Fundamental analysis of stocks is a method of looking into the basics or fundamentals of a company at its financial level. The ratios which are calculated from these financials are helpful in determining the health and growth prospects of the company. Also, it gives you an idea about your stock.
If you want to do fundamental analysis with the combination of other tools, you have many other tools also which will help you to evaluate your stock. These tools tell you your stock’s value without going into an in-depth analysis of a stock.
The main aim of investors is to know that what market is giving value to their stock. And by going through fundamental analysis and different tools, you can easily know that.
Earnings play a vital role in the analysis.
Earning is profit and Investors want to know that what profit a company is making because earnings help a stock to earn value in the market. If a company has good earning, then the price of the stock is possibly high and vice-versa. Also, a good profit making company gives a good and regular dividend to its investors.
Only earnings don’t tell you about the stock’s value. So, you need to go through different fundamental analysis tools which help you know that what market is valuing your stock.
Here we are going to discuss different fundamental analysis tools one by one.
Earnings per share (EPS):
Among fundamental analysis tools, earnings per share are one of the most popular tools. It is the term which is very important to the investors and stock market players. This term gives a clear picture of a company’s stock value up to a maximum extent.
Earnings per share are the portion of the profit which is allocated to each share of the company. It is calculated by dividing the total profit of the company by the total number of outstanding share.
Earnings per share of the company are higher means the profitability of the company is better.
Earnings per share can be calculated in two ways.
EPS = Net Income after tax/ total number of outstanding share.
Weighted EPS= Net income after tax-total dividends/total number of outstanding shares of a company.
Weighted EPS is advisable to calculate while calculating EPS because the number of outstanding share changes over time.
You must compare one company’s EPS to another in the same industry so that you can get an idea that which company is better to invest. But, only calculation of EPS is not enough to know about your stock’s value and what market think about your stock. You should calculate some ratios also for this purpose.
Types of Earnings per share (EPS)
Trailing EPS: This is the EPS of the most recently completed fiscal year of the company. It is actual EPS.
Current EPS: This is the EPS of this fiscal year, which is a projected EPS.
Forward EPS: This EPS of next fiscal year, which is obviously a projection.
So, above all helps you to know about a stock and compare it with its peers. But, this is just a small portion of your research. You must move forward for the next step of research.
Price – to – earning (P/E Ratio)
Price-to-earnings ratio plays an important role in Fundamental analysis tools. This ratio is also referred to as P/E ratio.
Meaning: This is the ratio which indicates that what an investor can expect from the earning of a company in order to invest one dollar. Means how much an investor is willing to pay for one dollar of earning.Or, we can say it is what market is willing to pay for the company’s earning.
P/E Ratio = Market value of each share/Earning per share
Here, Market value of each share is the value per share in the market and second is EPS.
Example: If EPS of a company is ₹8 and market value per share is ₹48, then P/E ratio would be 48/8=6
Types of P/E
Trailing P/E ratio – I t refers to the current share price divided by EPS of past 12 months.
Forward P/E ratio – It refers to the current share price divided by EPS of next 12 months.
A decrease in earnings is expected if forward P/E is higher than current P/E ratio; on the other hand, if forward P/E is lower than trailing P/E, it means analysts expect an increase of earnings.
It is a very complicated question if you want to know that what the right P/E ratio is. Because it depends on your willingness that how much you want to pay for the company earnings. If you are willing to pay more, means you see the bright future of the company in long term.
But, remember other investor opinions may totally differ from yours and he may not think the value of stock same as yours. And your right P/E is wrong to him.
So, P/E alone cannot tell you the whole story. But, yes it is the most important player in fundamental analysis tools.
Price – to – book ratio (P/B Ratio)
P/B ratio is one of the fundamental analysis tools which tells you that how much equity investors are paying for one dollar in the net asset. It usually located on the company’s balance sheet as” stockholders equity”.
P/B ratio is a financial ratio which is used to compare the company’s current market share to its book value. It tells that what company will be left if the company liquidates all its assets and repaid its liabilities.
Price-to-book ratio = stock price/ book value per share
Here, book value per share is the Owner’s equity.
A P/B ratio less than 1 indicates the stock is undervalued, while P/B ratio more than 1 indicates the stock is overvalued.
