The fundamental analysis determines the fair value of a stock which helps the investor in forming an opinion if the stock is undervalued or overvalued in respect to the current stock price.
The stock is considered to be an overvalued security if the fair value of the stock is higher than the current market price.
Similarly, the stock is considered to be undervalued security if the fair value of the stock is lower than the current market price.
An investor always looks for an undervalued stock that has the potential to be a multibagger in the long run.
Now a certain question arises such as:
How to calculate the fair value of a stock?
How to determine if the stock is undervalued or overvalued?
How to determine the type of industry to invest in?
Well, to answer them we have to learn some analysis:
Types of Fundamental Analysis
1. Company Analysis
There are a lot of ratios when it comes to company analysis. However, I use these 8 in analyzing the financials of a company.
Consider these as an 8 point system of ranking a company based on the fundamentals.
|1.||Current Ratio||Current Assets /Current Liabilities||Determines the liquidity position of the company.|
Higher the better
|2.||Debt to equity Ratio||Total long term debt /Shareholder’s Equity||Determines the amount of capital that comes from the debt.|
Lower the better
|3.||Return on Capital employed||EBIT/ Total Capital Employed||Determines the return on the money invested in the company|
Higher the better
|4.||Shareholding Pattern – Pledged Share||Shares Pledged by the promoter||Companies with high promoter pledges are risky to invest in.|
Pledged shares should ideally be zero.
A company with very good financials should not have more than 30% pledged shares.
|5.||Inventory turnover ratio||COGS/Average Inventory||Determine the number of times inventory was replenished|
Measures the operational efficiency of the company.
Higher the better
|6.||Free Cash Flow||Cash flow from Operations – Purchase of Fixed Assets + Sale of Fixed Assets||Determines the free cash available with the company.|
Can be used to pay off creditors.
Higher the better
|7.||Reserves and Surplus||Shown in the balance sheet||Look for continuous growth in the reserves.|
Compare 5 years of data
|8.||P/E Ratio||EBIT/ Total Capital Employed||Determines how costly the shares of the company are with respect to industry.|
High P/E ratio = Costly
Lower P/E Ratio = Cheap
- Current Ratio:
- The current ratio of the company determines the liquidity position of the company.
- A company with a very low current ratio is dangerous to invest in in the long term.
- An ideal current ratio is 2:1.
- Debt to Equity:
- A debt to equity ratio is a leverage ratio that signifies how much capital comes in the form of debt.
- A debt-free company is an amazing company to consider for investment.
- The maximum debt to equity ratio is 2:1. A ratio higher than that is considered to be dangerous.
- The ROCE ratio is a financial ratio that measures the company’s ability to generate profit from its capital.
- A company with a ROCE of 10% or higher is considered a good investment.
- Shareholder’s pattern:
- Sharing holding pattern plays an important role while selecting a company.
- A high promoter shareholding indicates that the promoters believe in their company and is considered a good sign.
- On the other hand, a company with high promoter pledged is considered a negative sign.
- Inventory turnover ratio:
- This ratio determines the number of times the inventory is replenished during a particular period.
- A high inventory ratio is considered a positive sign.
- Reserves and Surplus:
- Before investing in any company an investor should consider if there is continuous growth in the reserves and surplus of the company or not.
- An ideal time frame is 5 years of data for good analysis.
- Free Cash Flow:
- Free cash flow represents the amount of excess cash available in the company basically to declare dividends and the ability to pay off its creditors.
- The calculation of free cash flow can only be done through the annual report of the company.
- The required figures for calculation are available as a separate line item under the investment activities.
- P/E Ratio:
- It is the ratio of the current price of the stock to earnings per share of the company.
- An investor should always compare the industry P/E to the stock P/E.
- If the company’s P/E is higher than the industry P/E then the investor can consider buying such a share as it is at a cheaper value than the industry.
- However, a low P/E ratio may also indicate that the company does not deserve a good valuation and thus a low P/E.
2. Economy Analysis
Economic analysis refers to performing an analysis of the entire economy and assessing what industries are currently booming considering the present economic conditions.
Stock prices often react to certain factors such as GDP, Inflation, Balance of trade, and other macroeconomic factors.
A rising GDP, low inflation, and better balance of trade will act in favor of the stock prices and the market will be positively impacted.
Similarly, a higher inflation rate and lack of employment will act against the stock price and the market will be negatively impacted.
A recession in the economy will impact all high and low-performing companies negatively.
Whereas a boom in the economy will positively impact the stock market.
An investor should keep a check on such macroeconomic factors and take a rational decision by taking into account the impact of such economical factors.
3. Industry Analysis
Industry analysis refers to analyzing the industry of a company as a whole and evaluating a company’s performance with respect to its competitors.
- Cyclical Industries:
- These are the types of industries that perform very well when a country’s GDP growth is high.
- An ideal example of such an industry is the automobile sector.
- An investor should look for such cyclical industries while investing.
- A subset of the industry:
- An industry that has a good future in the coming years should ideally impact the subsets of such an industry positively.
- For example – EV’s have good potential in the near future.
- Now the subset of that industry is the battery sector that produces batteries for such vehicles.
- The phase of a company:
A company goes through various phases such as:
- Birth phase
- Growth Phase
- Saturation Phase
- Decline Phase
- An investor should be able to analyze the current phase of the company.
- A company in a birth phase has higher chances of growing.
- Similarly, a company in a decline phase is quite a risky investment.
4. Management Analysis
Doing a management analysis can be quite complicated and time-consuming.
However, an investor can perform certain checks for a quick analysis such as :
- Search the company name on Google and check if it has any ongoing “Fraud” cases.
- Check the LinkedIn profile of promoters to check their Qualification and experience.
- Look for the MDA section in the Annual report of the company to know about upcoming projects or any punishment or penalty borne by the company,
- Check for any Insider trading charges against the management.
- Check the Transcript analysis of the quarterly earnings conference calls.
Sector – Wise tips for Analysis analysis
The 8 Point system is the standard matrix for analyzing a company. However, there are certain sector–wise exceptions to it which are as follows :
- Fast Moving Consumer Goods :
- Inventory turnover ratio plays a crucial role in the FMCG sector. A high ratio is a positive sign in the FMCG sector.
- Infrastructure :
- Check for order book – The order book contains the information for orders which are received but are yet to be executed. Multiple orders indicate the good financials of the company.
- Automobiles :
- Automobile sector publishes monthly data of the total vehicles which are sold. This gives a fair idea about the increasing or decreasing sales of the company.
- Oil and Gas :
- Oil and gas prices are affected by government policies. Always be updated about the government policies that affect the profitability of this sector.
- Banks and Non-Banking Financial Companies :
- Debt to Equity ratio does not apply to this sector as their primary source of revenue is giving loans.
- Operating cash flows of banking companies can be negative.
- Inventory turnover ratio is not relevant to the Banking sector.
- A good growth in Current and Saving Account is a positive sign.
- Net interest Margin growth should be high.
- Non Performing assets should be low.
A commerce graduate who is on a mission to educate people about investment and personal finance.