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Fundamental Analysis

Overview

Fundamental analysis is the study of economic, industry, and companyconditions in an effort to determine the value of a company's stock. Fundamentalanalysis typically focuses on key statistics in a company's financial statements todetermine if the stock price is correctly valued.I realize that some people will find a discussion on fundamental analysis within a

 book on technical analysis peculiar, but the two theories are not as different asmany people believe. It is quite popular to apply technical analysis to charts of fundamental data, for example, to compare trends in interest rates with changesin security prices. It is also popular to use fundamental analysis to selectsecurities and then use technical analysis to time individual trades. Even diehard

technicians can benefit from an understanding of fundamental analysis (and viceversa).

INTRODUCTION

Fundamental analysis is the cornerstone of investing. In fact, some would say that you aren't really

investing if you aren't performing fundamental analysis. Because the subject is so broad, however, it'stough to know where to start. There are an endless number of investment strategies that are verydifferent from each other, yet almost all use the fundamentals.

The goal of this tutorial is to provide a foundation for understanding fundamentalanalysis. It's geared primarily at new investors who don't know a balance sheet from an

income statement .While you may not be a "stock-picker extraordinaire" by the end of this tutorial, youwill have a much more solid grasp of the language and concepts behind security analysis and be able touse this to further your knowledge in other areas without feeling totally lost.

The biggest part of fundamental analysis involves delving into the financialstatements. Also known as quantitative analysis, this involves looking at revenue,

expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts lookat this information to gain insight on a company's future performance. A good part of this tutorial will bespent learning about the balance sheet, income statement, cash flow statement and how they all fittogether.

But there is more than just number crunching when it comes to analyzing a company.This is where qualitative analysis comes in - the breakdown of all the intangible,difficult-to-measure aspects of a company. Finally, we'll wrap up the tutorial with anintro on valuation and point you in the direction of additional tutorials you might beinterested in.

Interpretation

Most fundamental information focuses on economic, industry, and company

statistics. The typical approach to analyzing a company involves four basic steps:1. Determine the condition of the general economy.

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2. Determine the condition of the industry.3. Determine the condition of the company.4. Determine the value of the company's stock.

Economic AnalysisThe economy is studied to determine if overall conditions are good for the stock market. Is inflation a concern? Are interest rates likely to rise or fall? Areconsumers spending? Is the trade balance favorable? Is the money supplyexpanding or contracting? These are just some of the questions that thefundamental analyst would ask to determine if economic conditions are right for the stock market.

Industry Analysis

The company's industry obviously influences the outlook for the company. Eventhe best stocks can post mediocre returns if they are in an industry that isstruggling. It is often said that a weak stock in a strong industry is preferable to astrong stock in a weak industry.

Company Analysis

After determining the economic and industry conditions, the company itself isanalyzed to determine its financial health. This is usually done by studying thecompany's financial statements. From these statements a number of useful ratioscan be calculated. The ratios fall under five main categories: profitability, price,liquidity, leverage, and efficiency. When performing ratio analysis on a company,the ratios should be compared to other companies within the same or similar industry to get a feel for what is considered "normal." At least one popular ratiofrom each category is shown below.

Tools of Fundamental Analysis

Fundamental analysis is the process of looking at a business at the basic or 

fundamental financial level. This type of analysis examines key ratios of a business todetermine its financial health and gives you an idea of the value its stock.

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Many investors use fundamental analysis alone or in combination with other tools toevaluate stocks for investment purposes. The goal is to determine the current worthand, more importantly, how the market values the stock.

This article focuses on the key tools of fundamental analysis and what they tell you.

Even if you don’t plan to do in-depth fundamental analysis yourself, it will help youfollow stocks more closely if you understand the key ratios and terms.

Earnings

It’s all about earnings. When you come to the bottom line, that’s what investors wantto know. How much money is the company making and how much is it going to makein the future.

Earnings are profits. It may be complicated to calculate, but that’s what buying acompany is about. Increasing earnings generally leads to a higher stock price and, insome cases, a regular dividend.

When earnings fall short, the market may hammer the stock. Every quarter,companies report earnings. Analysts follow major companies closely and if they fallshort of projected earnings, sound the alarm. For more information on earnings, seemy article: It’s the Earnings.

