Important Factors in Fundamental Analysis

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What do you mean by Fundamental Analysis? Fundamental Analysis is about understanding a company, the health of its business, and its forecasts. Some factors to look at while doing fundamental analysis are as follows:-

Define Fundamental Analysis of a Company? Fundamental Analysis is about understanding a company, the health of its business, and its forecasts. It includes reading and analyzing annual reports and financial statements to get an understanding of the company’s comparative advantages, competitors. Importance of fundamental analysis, Components of fundamental analysis, Economic analysis in fundamental analysis, Industry analysis in fundamental analysis, company analysis in fundamental analysis, and much more.

Some factors to look at while understanding company fundamentals are as follows:-

1] Net Profit –

Net profit can have a different meaning for different people. Net means ‘after all deductions’. Net profit normally refers to profit after deduction of all operating expenses, particularly after deduction of fixed costs or fixed overheads. This contrasts with the term ‘gross profit’ which generally refers to the difference between sales and direct cost of goods sold, before the deduction of operating costs or overheads. PAT refers to net profit after deducting taxes, or profit after tax.

2] Profit Margins –

  • The number of earnings doesn’t tell the complete story. Increasing earnings are good but if the cost increases more than revenues then the profit margin is not improving. Every rupee of a company’s revenue is reflected in its profit margin. Thus, this measure is very useful for comparing similar companies, within the same industry.
  • Profit Margin is calculated on the basis of a simple formula that is:
  • Profit margin= Net income/Revenue
  • A higher profit margin indicates that the company has better control over its costs than its competitors. Profit margin is expressed in percentage.
  • For example, a 10% profit margin denotes that the company has a net income of 10 paise for each rupee of their revenues.

3] Return on Equity Ratio –

Return on Equity (ROE) shows the efficiency of a company in earning its profits. It is a ratio of revenue and profits to owners’ (shareholders) equity. Regardless of how much money its shareholders invested, a company’s profitability can be measured by calculating how much profit it can earn. This can be made easy with the return on equity ratio.

Return on Equity Ratio is calculated as follows;

Return on equity = Net Income / Shareholder’s Equity

This ratio is expressed in the form of rupees.

The reason why this factor is so important is that it contains information about several factors, such as:

  • Leverage (which is the debt of the company)
  • Revenue, profits, and margins
  • Returns to shareholders

For example, an SMG Ltd. company reported a net profit (before dividend) of Rs. 1,00,000 and issued dividends of Rs. 10,000 during the year. SMG Ltd. also had 500, Rs.50 par common shares outstanding during the year. Then ROE would be calculated like this:

ROE = 1,00,000 – 10,000 / 500×50

ROE = Rs. 3.6

This means that the shareholders will earn Rs. 3.6 for every rupee invested by them in the company.

4] Price to Earnings (P/E) Ratio –

  • Price-to-Earnings (P/E) ratio is commonly used to know the valuation of a share of the company. It gives us the current share price in the market in reference to its per-share earnings.
  • Thus, we can calculate the Price of earnings or PE ratio as follows;
  • PE = Price per Share / Earnings per Share
  • Comparing companies also becomes easier. However, companies should first calculate their EPS before calculating their PE ratios.
  • A high P/E indicates that the stock is priced relatively high to its earnings, and companies with higher P/E, therefore, seem more expensive. However, this measure, as well as other financial ratios, needs to be compared to similar companies within the same sector or to their own historical P/E.

For example, the SMG Corporation share is currently trading at Rs. 50 a share and its earnings per share for the year is Rs. 10. Its P/E ratio would be calculated like this:

P/E Ratio = 50 / 10

P/E Ratio = 5

The company’s ratio is 5 times. This means that investors will get 5 rupees (if sold in the market) for every rupee they have invested.

5] Price-to-Book (P/B) Ratio –

  • A Price-to-Book (P/B) ratio is used to compare a stock’s market value to its book value. This ratio gives a certain idea of whether you are paying a too high a price for the stock as it denotes what would be the leftover value if the company was to wind up today.
  • It can be calculated as:
  • P/BV Ratio = Current Market Price per Share / Book Value per Share
  • Book Value per Share = Book Value / Total number of shares
  • In a broader sense, it can also be calculated as the total market capitalization of the company divided by all the shareholder’s equity.
  • A higher P/B ratio than 1 denotes that the share price is higher than what the company’s asset would be sold for. The difference indicates what investors think about the future growth potential of the com
  • Earning Per Share is one such useful measure that the investors look for all the time. It shows the amount of money that the company is earning on every share. EPS of a company needs to increase in a consistent manner to show superior management performance.
  • Earning Per Share = (Net Income – Preference Dividend)/Weighted Average Number of Shares Outstanding

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