If you are looking to invest in the stock market and want to purchase any stock, have you asked the following questions to yourself?
- How you decide which stock you want to buy??
- Have you done any homework before purchasing that stock??
- Have you done a fundamental analysis of stocks??
- Have you done technical analysis of stocks??
As per my experience, 90% of investor has Big “NO” for all above these answers.
Because most of the investor rely on their broker, friend, relative or maybe take help of an advisory company or purchase stocks based on the news channel’s recommendation.
Now, the question is how can you find a fundamentally strong company by your own knowledge. For that, you have to learn the fundamental analysis of stocks.
After learning this analysis you don’t need to depend on anyone for your profitable portfolio creation.
The practice of fundamental analysis of stocks is very helpful for your entire life to find good quality stocks that have the capability to generate multibagger return on your investment.
In this post we will learn how to find fundamentally strong company. What are the factors that matters to find best investment shares for long term growth. So, let’s get start…
Now the question is
What is Fundamental Analysis of Stocks??
In simple language, it is the process to analyze business and financial performance of the company. This process gives an idea about the current valuation, future aspects, and growth potential of the company.
To do fundamental analysis of stocks various financial ratios are very vital part of this investigation.
Financial Ratios for Fundamental Analysis of Stocks
There are various financial ratios available to understand the proper valuation of stocks and that is easy for investors also to understand.
In the above image, you can find different ratios useful to do Fundamental Analysis of Stocks
Also Read: 6 Risk-Free Investment Option In India
(1) Earning Per Share (EPS)
EPS is the key financial ratio to identify the net income per outstanding share calculated based on quarterly or yearly earnings of the company. This ratio is used to compare different companies from the same sectors.
The equation to find EPS is given bellow.
EPS = Net Income/ Total outstanding shares in market
Now, suppose the board of company or management wants to distribute some dividends from net earnings in this case we have to calculate Weighted EPS.
The equation to find weighted EPS is given bellow.
Weighted EPS = (Net Income – Distributed dividend) / Total outstanding share in the market
Investor’s perspective it’s advisable to invest in the company which has higher and continually improving.
Benjamin Graham’s perspective investing in the company having EPS is 16 or above.
I also recommend reading The Intelligent Investor by Benjamin Graham if you really want to become a successful investor in the stock market.
(2) Price to Earning (P/E)
Price to earnings ratio is also very important when finding the fundamental health of any stock for long term investment.
Actually this ratio is used to find how much do you pay for earing one rupee on the share price.
So, if the P/E is high it means you pay high money to earn one rupee on share price, and if the P/E is low means you pay low money to earn one rupee on the share price.
The formula to find Price to Earnings ratio is given bellow.
P/E Ratio = Market Price per Share / Earning Per Share (EPS)
Suppose Infosys has a current market price is 700Rs and EPS is 39Rs. so, P/E of Infosys is 17.95. So, the investor needs to pay 17.95 rupees to earn 1 rupee on the share price.
As share price increase PE ratio also increases and as the share price decrease PE ratio decrease.
Now there are two P/E ratio available (i) Trailing PE & (ii) Forward PE
(i) Trailing PE, use the prior 12 months of earnings (here use past 12 months EPS). Trailing PE is easy to calculate because of all the data available to find it.
(ii) Forward PE, use the expected earnings for the next 12 months (here use EPS based on the next 12 months projection), Forward PE is a better indicator for future projection.
This ratio is mostly suitable to compare stocks with the same sector. As an example we are comparing the PE ratio between two companies in that one is from the FMCG sector and one is from the IT sector. So, this comparison is insignificant.
(3) Debt to Equity Ratio (D/E)
D/E ratio is the relation between total borrowing amounts with its shareholder’s equity. In simple terms to understand we can say that company has how much debt for every rupee of shareholder’s equity.
This ratio is also very useful to understand financial health of company.
The equation to find Debt to Equity ratio is given bellow.
Debt to Equity Ratio = (Total borrowing)/ total shareholders fund/equity
Here, total borrowing includes short term and long term borrowing.
You get short term borrowing, long term borrowing & total shareholders’ equity from the company’s balance sheet.
A Higher D/E is risker for the company’s financial health because the company has to pay interest on a regular basis on that and if a company fails to do that it is risky to bankruptcy.
While, lower D/E is the sign that company using less borrowing and has strong equity position. In this situation company has chance more chance to survive during hard time or poor financial performance.
This ratio is mostly suitable to compare stocks with same sector. As an example we are comparing D/E ratio between two companies in that one is from banking sector and one is from IT sector. So, this comparison is insignificant.
