Tuesday, October 28, 2008

How to perform stock research using fundamental analysis

Performing stock research is tedious task but you will be surprised to see how quickly you can do once you do it for 2-3 times.

In this article, I will try to provide various parameters mainly related to fundamental analysis (which I believe is backbone of investing) to perform stock research. I have specifically kept in mind that this should be easy to calculate stuff from balance sheets and profit/loss statements, as main target audience for this article is retail investor. And, I will be focused on company research only, not on industry outlook.

This is relatively big article, so if you don’t have time now then bookmark it or print it and read it out later.

Why do I recommend performing through analysis before investing:

  1. Relatively less stress, when things are not going right in market. As, you know reasons behind your investment decision.
  2. In case of any failure, one can at least know what went wrong and take priceless learnings from it.
  3. I am firm believer that if you need to put 10 minutes to earn Rs. 100 then investing Rs. 100 deserves at least 1 minute (10%) of your time.
  4. Great wealth can be achieved by only un-earned income and investing is probably the most easiest way to generate un-earned income.
What is Fundamental Analysis?

The main goal of fundamental analysis is to find out intrinsic value of stock, means primary assumption for fundamental analysis is that the price on the stock market does not reflect the ‘true’ value of stock (share). In a nutshell, focus of fundamental analysis is to determine true value of stock by focusing on various factor’s like growth, company’s actual business, company’s financial strength and its future prospects.

How to perform fundamental analysis?

I will like to break fundamental analysis mainly in three parts:

  1. Financial stability ratios
  2. Performance indicators
  3. Valuation parameters

Broadly speaking, fundamental analysis should be performed at least for past 3 years (more you go, better it is).

In addition to this analysis, there are some other things to look at, which I have mentioned at the end of this article (in conclusion section).

1. Financial stability ratios:

These ratios are useful to check inherent financial strength of company and it’s cashflow patterns.

a) Debt-Equity ratio:

Debt-Equity ratio = Total Liabilities / Total Share Capital

This ratio provides leverage situation of company in the sense that it compares company’s total liabilities to total shareholder equity.

Broadly speaking, it should not be much higher (should not be greater than 2 or 3, there are exceptions like financing stocks)

b) Interest Coverage ratio:

Interest coverage ratio = Earnings before interest and Tax (EBIT) / Interest

This ratio indicates how easily can company pay interest on its outstanding debts. Warning signs are triggered when this ratio become less than 2.

c) Current ratio:

Current ratio = Current Assets / Current Liabilities

This ratio indicates company’s liquidity condition, in terms of paying of short-term liabilities from its short-term assets.

Warning signs are triggered when this ratio becomes less than 1 and be cautious if this ratio is less than 1.5

2. Performance indicators:

These ratios are useful to check performance of the company.

a) Operating Margin:

Operating Margin = EBDIT / Net Sales * 100

EBDIT indicates Earnings Before Depreciation, Interest and Taxes. This ratio indicates net profitability of the operation of the business.

b) Gross Margin:

Gross Margin = EBDT / Net Sales * 100

EBDT indicates Earnings Before Depreciation and Taxes. This ratio indicates Gross profitability of company (margin after paying interest).

c) Net Margin:

Net Margin = Net Profit / Net Sales * 100

Net Profit is derived after depreciation and payment of interest and taxes. Higher the margin better it is.

d) Return on Assets (ROA):

ROA = Net Profit / Total Assets * 100

This ratio indicates how profitable the company is relative to its assets and ability of management in generating profits from assets.

e) Return on Equity (ROE):

ROE = (Net Profit – Preferred Dividend) / Total Share Capital * 100

This is perhaps Warren Buffet’s favorite parameter. This ratio provides percentage return on shareholder’s equity.

f) Return on Capital Employed (ROCE):

ROCE = Net Profit / (Total Debt + Total Share Capital) * 100

This ratio indicates how profitable the company is relative to total capital employed and ability of management in generating profit out of it.

g) Sales Growth:

Sales Growth = (This Year’s Sales / Last Year’s Sales – 1) * 100

As name indicates, this ratio Net Sales (revenues, top-line) growth. Above formula will provide YoY (Year on Year) sales growth, similar way we can find Half yearly sales growth and QoQ (Quarter on Quarter) sales growth.

h) EBIT Growth:

EBIT Growth = (This Year’s EBIT / Last Year’s EBIT – 1) * 100

This ratio provides growth percentage in EBIT (Earnings Before Interest and Taxes) term.

i) PAT Growth:

PAT Growth = (This Year’s PAT / Last Year’s PAT – 1) * 100

PAT indicated Profit After Tax (Net Profit).

j) EPS Growth:

EPS Growth = (This Year’s EPS / Last Year’s EPS – 1) * 100

EPS indicates Earnings Per Share.

k) BV Growth:

BV Growth = (This Year’s BV / Last Year’s BV – 1) * 100

BV indicates Book Value.

3. Valuation Parameters:

First of all, valuation ratios are related to CMP (Current Market Price). So, they are quite volatile in general. As someone rightly said profits are made when you buy and not when you sell, so in that regard valuations are key.