While earnings are important, by themselves they don’t tell you anything about how

the market values the stock. To begin building a picture of how the stock is valuedyou need to use some fundamental analysis tools. These ratios are easy to calculate, but you can find most of them already done on sites like

• cnn.money.com or MSN MoneyCentral.com.

• http://www.contentlinks.asiancerc.com/IB/FinalCompanyProfile.as

 p?txtCompanycode=15530059 

Fundamental Analysis Tools

These are the most popular tools of fundamental analysis. They focus on earnings,growth, and value in the market. For convenience, I have broken them into separate

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articles. Each article discusses related ratios. There are links in each article to theother articles and back to this article.

The articles are:

1. Earnings per Share – EPS

2. Price to Earnings Ratio – P/E

3. Projected Earning Growth – PEG

4. Price to Sales – P/S

5. Price to Book – P/B

6. Dividend Payout Ratio

7. Dividend Yield

8. Book Value

9. Return on Equity

 No single number from this list is a magic bullet that will give you a buy or sellrecommendation by itself, however as you begin developing a picture of what youwant in a stock, these numbers will become benchmarks to measure the worth of 

 potential investments.

Understanding Earnings Per Share

One of the challenges of evaluating stocks is establishing an “apples to apples”

comparison. What I mean by this is setting up a comparison that is meaningful so thatthe results help you make an investment decision.

Comparing the price of two stocks is meaningless.

Similarly, comparing the earnings of one company to another really doesn’t make anysense, if you think about it. Using the raw numbers ignores the fact that the twocompanies undoubtedly have a different number of outstanding shares.

For example, companies A and B both earn 100 rs, but company A has 10 shares

outstanding, while company B has 50 shares outstanding. Which company’s stock doyou want to own?

It makes more sense to look at earnings per share (EPS) for use as a comparison tool.You calculate earnings per share by taking the net earnings and divide by theoutstanding shares.

EPS = Net Earnings / Outstanding Shares

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Using our example above, Company A had earnings of $100 and 10 sharesoutstanding, which equals an EPS of 10 (100 rs / 10 = 10). Company B had earningsof 100 rs and 50 shares outstanding, which equals an EPS of 2 (100 rs / 50 = 2).

So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on

the basis of its EPS. The EPS is helpful in comparing one company to another,assuming they are in the same industry, but it doesn’t tell you whether it’s a goodstock to buy or what the market thinks of it. For that information, we need to look atsome ratios.

Before we move on, you should note that there are three types of EPS numbers:

• Trailing EPS – last year’s numbers and the only actual EPS

• Current EPS – this year’s numbers, which are still projections

• Forward EPS – future numbers, which are obviously projections

Understanding Price to Earnings Ratio

If there is one number that people look at than more any other it is the Price toEarnings Ratio (P/E). The P/E is one of those numbers that investors throw aroundwith great authority as if it told the whole story. Of course, it doesn’t tell the wholestory (if it did, we wouldn’t need all the other numbers.)

The P/E looks at the relationship between the stock price and the company’s earnings.The P/E is the most popular metric of stock analysis, although it is far from the onlyone you should consider.

You calculate the P/E by taking the share price and dividing it by the company’s EPS.

P/E = Stock Price / EPS

For example, a company with a share price of 40 rs and an EPS of 8 would have a P/E

of 5 (40 rs / 8 = 5).

What does P/E tell you? The P/E gives you an idea of what the market is willing to pay for the company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. Some investors read a high P/E as an overpricedstock and that may be the case, however it can also indicate the market has high hopesfor this stock’s future and has bid up the price.

Conversely, a low P/E may indicate a “vote of no confidence” by the market or itcould mean this is a sleeper that the market has overlooked. Known as value stocks,many investors made their fortunes spotting these “diamonds in the rough” before therest of the market discovered their true worth.

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What is the “right” P/E? There is no correct answer to this question, because part of the answer depends on your willingness to pay for earnings. The more you are willingto pay, which means you believe the company has good long term prospects over andabove its current position, the higher the “right” P/E is for that particular stock in your decision-making process. Another investor may not see the same value and think your 

“right” P/E is all wrong. The articles in this series:

Understanding the PEG

Price to Earnings Ratio or P/E Ratio gave us an idea of what value the market placeon a company’s earnings.

The P/E is the most popular way to compare the relative value of stocks based onearnings because you calculate it by taking the current price of the stock and divide it

 by the Earnings Per Share (EPS). This tells you whether a stock’s price is high or low

relative to its earnings.

