Are you in a witch hunt for the best stocks that are available at an attractive valuation and will multi-fold your investment in the long run?
Then you must invest in fundamentally sound companies that will yield the best returns in the long run.
But how do I pick the best stocks that will deliver the best returns in the long run?
Simply put, picking a stock requires deep down research. By reading this article I assure you that you will learn not only what fundamental analysis is but also how to do fundamental analysis of stocks.
What is Fundamental Analysis?
Fundamental analysis helps an investor to find the underlying value of a company. You should invest in a stock when you find that the intrinsic value of a company is much lower than the market value of the stock. When you are investing in the stock market to experience compound interest then stick to the stock market without worrying about the daily price fluctuations of the stock.
Why a retail investor should do Fundamental Analysis?
To calculate the intrinsic value of a company, you will find fundamental analysis is helpful. Suppose a stock’s current market price is 100. But if you have found that the true value or intrinsic value of a stock is 70 then it can be assumed that the stock is available at a steep discount. You are free to invest in that stock.
On the contrary, if the stock is trading at 120 then it signifies that the stock is trading at a premium and doesn’t deem fit to start investing in it.
How to do Fundamental Analysis of Stocks?
To do fundamental analysis of stock you must analyze a company on the basis of Quantitative factors and Qualitative factors.
What is Quantitative Analysis of a stock?
A quick overview of the quantitative analysis can help an investor to find how much profitable a company is, or if the company is undervalued or overvalued, etc. Quantitative analysis of a company enables an investor to calculate if the company is worth the investment or not. Quantitative factors can be described in numbers that you will find from the income statement or balance sheet.
By analyzing the quantitative factors you will find the following key numbers,
- Debt to Equity Ratio
- Profit Margin
- Earnings per Share
- Dividend Payout
- Return on Equity
- Return on Capital Employed
- Price to Earnings Ratio
- Price to Book Ratio
- Price to Sales Ratio
- Current Ratio.
Parameter #1. Debt to Equity Ratio
The Debt to Equity ratio gives a detailed snapshot of the outstanding debt liabilities a company has, be it for the short term or long term.
The debt to equity ratio can be calculated by dividing a company’s total debt obligations by its total shareholders’ equity.
To gauge the investment risk while investing in any company, do analyze if the company has a heavy debt or not. Stay clear from those companies that have a debt to equity ratio much higher than the peer average. As a good rule of thumb, you can start investing in those companies that are either debt-free or have a marginal debt to equity ratio of 0.25 or lower.
Parameter #2. Profit Margin
Find out if the business successfully mints money profit by running a business operation year on year. Typically, a profit margin can be described as what percentage of sales the company has turned into the profit. For example, if the profit margin is 25% then it can be assumed that the company has made 25 when the total sales earning is 100.
To find the efficiency of the management and the profitability of a company, the profit margin is a widely used profitability ratio. Since the profit margin varies from sector to sector, it’s hard to interpret the ideal profit margin. But do invest in those stocks that have delivered a double-digit growth year on year.
Parameter #3. Earnings per Share
When you divide the company’s net profit by its outstanding shares available, you will find the Earnings per Share.
The EPS will give a detailed snapshot of to what extend the business is profitable. The higher the EPS of the company is, the more lucrative the investment opportunity is.
Apart from that, when a company’s EPS increases year on year then the chances are higher that the stock price will surge. The investors will pay more to buy the stocks if they find that the EPS is higher in comparison to its market price of a share.
Parameter #5. Dividend Yield
Contrary to the dividend rate that typically describes what an investor should expect a year on dividend payouts, the dividend yield will help you to find if the share price of a company is in line with the dividend payout in a financial year.
Suppose there are two stocks operating in the same sector and having an identical stock price. If you find that the first company gives 100 on dividend payout and the second one’s dividend payout stands at 50 then you must invest in the first one, since the dividend payout is higher than the latter one.
Simply put, by analyzing the dividend payout in a year, you can easily find to what extend the company rewards the shareholders by announcing the dividend in a fiscal year. If you find that the company declares dividends and reinvests the profit into the business then you should invest in that stock.
Parameter #6. Return on Equity
By analyzing the Return on Equity you will find the financial performance of a corporation. Return on Equity can be calculated by dividing the Net income of a firm in a financial year by its total shareholders’ equity.
Since the shareholders’ equity takes account the assets and the total outstanding debt obligation a company has, you will get a clear picture of how much profit a firm generates in a financial year.
It’s hard to interpret the ideal return on equity ratio. The return on equity varies from sector to sector. Invest in those companies that have outperformed their peer average. As a good rule of thumb, you must invest in those companies that have delivered an ROE of 15% or higher during the past 5 years.
Parameter #6. Return on Capital Employed
The Return on Capital Employed helps an investor to find not only the management’s efficiency to generate profit from the available capital of the shareholders but also whether the management is efficient enough to generate additional profits by leveraging the assets a company has.
ROCE can be calculated once you have divided the Earnings before interest and tax with capital employed.
RoCE takes into account of the assets, liabilities, and debt obligations. By analyzing the RoCE you can gauge the performance of the companies that are operating in the capital-intensive sectors with significant debt obligations.