But in general, valuations have significance after particular stock is passed through criterias of above two sections. (sometimes its easiest to ignore any scripts just on the basis of valuations like, 100 PE stock with only around 15-20% growth)

a) PE:

PE = CMP / EPS

PE – Price to Earnings, perhaps the most looked parameter. In general, stocks with higher forecast earnings growth will have higher PE and those expected with lower earnings growth will have lower PE.

b) P/B:

P/B = CMP / BV

P/B – Price to Book, very important ratio for value investors (historically, these group of investors have made most money out of stock market).

c) Dividend Yield:

Dividend Yield = Dividend per share / CMP

This indicates dividend return in percentage terms of total investments.

d) PEG:

PEG = PE / Earnings Growth

PEG – PE to Growth, Peter Lynch’s parameter. This ratio provides relative values of PE and growth projections.

e) PES:

PES = PE / Sales Growth

PES – PE to Sales Growth. My own finding, as I believe that to increase earnings in long term, sales have to improve (only profit improvement may not work in all cases)

In conclusion:

There are mainly three aspects of fundamental analysis: financial stability ratios, performance indicators and valuation parameters.

Some Miscellaneous Notes:

  1. Quality of management. As a retail investor, it’s difficult to judge quality of management. I generally tend to look at ROCE, ROA and MF holdings. I request readers to let me know through comment/emails, if there are any other better ways.
  2. Order Book. I haven’t mentioned regarding order book in this article. Again, I request readers to let me know through comment/emails, if there are any better ways.
  3. Earning estimates. I tend to look at ICICI Direct for that. This point is specific to Indian equities.
  4. As stated above, I haven’t talked about industry outlook and broadly speaking, stock prices are hugely dependent on industry performance.
  5. Peer competition (competition between companies in same sector) is not considered here.
  6. Take a look at share capital, and if that is increasing then be extra careful, as ROE will be affected by increased share capital.
  7. Shareholding pattern is fairly important thing to look at. Mainly three things: promoter, institutions (DII and FII) and retail holdings. Broadly speaking, it’s good to have high promoter holdings and if retails holdings are high then stock will not perform well.
  8. Secured loans and unsecured loans in balance sheet. If unsecured loans are high, then be extra careful as it will require to pay more interest (and other question comes as, is the company desperate for funds?)
  9. I tend to look at whether MFs are dumping that stock and if yes, then why?
  10. Be cautious when you see high "other income" in profit/loss statement.
  11. Many of above mentioned ratio can be found directly calculated at India Infoline. This point is specific to Indian Equities.
  12. After seeing October-2008 carnage in emerging markets, I will like to add one more parameter and that is FII holdings in stock.
  13. Some cautious words: Don’t always believe what you see in balance sheets and profit/loss statements. Check this article to know more. But frankly speaking, as a retail investor, we do not have any further meaningful information. I like to here comments on this point as well.
Disclaimer: Use your own judgement before making decisions. I am not responsible for any of your decisions based on this article.

14 comments:

Dr.Krishna said...

Ajay, this is an excellent article in understanding markets and company fundamentals. But many people don't have such patience to spend enough time on research. That's why many people lose money in stocks. Keep it up!

mohit said...

Excellent article...you should write regularly on your blog.

Thanks for sharing information

Keep it up

rahul said...

AN EXCELLENT ARTICLE VERY USEFUL

gsumit said...

well categorized, good article.
write more frequent !!

thavva said...

Very well written. No recent posts on this blog since long time it seems.

Ajay said...

thavva, thanks.
I am busy with some other things.
will try to write more often; let's see how it goes.

kevin said...

Superb article..Keep it up...

raji said...

This article is pretty much usefulin terms of stock trade and research

Girish. H.R. said...

can u tell about technical analysis alsoc

Ajay said...

Girish, I am not good at technical analysis. Will write about it, if I ever get into it seriously.

Shivam said...

I think Quick ratio should also be Considered because Current Asset Ratio may tell about the Co.'s ability to pay short term Liabilities but Acid test shows by how many times short term liabilities of the co. are covered by quick assets(Current Asset other than stock) . so it helps the investor to assess about the payment power of the co.

Shivam said...

Absolute Liquidity ration should also be used.

Liquidity ratio, expresses a company's ability to repay short-term creditors out of its total cash. It shows the number of times short-term liabilities are covered by cash & Cash Equivalents. If the value is greater than 1.00, it means fully covered.

The formula is the following:

= cash & equivalents / creditors,short

Juhi Shahab said...

Very nice explanation. Fundamental Analysis is actually finding out the most efficient and rewarding stocks for long term investment. Though, with short term investment, you can gain instant returns, but those do not have longer lives. For a greater and continuous generation of returns, you must invest for long term and Fundamental Analysis is the best method to pick potential stocks for long term investment.

Anonymous said...

good one brother....u made a start of my fundamental analysis learning phase.
thanks a lot.
its so simple and easy-to-understand.
would appreciate to get ur email for any doubts during learning process.

thx