In stock investing, fundamental analysis/research relates to detailed study of the most important information available in the company’s earnings report.
In simple terms, it’s all about arriving at four key pieces of information from the earnings report that has relevance to stock value or stock price.
1. How efficiently the company is managing its existing investment and assets?
Earnings and cash generated during the accounting period (Quarterly or Year) measure how efficiently the firm put existing assets to use.
2. How is the company’s growth potential shaping up?
Growth in earnings, cash flows, and revenues over prior periods all signal whether the overall market for the firm’s product/ service is expanding, stagnating or contracting .
3. How effectively the company is sustaining its competitive advantages?
Margins and returns on capital indicate how the firm’s competition is shaping up, and whether the firm’s competitive advantages are strengthening or weakening.
4. What is company’s cost of financing its operations?
Costs of financing comes from both debt and equity; while the interest expense represents the former, dividends & stock buybacks forms the latter.
The answer to above questions can be arrived from six key figures that allow us to gauge a company’s fundamentals. To find these figures, we have to study the company’s five years worth of balance sheets, income statements, and cash flow statements.
1. Return on equity (ROE)
The first number we’re interested is in return on equity. This figure is essentially the company’s net income divided by the shareholder’s equity. Return on Equity is expressed in percentage.
2. Return on capital employed (ROCE)
The second number we’re interested is in is return on capital employed. It is the company’s net income divided by the shareholder’s equity. Return on Equity is also expressed in percentage.
3. Consistency in Net Income Growth
The next figure we’re looking at is the company’s income growth. This is the company’s net income and it has to be consistently rising.
4. Consistency in CashFlow Growth
We now turn our attention to cash flow. A company’s cash flow is the change in cash the company goes through over a given period. Obviously, the more cash inflow and the less cash outflow, the more cash a company will have on hand.
5. Profitability against the company’s past and against the peers
Profit margin is the company’s net income divided by its net revenues (or sales). If a product costs us Rs.9 to make and we sell it for Rs.10, that means we make Rs.1 in net income for every Rs.10 in sales, giving us a profit margin of 10%. A high profit margin is a sign of strength for a company.
However, profit margins vary a great deal from industry to industry. For this reason, it’s extremely important to only compare a company’s profit margin with the profit margins common throughout its industry and with its own past performance.
What we have to see is whether1) the company is having a higher profit margin than its direct competition and 2) higher current profit margin than what it had in the past. This analysis indicates whether the company is getting stronger and more efficient or not
6. Debt Productivity
The final figure we want to check on is the company’s debt in relation to its income.
Many investors get scared off by a company’s debt and it’s true that excessive debt can be a disaster waiting to happen. But at the same time, debt can be a powerful tool that a company uses to its advantage.
As an example, a great use of debt would be if you took out a loan to buy a building and then charged other people rent to live in the building. That rent produced income for you and paid off the loan while the property also increased in value to the point that it was eventually worth much more than you bought it for. Even though you had to go deep in debt to buy the building initially, you earned income with renters and eventually sold the building for a lot more than you paid for it.
It’s no different for businesses. The key is to recognize whether a business has taken on more debt than it can handle.
Equityboss looks at all the above metrics for last 5 years and overlay it with the stock prices to find out which combinations has positive correlation with stock prices and then analytically grade stocks based on the outcome and the grade looks like