If you are a beginner in the whole world of investing, you have probably heard that investing in stocks have historically generated more wealth than most other asset classes. So, a good chunk of your financial portfolio should be invested in stocks to get superior return and reap the benefit of country’s economic growth.
But the main challenge new investors face is identifying the right stocks for investment. Newcomers in the market often put their hard-earned money into random stocks based on tips from friends or relatives or from so-called experts on the social media and end up on the losing side. But they could do fairly well with only a basic understanding of the businesses behind the stocks. And this is where fundamental analysis kicks in.
What is Fundamental Analysis of Stocks?
In the stock market, fundamental analysis is simply the assessment of a company’s future growth prospects based on its business model, future business plans, financial statements and management ability and integrity.
A fundamental analyst not only tries to judge whether a company can grow its sales and profits in coming years but also tries to determine the fair value of the company’s stock and whether it would be a good long-term investment opportunity at the current market price. Sounds too complex? Nope, with some extra efforts you too can do fundamental analysis of a company’s share and select good stocks for investment.
How to do Fundamental Analysis of Stocks?
Fundamental analysis of a company’s stock includes both quantitative and qualitative factors and basically involves four major components –
- Business & Sector analysis
- Company Financials
- Management analysis
- Valuation analysis
1. Business and Sector Analysis
Well, the very first and basic thing you need to do before investing in a company is to understand their business. A simple Google search will give you the basics of a company’s business. You may also find useful videos on YouTube. For in-depth understanding, you should download and read the company’s annual report. You can get it from the company’s website or use a site like screener.in to download the annual reports of any listed company in India.
The things you need to know are –
- In which sector is the company working? (Is it banking, retail, IT, pharma, auto or anything else?)
- What is the future potential of the sector? (While some sectors like banking, IT, pharma, green energy, organised retail etc. are likely to grow, sectors like oil & natural gas, coal, cigarette, paper etc. are likely to go down over time.)
- What products and services does the company offer?
- Are the company’s products or services better than its competitors? How?
- Is the company’s business cyclical or evergreen? (While industries like steel, cement, construction etc. are sensitive to economic cycles, sectors like FMCG, healthcare, IT etc. are evergreen.)
- Who are its suppliers and customers? (catering to value segment or premium and luxury segment? selling in India only or globally? Where do the raw materials come from?)
- Where are the company’s manufacturing units, offices, warehouses etc. situated?
- Does the company have a great brand recognition?
- Is the company a market leader? What are the moats protecting the company from its competitors? (less production cost? better distribution channel? management efficiency? better technology?)
- Do you think the demand for the company’s products/services will grow in future? Why?
- What are the growth triggers? (company planning for expansion? new product launches? something new happening in the sector?)
- What are the key risks for the business? (Is the company over-dependent on a single supplier or a single customer? Is the industry over-regulated by the govt? Is the competition growing heavily? ) etc.
Read about the company’s business from its website, its annual reports, investor presentations and follow the company announcements from time to time to get answers to the above questions and also keep yourself updated with the progress of the business. Write down all the important information in bullet points. This is how to do the basic business and sector analysis of a company in which you may be thinking to invest.
If you find a company which is operating in a growing sector and you believe that the company’s products and services are better than its competitors and are going to remain in high demand in future, then the company’s stock has a potential to give good returns in the long run.
Why is understanding the business important? It is because when you deeply understand a company’s business and future growth prospects, you feel confident about the company’s long term performance. That confidence helps in holding your stake in the company firmly for a long period of time through short-term upsets and market volatility.
2. Company Financials
After you complete a qualitative business and sector analysis, it’s time to look at the financials or quantitative details of a business. Listed companies in India publish their financial results every quarter. You can easily view and analyse those numbers on a site like Screener or Tickertape.
As a newbie investor, you need to check some basic financial parameters like –
- Market capitalisation (how big the company is in terms of valuation) – larger companies are generally less risky but growth rate is also slower.
- Yearly sales and profit (how big the company is in terms of sales and profits)
- Last 5 and 10 years sales growth rate – should be 10% or more
- Last 5 and 10 years profit growth rate – should be 12% or more
- ROE (Return on equity) – should be 12% or more
- Free cash flow – should be in positive and growing
- Total cash balance – The more the better. Healthy cash balance helps company tackle a crisis situation and/or expand its business operations
- Debt to Equity ratio (loan burden on the company) – should be less than 1 (the less the better)
- Current ratio (current assets/current liabilities) – should be 1.5 or more; shows the strength of the balance sheet, and company’s ability to repay its short-term debts
- Operating profit margin (OPM) and Net profit margin (NPM) – should be stable or growing
The above parameters are just for a reference and you should adjust it for your personal liking and comfort zone. For example, some investors would invest in a company only if its profit growth or ROE is more than 20%. While some investors like to invest in companies with a market cap of more than 20000 Cr, some would like to invest in small and micro-cap companies with market capitalisation of below 5000 Cr. These depend on one’s personal preference and risk appetite.
Again, all these numbers should be seen in comparison to the competitors. This is because it all depends on the sector. For example, companies in the retail sector (like Reliance Retail, DMart, VMart, Trent etc.) generally operate at a net profit margin below 5% while pharma companies (like Sun Pharma, Cipla or Alkem) work with a net profit margin of 12-15%. So a competitor analysis would reveal which company is ahead in terms of operating efficiency.
