April 25

FUNDAMENTAL
ANALYSIS 2020
Complete Guide To Fundamental -YOGI.N
Analysis of Indian Stocks
 CONTENTS

1 Fundamental Analysis of Indian Stocks

1.1 Fundamental Analysis of Indian Stocks: Introduction
1.2 What is Fundamental Analysis?
1.3 What is a Stock?
1.4 Fundamental Analysis of Indian Stocks Step #1: Understanding the
Business:
1.4.1 Understanding the Management:
1.4.2 A Forward Looking Management:

1.5 Fundamental Analysis of Indian Stocks Step #2: Financial Statement

Analysis:
1.5.1 Earnings Growth:
1.5.2 Liquidity Status:
1.5.3 Efficiency Ratios:
1.5.4 Valuation Ratios:

1.6 Fundamental Analysis of Indian Stocks Step #3: Macroeconomic

Support:
1.7 Fundamental Analysis of Indian Stocks Step #4: Understand The
Psychology of Investing
1.7.1 Be Patient:
1.7.2 Un-follow the herd:
1.7.3 Learn from your mistakes:
1.8 Conclusion:

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 •Understanding the
Management •Earnings Growth
•A Forward Looking •Liquidity Status
Management •Efficiency Ratios
•Valuation Ratios

STEP 2
STEP 1
Understanding Financial
the Business Statement
Analysis

STEP 3 STEP 4
Understand The
Macroeconomic Psychology of
Support Investing

•Be Patient
•Un-follow the herd
•Learn from your
mistakes

Hi investors, in this post of “Complete Guide to Fundamental

Analysis of Indian Stocks”, you will understand each and every
aspect of analyzing the fundamentals of a business, and how
you can become an expert stock picker.

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1.1 Fundamental Analysis of Indian Stocks: Introduction
Fundamental analysis has always been the best way of stock picking.
It is something that is practiced by some of the most successful
investors across the world such as Warren Buffett, Peter Lynch, John
Templeton etc.

Warren Buffett’s Company Berkshire Hathaway, over the past 50

years have compounded their investor’s wealth by 20.9%. In other
words, Rs.1,000 invested in Berkshire Hathaway 50 years back
would become Rs. 1,32,22, 544 (Rs.One Crore Thirty Two Lac
Twenty Two Thousand Five Hundred Forty Four)
The phenomenal success achieved by these investors shows that
fundamental analysis has been a time tested, proven and the best
way of analyzing and picking stocks.

1.2 What is Fundamental Analysis?

Fundamental analysis is about analyzing the business and financial
performance of the company in order to understand its current
valuation and future growth potential and make an investment
decision.
The question now is why fundamental analysis is so important? To
answer this question, you need to understand what is a stock or share.

1.3 What is a Stock?

Every stock (or share) is a part of your ownership in a business. When
you buy a share, you buy a small portion of a business.

When companies do well, they earn bigger profit, thereby increasing

the value of the business.

Since stocks are part ownership in the business, the price of the share
appreciates proportionately.
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In order to understand which businesses are doing well, and will
continue to do well in the future, you must analyze various aspects of
the business such as the business model, past performance, future
growth potential and its business value against market price.

In other words, fundamental analysis helps you in answering following

questions:

What is the business of the company (Business Model)

How well the company has performed in the past?

What are its future growth prospects?

Is it the right price to enter into stock?

In our guide to fundamental analysis of Indian stocks, you will learn to

analyze each of these aspects step by step.

1.4 Fundamental Analysis of Indian Stocks Step #1:

Understanding the Business:
The first step to fundamental analysis of Indian stocks, is to
understand the business of a company.
There are more than 5,500 listed companies in Indian stock market, it
is impossible to analyze all of them and pick a few.
That is why you should invest in only those businesses that fall under
your “circle of competence”.
What’s that? The concept of circle of competence was introduced
by Warren Buffett. This is how he has explained it.

“I expect to make money from the things that I understand, where I can
foresee how the economics of the business are going to look like 10-15 years
in the future.

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I am not an expert in understanding everything so I stick to the businesses
that I understand, and I call it my circle of competence, and try to stay
around my circle of competence”

Put simply, One cannot be an expert in understanding all types of

businesses.
There are some you will understand better and others that you don’t.
Businesses that you really understand well are within your circle of
competence.

As an investor, it is always in your favor to invest in businesses that

you understand.
When you understand the business well, you also understand the inner
workings of the company and the factors that may work in favor or
against the business.

All of this helps you understand the future economics of the business
and how business is supposed to pan out.
But how do you know what is your circle of competence? It is often
seen that businesses with simple business models are usually easier
to understand and thus fall under our circle of competence.

