In this blog we will break what all constitutes fundamental analysis. Fundamental analysis is usually used by investors and is a useful skill to master.
Introduction - Fundamental Analysis
Annual Report
1. Qualitative
Corporate governance
Moat of the business
Competition landscape
Regulatory environment
Promoter background
2. Quantitative:
Profit & Loss
Balance Sheet
Cash Flow
Mindset of Investor
Trader: Design trade.
Speculator: Gut feel, Friend told.
Investor: Does deep down fundamental analysis.
How to read annual report of a Company
Download from the company website.
Includes financial and non-financial.
Figure out your main area 1. Management Discussion & Analysis. 2. General Shareholder Information. 3. Consolidated Financial Statements.
Management Discussion & Analysis 1. Business Strategy of the Company 2. Growth Prospects of the Company 3. Risk that the company faces.
Revenue (Top Line) Total Income = Revenue from operation + Other Income
Expense: Raw materials + Salary paid to the Employees + Depreciation & Amortization + Interest Payments + Electricity & Rent + Power & Advertisement.
Operating Profit = Revenue − Expenses
Tax: Profit after Tax (PAT: Final Profit or Bottom Line) PAT = Operating Profit − Tax
Understanding Balance Sheet
Year on Year basis
Two broad sections: Assets & Liability (Both are sub-divided into Non-current and Current)
Non-Current Assets 1. Have a long-term economic benefit to the company. 2. Includes: Tangible Assets (Like — Property, Plant & Machinery) and Intangible Assets (Like — Trademark, Patent & Certificate, Financial Instruments)
Current Assets: Economic output within a year time frame. 1. Inventories: Finished goods ready to be sold. (Dig Deep) 2. Trade Receivables 3. Repayment of Loan by others to them 4. Cash & cash balance held with the Bank
Non-current Liabilities: Financial obligations which can be fulfilled within a few years.
Current Liabilities: This should be fulfilled within a year.
Equity Liabilities: 2 Parts — Share Captial + Reserves & Suplusses(Profit from P&L)
The Cash Flow Statement
It gives the exact cash position of a company
Three Activities a company can conduct: Operating + Investing + Financing. Sum total forms cash statement
Generate or consume cash
Operating Cash: Represent the core operation of the company.
Investing: Capital expenditure: New plant, acquisitions.
Generate Cash: Positive Cashflow
Consume Cash: Negative Cashflow
Financing: Borrowing from banks, paying out dividends.
The Connection between Balance Sheet, P&L and Cash Flow Statement
All three are deeply connected.
P&L: Revenue + Significant Expense + Effective Tax Rates+ PAT
Balance: Borrowings +Account receivables + Cash available at hand or banks
Cashflow: Cashflow from Balance + Investing + Financing Activities
Financial Ratio Analysis
Metric that helps in understanding the financial health of a company. It is divided into 3 broad categories — Profitability ratio, leverage (or solvency) ratio, and valuation ratio.
The profitability ratio helps us understand the profitability of the business. Profits are important to expand the business and pay dividends to shareholders. To analyze a company on the basis of this ratio, ensure that the PAT margin and EBIDTA Margin are trending upwards and are stable.
Some of the Profitability ratios are:
Operating Profit Margins (OPM) Percentage of profit a company produces from its core operations. Calculated by calculating the EBITDA (Earning before Tax, the interest cost, depreciation & amortization) of a company. EBITDA = Total Income − Total Expenses OPM = EBITDA ÷ Revenue from operation
Net Profit Margin Calculate the percentage of profit a company produces from its total revenue. PAT Number ÷ Total Income
Return on Equity (ROE) The ratio measures the efficiency with which a company generated profits from each unit of shareholder’s equity or capital invested. The higher the ROE, the better it is (>25%). A company should not have much debt as it can skew the ROE number. It is different for different sectors. Like IT company has a very high ROE as they don’t have to re-invest more as compared to a manufacturing company which has a low ROE. ROE = Net Profit after Tax ÷ Shareholder’s Equity
Theleverage in the context of the balance sheet refers to the debt that a company has taken from the bank to run its operation. It is also called the Solvency ratio. This ratio measures the operational efficiency of the business. Some of the leverage ratios are:
Interest Coverage Ratio Helps us understand how much the company is earning wrt the interest burden it has. This ratio determines how efficiently a company repays interest on its outstanding debt. Higher the better(>1). Interest coverage ratio = EBIDTA ÷ Finance Costs (Interest Obligations)
Debt to Equity Ratio D/E = DEBT ÷ EQUITY A measure of the total debt of the company against the total shareholder’s equity in the company. Minimum the best. Lower than 1 is better.
The valuation ratiocompares the stock price with the valuation of the company to get a sense of how cheap or expensive a company’s stock is. Popular valuation ratios are:
Price to Sales Helps to compare the stock price of the share with the sales per share. Higher associated with PAT margins. Ratio = Current Share Price ÷ Sales per share
Price to Book Book value = Tangible Asset − Liabilities It is simply the amount of money that is left on the table after a company pays off all its obligations. Book value = Total Equity ÷ Total Outstanding Shares PB = Share Price ÷ Book value A higher price to book value ratio signifies that the firm is overvalued wrt the company’s equity/book value. A lower price to book value signifies that the firm is undervalued wrt the company’s equity/book value.
Price to Equity Earnings per Share (EPS) = PAT ÷ Total Outstanding Shares PE = Share Price ÷ EPS For every unit of profit that a company generates the market participants are willing to pay PEx (times) more to acquire the share. Compare to industry-specific.
Compare the financial ratios of a company to its peers to have a better understanding.
How to value a company
Very elaborate process. The different techniques used
Intrinsic valuation Discounted Cash Flow analysis Model (DCF): It considers Free cash Flow and Growth rate of cash flow and risk.
Relative valuation Used when there is no positive free cash flow.
New Fund offers in mutual funds are like IPO for shares, where the fund houses come up with an investment proposal and public can subscribe to it.
What are NFOs?
An NFO or New Fund Offer is offered by Asset Management Company (AMC).
It is an invitation to the investors to subscribe to the units of a newly launched fund.
These are launched to introduce a new investment theme that any of AMCs existing funds do not offer.
A contribution is made to the pool of investment that is yet to be invested by subscribing to NFO.
How to Analyse an NFO (Checklist)
Asset Management Company (AMC): Good experience (At least 10 years), Good growth in its Asset Under Management (AUM), Lower expense ratio, Good portfolio of existing funds.
Fund Manager
Investment Strategy: Does the offering meets your investment needs (theme).