Parameter #7. Price to Sales Ratio
To find out if the stock’s current market price is in line with the revenue generated by a company, various analysts employ the Price to Sales Ratio. Typically, the price to sales ratio reveals what the market is willing to pay when the company generates one rupee in sales or revenue in a financial year.
The price to sales ratio can be calculated by dividing the market price of a stock with its per-share sales revenue in a financial year.
There’s no ideal price to sales ratio, but the lower the price to sales ratio is the better the investment opportunity is.
Parameter #8. Price to Earnings Ratio
The price-to-earnings ratio helps you to find if the current stock price is in line with the earnings. It takes into account of the current share price and the earnings per share. When you buy a stock with the current P/E of 17, then it can be assumed that it will take 17 long years to get back the initial investment from the continuing profits of the company.
The Price to Earnings ratio can be determined when you divide the current market price of a share with its earnings per share.
By calculating the price-to-earnings ratio you can easily find the stock status, undervalued or overvalued. As different sectors have different P/E ratio it’s hard to interpret the ideal P/E ratio, but as a good rule of thumb compare a stock P/E to its peer average to gauge if the stock is trading higher or lower than its underlying values.
Parameter #9. Price to Book Ratio
To measure the potential risk of investing in any company, the Price to Book ratio is one of the widely used matrices.
The price to Book ratio can be determined by dividing the company’s current market price with its book value per share.
The book value helps an investor to calculate what he will get after the company pays off all the debts outstanding in the scenario of the company goes bankrupt.
Frankly speaking, it’s hard to find the companies with a P/B lower than 1.0 with robust earnings. That’s why conduct a search for those companies P/B ratio of which varies between 1 and 3 with robust earnings during the past 5 years.
Parameter #10. Current Ratio
The current ratio gives a detailed snapshot about if the company can clear all the debts outstanding that are payable within a year after liquidating its current assets.
If the current ratio of a company is 2 then it gives a clear signal that the company has enough current assets that can be liquidated to pay off all the current liabilities due within a year and still is left with the working capital to run the business operation as usual.
What is Qualitative Analysis of a stock?
Qualitative factors can’t be described by offering numbers. You can’t gauge by applying what strategies the company is making money to run a business operation. Or what factors give a company a competitive advantage over its peer competitors. These are the soft matrices that can’t be described in numbers.
Simply put, the Qualitative analysis requires a judgment or wisdom to analyze the brand value, the management of the company, work ethics, etc.
By analyzing the Qualitative factors you will find,
- Business Model,
- Management of the company,
- Competitive Advantage,
- Corporate Governanace.
Parameter #1. Business Model
A business model can be described as how the company generates a profit by running a business operation. Before investing in any company do consider the following points.
- What types of products or services the company is offering.
- Who is the target audience of the company?
- What marketing strategies the company is leveraging to gear up the sales.
- Whether the products or services the company is offering will still be relevant even after 50 years from now.
Apart from the above-mentioned questions, do consider what features or specifications make the company’s products or services the first choice when compared to its peer competitors.
After you have gone through a detailed analysis, invest in those companies the business model of which is as clear as a day.
Parameter #2. Management of the company
It’s a good idea to invest in those companies that are with a strong and efficient management team even if the company is operating in the distressed industries instead of the companies operating in the hottest industries with an average management team.
No matter what the total sales or market capitalization is, do consider the following points before investing.
- Who are sitting on the key positions namely CEO, CFO, COO, etc.?
- What are their educational qualifications and experience?
- For what period of time is the management unchanged?
- What are the future plans of the management of the company to accelerate the growth be it by recruiting talented personnel or developing newer products by applying upgraded technology?
There is no hard and fast rule to evaluate the efficiency of the management of the company in the right way. But once you have got the answers to the above-mentioned questions, you will find if the company’s management is efficient enough or an average one.
Parameter #3. Competitive Advantage
Competitive advantage enables a company to offer products or services at a much cheaper rate in comparison to its competitors. When a company delivers the best build quality of the products or has a widespread distribution network or consumer satisfaction, etc. this gives the company a competitive advantage in comparison to the peer companies.
Take the example of Maruti Suzuki. The company has a wide range of products with multiple price ranges, a wide distribution and facilitation centers across the country. These factors give a sustainable competitive advantage over its peer companies.
Parameter #4. Corporate Governance
In simple terms, corporate governance refers to the rules, set by the board of directors that are in line with the government’s guidelines to run a company.
The best company to invest in is the management of which runs the business in an ethical, fair, and transparent way. Apart from that, investigate whether the company runs a company audit periodically to enhance the trust with the investors or shareholders.
By doing a detailed Fundamental analysis, you can discover the best stocks to buy for the long run in India that will yield the best returns in the long run.
Once you take a close look at the balance sheet and income statement you will find all the relevant information that will help you to pick the best stocks to buy.
After screening the quantitative factors, do analyze the qualitative factors such as business model, peer competitors, competitive advantage to pick the best stocks when you stay invested for the long run.
- Read also: Best Undervalued Stocks to Buy Now in India
- Read also: Best Insurance Stocks to buy in India
Still have a question regarding how to do fundamental analysis of Indian stocks?
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Hope this article helps you to find how to do a fundamental analysis of stock.
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