Fundamental Analysis of Stocks
Fundamental analysis of stocks assess the intrinsic value of a stock using various financial, qualitative and quantitative tools. Such analysis helps you identify key attributes of the company and analyze its actual worth, taking into account macro and microeconomic factors.
Fundamental Analysis of Stocks : 5 Key Takeways
- Fundamental analysis helps in predicting the long-term trends in the market.
- There are also two processes of fundamental analysis. One is top-down, and the other is a bottom-up approach. The top-down approach looks into the macroeconomic factors first and then digs into the specific company. On the other hand, the bottom-up approach analyses the company first and then checks the effect of macroeconomic factors on the company’s performance.
- It assists you in finding good companies for investment, such as those with strong growth potential.
- The current price of a stock may not reflect the actual value of the stock. The stock may be overvalued or undervalued in the market. Fundamental analysts study the underlying health of the company in order to find the intrinsic value.
- Fundamental analysis of a company helps you get to its stock’s fair price, which may not always be trading at its fair value. Often it is overpriced or underrated.
Fundamental Analysis of Stocks : Top Ten Tools
1. 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
EPS not only gives a good idea to analyze a company performance . Traders can compare it to other companies to find out a better option.
2. Price-to-earnings (P/E) ratio
P/E is one of the essential tools of fundamental stock analysis. 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.
3. Return on Equity
Return on Equity or RoE shows the efficiency of a company to generate profits on its shareholder’s investment.
To calculate ROE, divide 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%. A higher ROE signifies a more efficient company. It means the company can increase its profitability without any additional capital.
4.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.
5.Dividend Payout Ratio
It gives you two important information – one is how much dividend is paid to the shareholders out of the profit of the company. Second is retained earnings of the company.
Expressed in percentage terms, the dividend yield ratio can be calculated by dividing the annual dividend of stock by the current share price.
6.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.
You can calculate PEG ratio by dividing the P/E ratio by projected growth in revenues.
A stock with a smaller PEG ratio is fundamentally stronger as it has higher projected growth in earnings. Investors usually avoid a stock with a higher PEG ratio.
7.Debt-to-Equity (D/E) Ratio
The debt-to-equity (D/E) ratio compares a company’s total liabilities to its shareholder equity and we can use it to evaluate how much leverage a company is using.
Higher-leverage ratios tend to indicate a company or stock with higher risk to shareholders. So, if you see a high debt to equity ratio for a particular company, better to avoid investing in securities of that particular one. Generally, companies that are debt free or have a D/E < 1 are considered of good quality.
8.Free cash flow:
FCF represents the amount of cash that the company is able to retain out of cash generated from operations after meeting all its operating capital expenses. A consistently negative FCF means that the company is struggling to meet its operating capital needs with the cash that it generates from operations.
9.Return on capital employed (ROCE)
Return on capital employed, or ROCE, is a long-term profitability ratio that measures how effectively a company uses its capital.
ROCE = EBIT/Capital Employed
EBIT(Earnings Before Interest and Taxes) includes profit but excludes interest and tax expenses.
Capital Employed = Total Assets – Current Liabilities
ROCE should increase over the quarters . Companies with higher ROCE in share market indicate that these companies employ capital in an efficient manner thereby generating higher profits.
10.Price to Sales (P/S) Ratio
In many cases, investors may use sales instead of earnings to value their investments. The earnings figure may not be true as some companies might be experiencing a cyclical low in their earning cycle. So, investors would prefer to use this ratio.
The formula to calculate the P/S ratio is:
Price to sales ratio = Current Share Price / Sales per Share
A low ratio could imply the stock is undervalued, while a ratio that is higher-than-average could indicate that the stock is overvalued. Like all ratios, the P/S ratio is most relevant when used to compare companies in the same sector.
Understanding the above ten fundamental analysis tools helps in closely and accurately monitoring stocks.
Also know that, not all these tools will give you all the information you need. They can’t give you buy, hold or sell advice by themselves. They must be weighed along with other considerations.
As you create a picture of what you want in an investment, these tools can serve as benchmarks to help you measure and compare different companies.
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