Let me give you a simple example.

Do you understand the business model of Britannia Industries?
Yes, they make quality confectionery products, such as cookies, cakes and
biscuits.
They have a strong brand trusted by many allowing them to charge a
premium price from their customers.
How do you see Britannia 10 years from now? Since there is rising demand
for such products, and there are few players in the market that can compete
with Britannia, I think Britannia will continue to grow for the next 5-10
years.
Now let’s look at another business. Infosys.
Do you understand their business model? Not very clearly, but, they provide
software solutions to clients from various sectors
How do you see Infosys 10 years from now? It’s hard to say if they will
remain market leaders 10 years from now as there are many other players
like TCS, Tech Mahindra, Wipro, etc.
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If understanding business model Britannia is much easier than Infosys,
Britannia fall under your circle of competence while infosys does not.

The second step in our Guide to Fundamental Analysis of Indian

Stocks is to analyze the management of the company.

1.4.1 Understanding the Management:

The second key step to fundamental analysis of Indian stocks is to
understand the management.

A good management is always vocal about its business, its current

situation, opportunities, future growth plans.

You can find all the information related to business growth plans in
company’s annual report under “Management Discussion and
Analysis” section.

A good business should clearly state its future expansion plans, how
it’s going to achieve them and steps being taken in that direction.
A management using vague statements while explaining its business,
using lot of complex jargons, should be carefully dealt with.
For Example, if a company says “We expect to see exponential growth in
the coming years” but fails to answer “How?” better be careful with such
people, chances are they may not have any plans at all.

On the other hand, if a company says “We expect to grow at 20% in the
next 5 years” and presents a concrete plan on how it is going to achieve
them, you can trust the honesty of the management.

Also, it is always better to have right mix of people running the

business. Make sure that people in top management have sufficient
experience in relevant industry and have a successful track record.

Companies that have directors with little or no experience may not be

able to understand the intricacies business and thus may not be able
to take the business forward.

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In order to understand who are the directors and their work experience
look at the annual report and you will find all the relevant information
under the heading “Corporate Information”.

To some, this may not look like an important aspect of

fundamental analysis, but it is. A dishonest management
can destroy a great business.

1.4.2 A Forward Looking Management:

A business should always be forward looking in order to grow. A good
business has a forward looking management, and should be able to
plan accordingly.

This not only helps company stay ahead of the competitors but also
helps them expand business their business in a better way.

To give you an example of a forward looking management, HUL

(Hindustan Unilever Limited) a leading FMCG company understood
earlier that consumers are now more inclined towards ayurvedic
products over cosmetic ones, and launched a series of ayurvedic
products under brand name “Lever Ayush”, to capture the rising
demand.

In short, an ambitious and forward looking management which is also

vocal and transparent about its future plans takes the business
forward.

1.5 Fundamental Analysis of Indian Stocks Step #2: Financial

Statement Analysis:
The third step in Fundamental Analysis of Indian Stocks is to analyze
the past performance of the business, which can best be understood
by analyzing its financial statements.

It is usually believed that you need a degree in finance to understand

the financial statements of a company.

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Trust me, you don’t have to be an expert in finance to analyze the
financial statements.

Today by using financial ratios, it has become much easier to analyze

financial performance of a company than it was many years back.
You just have to look at few crucial ratios in order to understand the
complete picture of the financial performance of a company.

1.5.1Earnings Growth:
Earnings growth is a great measure to understand how fast a
company’s business is growing. There are many parameters that can
be used to assess the earnings growth of the company, but the most
accurate is calculating the EPS growth.
EPS stands for Earnings Per Share, calculated by dividing Net Profit
by number of outstanding shares of the company. EPS growth is
percentage growth in earning of a business compared to previous
year.
To calculate EPS growth, you need to use the following formula:

EPS Growth = EPS(current Year)-EPS(previous year)/EPS(previous

year)*100

Some conservative investors also look for past 5-10 years of EPS
growth, based on their investment horizon.

Word of Caution: Some companies can manipulate EPS numbers

using creative accounting methods.

For Example, a company may announce buyback of shares, thereby

reducing number of outstanding shares in the market. This boosts the
EPS numbers without any real growth in earnings.

Investors using EPS growth as a metric should make sure company

has not announced any buybacks recently.

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1.5.2Liquidity Status:
Liquidity is the ability of a company to meet its financial obligations,
such as interest payment on loans, payment to its creditors etc.

Liquidity is an important metric as it determines if a company will be

able to run its business smoothly after paying all its obligations.

There are two types of liquidity, short term and long term. Short term
liquidity measure whether the company will be able to meet all its
financial obligations that are due this year.

