Module for Investors
Advanced Fundamental Analysis - Valuation
Recap of fundamental analysis
It’s the weekend, and you decide to pay a visit to your friend in the city. Despite living within a few miles of each other, it’s been months since you two met, because, you know, life can get quite busy. So, you think of doing something nice, and you stop by the florist on your way. A bunch of sunflowers catches your eye, and you enquire about the price.
“Rs. 299 only,” the florist announces with a grin.
But the price shocks you. “Rs. 299 for a bunch of flowers?” you exclaim. You’d much rather buy something more worthwhile for that money. So, you put the bouquet down on the counter and keep walking. As you turn the corner, you notice a quaint little bookstore.
Ah! Your eyes light up. Your friend, she’s an avid reader. This would make for a much nicer good-to-see-you-again present than a bunch of overpriced flowers anyway. So, you head to the bookstore and browse through the stacks of books laid out there.
After rummaging for a bit, you spot a classic box set that your friend has always been looking for. It’s got all the 8 books in the series. It’s a little weathered, but in very good condition. And you know you hit the jackpot. So again, you ask the owner about the price.
“Rs. 500 only,” he says. And then, he goes on to add, “But I’ll give you a 50-rupees discount. Take it for Rs. 450.” This deal is too good to be true – you think. And quickly, you shell out Rs. 450 and get on your way.
So, in this case, what made you arrive at the conclusion that spending Rs. 450 on a box set of books was better than spending Rs. 299 on a bouquet of flowers. After all, Rs. 299 is a smaller amount to pay than Rs. 450, isn’t it?
The answer lies in the value of the product. You assessed that the flowers weren’t worth Rs. 299, but the books were worth way more than Rs. 450. That’s just what valuation is all about. It helps you understand the worth of something.
What is valuation in the financial markets?
With regard to the financial markets, valuation is the process of calculating and assessing the worth of a company’s shares. Valuation helps you determine if a share is overvalued or undervalued. But before you get to this phase, it’s important to perform fundamental analysis. Let’s have a quick recap of the nuances of this analysis technique, so you can understand and appreciate valuation better.
Fundamental analysis: A quick recap
As we saw in the previous module, fundamental analysis is effectively a technique that is used to determine the value of an asset. It focuses on the many underlying factors that affect the company’s future aspects and its actual business. It helps you understand the stock fundamentals and determine if the price of a stock is in tune with the actual value of the stock.
Fundamental analysis involves looking at the quantitative as well as the qualitative details of a company. Now, what’s the difference between these two categories? Well, quantitative factors include anything that can be measured and expressed numerically, while qualitative details are more subjective. Let’s revisit some examples of quantitative and qualitative nuances.
What is the company’s revenue?
How efficient are the company’s operations?
How much profit has it made in the past year?
What is the quality of its key management personnel?
How much capital does it have?
How does the company’s brand value appear?
How is the company using its cash?
Does the company use any proprietary technology?
What does the company spend on?
What socially responsible initiatives is the company undertaking?
How much debt does it owe its creditors?
What is the company’s vision like for the future?
The annual report
Now, as a part of your fundamental analysis, you’ll be required to read through and analyse various financial statements and reports. Of these, the annual report is perhaps the biggest repository of information that you’ll find. When you go through the annual report, you’ll find a great deal of information about the company, like its strategy, its range of products and services, and even the details of the company’s performance. Getting to know these details can help you assess how strong a company is. Let’s quickly revisit the different sections that you’ll find in the annual report.
- An overview about the company
- The chairman’s statement
- The details of the board of directors and the management committee
- The company’s performance
- The macroeconomic conditions
- The company’s strategy and business model
- Report of board of directors and management discussion and analysis
- Standalone financial statements
- Consolidated financial statements
The financial statements
The financial statements, which you’ll also find in the annual report, can tell you a lot about the company’s performance and its strength. But to make sense of the numbers in the reports, it’s important to understand the terms mentioned in there. That’s just what we saw in the previous module. Remember how we went into the details of reading and analysing the profit and loss statement, the balance sheet, and the cash flow statements? These documents are vital components of fundamental analysis.
The profit and loss statement
As the name makes it evident enough, the profit and loss statement is a report that leads up to the overall profit or loss made by a company during a financial year. This statement basically has two main sections – the income and the expenses. In the income section, you’ll find the top line of the company, also known as the revenue from operations. Additionally, the income generated by a company through activities other than its main business are categorised as ‘other income’ in the P&L statement.
In the expenses section, you’ll find all the costs incurred by the company. These include:
- Costs of materials consumed
- Purchases of stock-in-trade
- Changes in inventory
- Employee benefit expenses
- Finance costs
- Depreciation and amortisation
- Other expenses
The net of the income and the expenses leads to the profit before exceptional items and tax. Next, it’s necessary to adjust the profit obtained above for the exceptional items, which are basically any incomes or expenses that are unusual and non-recurring, but still arising from normal day-to-day activities of a company. This gives you the Profit Before Tax (PBT). And the PBT minus tax expenses gives you the Profit After Tax (PAT).
The earnings per share (EPS) is calculated by dividing the PAT by the total number of equity shares outstanding.
The balance sheet
The balance sheet is a statement that tells you how much a company owes and owns. It primarily has two sections: the assets side and the equity and liabilities side. The assets side of the balance sheet shows you the long-term assets and the short-term assets owned by the company. The equity segment gives you information about the equity and preference shares issued by the company. The liabilities segment, on the other hand, shows you how much the company owes other parties like banks and creditors over the short term and the long term.
The cash flow statement
This is another important part of fundamental analysis, since it gives you a lot of insight into how a company manages its cash flow. The cash flow statement primarily reveals three kinds of information.
- Cash flow from operating activities
- Cash flow from financing activities
- Cash flow from investing activities
Fundamental analysis ratios and numbers
Merely reading through these statements will not be of great use. The real value addition comes from being able to make sense of the information presented in these reports. Here’s where fundamental analysis ratios like the P&L ratios, balance sheet ratios and cash flow ratios come into the picture. As you’ll recall from the earlier module, there are many key fundamental analysis ratios and numbers that you can compute with the information presented in the financials of a company. These metrics help you understand the financial performance of a company much better.
So, the first step to understanding stock fundamentals and analysing your prospects for investment in a company is to understand its industry and its business. Then, you move on to fundamental analysis, where reading and analysing the financials play a key role in helping you understand the company’s performance. And with that done, it’s time to make your way to the end game: valuation. Wondering what that is? Head to the next chapter to find out.
A quick recap
- With regard to the financial markets, valuation is the process of calculating and assessing the worth of a company’s shares.
- Valuation helps you determine if a share is overvalued or undervalued.
- But before you get to this phase, it’s important to perform fundamental analysis.
- Fundamental analysis is effectively a technique that is used to determine the value of an asset.
- It focuses on the many underlying factors that affect the company’s future aspects and its actual business.
- It helps you determine if the price of a stock is in tune with the actual value of the stock.
- Fundamental analysis involves looking at the quantitative as well as the qualitative details of a company.
- It involves reading and analysing the annual report, the profit and loss statement, the balance sheet and the cash flow statement.