Fundamental

Stock
Analysis
Theory

Rajib Chatterjee.
Fundamental Analysis Definition

Fundamental analysis is a stock valuation method that uses financial and economic analysis to predict the
movement of stock prices.
 
The fundamental information that is analyzed can include a company's financial reports, and non-
financial information such as estimates of the growth of demand for products sold by the company,
industry comparisons, and economy-wide changes, changes in government policies etc..

General Strategy

To a fundamentalist, the market price of a stock tends to move towards it's “real value” or “intrinsic
value”. If the “intrinsic/real value” of a stock is above the current market price, the investor would
purchase the stock because he knows that the stock price would rise and move towards its “intrinsic or
real value”

If the intrinsic value of a stock was below the market price, the investor would sell the stock because he
knows that the stock price is going to fall and come closer to its intrinsic value.

All this seems simple. Now the next obvious question is how do you find out what the intrinsic value of a
company is? Once you know this, you will be able to compare this price to the market price of the
company and decide whether you want to buy it (or sell it if you already own that stock). 

To start finding out the intrinsic value, the fundamentalist analyzer makes an examination of the current
and future overall health of the economy as a whole.

After you analyzed the overall economy, you have to analyze firm you are interested in. You should
analyze factors that give the firm a competitive advantage in it’s sector such as management experience,
history of performance, growth potential, low cost producer, brand name etc. Find out as much as
possible about the company and their products.

Do they have any “core competency” or “fundamental strength” that puts them ahead of all the other
competing firms?

What advantage do they have over their competing firms?

Do they have a strong market presence and market share? 

Or do they constantly have to employ a large part of their profits and resources in marketing and finding
new customers and fighting for market share?

After you understand the company & what they do, how they relate to the market and their customers,
you will be in a much better position to decide whether the price of the companies stock is going to go up
or down.

Having understood the basics of fundamental analysis, let us go into some more details.

When investing in the stocks, we want the price of our stock to rise. Not only do we want our stock price
to rise, we want it to rise FAST! So the challenge is to figure out: which stock prices are going to rise

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fast?

Some stocks are cheap and some are costly. Some are worth Rs.500 and some are even worth 50paise.
But the price of the stock is not important. The price of the stock does not make a stock good to buy.
What is important is how much the price of the stock is likely to rise. 

If you invest Rs.500 in one stock of Rs.500 and the price goes up to Rs.540 you will make Rs.40.
However, if you invest Rs.500 in a 50paise stock, you will have 1000 stocks. If the price of the stock goes
up from 50paise to Rs.1, then the Rs.500 you invested is now Rs.1000. You made a profit of Rs.500.

If you understand this, you can see that the price of the stock is not important. What is important is the
rise in the stock’s price. More specifically the “percentage” rise in the stock price is important.

If the Rs.500 stock becomes worth Rs.540, then that is a 8% rise. This 8% rise only makes us Rs.40. On
the other hand when we invest the same Rs.500 in the 50paise stock and the stock price goes up to Rs.1, it
is a 100% rise as the stock price has doubled. This 100% rise makes us Rs.500.

The point is that when picking a company, we are interested in a company whose stock price will rise by
a large percentage.

Please note: Looking at the above paragraphs, it may seem like a good idea to buy all the really cheap
50paise and Rs.1 stocks hoping that their price will rise by 100% or more. This sounds good, but it can
also be really really bad some times! These really small stocks are very volatile and unless you know
what you are doing, do NOT get into them.

However, the point to be noted is that we are interested in stocks that will have the highest % rise in the
stock price. Now the question is, how do you compare stocks. How do you compare a stock worth Rs.500
to a stock worth 50paise and figure out which one will have a higher percentage rise. 
How do you compare  two companies that are in different fields and different industries? How do you
know which one is fundamentally strong and which one is week?

If you try to compare two companies in different industries and different customers it is like comparing
apples and elephants. There is no way to compare them! 
So fundamental analysts use different tools and ratios to compare all sorts of companies no matter what
business they are in or what they do!

Next let us get into the tools and ratios that tell us about the companies and their comparison....

Earnings per share (EPS) ratio & what it means!

