Fundamental analysis of equity shares is the basic understanding of the basic foundation of every share before investing.
Intelligent investors will always focus on fundamental analysis. This analysis is a valuation of financial ratios into various aspects.
Before that we have to understand, that investing in a share is the same as investing in a company. Investors of a company are called a promoter. These promoters will invest in crores by earning some equity portion of the company.
Same way, we invest in the market to buy the shares of the company. As we can’t buy in huge crores on a company. We use a stock exchange or stock market to buy a few stocks. This is the reason why there is bidding in price that always happens with an equity stock.
Henceforth, before investing in a company stock understand the fundamental earnings and invest for the business and not for the stock price.
Let us go into detail to understand the fundamental tools.
Fundamental Analysis Tools:
1. Book Value:
The book value is calculated from the balance sheet of a company. It is also known as the asset value of a company. Book Value is calculated by the total assets of the company minus the intangible assets (patents, rights issues) and liabilities.
BOOK VALUE = ASSETS – LIABILITIES
The book value is the first tool in fundamental analysis to estimate the value of the company. In a bank, the balance sheet is known as the loan book and book value is a more important parameter for every investor when it comes to bank stocks.
2. P/B Ratio:
The P/B ratio is termed as the price of the share divided by the book value. P/B serves as an important fundamental parameter for investors on how many times the stocks have been traded to book value in the market.
P/B Ratio = Price of single share / Book Value
An intelligent investor will check the number of times the share price is trading to its asset value.
P/B Ratio < 2 – Attractive price of stock
P/B Ratio > 2 – Highly-priced.
Anyhow, we can compare with the industry average P/B ratio and we can prefer for other sectors except for the banking sector.
For banking sector, P/B will be the most important tool and it should not be greater than 1. In the case of stocks like HDFC bank which has higher market capital and low NPA% maximum, P/B can be 2 times its book value.
3. Earnings Per Share (EPS):
The most important tool to understand the company’s earnings. These earnings per share are calculated on the profits earned by a company. Before calculating EPS, we have to first understand Profit after tax (PAT).
PAT is the calculation of Total profits gained minus total tax paid.
PAT = Profit Earned – Tax.
EPS is calculated by PAT divided by the total number of shares in the company.
EPS = PAT/ Total No. of. Shares
This gives the value of earning on a single share. As EPS increases quarterly or annually, Investors will be happy that their company is performing well.
It is always advised to check whether the EPS has been growing continuously for the last 5 years before investing in a company.
4. P/E Ratio:
P/E is termed as the price of the share divided by Earnings per share. In simple terms, the valuation is to find how many times the price of stocks is been trading to its earnings.
P/E RATIO = PRICE OF SHARE / EARNINGS PER SHARE
For every investor, it is a mandated tool to check the valuation of P/E. This is the most important valuation in the fundamental analysis. The lower the P/E ratio higher the attractiveness of the stocks.
- P/ E ratio < 12 – Very Attractive (Undervalued)
- P/E ratio 12-16 – Attractive
- P/E ratio 17-21 – Fair Value
- P/E ratio 22-25 – Expensive
- P/E ratio > 26 – Very Expensive (Over Valued)
So, you can invest in a stock when it is at a fair or attractive price. If the EPS is growing and still P/E is undervalued (<12), we can invest still. If EPS is degrowing for more than 3 years and P/E is falling under 12, it will be the time to quit. For example, YES bank.
5. Dividend Yield Ratio:
This is the tool to understand whether the company is honoring its investors every year by providing some part of its profit as dividends.
Dividend: Dividend is calculated from the profit after tax, and the company decides to share some percentage of its profit to investors. It is calculated by dividend percentage into face value. The company which provides dividend every year is considered to be fundamentally strong and will attract investors. The dividend is also known as rental income
DIVIDEND YIELD RATIO = Total Dividend paid in a year/Current share price
This will tell the investors, how much they are paid out as rental income on the stock price.
6. Return On Equity (ROE):
Return on equity is a clear understanding of the return on the total assets of the company. The asset of the company has investments from investors and they are part of it. This fundamental calculation will give investors an idea of how much their investments in a company have yielded as income.
RETURN ON EQUITY = (Total Income / Book value) * 100%
7. D/E RATIO:
D/E ratio is termed as debt to equity ratio. It is calculated by total liabilities divided by total Shareholder’s equity.
D/E Ratio = Total Liabilities of a company / Total Shareholder’s Equity
D/E is used to calculate the debt of a company. Investing in a company having more debt will be always a dangerous sign for investors.
Investors should focus on investing in companies with a D/E less than 1. There are few companies in the market having less than 0.1.
8. Current Ratio:
The current ratio is the calculation of the total assets divided by the total liabilities
Current ratio = Total Assets / Total Liabilities
A company can be determined to be in good shape if the current ratio is more than 2. It means the assets are two times higher than the liabilities of the company. To have a clear understanding of the fundamental analysis of a stock, please have a look at Investello.
Conclusion:
- Fundamental analysis of equity shares is more important for investors for a company to choose from.
- Please find all the important analytical tools to do a fundamental analysis of an equity share before investing.
- If all the fundamental criteria are in good shape. Then you will be an intelligent investor.
- Don’t invest in seeing the equity share price, invest in looking at their business.