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Fundamental Analysis

Overview
Fundamental analysis is the study of economic, industry, and company conditions in an effort to determine the value of a company's stock. Fundamental analysis typically focuses on key statistics in a company's financial statements to determine if the stock price is correctly valued. I realize that some people will find a discussion on fundamental analysis within a book on technical analysis peculiar, but the two theories are not as different as many people believe. It is quite popular to apply technical analysis to charts of fundamental data, for example, to compare trends in interest rates with changes in security prices. It is also popular to use fundamental analysis to select securities and then use technical analysis to time individual trades. Even diehard technicians can benefit from an understanding of fundamental analysis (and vice versa).

INTRODUCTION
Fundamental analysis is the cornerstone of investing. In fact, some would say that you aren't really
investing if you aren't performing fundamental analysis. Because the subject is so broad, however, it's tough to know where to start. There are an endless number of investment strategies that are very different from each other, yet almost all use the fundamentals.

The goal of this tutorial is to provide a foundation for understanding fundamental analysis. It's geared primarily at new investors who don't know a balance sheet from an
income statement .While you may not be a "stock-picker extraordinaire" by the end of this tutorial, you will have a much more solid grasp of the language and concepts behind security analysis and be able to use this to further your knowledge in other areas without feeling totally lost.

The biggest part of fundamental analysis involves delving into the financial statements. Also known as quantitative analysis, this involves looking at revenue,
expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain insight on a company's future performance. A good part of this tutorial will be spent learning about the balance sheet, income statement, cash flow statement and how they all fit together.

But there is more than just number crunching when it comes to analyzing a company. This is where qualitative analysis comes in - the breakdown of all the intangible, difficult-to-measure aspects of a company. Finally, we'll wrap up the tutorial with an intro on valuation and point you in the direction of additional tutorials you might be interested in.

Interpretation
Most fundamental information focuses on economic, industry, and company statistics. The typical approach to analyzing a company involves four basic steps: 1. Determine the condition of the general economy.

2. Determine the condition of the industry. 3. Determine the condition of the company. 4. Determine the value of the company's stock.

Economic Analysis
The economy is studied to determine if overall conditions are good for the stock market. Is inflation a concern? Are interest rates likely to rise or fall? Are consumers spending? Is the trade balance favorable? Is the money supply expanding or contracting? These are just some of the questions that the fundamental analyst would ask to determine if economic conditions are right for the stock market.

Industry Analysis
The company's industry obviously influences the outlook for the company. Even the best stocks can post mediocre returns if they are in an industry that is struggling. It is often said that a weak stock in a strong industry is preferable to a strong stock in a weak industry.

Company Analysis
After determining the economic and industry conditions, the company itself is analyzed to determine its financial health. This is usually done by studying the company's financial statements. From these statements a number of useful ratios can be calculated. The ratios fall under five main categories: profitability, price, liquidity, leverage, and efficiency. When performing ratio analysis on a company, the ratios should be compared to other companies within the same or similar industry to get a feel for what is considered "normal." At least one popular ratio from each category is shown below.

Tools of Fundamental Analysis


Fundamental analysis is the process of looking at a business at the basic or fundamental financial level. This type of analysis examines key ratios of a business to determine its financial health and gives you an idea of the value its stock.

Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes. The goal is to determine the current worth and, more importantly, how the market values the stock. This article focuses on the key tools of fundamental analysis and what they tell you. Even if you dont plan to do in-depth fundamental analysis yourself, it will help you follow stocks more closely if you understand the key ratios and terms.

Earnings
Its all about earnings. When you come to the bottom line, thats what investors want to know. How much money is the company making and how much is it going to make in the future. Earnings are profits. It may be complicated to calculate, but thats what buying a company is about. Increasing earnings generally leads to a higher stock price and, in some cases, a regular dividend. When earnings fall short, the market may hammer the stock. Every quarter, companies report earnings. Analysts follow major companies closely and if they fall short of projected earnings, sound the alarm. For more information on earnings, see my article: Its the Earnings. While earnings are important, by themselves they dont tell you anything about how the market values the stock. To begin building a picture of how the stock is valued you need to use some fundamental analysis tools. These ratios are easy to calculate, but you can find most of them already done on sites like

cnn.money.com or MSN MoneyCentral.com. http://www.contentlinks.asiancerc.com/IB/FinalCompanyProfile.as p?txtCompanycode=15530059

Fundamental Analysis Tools


These are the most popular tools of fundamental analysis. They focus on earnings, growth, and value in the market. For convenience, I have broken them into separate

articles. Each article discusses related ratios. There are links in each article to the other articles and back to this article. The articles are:

1. 2. 3. 4. 5. 6. 7. 8. 9.