The best measure of short term liquidity is Current Ratio which can be
calculated using this formula
Current ratio = current assets – current liabilities

Although you don’t have to go through the pain of calculating this

number as it is easily available on many websites
like Moneycontrol.com.
Simply search the name of the company and on the left side bar and
go to Financials > Ratios. You will get all the important ratios for the
past 5 years of the company.

As a thumb rule companies with current ratio of 1 or above are

supposed to be sufficiently liquid.
The second is the long term liquidity ratios, which signifies of the
company is able to meet its long term obligations.

If a company has poor long term liquidity, it may default on its loans
and even file for bankruptcy. There are many examples in the recent
past where companies(such as Lanco Infra, Kingfisher Airlines) went
bust as they were unable to meet their long term financial
commitments.

The best way to assess the long term liquidity of a company is Debt to
Equity ratio.
It is calculated by dividing total long term debt by shareholders Equity
Debt to Equity = Total Debt/Shareholder Equity

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An ideal level of debt to equity ratio is that it should be below 1.
However, debt to equity varies from industry to industry and is usually
seen on the higher side in capital intensive sectors (such as
Infrastructure, Iron and Steel, Power generation etc).

Note: While analyzing Non Banking Finance Companies or Banks, it is

better to look at their NPA numbers rather than debt to equity.
Again, you don’t have to calculate these numbers as you can easily find them
on Moneycontrol.com.
Word of caution: Just like earnings numbers, even debt to equity ratio
can be manipulated if company goes fro equity dilution, resulting in
issuing more equity shares.

1.5.3Efficiency Ratios:
Efficiency ratios are used to measure how efficiently the capital of the
company is allocated. In other words, it shows how prudent the
management is in terms of allocation money in such a way that it
maximizes the return on invested capital.

The best way to assess capital efficiency is to look at Return on

Capital Employed(ROCE), which is calculated using the following
formula.
Return on Capital Employed = Net Operating Profit/Capital Employed.
Some analysts also use Return on Equity as a capital efficiency metric,
but in my opinion, ROCE is a more conservative measure as it
measures capital efficiency using both debt and equity of the company.

An ideal level of Return on Capital Employed should be higher than

prevailing interest rates and inflation of the country.

1.5.4Valuation Ratios:
Valuation is the most important step while performing Fundamental
Analysis of Indian Stocks as it not only helps you understand what the
business is worth and how much you are paying for it(also called
absolute valuation), it also helps you in peer comparison, that is,
compare two or more similar companies in the same sector to
understand which one is cheaper(called relative valuation).
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Although there are many valuation ratios such as EV/EBITDA, Price to
Book Value, etc, we are going to focus on two most popular and
efficient valuations ratios. The Price to earnings Ratio and Price to
earnings growth ratio (PEG ratio).

Price to Earning Ratio: popularly known as the P/E ratio, it is

calculated by dividing the current market price of the share by EPS.

P/E Ratio measures how much price an investor is paying against

each rupee earned by the company. For example if a company is
trading at a P/E of 10, it means that investors are paying Rs. 10 for
each rupee earned by the company.
Assume two companies in the same sector, one is trading at a P/E of
10 and other is trading at a P/E of 8.

As its obvious, company trading at P/E of 8 seems to be cheaper and

hence a better investment.

The problem with P/E Ratio is that it assumes that both the companies
are growing at the same growth rate, which may not always be the
case.
Different companies, despite being in the same sector, may grow at
different growth rates.
when a company grows rapidly, investors usually pay higher price for
perceived higher growth in the future, pushing P/E ratio higher for such
companies.
To make a better comparison between companies with different growth
rates, we use a better metric called PEG ratio,
PEG Ratio: PEG ratio is a more advanced version of P/E ratio that
takes into account the expected growth of the company as well. PEG
ratio is calculated by dividing P/E ratio with estimated future growth
rate of the company.

As a thumb rule, lower the PEG number, better it is. If the PEG ratio is
below 1, the stock is assumed to be undervalued.

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For example, assume two companies, X and Y. While X is trading at a
P/E of 5 and Y is trading at a PE of 8. By just looking at the P/E it
seems X, being lower P/E, is a better bargain.

Let’s now look at the expected growth rates of both the companies.
Expected Growth Rate of X 5% CAGR
Expected Growth Rate of Y 12% CAGR

Now dividing P/E ratio by its expected growth rate, here are the
respective PEG Ratios.
PEG Ratio of Company X 5/5=1
PEG Ratio of Company Y 8/12=0.66.

As you can see clearly, the picture has changed completely. Despite
having higher P/E Ratio, Company Y is still a bargain compared to
Company X.
While performing relative valuation, it is always wise not to rely on a
single metric and cross check your analysis using different valuation
ratios to test your assumptions.

