In fundamental Analysis of a stock, we need to check financial health of the company for determining the intrinsic value of a share. If market price of share is below its intrinsic value, then it is opportunity to buy otherwise check next script.Fundamental analysis focus on the business model, industry, revenue growth, margins, PBT, EPS, risk model, leverages and financial stability of a company. Let’s discuss some terms which are basic need for fundamental analysis: –
Market capitalisation is market value of total capital of a company. Market capitalisation can be arrived at by multiplying the outstanding number of shares of a company by its market price. For example, automobile company, Ashok Leyland is having 2,93,55,27,276 outstanding shares and market price per share is Rs. 162.50 (as on 20.09.2022) Hence total market capitalisation of Ashok Leyland is Rs. 47702 crores. When share price change, its market cap also changes. At present “Reliance Industries” is the largest Indian company by market capitalisation (Rs. 16.92 lakh crores as on 20.09.2022)
Free Flow Market capitalisation
Free flow market cap is the market value of those shares which are already available in the market for trading (buy & sell) by the public. Hence free flow market cap does not include the value of shares held by promoters. For example, The promoters of Ashok Leyland are holding 1,50,06,60,261shares out of total outstanding shares of 2,93,55,27,276. Hence Market value of balance shares are around 23374 crores, which is Free flow market cap of this company and it changes with change in share price. If promoters of a company sell some portion of their holding, then free flow market cap increases. Before IPO (initial public offering), free flow market cap remain zero , when IPO comes and promoters offload their holdings free flow market cap increases, which further increases with FPO (follow on public offerings).
EBITDA (Earning before interest, tax, depreciation, and amortisation)
EBITDA is termed as true measure of the profitability of a company because EBITDA is the profit calculated before impact of—
- Interest i.e. financing decision (debt or equity)
- Tax benefits or high tax rates.
- Any manipulative assumptions or amortisations.
- Other income if irregular or extraordinary.
EBITDA = PBT (net income) + interest + depreciation + amortisation
EBITDA = PAT + taxes + interest+ depreciation + amortisation
EBITDA = operating profit + depreciation (if deducted on factory machinery) + amortisation + other income (if regular)
If there is no other regular income and no factory depreciation or amortisation, then operating profit is equal to EBITDA.
Operating Profits is the profit from the regular business operations of a company before interest and depreciation. If there is no other regular income and no factory depreciation or amortisation, then operating profit is equal to EBITDA.
Operating Margin % (OPM%)
Operating margin is the percentage of operating profit over sales. This show the profitability of a business. For example, if Operating margin are 10% then it means, on sale of every 100 rupees, company is earning Rs. 10. If company reduces its sales prices, then its margin declines, sometimes company reduces its product prices to gain over competitors but if raw material prices are not controlled then margin declines. In such cases, we see that overall sales are increased but profits are not as increased as expected that happens due to lesser margins. But in long run, this turn beneficial when competitor is out of market then company, hike its product price then sales is not declined (as no choice left with consumer), and margins are increased resulting in high profits for the company.
Book Value per share
Book value is the value that is left for the holder of each share if all liability of company are paid back from all the assets of the company. In other words, book value is the worth of each share if all liabilities are disposed off from all the assets of a company.
Book value per share = (Total Assets – all outside liabilities) / no. of o/s shares
Book value per share = (share capital + reserves) / no of outstanding shares.
For example , as on march 2022, share capital of Ashok Leyland is 294 crores and it has reserves of Rs. 7010 crore, total outstanding shares are 293.55 crores. Now book value per share is
Book value per shares = (294+7010) / 293.55 = Rs. 24.08 per shares.
Please note that book value is not intrinsic value of shares, book value is calculated only on the basis of value reflected in balance sheet. It does not take into account the market value and future earning potentials of assets available in the books of the company.
Return on Equity (ROE)
Return on equity (ROE) shows the percentage return for each penny invested by shareholders. ROE can be understood as net income as a percentage of average equity.
ROE can be calculated as –
ROE = Net income / average Equity & Reserves
ROE = Net Income / (Total assets – outside liability)
ROE = Net income / Net assets
Hence ROE can also determed as return on net assets. ROE shows that how efficiently the owners fund are utilised and how much each penny (invested by owner/shareholder) is earning.
Return on Capital Employed (ROCE)
ROCE shows much how each penny invested in the company (by owner or lender) is utilised and how much it is earning. ROCE takes into account total capital employed. ROCE can be calculated as
ROCE = Earning before interest & tax / capital employed
ROCE = Earning before interest & tax / (Total assets – current liabilities)
ROCE = (PAT + interest + taxes) / (equity+ reserves + long terms liabilities)
PE Ratio (Price-Earing) Ratio
PE Ratio shows the ratio between market price of a share and earning per share. PE ratio is arrived at by diving the market price by EPS. For example, as on March 2022, EPS (earning per share) of Reliance industries is Rs. 89.74 and if market price of reliance is Rs. 2500 then PE ration would be 2500/89.74 i.e. 27.8.
PE Ratio = market price / EPS
PE Ratio = Market price per share / (net income / no of o/s shares)
To clarify let’s take one more example, if EPS of a company is 10 and market price per share is 250 then PE ratio is 250/10 i.e. 25.
It shows that a share of Rs. 250 is earning Rs. 10 for the company which is only 4% . But this should not be taken as 4% because company is earning this Rs. 10 not from 250 but from issue price of share which is shown as capital in books of the company. Market price of a share does not get invested in the business of a company but it goes the pocket of seller who may be bought this share at issue price or lesser market price. Now the concepts is that it cannot be understood that high PE are bad or lower PE are good. As PE also reflects the future expectations of the investors. Hence we may compare PE of companies in same industry with Industry PE but it may not be compared between companies of different industries.
Dividend yield can be understood as percentage return by a company in the form of dividend. For example, Market price of a share if Rs. 100 and company paid a dividend of rs. 10 per share then divided yield is 10% .
Dividend Yield = Cash dividend per share X 100 / market price per share.
In the above example, if I had bought that share for Rs. 80 and market price now is 100 and company paid dividend of Rs. 10 then also dividend yield is 10% but my return is 12.5%.
CAGR (Compound Annual Growth Rate)
CAGR is the rate of return given by an investment over many year if compounded annually. For example, If I Invested Rs. 100 and received Rs. 121 at the end of two year. Then My CAGR would be 10%.
CAGR = (Final value / starting value)^1/t – 1
Expected Return by CAPM (Capital assets pricing model)
Expected return is the minimum return which should be given by an investment considering the underlying risk factors. We know that there risk free return (like bank FD, Govt securities etc) which can be earned without taking any risk. But still if someone is putting his money in some risky investment then a premium over risk free return is expected.
Expected Return = Risk free return + beta of security(Risk premium)
Expected Return = Risk free return + Beta of transaction (Market return – Risk free return)
If actual return is more than expected return then it is called as Alpha return.
Alpha = Actual return – expected return as above.
Beta = Covariance of script return with market return / Variance of market return.