Earnings per Share EPS Price to Earnings Ratio P/E Projected Earning Growth PEG Price to Sales P/S Price to Book P/B Dividend Payout Ratio Dividend Yield Book Value Return on Equity

No single number from this list is a magic bullet that will give you a buy or sell recommendation by itself, however as you begin developing a picture of what you want in a stock, these numbers will become benchmarks to measure the worth of potential investments.

Understanding Earnings Per Share


One of the challenges of evaluating stocks is establishing an apples to apples comparison. What I mean by this is setting up a comparison that is meaningful so that the results help you make an investment decision. Comparing the price of two stocks is meaningless. Similarly, comparing the earnings of one company to another really doesnt make any sense, if you think about it. Using the raw numbers ignores the fact that the two companies undoubtedly have a different number of outstanding shares. For example, companies A and B both earn 100 rs, but company A has 10 shares outstanding, while company B has 50 shares outstanding. Which companys stock do you want to own? It makes more sense to look at earnings per share (EPS) for use as a comparison tool. You calculate earnings per share by taking the net earnings and divide by the outstanding shares.

EPS = Net Earnings / Outstanding Shares

Using our example above, Company A had earnings of $100 and 10 shares outstanding, which equals an EPS of 10 (100 rs / 10 = 10). Company B had earnings of 100 rs and 50 shares outstanding, which equals an EPS of 2 (100 rs / 50 = 2). So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS. The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it doesnt tell you whether its a good stock to buy or what the market thinks of it. For that information, we need to look at some ratios. Before we move on, you should note that there are three types of EPS numbers:

Trailing EPS last years numbers and the only actual EPS Current EPS this years numbers, which are still projections Forward EPS future numbers, which are obviously projections

Understanding Price to Earnings Ratio


If there is one number that people look at than more any other it is the Price to Earnings Ratio (P/E). The P/E is one of those numbers that investors throw around with great authority as if it told the whole story. Of course, it doesnt tell the whole story (if it did, we wouldnt need all the other numbers.) The P/E looks at the relationship between the stock price and the companys earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider. You calculate the P/E by taking the share price and dividing it by the companys EPS.

P/E = Stock Price / EPS


For example, a company with a share price of 40 rs and an EPS of 8 would have a P/E of 5 (40 rs / 8 = 5). What does P/E tell you? The P/E gives you an idea of what the market is willing to pay for the companys earnings. The higher the P/E the more the market is willing to pay for the companys earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stocks future and has bid up the price. Conversely, a low P/E may indicate a vote of no confidence by the market or it could mean this is a sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes spotting these diamonds in the rough before the rest of the market discovered their true worth.

What is the right P/E? There is no correct answer to this question, because part of the answer depends on your willingness to pay for earnings. The more you are willing to pay, which means you believe the company has good long term prospects over and above its current position, the higher the right P/E is for that particular stock in your decision-making process. Another investor may not see the same value and think your right P/E is all wrong. The articles in this series:

Understanding the PEG


Price to Earnings Ratio or P/E Ratio gave us an idea of what value the market place on a companys earnings. The P/E is the most popular way to compare the relative value of stocks based on earnings because you calculate it by taking the current price of the stock and divide it by the Earnings Per Share (EPS). This tells you whether a stocks price is high or low relative to its earnings. Some investors may consider a company with a high P/E overpriced and they may be correct. A high P/E may be a signal that traders have pushed a stocks price beyond the point where any reasonable near term growth is probable. However, a high P/E may also be a strong vote of confidence that the company still has strong growth prospects in the future, which should mean an even higher stock price. Because the market is usually more concerned about the future than the present, it is always looking for some way to project out. Another ratio you can use will help you look at future earnings growth is called the PEG ratio. The PEG factors in projected earnings growth rates to the P/E for another number to remember. You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.

PEG = P/E / (projected growth in earnings)


For example, a stock with a P/E of 30 and projected earning growth next year of 15% would have a PEG of 2 (30 / 15 = 2). What does the 2 mean? Like all ratios, it simply shows you a relationship. In this case, the lower the number the less you pay for each unit of future earnings growth. So even a stock with a high P/E , but high projected earning growth may be a good value. Looking at the opposite situation; a low P/E stock with low or no projected earnings growth, you see that what looks like a value may not work out that way. For example,

a stock with a P/E of 8 and flat earnings growth equals a PEG of 8. This could prove to be an expensive investment. A few important things to remember about PEG:

It is about year-to-year earnings growth It relies on projections, which may not always be accurate

