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
- Corporate governance
- Moat of the business
- Competition landscape
- Regulatory environment
- Promoter background
- 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.
- Insight into corporate governance
1. Director’s Background
2. Director’s Remuneration
3. Shareholding Pattern
- Consolidated Financial Statements
Understanding P&L Statement
- 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
The leverage 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 ratio compares 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.
- Option based valuation
Gross Profit Margin > 20.
ROE = 20–25 %
Business diversity of a company
Be reasonable with your expectations.