Some investors may consider a company with a high P/E overpriced and they may becorrect. A high P/E may be a signal that traders have pushed a stock’s price beyondthe point where any reasonable near term growth is probable.

However, a high P/E may also be a strong vote of confidence that the company stillhas strong growth prospects in the future, which should mean an even higher stock 

 price.

Because the market is usually more concerned about the future than the present, it isalways looking for some way to project out. Another ratio you can use will help youlook at future earnings growth is called the PEG ratio. The PEG factors in projectedearnings growth rates to the P/E for another number to remember.

You calculate the PEG by taking the P/E and dividing it by the projected growth inearnings.

PEG = P/E / (projected growth in earnings)

For example, a stock with a P/E of 30 and projected earning growth next year of 15%would have a PEG of 2 (30 / 15 = 2).

What does the “2” mean? Like all ratios, it simply shows you a relationship. In thiscase, the lower the number the less you pay for each unit of future earnings growth.So even a stock with a high P/E , but high projected earning growth may be a goodvalue.

Looking at the opposite situation; a low P/E stock with low or no projected earnings

growth, you see that what looks like a value may not work out that way. For example,

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a stock with a P/E of 8 and flat earnings growth equals a PEG of 8. This could proveto be an expensive investment.

A few important things to remember about PEG:

• It is about year-to-year earnings growth

• It relies on projections, which may not always be accurate

Understanding Price to Sales Ratio

The first three ratios discussed particularly deal with earnings directly. You can addthe two others on dividends and the one on return on equity to the list as specific tocompanies that are or have made money in the past.

It does’nt mean that companies that don’t have any earnings are bad investments, butyou should approach companies with no history of actually making money withcaution.

The Internet boom of the late 1990s was a classic example of hundreds of companiescoming to the market with no history of earning – some of them didn’t even have

 products yet. Fortunately, that’s behind us.

However, we still have the problem of needing some measure of young companieswith no earnings, yet worthy of consideration. After all, Microsoft had no earnings atone point in its corporate life.

One ratio you can use is Price to Sales or P/S ratio. This metric looks at the currentstock price relative to the total sales per share. You calculate the P/S by dividing themarket cap of the stock by the total revenues of the company.

You can also calculate the P/S by dividing the current stock price by the sales per share.

P/S = Market Cap / Revenuesor

P/S = Stock Price / Sales Price Per Share

Much like P/E, the P/S number reflects the value placed on sales by the market. Thelower the P/S, the better the value, at least that’s the conventional wisdom. However,this is definitely not a number you want to use in isolation. When dealing with ayoung company, there are many questions to answer and the P/S supplies just oneanswer.

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Understanding Price to Book Ratio

Investors looking for hot stocks aren’t the only ones trolling the markets. A quietgroup of folks called value investors go about their business looking for companies

that the market has passed by.

Some of these investors become quite wealthy finding sleepers, holding on to themfor the long term as the companies go about their business without much attentionfrom the market, until one day they pop up on the screen, and some analyst“discovers” them and bids up the stock. Meanwhile, the value investor pockets a hefty

 profit.

Value investors look for some other indicators besides earnings growth and so on.One of the metrics they look for is the Price to Book ratio or P/B. This measurement

looks at the value the market places on the book value of the company.

You calculate the P/B by taking the current price per share and dividing by the book value per share.

P/B = Share Price / Book Value Per Share

Like the P/E, the lower the P/B, the better the value. Value investors would use a lowP/B is stock screens, for instance, to identify potential candidates.

Understanding Dividend Payout Ratio

There are some metrics used in fundamental analysis that fall into what I call the “ho-hum” category.

The Dividend Payout Ratio (DPR) is one of those numbers. It almost seems like ameasurement invented because it looked like it was important, but nobody can reallyagree on why.

The DPR (it usually doesn’t even warrant a capitalized abbreviation) measures what acompany’s pays out to investors in the form of dividends.

You calculate the DPR by dividing the annual dividends per share by the Earnings Per Share.

DPR = Dividends Per Share / EPS

For example, if a company paid out $1 per share in annual dividends and had $3 in

EPS, the DPR would be 33%. ($1 / $3 = 33%)

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The real question is whether 33% is good or bad and that is subject to interpretation.Growing companies will typically retain more profits to fund growth and pay lower or no dividends.

