Fundamental analysis is the tool which investors can use to earn above average returns from stock market in the long run. Fundamental analysis basically answers the questions regarding viability, profitability, sustainability and competitive advantage of the business model any firm adopts. All these answers are hidden in the financial statements of the target firm. Although, fundamental analysis is a very big topic and hard to present in the word limit of a one page article, I have tried to summarise the key parameters investors should focus on while searching for portfolio winners.

 


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Net Sales

From fundamental analysis perspective, the net sales figure is an important measure of company's ongoing growth and financial health. It is the starting point for calculation of many other important parameters such as operating profit and net profit. As the company grows and matures, due to competition and other market factors, it gets difficult for companies to earn higher profit margins. Thus the only way company continues to grow its profit is by increasing its revenues and market share. In addition to providing data on actual company performance, net sales analysis helps in estimating the future performance of the company too. If sales of a company have been increasing at a steady rate for past few years, one can safely assume that the trend will continue in the next year too. For trends that have variations, as a stock market investor, you must find reasons for the variation before making an investment decision in the company.

Operating Profit

Operating profit or operating income is the amount left with the company after subtracting cost of goods sold and other day to day operational expenses such as employee cost, rent, electricity, transportation etc. from the revenues.From fundamental analysis perspective, operating profit is a crucial figure to observe as it is the direct indicator of companies operational and managerial efficiency. It is important to note that any money that will flow to shareholders in the form of stock price appreciation or dividends is by and large generated from a company operations (manufacturing and selling products or services efficiently). As a stock market investor, while choosing a company for investment, one must watch this number closely as it reflects the overall demand of the company products in the market along with companies manufacturing and sales efficiency. The higher the number, the more efficient and profitable the company core business operations are.

Profit before interest and Taxes or PBIT

Profit before Interest and Taxes or PBIT is a measure of a firms profitability that excludes interest and income tax expenses. PBIT helps evaluate the operational efficiency of a firm which ultimately leads to company profits. PBIT is frequently used by investors to measure firms earning and paying capacity. Exclusion of both taxes and interest expenses makes comparison of profitability of different companies easy. It is a true measure of company earning power as interest expense depends on capital structure of a firm and taxes do not have anything to do with how well management is running the company. Investors should use this figure for cross-company comparison from same industry, having different capital structure (amount of debt and equity) and choose firms with increasing PBIT numbers year on year.

Profit before tax or PBT

Profit before tax or PBT provides investors useful information on company’s operating performance without taking taxes into consideration. As taxes do not have anything to do with firms operating performance and management quality, PBT numbers makes comparison of similar firms from same sector easy. While doing analysis, investors should look for increasing PBT numbers year on year. Investors should avoid investing in firms with decreasing or fluctuating PBT numbers in a shorter time frame.

Net profit

 

Net profit is what remains after subtracting companies total expenses from total revenue. It shows what the company has earned or lost in a given period of time and is also referred to as the bottom line, net income or net earnings. Net profit is one of the most closely watched numbers and plays a key role in various ratio analysis. Analysts and investors look at the net profit closely as it directly correlates to the stock price. Stocks with increasing net profit numbers yoy enjoys premium over their peers. Conversely, if a company is not generating healthy net profits, or if there is a lot of variation in net profit numbers the same will be reflected in decreasing share price over time. Investors should always look for increasing net profit numbers year on year, while choosing companies for long term investment. This is pure common sense and following this one rule only will help you avoid most of your stock market losses.

 

 EPS

 

Earning per share is the amount of net profit earned per share of stock outstanding. This is the amount each share of stock would get if all of the profits earned by a company in a year are distributed to the outstanding shareholders at year end. Higher earnings per share numbers are always better as this signifies that the company is more profitable and the company has more earnings to distribute to its shareholders. Long term investors should analyse the EPS figure for a number of years and also compare it with the EPS figure of peers from the same industry before making an investment decision.  Investors should choose companies with consistently improving EPS year after year as it is an indication of financial stability and superior earning power in the long run.

 

Dividend

 

Companies declare dividends on equity shares from the profits they earn. The amount left after paying all expenses are used to distribute dividends and build reserves. Investors investing in shares seek two types of returns. First is capital appreciation i.e. an increase in the share price and the second is the dividend income. Dividend-paying stocks are good investment options as they generate regular income through distribution of corporate profits to shareholders. Investors can think of this as receiving interest payments for investing in the company shares. Investors should analyse the dividend paying history of companies over the long term and choose companies having consistent and upward sloping dividend payment history.

 

 

Book Value per Share

 

 Book Value is the amount a common shareholder would receive upon liquidation of the company. The book value per share is used by investors to determine the relative valuation of a company with respect to the market price of its stock. If Book Value per Share is higher than the currently traded stock price, the company can be considered undervalued and vice versa. Comparing the market value to the book value in general can indicate whether or not the overall stock market is overvalued or undervalued. During bull markets the stock price is more likely to trade significantly higher than book value, and in a bear market the two values will be similar. Investors should prefer stocks with relatively higher book value while selecting stocks for long term investment.

 

 

Return on Equity or ROE

ROE means the returns on equity. High ROE is certainly a good thing. It simply means the company is earning good returns for the common shareholders. If ROE is less than the safe rate of returns, such as bank deposit and government bond returns, it means the management is poor or the performance of the company is bad. Also, an ROE less than the industry ROE is bad. It shows that the company is below average in performance. However, ROE should not be seen in isolation, but as a part of the entire fundamental analysis. Normally a high debt capital structure has the tendency to inflate the ROE. So investors should also take capital structure into account while studying ROE. The high debt capital structure works well as long as the market condition is good and the business is growing, but any slowdown in business will impact the companies adversely that have high ROE and high debt.

 

Cash Flow from operations

 

Cash flow from operation provides information regarding the cash-generating abilities of companies core activities. This is the area investors should focus their attention on because it paints the best picture of how well firms business operations are producing cash that will ultimately benefit shareholders. While choosing companies for long term investment, investors should study cash flow from operations and try to match its sources from income statement (net income, non cash expenses)) and balance sheet (increase, decrease in assets and liabilities). A healthy CFO is an indication of good financial health and ascertains business viability in tough economic conditions. Investors should look for consistently increasing CFO numbers and should always cross check the reason for a lot of variation in this number before making an investment decision.

 

Cash Flow from Investing

 

Cash flow from investing activities provides information regarding firms purchases or sale of capital assets or monetary assets. Although analysts and investors always like to see positive cash flow as without positive cash flow a company may have to borrow money to remain in operations. However, cash flow from investing can be negative for firms at times and is not bad unless management is spending mindlessly on acquisitions or capex to grow.  Investors should hunt for firms that have upward sloping cash flow, but lower share prices as this divergence often means the share price will increase sooner than later.

 

Cash Flow from Financing

 

The cash flow from financing provides details about how a firm raises capital and pays it back to investors. It indicates how a company borrows and repays money, issues stock, and pays dividends. Investors should analyse CFF to understand how often a company raises capital from debt and equity market as well as how it pays them back. A positive CFF number indicates that cash has come into the company, which will be used for companies growth in future. A negative figure indicates that company has paid out capital, such as debt payment or dividend payment to shareholders. Investors should analyse the source and application of CFF specially how much stock a company is issuing or repurchasing before making an investment decision.

 

 

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