How do you decide what you want to buy? and what you want to sell?
That's what we are going to take you through today!
The very Basics of
- How to value the price of stock and
- How to judge the current and future growth of companies
- That you want to invest in.
An introduction to what is popularly known as the fundamental analysis of the company
Fundamental Analysis of a stock can simply be viewed as
An Extensive Health Check Of the Company or
360 Degree Check On Various Parameters:
- Be it the Financials,
- Quality Of Management, or
- The Overall Economy And the Industry Conditions
That might Effect the Performance Of the Company.
So let's start by
understanding some of the popularly used financials ratios
to judge the health of a company.
One of the first thing you should focus on the Earnings Performance of the company
How has the company delivered on earnings over the past few years..
And What Are Its Earnings Expectations Over the Next Few Years..
You Can Measure A company's Profitability By Looking At Its Earnings Per Share Or EPS
- EPS is Used To Judge the Profitability Of Company
- Good Performance Comparison On Year on Year (YoY) Basis
The EPS Is Calculated by dividing the Net Profits after Taxes and Preference Dividend by the Number of Outstanding Equity Shares.
This can be expressed in terms of the following formula:
Earnings per share = (Net Profit after Taxes – Preference Dividends) / Number of Equity Shares
e.g. Company A has Earned ₹100 Cr Profit and has 10 Cr Outstanding Shares, the EPS of this Company will Be ₹10
Now Let's take this Example Forward and use the EPS to Compare 2 Companies
Suppose Company B Has Earned 200 Cr Profit And Has 50 Cr Outstanding Shares, the EPS Of This Company will Be Just 4
Hence, though, the Profits of Company B are Doubled of Company A. Company A will still be seen as a Stronger company based on its EPS
EPS Is One Of the Basic Parameters
Based On Which You Choose to Pick Up A Particular Stock To Invest in and
Generally we check as to
How the Stock has been Performing?
Has the EPS been Growing?
Because It Could Possibly Have the Profits Growing By the Same Time In Case the EPS Base Also Growing Along With the Shares then the EPS does not Grow Based On That the Stock Price Also May Not Rally More.
Looking At The EPS Growth YoY Is Very Very Important.
Another Financial Ratio commonly used to judge the Valuation of a Stock is Price To Earnings or P/E Ratio
Compares Stock Price To Earnings
Crucial For Peer Comparison
Lower The P/E Ratio, Better The Valuation
This Gives An Indication Of What Price The Market Is willing To Pay For The Company's Earnings
And This Is Calculated By Dividing The Current Market Price of the Stock (CMP or MPS) With Its Earnings Per Share (EPS)
So Let's Take Our Previous Example Forward
Suppose That The Stock Price Of Both Company A and B is ₹500 and we need to Compare the P/E Ratio of These Companies
This is What we will Do
We will Divide The CMP With EPS
P/E Of A is 50 And P/E of B is 125
Which Basically Means
That For Every ₹1 of of Company A's Earning, The Market is Paying ₹50 And
For Every ₹1 of Company B's Earning, The Market Is Paying ₹125.
A High P/E Ratio Usually Indicates That The Investors Are Expecting Higher Earnings in The Future.
However A Stock With Lower P/E Ratio But Higher Earnings Visibility Is Considered A Better Investment.
Clearly What The Ratio Suggests is The MPS And The EPS
And that’s Basically What Ratios Are All About
The Importance Of Ratio In Absence Of Capital Appreciation Works Out The Way That It Is The Kind On Number Of Years Or The Time Period That will Take The Shareholder Or An Investor For Him To Return Or Get Het His Principal Back While Investing Into The Company.
Therefore The P/E Ratio Is Very Important Tool When You Are Doing Financial Analysis Of Company.
It Is Very Important To Have A Peer Comparison When You Are Looking At P/E Ratios.
General Thumb Rule is that The Lower The P/E, The Better Valuation The Company Derives and in That Sense The Better Multiple.
Price To Book Value is Another Financial Ratio that is used extensively for Fundamental Analysis
Used to Judge Discount on a Stock
Cannot be seen in Isolation
To understand How this Ratio is Calculated,
Let's First Understand The Meaning of Book Value
Book Value Is The Total Value of The Company's Assets, that The Shareholders will Theoretically Receive, if a company will Closed Down.
And if you Divide the Total Book Value With The Total Number Of Outstanding Equity Shares, you will get the Book Value Per Share.
If This Value Is Closer To The CMP Of A Stock, It Indicates That The Stock Is Underpriced according to this parameter.
And If You Divide The CMP With The Book Value Per Share, It will Give You The Price To Book Value Or The P/B Ratio
And In This Case if the Ratio is Below 1, It Is Considered Value Investing.
Price To Book is Something Where You Try And Find out as To Which Stocks Are Available At A Discount.
But Again This Cant Be Looked In Insolation
This Could Be One Of The Parameters To Look At A Particular Stock
And This Is Very Important Specially In Terms Of Financial Services Of Banks Where Price To Book Is Very Very Important.
When It Comes To Manufacturing Sector, The Importance Actually Reduces
DEBT IS OFTEN PERCEIVED AS A NEGATIVE WORD IN OUR PERSONAL LIVES
Capital Intensive Companies Use Debt For Expansion
Used To Judge Leverage Positions
Excessive Debt = Higher Interest Costs
Reflection Of Impact on Profitability
But Not All Debt Is Bad
When It Comes To Companies And Economy
Companies Need To Take On Loans And Debts To Finance Their Businesses
Especially The Companies That Afraid In Capital Intensive Sectors Like Infrastructure And Auto
But That Is Not Mean A Company Should Overleverage Themselves
Or In Simple Words Take On More Debt That They Can Afford To Pay Off From The Returns They Expect From Their Investments
Hence Businesses Balance The Use Of Debt And Equity To Give The Average Cost Of Capital At Its Minimum
And we Can Assess If A Company is Using Its Debts Smartly By Its Debt To Equity Ratio
This Is Done By Dividing A Company's Total Liabilities By Its Total Equity
A Debt Equity Ratio Of Around 1 will Mean That Its Liabilities Equal To Equity
Capital Intensive Industries Have Huge Amounts Of Debt On To Their Books Both In Terms Of Long Term Borrowings And Short Term Borrowings
Because A Lot Of Money will Get Invested In Setting Plants
E.G. Power Plants, Cement Plants
Lot Of Capital Employed On Capital Expenditure Happens In Setting Up these Plants And they Have To borrow Lot Of Debt
When It Comes To the Short Term Borrowings
Lot Of Working Capital Requirements Are Created For A Lot Of these Manufacturing Companies For Continuing their Working Capital Needs
So Debt Equity Ratio Becomes An Important Integral Component While Judging the Leverage Positions Of Companies
And Excessive Debt Equity Ratio Is Not Suitable Because the Kind Of Interest Servicing That will Due On the Debt will Have An Impact On Your Profitability
And therefore Lower Margins And Lower Profits After Tax
And Corresponding Cascading Effect Happens On Your EPS
The last Financial Ratio that we will focus on is Return on Equity also called the ROE
Return On Investment By Equity Shareholders
Broadly, ROE Below 10% Perceived Negatively
This Ratio Measures the company's Profitability by showing how much Profit a company generates with the Money Shareholders have Invested
And this is Calculated by dividing the Net Income of a Company with its Total Shareholders Equity And it is Expressed in Percentage Terms
Higher the Return on Equity the Better is
Companies with the High Return on Equity are Looked at as Efficient
This actually shows you as to what is the Return on the Investments made by the Equity Shareholders.
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