Even comparing the earnings of one company to another really doesn’t make any sense, if you think
about it. Earnings will tell you nothing about how many shares the company has. Because you do not
know how many shares a company has, you do not know how many parts that companies earnings have
to be divided into. If the company has more shares, the earnings will be divided into more parts.

For example, companies A and B both earn Rs.100, but company A has 10 shares outstanding, so each
share holder has in effect earned Rs.10.

On the other hand, if company B has 50 shares outstanding and they too have earned Rs.100 then each
shareholder has earned Rs.2. So you see it is important to know what is the total number of outstanding

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 shares are as well as the earnings.

Thus it makes more sense to look at earnings per share (EPS), 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

So looking at the EPS ratio, you should go buy Company A with an EPS of 10, right? EPS is not the only
basis of comparing two companies, but it is one of the methods used.

Note that there are three types of EPS numbers: 

 Trailing EPS – last year’s numbers and the only actual EPS
 Current EPS – this year’s numbers, which are still projections
 Forward EPS – future numbers, which are obviously projections 
EPS doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information,
we need to look at some other ratios next....

Price to earning (P/E) ratio & what it means?

If there is one number that people look at than more any other number, it is the “Price to Earning Ratio
(P/E)”. The P/E is a ratio that investors throw around with confidence as if it told the complete story. Of
course, it doesn’t tell the whole story (if it did, we wouldn’t need all the other numbers.)

The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most
popular stock analysis ratio, although it is not the only one you should consider.

You calculate the P/E by taking the share price and dividing it by the company’s EPS (Earnings Per Share
that we saw above)

P/E = Stock Price / EPS

For example: A company with a share price of Rs.40 and an EPS of 8 would have a P/E of: (40 / 8) = 5
 
What does P/E tell you?

Some investors read a high P/E as an “overpriced stock”.

However, it can also indicate the market has high hopes for this stock’s 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 that the
market has just overlooked the stock. Many investors made their fortunes spotting these overlooked but
fundamentally strong stocks before the rest of the market discovered their true worth.

In conclusion, the P/E tells you what the market thinks of a stock. It tells you whether the market likes or
dislikes the stock. If things are vague and unclear to you, do not worry. The next ratio will make
everything you read till now make sense..

PEG (Price to future growth ratio!) and what it tells you!

The market is usually more concerned about the future than the present, it is always looking for some way
to figure out what is going to happen in the companies future.

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A ratio that will help you look at future earnings growth is called the PEG ratio.

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 30 / 15 = 2.

What does the “2” mean?

Technically speaking: The lower the PEG number, the less you pay for each unit of future earnings
growth. So even a stock with a high P/E, but high projected earnings growth may be a good value.
So, to put it very simply, we are interested in stocks with a low PEG value.

Just for the sake of understanding, consider this situation, you have a stock with a low P/E. Since the
stock is has a low P/E, you start do wonder why the stock has a low P/E. Is it that the stock market does
not like the stock? Or is it that the stock market has overlooked a stock that is actually fundamentally very
strong and of good value?

To figure this out, you look at the PEG ratio. Now, if the PEG ratio is big (or close to the P/E ratio), you
can understand that this is probably because the “projected growth earnings” are low. This is the kind of
stock that the stock market thinks is of not much value.

On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio, then you know
that it is a valuable stock) you know that the projected earnings must be high. You know that this is the
kind of fundamentally strong stock that the market has overlooked for some reason.

Important note: You must understand that the PEG ratio relies on the projected % earnings. These
earnings are not always accurate and so the PEG ratio is not always accurate.

Having understood these basic three ratios, you probably have started to understand how these ratios help
you understand a stock and what is valuable and what is not. 
In the next section we shall look at some of the things that every investor must know about. Something
that SILENTLY eats into the profits of each and every investor and how to beat it...

"Inflation" & how it eats your money silently & affects your investments!

Inflation, is an economic concept. What the cause of inflation is, is not important to us from the point of
view of this article. What is important to us is the effect of inflation! The effect of inflation is the prices of
everything going up over the years. 
A movie ticket was for a few paise in my dad’s time. Now it is worth Rs.50. My dads first salary for the
month was Rs.400 and over he years it has now become Rs.75,000. This is what inflation is, the price of
everything goes up. Because the price goes up, the salaries go up.