Why Calculate P/B ratio?
This ratio is calculated because it helps you to know that whether or not the company’s asset is comparable to the market value of its stock. Also, this ratio is very helpful to those companies which have more liquid assets like banking, finance, investment and insurance companies.
In the same way, this ratio is not helpful to companies which have more expenditure on R&D and more fixed assets.
P/B ratio is best to compare in the same industry, just like most of the other ratios.
Dividend yield ratio
Fundamental analysis tools, not all tools under this analysis suits to every investor. So, depending on your requirement from the stock, you must select a tool to look after the stock.
Dividend yield refers to the financial ratio in which you can know how much a company is paying out in dividend every year relative to its share price. This ratio is represented in percentage.
This ratio is an important fundamental analysis tool to those investors who want to invest in a particular stock for getting the dividend.
Dividend Yield Ratio= Annual dividend of a stock/ current share price
Example- If the current share price of a company is $50 and an annualized dividend of $1, then its yield would be 2%.
The dividend yield is an important ratio because it tells you how much you are getting back from each dollar you have invested in a company’s stock. Investors who want a minimum amount f cash flow invest in the dividend stock.
A well-established company pays the regular and consistent dividend, while a new company uses their profit for business expansion. So, don’t give any dividend to their investors.
If the value of your stock increases while holding, you can earn a high return on a dividend paying stock.
Dividend Payout Ratio
As you know that companies pay a part of their profit as dividend to shareholders. But it’s also important to know, how much company has earned and what portion paid as a dividend. And dividend payout ratio, which is a fundamental analysis tool tells about the same.
The portion of profit which is held by the company, used for the growth of their business.
The dividend payout ratio is the method by which you can know what portion of net income a company is returning to its shareholders, and how much retaining for growth, debt pay off and cash reserve. OR you can say it is the amount of dividend which is paid to the shareholder in relation to the net income of the company.
Dividend payout ratio = total amount of dividend/ net income of the company
Dividend payout ratio= dividend per share/earnings per share
Example: If EPS of a company is $5 and pays an annual dividend of $1 per share, the dividend per share would be 20%.
Higher dividend-paying companies are mature that’s why paying the dividend is the best use of profit because they have very little room for growth.
But, DPS alone can’t say much about itself. So, its comparison with peers and industry is important.
Price to sales ratio (P/S Ratio):
Investors are always ready to compare stocks value in anyways. Whether it is dividend, Assets or revenue. Sales or revenue of the company tells a lot about the company, not alone but up to maximum extent.
Price to sales ratio is fundamental analysis tool, which compares a company’s stock price to its revenue.
Price to sales = Market cap/Revenue OR Per Share – Stock Price/Per Share Revenue.
Like all ratios, Price to sales ratio is also useful when comparing it with other companies of the same sector. Better to compare with the industry average. A low ratio indicates possible undervaluation, while valuation above average indicates overvaluation.
But ideally, Low price to sales is better because it indicates investors are ready to pay less for each unit of sales or revenue.
But, this ratio does not tell much as it provides very limited information to investors. Like it does not take into account debt or any expenses of the company. Also, a company with high sales/revenue may be unprofitable.
Return on equity (ROE)
It is a very important fundamental analysis tool which you need to understand. This ratio signifies how efficient a company is generating a return to its shareholder’s investment.
ROE refers to the rate of return a shareholder is receiving for the portion of its investment in the company. Or we can say it measures the profitability of the company which is generated by using the invested money of shareholder.
Return on equity = (net income/ book value) X 100%
Example: If your company is generating $15 million of income by using $90 million of the asset, then ROE would be (15*100%)/90=16.67%
ROE in the range of 13-15 is considered a healthy company. Like other ratios, this ratio also gives a better result if compare to the same industry.
A higher ROE suggests that a company is capable of increasing its profitability without any more capital. But, at the same time, if the company has a high level of debt, it can also boost ROE artificially. The more debt is in books of the company, the less shareholder’s equity is, and higher ROE.
Conclusion: Fundamental Analysis Tools
All above fundamental analysis tools have their own significance. It depends on you, how you want to value a company and what is the goal of your investment. On the basis of that, you can choose a tool to analyze a stock.
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