Stocks from power, banking & NBFC sectors have higher D/E while stocks from retail & IT sectors have lower D/E ratio.
As a thumb rule, D/E ratio is less than one is safe and better option for investment purpose while greater than one is risky bet for investment.
(4) Return on Equity (ROE)
ROE is the relation between net incomes (profit) of company with its total shareholder’s equity investment.
ROE is the ratio used to find how the company’s management utilizes shareholders’ equity investment to generate profit.
In simple term how much company generate return using shareholder’s capital (here not include debt fund & preference capital).
The equation to find Return on Equity is given bellow.
Return on Equity = Net Income (profit) / total shareholder’s equity
The number of net income (profit) & total shareholder’s equity find from the balance sheet of the company.
If we are comparing two stocks based on ROE it’s advisable to consider the debt of both companies. This comparison is suitable for those both company has approximately similar debt ratio.
As a thumb rule company having more than 20% ROE for last 5 years is suitable for long-term investment and increasing ROE on yearly basis is also good sing for quality investment company.
(5) Return of Capital Employed (ROCE)
This ratio is also working same as ROE and use to measure company’s profitability. But ROCE is more accurate in comparison of ROE for fundamental analysis of stocks.
Reason is that ROCE use relation between company’s earnings before interest and tax (instead of only net profit) in relation with total capital employed (instead of only shareholder’s equity).
The equation to find ROCE is given bellow.
ROCE = EBIT (Earnings before Interest & Tax) / Total Capital Employed
Here total capital employed includes shareholder’s equity with debt and other source of fund.
The number of EBIT & total capital employed find from the balance sheet of company.
As a thumb rule, the company having more than 20% ROCE for the last 5 years is suitable for long-term investment, and increasing ROCE on yearly basis is also a good sign for quality Investment Company.
(6) Current Ratio
This ratio is also useful to check the financial health of the company for an upcoming short-term duration. The current ratio finds how much current assets available to the company to cover its current liability.
This ratio gives us a measure of how management utilizing its asset to cover short term borrowing.
The equation to find current ratio is given bellow.
Current Ratio = Current Asset / Current Liability
Here, current asset means the resources that consumed or converted to cash within 1 year (resources like cash, bank deposit, market securities, and account receivable).
On the other hand current liability is that which paid within 1 year (like account payables, outstanding expenses, cash credit & overdraft, short term loans and some other expenditure)
If Current Ratio > 1 means the company has the potential to beet short term liabilities. The ideal current ratio should be more or equal to 1.33.
However, if Current Ratio < 1 means it’s tough for a company to overcome short term liabilities.
All the above-given ratio is very helpful to check the financial health of any organization and effectively use for fundamental analysis of stocks.
Actually above-given ratio is directly available on different financial websites. So you don’t need to worry about how to calculate these ratios.
But the above note gives you a proper idea about what is that ratio and how to utilize it to find the financially healthy of the company for long term investment in the stock market.
To find the company balance sheet use this Money Control link and follow bellow steps.
Search company name (stock symbol) in the search bar found the top of the page
After searching company name you can find “Financials” option. Click on Financials tab.
Under “Financials” tab you can find different options like (Balance Sheet, Profit & Loss, Ratios) as given in bellow image.
In the above image, you can find options like Balance Sheet, Ratios under the Financials tab.
Under the balance sheet option, you can find different useful values like Total Shareholders Fund, Short term borrowings, Long term borrowings, and so on.
While under Ratios option you can find different ratios like EPS, P/E, ROC, ROCE, and many others.
There are other various online platform available to find this kind of ratios. Please go through bellow links to know more.
Now you have all required ratios for fundamental analysis of stocks. Based on these ratios you find any quality stocks then go for following search else do not west your time for bellow criteria.
Qualitative analysis mainly focuses on non-numerical data that include company’s business model & product, company management, promoter holding, future planning of company and so on.
Understand Company Business & Product
As an investor it’s necessary to understand company product and its business for fundamental analysis of stocks.
There are more than 5500 companies listed on the stock exchange and all the company has different products different working patterns different management with different vision and moat.
It’s necessary to understand that,
- What the product of the company is?
- What is the future of that product?
- How long people use that product?
- Is the product is unique from their peers?
- How is the distribution network of the company?
- How is the company maintaining its customer base?
- The company have only a local or global customer base?
- What is the monopoly of that company to maintain profitability and revenue generation?