If you really thing about it, inflation makes the worth of money reduce. What you could buy in my dad’s
time for Rs.10, now a days you will not be able to buy for Rs.400 also. The worth of money has reduced!
If this is still not clear consider this, when my father was a kid, he used to get 50paise pocket money. He
used to use this money to go and watch a movie (At that time you could watch a movie for 50paise!)

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Now, just for the sake of understanding assume that my dad decided in his childhood to save 50paise
thinking, that one day when he becomes big, he will go for a movie. Many years pass. The year now is
2006. My dad goes to the theater and asks for a ticket. He offers the ticket-booth-guy at the theater
50paise and asks for a ticket. The ticket booth guy says, “I am sorry sir, the ticket is worth Rs.50. You
will not be able to even buy a “paan” with the 50paise!!”

The moral of the story is that, the worth of the 50paise reduced dramatically. 50paise could buy a whole
lot when my dad was a kid. Now, 50paise can buy nothing. This is inflation. This tells us two important
things.

Firstly: Do not keep your money stagnant. If you just save money by putting it your safe it will loose
value over time. If you have Rs.1000 in your safe today and you keep it there for 10years or so, it will be
worth a lot less after 10 years. If you can buy something for Rs.1000 today, you will probably require
Rs.1500 to buy it 10 years from now. So do not keep money locked up in your safe. 
Always invest money. 
If you can’t think where to invest your money, then put it in a bank. Let it grow by gaining interest. But
whatever you do, do not just lock your money up in your safe and keep it stagnant. If you do this, you will
be loosing money without even knowing it. The more money you keep stagnant the more money you will
be loosing.   

Secondly: When investing, you have to make sure that the rate of return on your investment is higher than
the rate of inflation.

What is the rate of inflation?

As we said earlier, the prices of everything goes up over time and this phenomenon is called inflation.
The question is: By how much do the prices go up? At what rate do the prices do up?

The rate at which the prices of everything go up is called the "rate of inflation". For example, if the price
of something is Rs.100 this year and next year the price becomes approximately Rs.104 then the rate of
inflation is 4%. If the price of something is Rs.80 then after a year with a rate of inflation of 4% the price
go up to (80 x 1.04) = 83.2

So, when you make an investment, make sure that your rate of return on the investment is higher than the
rate of inflation in your country. In our county India, for the year 2005-2006 the rate of inflation was 4%
(Which is really low and amazing!).  This rate keeps changing every year. The finance minister generally
gives the official statement on the inflation rate of the country for a particular year.

What is the rate of return?

The rate of return is how much you make on an investment. Suppose you invest Rs.100 in the market and
over a year, you make Rs.120, then you rate of return is 20%.

If you invest Rs.100 in the market today and you make money at a 3% "rate of return" in one year you
will have Rs.103. But now, since the rate of inflation is at 4%, an item costing Rs.100 today will cost
Rs.104 a year from now. So what you can buy with today’s Rs.100, you will only be able to buy
with Rs.104 a year from now.

But the Rs.100 that you invested has grown only at a 3% rate of return and so it is worth Rs.103. In effect,
you are loosing money!

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So in conclusion, the rate of return on your investments, have to be higher than the rate of inflation.

From the above paragraphs you can note how silently, inflation eats into your money. You would not
even know about it an your money would sit loosing value for no fault of yours. But inflation is not the
only thing you should be considering, there are other things too that eat into you money. The first thing is
“brokerage” and the second thing is “taxation”.

Investors beware of: Brokerage and taxation!

You probably know the concept that all your transactions in the stock market are done though a
"stockbroker". A stockbroker earns a commission on whatever transaction you make. Suppose you make
a transaction of Rs.2000, and the stockbroker charges you a 3% commission, then you have to pay the
stockbroker Rs.60 (3% of Rs.2000) for the transaction. So your total investment in the transaction in “not
Rs.2000”. The total investment in the transaction is Rs.2060/-

So after sometime, if the price of the stocks you invested in goes up to Rs.2060 then you have not made
any money because the total amount you invested was Rs.2060/-

What is more, even when you sell the stocks, you have to pay the broker brokerage of 3%. This means
that, when you sell the stocks for Rs.2060, you have to pay the broker Rs.61.6 so the profit of Rs.60 you
made on the transaction is gone, in fact you actually make a loss of Rs.1.6!!

