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Fundamental Analysis - A Powerful Tool to Analyse Stocks

Fundamental analysis as an article explains the importance of analyzing the financial position of a company before investing, so that you can derive considerable profits from your investments which serve the very purpose of investing the hard earned funds. It is said that good investors analyze the company before investing but the best investors analyze the company even after investing. Hence, this article contains various tools that can help you know the net worth of the company, the earnings derived from the share as well as the returns from equity

Fundamental analysis in stock market

Fundamental analysis is a kind of stock evaluation method. This method involves the analysis of fundamental information such as financial reports of the company, demand for the product produced by the company, position of the company in the industry, changes that happens in the economy and in the government policies. Fundamentals deal with financial characteristics of the company. In the process of fundamental analysis a detailed study of the financial statements of the company is carried out in order to find out the level of profitability, investments, turn over, amount of cash in hand, return on equity, return on assets and return on investments etc. The main purpose of the fundamental analysis is to find out answers for many important questions like; is it worth investing on this company? What are the chances that this business is going to suffer losses or profits? How can I be certain that this stock will continue to pay dividends? What would be the position of this company in the market?

Analysis is all about earnings and the basic objective is to find out probability of getting profit from a company. The bottom line is to calculate how much money a company is making and how much is it going to make in the future. Profits are called earnings. It’s difficult to calculate the earnings of a company but one has to do this home work before investing and that’s what buying a company is all about. Higher earnings always lead to increase in stock price and sometimes regular dividends. But when the earnings go down then definitely stock prices will fall.
Some of the widely used tools of fundamental analysis are :
• Earnings per share-EPS
• Price to sales-P/S
• Dividend payout ratio
• Return on equity
• Price to earning ratio-P/E

Earnings per share-EPS

Earnings per share- EPS are very important tool of fundamental analysis and it is the primary focus of every investor. EPS = Net earnings of the company/ Outstanding shares.

One cannot decide which company shares to buy depending only on the basis of earnings.
For example: Company X earns 5 lakh and company Y earns Rs 10 lakh, but company X has 10000 outstanding shares whereas company Y has 100000 outstanding shares. Let’s calculate EPS for both companies. For Company X:EPS = 500000/10000=50For company Y: EPS=1000000/100000=10 In fundamental analysis, earnings is not the only consideration, and one cannot decide which company shares to buy only on the basis of earnings.

In the above example company Y has higher earnings of 10 Lakhs and company X has 5 lakhs, both companies may be good but primary focus of investment is making profit. So along with earnings, total outstanding shares are also taken into consideration. In the above example company X has EPS of 50, but company Y has EPS of 10 despite earning more profit so company X shares will give more profit to investors

Dividend payout ratio

This ratio is calculated by dividing annual dividends per share by earnings per share.DPR= Dividends per share/ earnings per share For example: if company X paid 10 Rs per share as dividend and had 15 in EPS then the DPR would be 66%. The percentage that is good and bad is subject to interpretation. Growing companies usually retain more profits for business expansion and pay lower dividends. But in some mature industries there is very little room for growth and they pay higher dividends so as to stay ahead in the market.

Return on Equity or return on net worth or return on ordinary Shareholder’s fund

It is the rate of return on shareholder’s equity. It indicates the firm’s or company’s efficiency of generating profits from shareholders equity. ROE is calculated by dividing net profit after tax by shareholders equity. ROE= Net earnings after tax/shareholders equity. Here net earnings of fiscal year are calculated after deducting preference shareholders’ dividends but not common stock dividends. ROE is a very useful tool of fundamental analysis and it is widely used. But all companies with high ROE are best and good to invest. For certain industries ROE is high because they require no assets E.g.: consulting company and certain industries have low ROE just because they require large infrastructure so just on this basis of this one cannot come to the conclusion that consulting industry is better to invest than large refineries and iron and steel industry. So ROE works better for the comparison of companies belonging to same industry. And the company with higher ROE is better to invest.

ROE can be split into three components and is equal to net margin multiplied by asset turn over and financial leverage. ROE= Net margin x Asset turnover x Financial leverage.

ROE is split into parts to clearly understand the changes that happen in the same. For example if the net margin hikes then every sale increases and the net income resulting in increase is overall ROE. If the assets turnover ratio increases, it means that the company is generating more income on every unit of asset it owns which in turn means increase in ROE. Financial leverage of the company indicates the capital structure of the company and by higher financial leverage it means more proportion of debt financing than equity financing. This increase in financial leverage is beneficial for any company as interest on debt is tax deductible but not dividends on equity. So a higher debt financing means higher ROE but increase in debt financing positively contributes to ROE only if the firm’s return on assets is more than interest on debt

Price to earning ratio-P/E

P/E relates to the stock price and the earnings of the company. And it is one of the most popular tools of stock analysis used in fundamental analysis.P/E calculated by dividing share price by earning per share of the company.P/E = stock price/EPS Assume that company X has EPS of 5 and its share value is 50 so the P/E ratio is 10. Some investors think that high P/E means over priced stock and it also indicates the high hopes on the stock’s future. And it also means that investor is paying more money for every unit of net income of the company which indicates stock is expensive.

By using the price per share and earnings per share one can easily evaluate the stocks of different companies. Stocks with higher forecast of the growth of earnings will usually have higher P/E, and stocks with lower forecast of earnings growth rate will usually have lower P/E.

PEG ratio-Price/earnings to growth ratio

PEG ratio takes into consideration the projected growth in earnings. It is calculated by dividing P/E ratio by projected growth in earnings.PEG=P/E / Projected growth of earnings. Example: consider a company has a P/E ratio of 50 and its projected growth in earnings is 10% then the PEG value becomes 5.In technical language PEG indicates how much you are going to pay per each unit of future earnings growth, the lower the value of PEG is the lesser would be the amount you are going to pay per each unit of future growth of earnings.

So if the PEG ratio is higher (close to P/E value) this makes sense that projected growth in earnings is lower, so kind of stocks are usually neglected by stock market.

If the PEG ratio is smaller (much smaller when compared to P/E value) then that means that projected growth in earnings is higher and the stock is said to be fundamentally strong. Now that you have read this article, we believe that this would help you to know the value of the company and to choose the best company to invest and earn adequate profits in this highly volatile market. For more information feel free to contact Moneymindz.com.

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