Fundamental Analysis

The great value investor, Mr. Warren Buffet, is not someone who looks for quarterly earnings projections, next year’s earnings etc. He is not concerned about what the investment research from any firms says, in relation to price momentum, volume or anything. He simply asks: “What is the business worth?”

Fundamental analysis is, as the name implies, deals with the study of the fundamentals based on which a firm is built upon. Such an analysis can help to identify stocks of value or in other words, its actual worth!

Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts.

Objectives of Fundamental Analysis

  • to conduct a company stock valuation and predict its probable price evolution,
  • to make a projection on its business performance,
  • to evaluate its management and make internal business decisions,
  • to calculate its credit risk.

Fundamental analysis includes

  •  Economic analysis
  •  Industry analysis
  • Company analysis

On the basis of these three analyses, the intrinsic value of the shares will be determined. This is considered as the fair value of the share.

The important aspect of fundamental analysis is the critical analysis of the financial statements. Also, known as quantitative analysis, this involves scrutinizing the revenue, expenses, assets, liabilities and all the related components if a company.

When to use Fundamental Analysis?

If you are trying to invest into companies business and can remain invested for few years, you should focus on the fundamentals of the company.

WealthCity uses techniques which are used to by investment gurus such as Warren Buffet, Peter Lynch, William O’Neil etc. The techniques to name a few are Value investing, Growth investing, GARP and CANSLIM.

Our Investing strategies

Value investing, made famous by Mr. Warren Buffet, deals with the art of finding stocks which are priced below an estimated value and is assumed to converge with the estimated value in the near future.

Growth investing looks for stocks which are already in an upward trend and are assumed to move up further, typical of IT stocks such as Infosys or Cognizant.  The stocks are assumed to have strong fundamentals in terms of efficient products, management, cost efficiency et al.  The table below shows some basic ratios, among others, based on which the investor selects the value or growth stock:

Some people enjoy the idea of getting a stock for a bargain price. Others prefer investing in companies with large growth potential and pursue growth stocks for their portfolio. But, for those who like the ideas presented in both strategies and find some of the stock picking criteria too severe, then the GARP stock investing strategy might be appropriate.

GARP (Growth at Reasonable Price) is a hybrid stock investment strategy that emphasizes picking investments slightly under valued but still expected to have solid earnings growth in the coming years. However, GARP investors do seek out specific valuation metrics in order to help them make individual stock selections. But, a degree of personal judgment is also required. Peter Lynch is one of the most famous GARP investors who had an amazing average return of 29% during the years 1977-1990.

CANSLIM was developed by William O’ Neil, a well known stock broker. The process is described in detail below:

• Current Quarterly Earnings per share: The higher the most recent quarterly EPS, the better. Ideally it should be the highest in the company’s history (Fundamental).

• Annual Earnings Increases: Significant growth is required from year to year. We’re talking about increases over 20% a year for a few years (Fundamental).

• New Products, New Management, New Highs: Buy at a time that enables you to take advantage of some positive news. New management might be getting positive media coverage or a new product like Apple’s iPhone might have been launched. New highs could be appearing in the stock’s price chart (Fundamental and/or Technical).

• Supply and Demand: The shares should be in demand with a larger pool of potential buyers than potential sellers (Technical).

• Leader or Laggard: Buy the leading stock in any sector (the one whose price is advancing fastest) and avoid the laggards (Technical).

• Institutional Sponsorship: Are the big boys buying? (Technical.)

• Market Direction: Buy when the market is in an uptrend (Technical).

Some people enjoy the idea of getting a stock for a bargain price. Others prefer investing in companies with large growth potential and pursue growth stocks for their portfolio. But, for those who like the ideas presented in both strategies and find some of the stock picking criteria too severe, then the GARP stock investing strategy might be appropriate.

A Sector Rotation approach is often used by investors with a strong strategic view on where the economy is headed. With this approach, the portfolio’s equity allocation is typically all sector-related investments. As economic conditions change, the portfolio is “rotated”, into other sectors considered more likely to outperform.

Sectors that are not expected to perform well are underweighted or eliminated from the portfolio. The portfolio is dynamically adjusted as the economic cycle progresses.

Tactical Asset Allocation (TAA) strategy involves shifting in and out of various asset classes depending upon economic and market conditions. The asset classes in a Shariah-compliant portfolio may be Stocks, Cash or Gold. In a turbulent market, the dynamic approach of TAA can buffer stock downturns.

Following are some of the most popular fundamental analysis ratios for prudent stock picking:

1) Earnings per Share (EPS): EPS is derived by dividing the net profit after taxes by the total number of equity shares issued. It is a fundamental ratio used as a measure of a company’s profitability. When comparing two stocks, the higher the Earnings per Share the better it is.

2) Price to Earning (P/E) ratio: This is a fundamental ratio and used extensively in valuation of company shares. It is a measure of the price paid for a share relative to the profit earned by the firm per share. Generally, the higher the price earnings ratio the better it is because the market is willing to pay more for each dollar of company’s earnings.

Implicit in this model of a perpetual annuity (Time value of money) is that the ‘flip’ of the P/E is the discount rate appropriate to the risk of the business. The multiple accepted is adjusted for expected growth (that is not built into the model).

3) Dividend Yield: One way to determine if a stock would be a good investment is to calculate its dividend yield. This ratio measures the percentage return a company paid out in the form of dividends.

4) Price/Earning to Growth (PEG) ratio: This ratio is calculated by dividing the P/E by the projected earnings growth rate. A lower PEG indicates that the stock is more undervalued.

Growth estimates are incorporated into the PEG ratio, but the math does not hold up to analysis. Its validity depends on the length of time you think the growth will continue.
It, more or less, deals with identifying the quality of management, operational efficiency, earnings growth, product demand and supply etc.

5) Book Value per Share: It is a ratio that is calculated by subtracting the company liabilities from the company assets, then dividing it by the total number of shares. This is often used by traders to determine the level of safety associated with a stock investment.

6) Debt: The amount of debt is also a major consideration in determining a company’s health. It can be quickly assessed using the debt to equity ratio and the current ratio (current assets/current liabilities).

7) Return of capital employed (ROCE): ROCE is the ratio that is calculated as follows:

Operating profit / Capital employed (net value + debt)
To get operating profit, add old taxes paid, depreciation, special one-off expenses, and special one-off income and miscellaneous income to get the net profit. The operating profit is a far better indicator of the profits earned by the company instead of the net profit.

Hence this ratio is the better indicator of the general performance of the company and the company’s operational efficiency. It is one of the most useful ratio that lets you compare amongst the companies.v

7. Return on net worth (RONW): RONW is calculated as follows:

Net Profit / Net Worth

This ratio gives you an idea of the returns generated by investing in the company. While ROCE is an effective measure to get a general overview of the profitability of the company’s business operations, RONW lets you gauge the returns you can earn on your investment.

When used along with ROCE, you get an overview of the company’s competence, financial standing and its capacity to generate returns on shareholders’ finances and capital employed.