BASICS OF FUNDAMENTAL ANALYSIS

Investing based on fundamental analysis of stocks is considered by many to be the best form for the long term investor. There are two broad approaches in which fundamental analysis may be carried out.

Based on the present and future prospects

This approach consists of valuing a business based on various factors related to the products of a company, its markets, its competitors, its efficiency and service levels, its reputation in the minds of its customers.

An evaluation on the above parameters may be done by carrying out a market study of the company. One way to achieve this would be by talking to the company’ suppliers, customers, competitors, ex employees and dealers and distributors. Doing this would enable an investor to judge the strength of the company’ products in the market and its perception in the minds of its customers and competitors. An investor can thereby determine whether the company has strong customer loyalty for its brands, do its competitors have respect for its business acumen and does it treat its stakeholders fairly.

After a complete market study is carried out and the company has performed well on the initial checks, the management may be approached to discuss its future plans with regard to capacity expansion, launch of new products, fund raising plans etc.

Based on past performance

This approach consists of looking to the past to see how a business has performed so far, in order to give us a reasonable picture of how well it may be expected to do in future. This involves looking at published accounts and annual results of the company for the past 5 years and examining the following parameters:

a) Average rate at which the company is growing its sales.
b) Average rates at which the profits are growing.
c) Growth in per share earnings. This gives a clue as to whether the profits are keeping pace with dilutions in equity capital.
d) Market Capitalization (M Cap) of the company. (For more on this refer May 08 archives)
e) The dividend yield of the stock. (For more on this refer May 08 archives)
f) Price to Earnings (PE) ratio and Price Earnings to Growth (PEG) ratio.(I shall discuss this in depth in a future post)
g) The Net Profit Margins.
h) Return on Capital Employed (ROCE). This is the ratio of net profit to capital employed (Equity Capital + Reserves and surpluses)
i) Book value of each share. (Particularly applicable in case of Banking and Financials stocks)
j) Net Current Assets (NCA) of the company ( If the business is available at a M Cap near to its NCA, it may be further investigated as an attractive value buy)

After all these ratios are calculated they may be looked at in relation to the ratios of other companies in similar lines of business, to determine whether the company being investigated is undervalued or not. Ratios should never be used in isolation but as a benchmark against which other alternatives may be compared.

If both these approaches are combined, it cannot fail to reveal several undervalued stocks which may prove to be multi baggers once the market realizes their potential.

The above is only a brief summation of the principles underlying financial analysis and is intended to serve as an introduction to the subject. Investors are advised to further read up on the subject to broaden their understanding of the principles involved.