Understanding Price to Sales Ratio


The first three ratios discussed particularly deal with earnings directly. You can add the two others on dividends and the one on return on equity to the list as specific to companies that are or have made money in the past. It doesnt mean that companies that dont have any earnings are bad investments, but you should approach companies with no history of actually making money with caution. The Internet boom of the late 1990s was a classic example of hundreds of companies coming to the market with no history of earning some of them didnt even have products yet. Fortunately, thats behind us. However, we still have the problem of needing some measure of young companies with no earnings, yet worthy of consideration. After all, Microsoft had no earnings at one point in its corporate life. One ratio you can use is Price to Sales or P/S ratio. This metric looks at the current stock price relative to the total sales per share. You calculate the P/S by dividing the market cap of the stock by the total revenues of the company. You can also calculate the P/S by dividing the current stock price by the sales per share.

P/S = Market Cap / Revenues or P/S = Stock Price / Sales Price Per Share
Much like P/E, the P/S number reflects the value placed on sales by the market. The lower the P/S, the better the value, at least thats the conventional wisdom. However, this is definitely not a number you want to use in isolation. When dealing with a young company, there are many questions to answer and the P/S supplies just one answer.

Understanding Price to Book Ratio


Investors looking for hot stocks arent the only ones trolling the markets. A quiet group of folks called value investors go about their business looking for companies that the market has passed by. Some of these investors become quite wealthy finding sleepers, holding on to them for the long term as the companies go about their business without much attention from the market, until one day they pop up on the screen, and some analyst discovers them and bids up the stock. Meanwhile, the value investor pockets a hefty profit. Value investors look for some other indicators besides earnings growth and so on. One of the metrics they look for is the Price to Book ratio or P/B. This measurement looks at the value the market places on the book value of the company. You calculate the P/B by taking the current price per share and dividing by the book value per share.

P/B = Share Price / Book Value Per Share


Like the P/E, the lower the P/B, the better the value. Value investors would use a low P/B is stock screens, for instance, to identify potential candidates.

Understanding Dividend Payout Ratio


There are some metrics used in fundamental analysis that fall into what I call the hohum category. The Dividend Payout Ratio (DPR) is one of those numbers. It almost seems like a measurement invented because it looked like it was important, but nobody can really agree on why. The DPR (it usually doesnt even warrant a capitalized abbreviation) measures what a companys pays out to investors in the form of dividends. You calculate the DPR by dividing the annual dividends per share by the Earnings Per Share.

DPR = Dividends Per Share / EPS


For example, if a company paid out $1 per share in annual dividends and had $3 in EPS, the DPR would be 33%. ($1 / $3 = 33%)

The real question is whether 33% is good or bad and that is subject to interpretation. Growing companies will typically retain more profits to fund growth and pay lower or no dividends. Companies that pay higher dividends may be in mature industries where there is little room for growth and paying higher dividends is the best use of profits (utilities used to fall into this group, although in recent years many of them have been diversifying). Either way, you must view the whole DPR issue in the context of the company and its industry. By itself, it tells you very little.

Understanding Dividend Yield


Not all of the tools of fundamental analysis work for every investor on every stock. If you are looking for high growth technology stocks, they are unlikely to turn up in any stock screens you run looking for dividend paying characteristics. However, if you are a value investor or looking for dividend income then there are a couple of measurements that are specific to you. For dividend investors, one of the telling metrics is Dividend Yield. This measurement tells you what percentage return a company pays out to shareholders in the form of dividends. Older, well-established companies tend to payout a higher percentage then do younger companies and their dividend history can be more consistent. You calculate the Dividend Yield by taking the annual dividend per share and divide by the stocks price.

Dividend Yield = annual dividend per share / stock's price per share
For example, if a companys annual dividend is $1.50 and the stock trades at $25, the Dividend Yield is 6%. ($1.50 / $25 = 0.06)

Understanding Book Value


How much is a company worth and is that value reflected in the stock price? There are several ways to define a companys worth or value. One of the ways you define value is market cap or how much money would you need to buy every single share of stock at the current price.

Another way to determine a companys value is to go to the balance statement and look at the Book Value. The Book Value is simply the companys assets minus its liabilities.

Book Value = Assets - Liabilities


In other words, if you wanted to close the doors, how much would be left after you settled all the outstanding obligations and sold off all the assets. A company that is a viable growing business will always be worth more than its book value for its ability to generate earnings and growth. Book value appeals more to value investors who look at the relationship to the stock's price by using the Price to Book ratio. To compare companies, you should convert to book value per share, which is simply the book value divided by outstanding shares.