1.6 Fundamental Analysis of Indian Stocks Step #3:

Macroeconomic Support:
The third step to Fundamental analysis of Indian Stocks is
understanding the macroeconomics. No matter how good the business
is, it cannot survive for long time if it is not supported by the economy.
Macroeconomic analysis involves study of broader economic factors
that support the growth of business.

You don’t have to be an economist to perform macroeconomic

analysis, just ask few simple questions such as:
Is there a demand for the products/services of the company?
Are Government Policies supporting the business growth?
Is the company well positioned in the market to take full advantage of
growth in the sector?

For Example, Let us analyze food processing sector. Ask these

questions to yourself.
Is there a demand for processed foods in India?
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The answer is yes, with more women joining the workforce(especially
in urban and semi urban areas), they may not have the time to cook
food. In such cases, there will be huge demand for semi cooked to
ready to eat canned food that can be consumed instantly.

Is the Government Policy Supporting the Food Processing Industry?

Yes, Government is willing to offer land for food parks to various
companies as these food parks also provide better price to farmers
produce.

Is the Company well positioned to take full advantage of the growth in the
sector?
Many companies like Nestle have launched new range of products to
serve the market, also many companies like ITC have also entered
processed food business offering frozen veggies that can last longer.
All these answers show that food processing companies have a bright
future ahead, and worth being invested for long term.
Macroeconomic factors plays a significant role in growth of any sector,
but it’s hard to go by numbers while analyzing macroeconomics as
there are too many variables that may lead to lot of confusion.
The best way to perform macroeconomic analysis is to keep it simple
and do not bother about daily changes or fluctuations.

1.7 Fundamental Analysis of Indian Stocks Step #4: Understand

The Psychology of Investing
The final step in our Guide to Fundamental Analysis of Indian Stocks is
something that is seldom talked about, but is a very important part of
successful investing.

Warren Buffett once said “Investing is 20% strategy and 80%

psychology”, which shows how significant is the role of psychology in
fundamental analysis.

No matter how good your stock picking skills are, if you don’t have the
right mindset and discipline, you can be your own worst enemy.

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So how do you approach the market in order to take maximum
advantage of other people’s irrational behaviour, while preventing
yourself from not being carried away by herd mentality?
Here are three most important disciplines to be followed while
investing in stock market:

1.7.1 Be Patient:
Investing in stock market is neither a lottery nor a gamble, that can
make you rich overnight. Look at some of the most successful
investors in the word, it took them decades to be where they are today.
When you invest in stocks, you own a part of a business. When
businesses grow and earn bigger profits, their total business value
increases. But since that does not happen overnight, you have to give
it time and be patient.

Investing in stocks is like planting a seed, you have to be patient in

order to get meaningful results.

So once you have found a great stock to invest in, don’t be hasty,
maintain discipline and give it chance to grow.
It’s as boring as watching the paint dry or grass grow, but if you are
serious about making money from investments, you have to follow the
rules of the game.
1.7.2 Un-follow the herd:
When the market nosedives, news channels show everything going
bad in the market, and all the stocks are deep in red, it’s hard to keep
your calm and stay invested.

But if you think rationally, this is the time when quality stocks are
available at a bargained price.

Successful investors do not focus on popular opinion, they focus on

the price of the stock and its underlying value.

If the underlying fundamentals of the company are largely unaffected,

but the price has corrected significantly, it’s always wise to grab such
an opportunity, as it will give you multifold returns in no time.

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1.7.3Learn from your mistakes:
No matter how good your stock picking skills are, you cannot avoid
making a mistake altogether.

This does not mean that you should get disheartened and quit.
Successful investors revisit their mistakes and learn from them, trying
to avoid making the same mistake in the future.

Remember, learning is a continuous process that never stops, it helps

you gain experience and become a better investor.

So be mistake friendly, and gain experience from them. Slowly you will
find your regrets going down while your bank balance going up.

Before I conclude this Post with final points, let us summarize all the
points we have learned so far through the info-graphic given below:

1.8 Conclusion:
Performing fundamental analysis of Indian Stocks is not difficult, but it
takes some time to learn, but if you are dedicated to learning
fundamental analysis of Indian stocks, it becomes much easier.

As already mentioned earlier, discipline plays an important role in

successful investing. While performing fundamental analysis of Indian
stock, you must not ignore the fact that no matter how good your stock
picking skills are, it’s of little use if you are not disciplined or easily
influenced by popular opinions of other people.

That concludes our guide to fundamental analysis of Indian Stocks,

hope you find this useful and knowledgeable.

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