Today I will discuss how to decide which stock you want to buy and which stock you want to sell. I will guide you the basics of fundamental analysis and how to value a stock and how to judge the current and future growth of companies that you want to invest in.
What Is Fundamental Analysis?
Fundamental Analysis can simply be thought like an extensive health check of a company. It is a 360-degree check on various parameters.
1) The financials.
2) The quality of its management.
3) The overall economy and the industry conditions that might affect the performance of a company.
So let’s start understanding the basics of fundamental analysis by discussing some popularly used terminologies like Profit, Debt, P/E, P/B, DoE, RoE, EPS.
You should first focus on the earnings of the company. How has the company performed over the past few years and what are the future earnings expectations.
You can measure a companies profitability by looking at its Earnings Per Share OR EPS. This is calculated by dividing Profit by Number of Outstanding Shares. Suppose a companies Profit is Rs. 100 crores and it has 10 Crore outstanding shares then EPS = (100 crores / 10 crores) = Rs. 10.
The greater the EPS the stronger the company. See example above though Company B has more profit still its EPS is only Rs. 4 and hence Company A is the stronger company.
Next is Price to Earning OR PE Ratio. PE Ratio = (Price of the company / Earnings per share). See in the example below:
Company B has a higher PE. A high PE denotes that investors are expecting higher earnings in the future. In case the company can’t meet up the expectations the price will correct severely.
Book Value: It is the total value the investors will receive if the company closes down. And you divide the total Book Value by the total number of outstanding shares you will get Book Value per Share. Generally, this value should be closer to the current market price of a company. If the companies current market price defers from book value it is either underpriced OR overpriced.
Price to Book Vale OR P/B Ratio is obtained by dividing the Current Market Price by Book Value per Share. P/B Ratio below 1 is considered as a value investment.
Another important terminology in the basics of fundamental analysis is Debt. A company can take debt that they can afford to pay off from their earnings. Hence business balances between debt and equity to keep the average cost of capital at its lowest. Debt to equity ratio is obtained by dividing the companies Total Liabilities by Total Equity.
The last term we will discuss the basics of fundamental analysis is Return on Equity OR RoE. This measures the companies profitability by showing how much profit a company generates with the money shareholders has invested. RoE is obtained by dividing the Net Income of the company by Total Equity and is expressed in percentage. Higher the RoE the better is the company.