So in effect even though you made a profit of Rs.60 because your stock price went up, you have actually
made a loss.

If combine this with the fact that inflation reduces the value of money over time, you are just loosing
money if you do not invest wisely without understanding brokerage and inflation.

Important note about brokerage: Brokers make money on whatever transaction you make. Whether you
buy or sell, brokers will make money. Because brokers basically make money on transactions. Because of
this, brokers tend to encourage you to trade. They don’t really care about whether you make a profit or
loss. They just care about whether you are trading. The more money you are using for trading, the more
they will make. Because of this, it would be wise to not blindly follow your brokers advise. The broker
will give you “hot tips” etc. not because they are looking out for you and your profit, but because they are
thinking about their own personal profit!

There is even one more factor that eats into your money. Tax!!!

Please note: We are not in any way encouraging you to not pay tax! We are just educating you about it. 

There is a “short term capital gain tax” in our country. For a short term (less than one year) you have to
pay tax on any capital gain you make though the stock market trading. How much % tax you have to pay,
depends on which "tax bracket" you fall in.

Just to give you an idea. If I make Rs.100 though a transaction in the stock market, since I fall in the 33%
tax bracket. It have to pay Rs.33 of that to the government!!

Please note: The government encourages you to be a long term-investor by having no long term capital

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gain tax. If you make a capital gain by investing for a period greater than one year, the you do not have to
pay any tax on the money you make.

Now combine this short term capital gain tax with brokerage and inflation! Think about it for some time.
You will almost make nothing on a small profit gains! If you want to make money out of the stock
market, you must make large profit gains.

Conclusion: As a general rule, just for the sake of simplicity, your investments must grow at a minimum
rate of 15% per year to stay ahead of inflation, tax and brokerage!! Remember this when making all your
investments.

This concludes our basics of the stock market guide. There is lot more to learn! And the best way to do it
is to start investing! (Don’t invest too much in the beginning but do start!) Once you have your money in
the market, you will start to understand things a whole lot better!

Best of luck!

Jai Hind.

Some expressions of Stock Fundamental Analysis

EPS: (Earnings Per Share)

The portion of a company's profit allocated to each outstanding share of common stock. The amount is
computed by dividing net earnings by the number of outstanding shares of common stock. For example, a
corporation that earned $10 million last year and has 10 million shares outstanding would report earnings
per share of $1.

P/E Ratio: (Price/ EPS)

Also called its "earnings multiple", Price of a stock divided by its earnings per share. The P/E ratio may
either use the reported earnings from the latest year or employ an analyst's forecast of next year's
earnings. P/E gives investors an idea of how much they are paying for a company's earning power.

An important notice here is that the P/E ratio is ultimately not an objective measure; a high P/E ratio
might show an overvalued stock, or it might reflect a company with high potential for growth.

Dividend

Dividend is an amount of the profits that a company pays to people who own shares in the company.
When a company earns a profit, some of this money is typically reinvested in the business and called
retained earnings, and some of it can be paid to its shareholders as a dividend.

Book Value

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The book value of an asset or group of assets is sometimes the price at which they were originally
acquired ( historic cost ), in many cases equal to purchase price.

Growth Stocks

Growth Stocks in finance are stocks that appreciate in value and yield a high return on equity (ROE).
Analysts compute ROE by taking the company's net income and dividing it by the company's equity. To
be classified as a growth stock, analysts expect to see at least 15 percent ROE.

References on Stock Analysis

Mastering Fundamental Analysis

By Michael C. Thomsett.

Technical Analysis Explained

By Martin J. Pring.

Japanese Candlestick Charting Techniques

By Steve Nison.

Value Investing Today

By Charles Brandes.

Reminiscences of a Stock Operator

By Edwin Lefevre.

Fundamental Stock Analysis Theory Page 9