Fundamental Analysis of Stocks in India
The process of fundamental analysis involves examining the economic, financial & other qualitative as well as quantitative factors related to a security so as to determine its intrinsic value. While usually this method is used to evaluate the value of a company’s stock, it can also be used for any kind of security, like bonds or currency.
Fundamental analysis is also known as quantitative analysis and involves delving into a company’s financial statements (such as profit and loss account and balance sheet) in order to study the various financial indicators (such as earnings, liabilities, revenues, expenses and assets). Such an analysis is usually carried out by brokers, analysts, and savvy investors.
Two approaches in fundamental analysis
While carrying out fundamental analysis, investors can use any of the following approaches:
- Top-down approach: In this approach, an analyst investigates both national and international economic indicators, like energy prices, GDP growth rates, inflation and interest rates. The analysis of total sales, price levels and foreign competition in a sector is also done in order to identify the best business in the sector.
- Bottom-up approach: In this method, an analyst starts the search with specific businesses, irrespective of the industry or region.
How does fundamental analysis work?
Fundamental analysis is done with the aim of predicting future performance of a company. It is based on the theory that market price of a security tends to move towards its 'real value' or the 'intrinsic value.' So when the intrinsic value of a security is higher than the security’s market value, it represents a time to buy. On the other hand, when the value of the security is lower than its market value, investors should sell it.
Steps in fundamental analysis are as follows:
- Macroeconomic analysis, that involves considering commodities, currencies, and indices.
- Industry sector analysis that involves the analysis of companies which are a part of the sector.
- Situational analysis of the company.
- Financial analysis of a company.
- Valuation
Valuation of any security is done through the discounted cash flow (DCF) model, that takes into consideration the following:
- Dividends which is received by investors
- Earnings or the cash flows of a company
- Debt, that is calculated by using debt to equity ratio and current ratio (current assets/current liabilities)
Fundamental Analysis Tools
- Earnings per Share
The overall earnings of a company are not in itself a useful indicator of a particular stock's worth. Low earnings and low outstanding shares could be more valuable than high earnings along with a high number of outstanding shares. The Earnings per share is much more practical information than earnings by itself. Earnings per share (EPS) is arrived at by dividing the net earnings by number of outstanding shares.
- Price to Earning Ratio
The Price to Earnings Ratio (P/E) indicates the relationship between stock prices and company earnings. It is computed by dividing the share price by the Earnings per Share. The P/E indicates how much investors are willing to pay for a particular company's earnings. A high P/E can mean that the company is overpriced or it could also mean that investors are expecting the company to continue growing and generate profits. A low P/E can mean that investors are wary of the company or it could also indicate a company that majority of the investors have overlooked.
In both cases, further analysis needs to be done to determine the accurate value of a particular stock.
- Price to Sales Ratio
When a company is having no earnings, there are other tools that help investors judge its worth. New companies in particular mostly have no earnings, but that does not indicate that they are bad investments. Price to Sales ratio (P/S) is very helpful for judging new companies. It is calculated by dividing the market cap (stock price times the number of outstanding shares) by the total revenues. Another method is to divide the current share price by sales per share. P/S ratio indicates the value that the market places on sales. Lower the P/S, better the value.
- Price to Book Ratio
Book value is calculated by subtracting liabilities from assets. Value of a growing company would always be greater than book value owing to the potential for future revenue. The P/B ratio is the value that the market places on book value of the company and is calculated by dividing current price per share by book value per share (i.e. book value / number of outstanding shares). Companies having a low P/B are good and often chosen by long term investors who see the company’s potential.
- Dividend Yield
Certain investors look for stocks that are able to maximize dividend income. Dividend yield is helpful for determining the percentage return that a company pays in form of dividends. Dividend yield is calculated by dividing annual dividend per share by stock's price per share. Generally the older & well-established companies pay a higher percentage, and such companies also have a more consistent dividend history as compared to younger companies.
Fundamental Analysis - Benefits
- The intrinsic value of a security can be identified using fundamental analysis
- It also helps in identifying long-term investment opportunities, as it involves real- time data.
Fundamental Analysis - Drawbacks
- Since there are too many economic indicators and extensive macroeconomic data, it can confuse novice investors.
- The same set of information based on macroeconomic indicators may have varied effects on same currencies at different times.
- It is useful only for long-term investments.
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