All the above questions are very basic and if you have the knowledge and a satisfactory answer for the entire above question, you can think to invest your money in this business and become a partner of that equity.
It is obvious that without proper knowledge and analysis you would not think to invest your hard earn money in such a business.
Here we are not talking only about buying stocks but talking about buying a business. I am discussing it with a proper example so you get a proper idea.
Let’s say you know the business of FMCG company Hindustan Unilever, you know its products (Lux, Fair & Lovely, Lifebuoy, Pond’s, Clinic Plus, CloseUp, Rin, Surf Excel, Wheel, etc.).
Also, you know the customer base of these products, how you are habitual to use these products, how long people use this product in the future; we can put assumption of profit and revenue generated by the company on its cost of investment.
So, this business is somewhat easy to understand for you and you can think to put your hard earn money in this business for long term growth.
On the other hand, you know the business of IT company TCS, You just know that this company is only providing service and support in software and technology sector but it’s difficult for you to identify the working pattern of the company, the product of a company, what are the customer base of the company? And many others
So, this business is vital for understanding for you and afraid to put you hard earn money in this business for long term growth. It doesn’t matter how company financially strong.
All the above observation is very crucial to understand if we want to learn fundamental analysis of stocks.
Understand Company Management
Management plays a very crucial role in any organization’s growth or decline story. Without analyzing company management it’s very hard to identify the future of any organization.
It’s very important to have a company in safe, strong, and honest management. To identify you have to ask some basic questions regarding management to analyze stocks.
- How is the order book of the company?
- What are the development planning of management to fulfill future goals?
- Whatever the goal and target decided by management, is it realistic or not?
- Does the company have a future goal and strategy to grow the financial health of the company?
To find above details go through the Management Discussion and Analysis under annual report section of company.
Also, TV interviews, blogs, and social media are a very important sources of information to find the latest update from top management.
As well as you can go through the profile of CEO, CFO, MD, Chairman of company and get knowledge of education, experience and expertise of that personal.
It’s necessary that management has sufficient experience, a proven track record of success in the relevant industry.
Mixtures of a high qualified persons with strong experience have the ability to lead business on new height. These kinds of management have guts to grow your money on the long run if you become a partner by purchasing equity of that business.
Recently we have seen that example of Yes Bank how investors lose hard earn money just because of management issues. There were so many unethical practice done by the promoter and top management and how the share price decline in very short time from around Rs.400 to around Rs.30.
To avoid this kind of loss in your portfolio you need to check what’s going inside the management and stay updated with that.
Now, you got an idea of why analyzing company management is very essential for the fundamental analysis of stocks.
Understand Promoter Holding
Promoter holding means how much percentage of stack hold by top management of the company. Top management and top designated person of an organization have a strong idea about the company’s future growth and potential.
If promoters and top management buy stock from the open market or share buyback are the signals those owners have faith and trust in the company’s future growth. Those companies are best to invest money.
On the other hand, sometimes promoters sell their holding and generate money for new development and expansion.
Company management declares why they are selling their stack in their financial statement. It’s advisable to go through it.
But if you find promotes selling their stocks continuously without any explanation or declaration it’s the matter of investigating and try to avoid this kind of stocks from your portfolio.
Also, Institutions holding are given some ideas to us. Institutions holding means, FII, DII, MF house have held in companies. If companies have high institutional holding that is the strong factor for company fundamentals.
These way promoters holding play important role during fundamental analysis of stocks.
So, Understanding company products, business, company management, promoter holding under qualitative analysis are very essential to for fundamental analysis of stocks.
This post is long but very essential for learning fundamental analysis of stocks.
Frequently Ask Question (FAQ)
What is the fundamental analysis of stocks?
It is the process to analyze the business and financial performance of the company. This process gives an idea about the current valuation, future aspects, and growth potential of the company.
What are the ratios used for the fundamental analysis of stocks?
(1) Earning Per Share (EPS)
(2) Price To Earnings (P/E)
(3) Debt To Equity (D/E)
(4) Return On Equity (ROE)
(5) Return On Capital Employed (ROCE)
(6) Current Ratio
What to look for fundamental analysis of stocks?
To do a fundamental analysis of stocks, different financial ratios are very important apart from that understanding of business, product, company management, and promoters holding play a very crucial role.
Why fundamental analysis of stock required?
To avoid losing in the stock market and generate a healthy return on your investment fundamental analysis is very important.
Who can learn fundamental analysis of stocks?
Everyone who is interested to learn stock investing and wants to do investment in the stock market for long term investment.
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