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 involves valuing financial ratios in various aspects.
Before that, we have to understand that investing in a share is the same as investing in a company. Investors in a company are called promoters. These promoters will invest crores by earning some equity portion of the company.
In the same way, we invest in the market to buy a company’s shares, as we can’t buy huge crores on a company. We use a stock exchange or stock market to buy a few stocks. This is 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:
Book value is calculated from a company’s balance sheet and is also known as its asset value. It is calculated by the total assets of the company minus the intangible assets (patents, rights issues) and liabilities.
BOOK VALUE = ASSETS – LIABILITIES
Book value is the first tool in fundamental analysis to estimate a company’s value. In a bank, the balance sheet is known as the loan book, and book value is an important parameter for every investor in bank stocks.
2. P/B Ratio:
The P/B ratio is the price of the share divided by its book value. It serves as an important fundamental parameter for investors, indicating how many times 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 trades to its asset value.
P/B Ratio < 2 – Attractive price of stock
P/B Ratio > 2 – Highly-priced.
We can compare it with the industry average P/B ratio and prefer it for other sectors except 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 is to understand the company’s earnings. Earnings per share (EPS) are calculated based on a company’s profits. Before calculating EPS, we must realize 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 a company’s EPS has been growing continuously for the last five years before investing.
4. P/E Ratio:
P/E is the price of the share divided by earnings per share. In simple terms, the valuation is to find how many times the price of a stock has been trading relative 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, the 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 at a fair or attractive price. We can still invest if the EPS grows and P/E is still undervalued (<12). If EPS has been degrowing for over 3 years and P/E is falling under 12, it will be time to quit—for example, at YES bank.
5. Dividend Yield Ratio:
This is the tool to understand whether the company is honoring its investors annually by providing some 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 as rental income based on the stock price.
6. Return On Equity (ROE):
Return on equity is a clear understanding of the return on the company’s total assets. The company’s assets include investments from investors who are part of them. 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:
The D/E ratio, also known as the debt-to-equity ratio, is calculated by total liabilities divided by total Shareholder equity.
D/E Ratio = Total Liabilities of a company / Total Shareholder’s Equity
D/E is used to calculate a company’s debt. Investing in a company with more debt is always a dangerous sign.
Investors should focus on investing in companies with a D/E less than 1. Few companies in the market have less than 0.1.
8. Current Ratio:
The current ratio calculates 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 its current ratio is more than 2. This means the company’s assets are two times higher than its liabilities. To understand a stock’s fundamental analysis, please 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.