Companies that pay higher dividends may be in mature industries where there is little

room for growth and paying higher dividends is the best use of profits (utilities usedto fall into this group, although in recent years many of them have been diversifying).

Either way, you must view the whole DPR issue in the context of the company and itsindustry. By itself, it tells you very little.

Understanding Dividend Yield

 Not all of the tools of fundamental analysis work for every investor on every stock. If 

you are looking for high growth technology stocks, they are unlikely to turn up in anystock screens you run looking for dividend paying characteristics.

However, if you are a value investor or looking for dividend income then there are acouple of measurements that are specific to you. For dividend investors, one of thetelling metrics is Dividend Yield.

This measurement tells you what percentage return a company pays out toshareholders in the form of dividends. Older, well-established companies tend to

 payout a higher percentage then do younger companies and their dividend history can

 be more consistent.

You calculate the Dividend Yield by taking the annual dividend per share and divide by the stock’s price.

Dividend Yield = annual dividend per share / stock's price

per share

For example, if a company’s annual dividend is $1.50 and the stock trades at $25, theDividend Yield is 6%. ($1.50 / $25 = 0.06)

Understanding Book Value

How much is a company worth and is that value reflected in the stock price?

There are several ways to define a company’s worth or value. One of the ways youdefine value is market cap or how much money would you need to buy every singleshare of stock at the current price.

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Another way to determine a company’s value is to go to the balance statement andlook at the Book Value. The Book Value is simply the company’s assets minus itsliabilities.

Book Value = Assets - Liabilities

In other words, if you wanted to close the doors, how much would be left after yousettled all the outstanding obligations and sold off all the assets.

A company that is a viable growing business will always be worth more than its book value for its ability to generate earnings and growth.

Book value appeals more to value investors who look at the relationship to the stock's price by using the Price to Book ratio. 

To compare companies, you should convert to book value per share, which is simplythe book value divided by outstanding shares.

Understanding Return on Equity

If you give some management teams a couple of boards, some glue, and a ball of string, they can build a profitable growing business, while other teams can’t make a

 profit with several billion dollars worth of assets.

Return on Equity (ROE) is one measure of how efficiently a company uses its assetsto produce earnings. You calculate ROE by dividing Net Income by Book Value. Ahealthy company may produce an ROE in the 13% to 15% range. Like all metrics,compare companies in the same industry to get a better picture.

While ROE is a useful measure, it does have some flaws that can give you a false picture, so never rely on it alone. For example, if a company carries a large debt andraises funds through borrowing rather than issuing stock it will reduce its book value.A lower book value means you’re dividing by a smaller number so the ROE isartificially higher. There are other situations such as taking write-downs, stock buy

 backs, or any other accounting slight of hand that reduces book value, which will produce a higher ROE without improving profits.

It may also be more meaningful to look at the ROE over a period of the past fiveyears, rather than one year to average out any abnormal numbers.

Given that you must look at the total picture, ROE is a useful tool in identifyingcompanies with a competitive advantage. All other things roughly equal, the companythat can consistently squeeze out more profits with their assets, will be a better investment in the long run. 

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Strengths of Fundamental Analysis

Long-term Trends

Fundamental analysis is good for long-term investments based on long-term trends,very long-term. The ability to identify and predict long-term economic, demographic,technological or consumer trends can benefit patient investors who pick the rightindustry groups or companies.

Value Spotting

Sound fundamental analysis will help identify companies that represent a good value.Some of the most legendary investors think long-term and value. Graham and Dodd,Warren Buffett and John Neff are seen as the champions of value investing.Fundamental analysis can help uncover companies with valuable assets, a strong

 balance sheet, stable earnings, and staying power.

Business Acumen

One of the most obvious, but less tangible, rewards of fundamental analysis is thedevelopment of a thorough understanding of the business. After such painstakingresearch and analysis, an investor will be familiar with the key revenue and profitdrivers behind a company. Earnings and earnings expectations can be potent driversof equity prices. Even some technicians will agree to that. A good understanding canhelp investors avoid companies that are prone to shortfalls and identify those thatcontinue to deliver. In addition to understanding the business, fundamental analysisallows investors to develop an understanding of the key value drivers and companieswithin an industry. A stock's price is heavily influenced by its industry group. Bystudying these groups, investors can better position themselves to identifyopportunities that are high-risk (tech), low-risk (utilities), growth oriented (computer),value driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).

