Important Factors in Fundamental Analysis
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.
Some factors to be looks while doing fundamental analysis are as follows:-
1] Net Profit –
Net profit can have 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. Net profit is also generally referred to as Profit After Tax (PAT), the profit figure after deduction of tax.
2] Profit Margins –
- Amount of earnings don’t tell the complete story. Increasing earnings are good but if the cost increases more than revenues then the profit margin is not improving. The profit margin measures how much the company keeps in earnings out of every rupee of their revenues. 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
- 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. The profitability of a company can be measured by finding out how much profit a company can earn with the money that has been invested by its shareholders. 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 for why this factor is so important is because it contains information about several factors, such as:
- Leverage (which is the debt of the company)
- Revenue, profits and margins
- Returns to shareholders
Example, a SMG Ltd. company reported 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 valuation of a share of the company. It gives us the current share price in the market in reference to it’s per share earnings.
- Thus, we can calculate the Price of earnings or PE ratio as follows;
- PE = Price per Share / Earnings per Share
- This also helps in comparison between companies. But first companies should calculate their EPS and then carry on with finding out their PE ratio value.
- 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 its own historical P/E.
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 certain idea of whether you are paying too high price for the stock as it denotes what would be the left over 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 shareholders equity.
- A higher P/B ratio than 1 denotes that the share price is higher than what the company’s assed 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 which the investors look for all the time. It shows the amount of money which 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
- EPS of one company can be compared with its past performance and with that of other companies in the same industry. It can be used to ascertain what portion of profit is the company allocating to each outstanding share.
- Investors usually go for companies which have steadily increasing earnings per share. It can be easily used to compare performance across industries.
Example, a SMG Ltd. company has 10,000 shares that are trading at Rs.10 per share. The company reported Rs. 50,000 of net worth (net worth) on their balance sheet this year. The company’s price to book ratio would look like this:
Book Value per Share = 50,000 / 10,000
P/BV Ratio = 10 / 5
P/BV Ratio = 2
The market price of the company is twice that of the book value. This means that the company’s share costs twice as much as the net worth reported on the balance sheet. Also, this company would be considered over valued because investors are willing to pay more for the company’s shares than they are worth.