3. Management Analysis
Another key element of fundamental analysis of a stock is to find out whether the management running the company is trustworthy. It is a qualitative indicator and of utmost importance. Every iconic investor including Warren Buffet stresses upon the importance of corporate governance and management integrity.
According to different sources, almost 80% companies in India are involved in some kind of accounting trickery and other fraudulent activities. On one side, there are trusted and respected names like Tata, Reliance, Bajaj, Mahindra, L&T etc. and on the other side, there are names like Satyam, Yes Bank, DHFL, Manpasand etc. who were involved in fraud and looted investors’ money. So, you should be very choosy in selecting the right company for investment.
Again, according to Saurabh Mukherjea, the management should be hungry, rational and honest. The investors would gain nothing if the management is lazy and not hungry for growth. Again, irrational allocation of money to unrelated business operations have destroyed many companies in the past. And, if the management is not honest and misrepresenting the company financials, they might be making money for themselves but not for investors like you and me.
Here are some quick tips to help you judge management integrity and capability –
- Simply do a Google search for “company name + scam”, “company name + fraud” etc. to know if the company or management has been involved in naughty things in the past.
- Check the history of the promoters and how long they have been in the business.
- See whether the management did what they promised in the past. Did they achieve the sales targets or executed the new projects which they talked about in the last years’ annual reports?
- Does the management give false excuses when the sales drop?
- Are the promoters taking disproportionately higher remunerations from the company compared to its profits? Not a good sign.
- Is the auditors’ fees increasing fast? Something fishy.
- Did any auditor or director resign from the company? For what reason?
- Is the company showing profits in paper only or is it converting into real cash? (need to see the balance sheet and cash-flow statement)
- Are receivables and/or inventory increasing disproportionately?
- Are the management investing money in a completely different sector where they have no prior experience?
- Do they talk big but under-deliver? Listen to the management’s interviews on business channels and on YouTube. Always go with the management who under-commit but over-deliver.
- Also, a deep dive into the company financials like OPM (growing or falling?), ROE, free cash flow, market share (gaining or losing?) etc. would reveal how capable and efficient the management is.
4. Valuation Analysis
Well, fundamental analysis of a company’s share will be incomplete without a valuation analysis. Even if you found a fundamentally sound stock by following the above three analysis (business & sector, financials and management analysis), whether you make a profit or not, and how much profit you make from the share depend on what price you buy the stock.
Here, price is what you pay and value is what you get. So always try to get more value at less price – look for undervalued stocks. But how do you know from the stock price if it is fairly valued, overvalued or undervalued?
In reality, the stock price simply means nothing. Yes, you read it right. Price of a stock is the most useless thing in valuation assessment. So, here are a list of valuation ratios which will help you judge the valuation of a business –
- Price to earnings (P/E ratio) – It means how much price you are ready to pay for 1 rupee of annual profit. As a general rule, the less PE, the better. But it’s not that simple though. Various other factors are taken into consideration to estimate the fair value of a business. Compare a stock PE with its peers (competitors) and also with 5 years median PE. High growth stocks generally trade at high P/E in the market.
- Price/Earnings to Growth (PEG ratio) – PEG ratio is calculated by dividing the PE ratio of a share by 5 years annual growth rate. A PEG ratio of 1 or less is generally considered good. But for high growth shares (annual growth rate of 25% or more) a PEG ratio up to 2 can be considered fair too.
- Price to book value (P/B ratio) – The P/B ratio indicates at what multiples a company’s share is priced against its book value according to the balance sheet.
- Market Cap to Sales (M.Cap/Sales) – This ratio tells you at what multiples is the company currently trading against its total annual sales.
- Enterprise value to EBITDA (EV/EBITDA) – This is at what price people are ready to buy the business against its annual EBITDA (earnings before interest, tax, depreciation and amortization).
All these numbers are easily available on the Screener website. You need to compare a company’s valuation ratios with its peers to get an idea of the relative valuation. It’s not always true that a company with less P/E, PEG, P/B or EV/EBITDA must be undervalued. There are lots of other factors to consider.
In the above image, you can see that while Polycab and KEI are trading at PE ratio of about 37 and 33 respectively, Finolex Cables is trading at a PE of 13. Similarly, P/B ratio and EV/EBITDA are also very less in case of Finolex. So is Finolex share undervalued? No. See the 5-year sales and profit growth numbers. Finolex profits have grown at a rate of 8.4% as compared to 31% and 32% of Polycab and KEI. So, Polycab and KEI rightly deserve premium valuation.
Here, the valuation ratios should be seen in relation to the company’s historical growth and future growth prospects. Mr. Market is always forward looking. If a company is perceived to be able to bring higher sales and profit growth in future, automatically its shares will be trading at a premium valuation. That doesn’t always mean overvaluation.
In the above example, 5-year median PE of Asian Paints is 66.8, but the stock is now trading at a PE of almost 80. This can be seen as overvalued at this price. Again, if someone thinks that the company can actually bring higher growth than the recent past, then this valuation may be justified.
Valuation is therefore highly subjective and depends on one’s personal opinion and risk profile. If you think the company can bring real fast growth, you can buy it at a premium valuation. But, in reality, if the company fails to meet the expectations and the growth slows down, then there would be deep correction in the price.
As they say, company valuation is an art, not a science. And numbers don’t always show the entire picture. You need to combine qualitative factors with numbers to see the bigger picture.
There will be up and down market cycles. But if you take a stock-specific approach and invest in high quality businesses based on your fundamental research of a company, you’ll likely do better than most of the common investors and traders out there.