Knowing Who's Who

Stocks move as a group. By understanding a company's business, investors can better 

 position themselves to categorize stocks within their relevant industry group. Businesscan change rapidly and with it the revenue mix of a company. This happened to manyof the pure Internet retailers, which were not really Internet companies, but plainretailers. Knowing a company's business and being able to place it in a group canmake a huge difference in relative valuations.

Weaknesses of Fundamental Analysis

Time Constraints

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Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictoryto the current price prevailing on Wall Street. When this happens, the analyst

 basically claims that the whole street has got it wrong. This is not to say that there arenot misunderstood companies out there, but it is quite brash to imply that the market

 price, and hence Wall Street, is wrong.

Industry/Company Specific

Valuation techniques vary depending on the industry group and specifics of eachcompany. For this reason, a different technique and model is required for differentindustries and different companies. This can get quite time-consuming, which canlimit the amount of research that can be performed. A subscription-based model maywork great for an Internet Service Provider (ISP), but is not likely to be the bestmodel to value an oil company.

Subjectivity

Fair value is based on assumptions. Any changes to growth or multiplier assumptionscan greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, an average-casevaluation and a worst-case valuation. However, even on a worst-case valuation, mostmodels are almost always bullish, the only question is how much so. The chart belowshows how stubbornly bullish many fundamental analysts can be.

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Analyst Bias

The majority of the information that goes into the analysis comes from the companyitself. Companies employ investor relations managers specifically to handle theanalyst community and release information. As Mark Twain said, "there are lies,

damn lies, and statistics." When it comes to massaging the data or spinning theannouncement, CFOs and investor relations managers are professionals. Only buy-side analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-sideanalysts who work for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CSFirst Boston, Paine Weber, DLJ to name a few). These brokers are also involved inunderwriting and investment banking for the companies. Even though there arerestrictions in place to prevent a conflict of interest, brokers have an ongoingrelationship with the company under analysis. When reading these reports, it isimportant to take into consideration any biases a sell-side analyst may have. The buy-side analyst, on the other hand, is analyzing the company purely from an investmentstandpoint for a portfolio manager. If there is a relationship with the company, it isusually on different terms. In some cases this may be as a large shareholder.

Definition of Fair Value

When market valuations extend beyond historical norms, there is pressure to adjustgrowth and multiplier assumptions to compensate. If Wall Street values a stock at 50times earnings and the current assumption is 30 times, the analyst would be pressuredto revise this assumption higher. There is an old Wall Street adage: the value of anyasset (stock) is only what someone is willing to pay for it (current price). Just as stock 

 prices fluctuate, so too do growth and multiplier assumptions. Are we to believe WallStreet and the stock price or the analyst and market assumptions?

It used to be that free cash flow or earnings were used with a multiplier to arrive at afair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However,

 because so many companies were and are losing money, it has become popular tovalue a business as a multiple of its revenues. This would seem to be OK, except thatthe multiple was higher than the PE of many stocks! Some companies wereconsidered bargains at 30 times revenues.

ANALYSIS

 Topics Tata SteelLtd. (803)

 JSW SteelLtd. (903)

Steel Authority of India(SAIL) Ltd. (803)

Adjusted EPS(Rs) 60.58 55.96 17.7

Cash EPS (Rs) 72 100.21 20.87

Book Value (Rs) 296.65 410.07 55.69Dividend Per Share (Rs) 16 1 3.7

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Return On NetWorth (%) 21.52 5.59 32.76Return On Capitalemployed(%) 17.16 12.35 44.47

Operating Profit Margin(%) 41.94 20.42 28.19

Gross Profit Margin(%) 37.7 14.51 25.1

Net Profit Margin(%) 23.43 3.23 18.16Current Ratio 3.92 0.52 1.73

Quick Ratio 3.52 0.28 1.23

Long term debt to equity 1.07 1.34 0.12

 Total Debt to equity 1.08 1.51 0.13

Interest Cover (times) 9.25 3.64 51.04

Assets Turnover Ratio 1.2 0.82 1.31Average Raw Material Holding(in Days) 71.68 33.03 36.42Average Finished Good

Holding (in Days) 29.45 23.67 48.69Number of days of networking capital 520.93 -111.72 104.06

Inventory Turnover Ratio 10.84 8.75 8.62Export as percent of TotalSales 11.64 29.94 3.08Bonus component inEquity(%) 34.61 0 0