Understanding Return on Equity


If you give some management teams a couple of boards, some glue, and a ball of string, they can build a profitable growing business, while other teams cant make a profit with several billion dollars worth of assets. Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings. You calculate ROE by dividing Net Income by Book Value. A healthy company may produce an ROE in the 13% to 15% range. Like all metrics, compare companies in the same industry to get a better picture. While ROE is a useful measure, it does have some flaws that can give you a false picture, so never rely on it alone. For example, if a company carries a large debt and raises funds through borrowing rather than issuing stock it will reduce its book value. A lower book value means youre dividing by a smaller number so the ROE is artificially higher. There are other situations such as taking write-downs, stock buy backs, or any other accounting slight of hand that reduces book value, which will produce a higher ROE without improving profits. It may also be more meaningful to look at the ROE over a period of the past five years, rather than one year to average out any abnormal numbers. Given that you must look at the total picture, ROE is a useful tool in identifying companies with a competitive advantage. All other things roughly equal, the company that can consistently squeeze out more profits with their assets, will be a better investment in the long run.

Strengths of Fundamental Analysis


Long-term Trends
Fundamental analysis is good for long-term investments based on long-term trends, very long-term. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies.

Value Spotting
Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.

Business Acumen
One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock's price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are high-risk (tech), low-risk (utilities), growth oriented (computer), value driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).

Knowing Who's Who


Stocks move as a group. By understanding a company's business, investors can better position themselves to categorize stocks within their relevant industry group. Business can change rapidly and with it the revenue mix of a company. This happened to many of the pure Internet retailers, which were not really Internet companies, but plain retailers. Knowing a company's business and being able to place it in a group can make a huge difference in relative valuations.

Weaknesses of Fundamental Analysis


Time Constraints

Fundamental analysis may offer excellent insights, but it can be extraordinarily timeconsuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it is quite brash to imply that the market price, and hence Wall Street, is wrong.

Industry/Company Specific
Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time-consuming, which can limit the amount of research that can be performed. A subscription-based model may work great for an Internet Service Provider (ISP), but is not likely to be the best model to value an oil company.

Subjectivity
Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, an average-case valuation and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so. The chart below shows how stubbornly bullish many fundamental analysts can be.

Analyst Bias
The majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, "there are lies, damn lies, and statistics." When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals. Only buyside analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-side analysts who work for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine Weber, DLJ to name a few). These brokers are also involved in underwriting and investment banking for the companies. Even though there are restrictions in place to prevent a conflict of interest, brokers have an ongoing relationship with the company under analysis. When reading these reports, it is important to take into consideration any biases a sell-side analyst may have. The buyside analyst, on the other hand, is analyzing the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases this may be as a large shareholder.

Definition of Fair Value


When market valuations extend beyond historical norms, there is pressure to adjust growth and multiplier assumptions to compensate. If Wall Street values a stock at 50 times earnings and the current assumption is 30 times, the analyst would be pressured to revise this assumption higher. There is an old Wall Street adage: the value of any asset (stock) is only what someone is willing to pay for it (current price). Just as stock prices fluctuate, so too do growth and multiplier assumptions. Are we to believe Wall Street and the stock price or the analyst and market assumptions? It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However, because so many companies were and are losing money, it has become popular to value a business as a multiple of its revenues. This would seem to be OK, except that the multiple was higher than the PE of many stocks! Some companies were considered bargains at 30 times revenues.

ANALYSIS

Topics Adjusted EPS(Rs) Cash EPS (Rs) Book Value (Rs) Dividend Per Share (Rs)

Tata Steel Ltd. (803) 60.58 72 296.65 16

JSW Steel Ltd. (903) 55.96 100.21 410.07 1

Steel Authority of India (SAIL) Ltd. (803) 17.7 20.87 55.69 3.7

Return On NetWorth (%) Return On Capital employed(%) Operating Profit Margin(%) Gross Profit Margin(%) Net Profit Margin(%) Current Ratio Quick Ratio Long term debt to equity Total Debt to equity Interest Cover (times) Assets Turnover Ratio Average Raw Material Holding (in Days) Average Finished Good Holding (in Days) Number of days of net working capital Inventory Turnover Ratio Export as percent of Total Sales Bonus component in Equity(%)

21.52 17.16 41.94 37.7 23.43 3.92 3.52 1.07 1.08 9.25 1.2 71.68 29.45 520.93 10.84 11.64 34.61

5.59 12.35 20.42 14.51 3.23 0.52 0.28 1.34 1.51 3.64 0.82 33.03 23.67 -111.72 8.75 29.94 0

32.76 44.47 28.19 25.1 18.16 1.73 1.23 0.12 0.13 51.04 1.31 36.42 48.69 104.06 8.62 3.08 0