessary. It helps him or her determine a company’s worth. Fundamental analysis takes the following components into account:
- Company’s financial reports
- Effectiveness of the management
- Asset management
- Demand for the product
- Company’s press releases
- Global industry review
- Trade agreements
- External policies of the government
- News releases
- Competitor analysis
If the analysis reveals that the current price of the stock differs from the market sentiments and fundamental factors, then there is an opportunity for investment.
A company’s earnings are the most crucial data point that you should look at before considering other components. A company’s earnings are its profits. Most companies announce their earnings every quarter, and these financial statements are monitored by all analysts. Earnings have a significant impact on share prices. If a company announces a rise in profits, share prices are likely to go up. If the company falls short of the earnings expectations, share prices are likely to be hammered. Good earnings of a company can also earn you rich dividends.
Revenues alone do not reveal much about how the market will value the stock. To know more about the stock’s market valuation, you need to use more fundamental analysis tools for a detailed study.
What are the types of fundamental analysis tools?
Some of the widely used fundamental analysis tools are:
- Earnings per share or EPS
- Price-to-earnings (P/E) ratio
- Return on equity
- Price-to-book (P/B) ratio
- Price-to-sales ratio
- Dividend payout ratio
- Dividend yield ratio
- Projected earnings growth
Earnings per share or EPS
EPS is the amount of profit that is assigned to each stock of the company. It is calculated by dividing the total revenues or gain of the company by the total number of outstanding shares. To put it in a formula:
EPS = Net income of the company after tax / total outstanding shares
As EPS is a symbol of the health of the company, a higher EPS means higher returns for the investor.
EPS can be basic and diluted. Basic EPS takes into account total outstanding shares, while diluted EPS includes shares the company holds and those that can be issued to investors in the future.
Apart from this, EPS can be subdivided into trailing, current and forward EPS. A trailing EPS is the actual EPS of the recently completed fiscal. A current EPS is the project EPS of the current fiscal. The forward EPS is a projection of the EPS for the upcoming fiscal.
EPS of one company can be compared to another in the same industry to know in which company to invest. However, a higher EPS may also lead to reduced earnings or increased stock prices to get back to normal.
A company’s EPS may be lower despite earning a good profit. For example, if a company makes 5 lakh and has 10000 outstanding shares, its EPS would be 500000/ 10000 = 50. Another company which earns Rs 10 lakh and has total outstanding shares of 1,00,000, will have an EPS of 10. Therefore, even though the second company makes more profit, the first company with a higher EPS is likely to give more profit to investors.
Price-to-earnings (P/E) ratio
P/E is one of the essential tools of fundamental stock analysis. It reflects the company’s payouts as compared to its stock price. With this, you can know if the share of stock pays wells for the price you pay. P/E ratio can be calculated by dividing the share price by the EPS. If a company’s share price is Rs 50 and the EPS is 5, then the P/E ratio is 10. A lower P/E ratio signifies the possibility of higher earnings compared to the stock price. A meagre P/E ratio may mean a lower price per share compared to earnings. This signifies the stock is undervalued and shows potential to rise in future. The opposite is the case for a higher P/E ratio.
P/E ratio can be categorised as:
1. Trailing P/E ratio which means the P/E ratio of the past 12 months
2. Forward P/E ratio which is the P/E ratio of the next 12 months
If the forward P/E ratio is higher than the trailing one, then there may be a decrease in earnings. If the forward P/E ratio is lower than the trailing P/E ratio, then there could be an increase in the profits of the company.
The significance of the P/E ratio differs from one investor to another. The P/E ratio shows how much you want to pay for the company’s earnings. Your willingness can be different from another investor.
Return on Equity
Return on Equity or RoE shows the efficiency of a company to generate profits on its shareholder’s investment. It is calculated by dividing net earnings after tax by shareholders’ equity. If the company has made Rs 50 lakh this year with shareholders’ equity at 5 lakh, then the ROE is 5000000/ 500000 = 10%. ROE is expressed in percentage terms. A higher ROE signifies a more efficient company. It means the company can increase its profitability without any additional capital. However, a company without many assets can also have a higher ROE. Therefore, not all companies with higher ROE are suitable for investment. It is best to compare ROE of companies within the same industry. An ROE within the range of 13 to 15 is considered good.
Price-to-book (P/B) ratio
Also known as “stockholders equity”, the price to book ratio is the comparison of a stock’s book value to its market value. Book value is the cost of each asset minus its cumulative depreciation. The P/B ratio can be calculated by dividing the last closing price by the previous quarter’s book value per share. It tells us what the company will be left with if it repays all its liabilities and liquidates its assets. If the P/B ratio is less than one, then the stock is undervalued. If the rate is more than one, then the stock is overvalued. The P/B ratio is essential as it tells you if the company’s assets are comparable to the stock’s market value. The ratio is more significant for companies with higher liquid assets such as insurance, banking, investment and finance companies. Companies with more fixed assets and expenditure of R&D do not get any help from the P/B ratio.
The Beta is the correlation of the stock price with its industry. You can calculate the Beta by comparing the stock to the benchmark index. The Beta mostly oscillates between -1 and 1. However, it can have a value above or below this mark. Any beta value above 0 signifies the stock correlates with the benchmark index. Beta values below 0 mean shares are inversely correlated. A higher beta means higher volatility signifying greater risk of assets. The lower the Beta, lesser is the volatility.
Price-to-sales (P/S) ratio:
Price-to-sales ratio compares a company’s stock price with its revenue. You can calculate the P/S ratio by dividing market capitalisation by income or using the formula:
P/S ratio = Per share stock price/Per share revenue
A lower P/S ratio indicates undervaluation, while anything above average suggests overvaluation.
A lower P/S ratio is preferable as it means investors are ready to pay less for each unit of sale. The limitation of this indicator is that it does not take into account the expenses and debt of the company. As such, a company with a higher P/S ratio can also be unprofitable.
Dividend payout ratio
A dividend payout ratio tells us how much the company has earned and what portion of it is being given out as a dividend. It can be calculated by dividing the total amount of dividend by the net income of the company. A company can choose to distribute its profit as a dividend because there may be little room for growth. Dividend payout ratio accounts for the amount of income that a company retains for future growth, debt payoff and cash reserve.
Dividend yield ratio
Dividend yield ratio is what the company pays to its shareholders as a dividend relative to its share price. Expressed in percentage terms, the dividend yield ratio can be calculated by dividing the annual dividend of stock by the current share price. The dividend yield ratio is important for investors who are looking for earning dividends from a company. This measure for fundamental analysis is not available for all companies as not every company uses its profit to pay dividends. Some companies retain the profit to use for future growth.
Projected earnings growth (PEG) ratio
Projected earnings growth indicates how much you have to pay for each unit of future growth of earnings of the company. It is calculated by dividing the P/E ratio by projected growth in revenues. A lower projected earnings growth indicates a lesser amount to be paid for each unit of future earnings growth. A stock with a smaller PEG ratio is fundamentally stronger as it has higher projected growth in earnings. A stock with a higher PEG ratio is generally avoided by investors.
Analysts use fundamental analysis tools to determine an estimated future value of a company’s stock price. If analysts expect a higher future value than the current market price, then the chances of buying a stock are higher. If analysts find the stock’s intrinsic value lesser than the current market price, there may be sell recommendations for the stock since it’s overvalued.
Not all investors can conduct a thorough fundamental analysis of a stock. However, understanding the fundamental analysis tools will help in closely and accurately monitoring stocks.