Fundamental Analysis of Stocks: Revenue, Profit, Ratios & Valuation Explained

Fundamental analysis of stocks is the process of evaluating a company’s financial health. It involves the review of company’s business, financial statements, cash flows, and other pertinent information. This type of analysis helps the investor determine if a company is worthy of investment.

While the focus of fundamental analysis is on the financial health of a company and not on price movements of a stock, investors can consider reviewing financial information of Indian companies which are either listed or unlisted. Indian investors can access a plethora of information.

One of the main objectives of this article is to define and explain various terms used in fundamental analysis of stocks in india. We hope this article will help the investor develop a structured and systematic approach in evaluating the fundamentals of companies. This article is not intended to be a recommendation list of stocks to buy and/or sell.

What Is Fundamental Analysis of Stocks?

Fundamental analysis studies the various business and financial factors of an enterprise. It helps in determining the quality of the business and its potential to generate earnings and cash flows. The analysis is useful to assess listed companies including banks, software, auto, pharma, FMCG, power and other manufacturing companies.

Generally, any analysis of a company includes

• Business fundamentals: What the company sells, who its customers are, how it competes and what drives growth.

• Financial performance: Revenue, operating profit, net profit, EPS and cash flow.

• Valuation: Whether the market price appears reasonable relative to earnings, book value, cash flows or other relevant measures.

No financial ratio can be deemed as the defining factor in value a business. An analysis should include several factors and be compared to the business’s past trends and the peers in the similar line of business.

Why Is Fundamental Analysis Important?

A number of factors can cause share prices to move including, company earnings, interest rates, the condition of the economy and the markets, sector and investment trends, investor sentiment, and changes in the way companies interact with the markets. Fundamental analysis is used to move beyond share price variability and focus on the business potential of the security.

As an example, two comparable sized companies may have differences in profitability, financial health and cash generation. In addition, a company may be experiencing an increase in earnings and, as a result, trade at a level that leaves little prospective upside potential.

Fundamental analysis therefore has two related objectives: understanding business quality and understanding price versus value.

Revenue and Sales Growth

Recognizing various terms used to denote different forms of revenues in financial statements may require thorough knowledge of the business. However, for financial analysis, revnues reflect a business’ operational activities.

It is better to analyze the trend of a firm’s revenues over a period, preferably over a few years. While outstanding performances of a firm are recognized and rewarded, consistent fluctuations in revenues of other firms may not be regarded positively.

While analyzing a firm’s revenues, the following questions may be helpful:

• Is revenue increasing?

• Is growth coming from higher volumes, higher prices, acquisitions or a combination?

• Is growth faster or slower than the company's industry?

• Does a small customer base account for a large percentage of the firm's sales?

• Do increases in revenues improve operating profits and cash inflows?

While increased sales may seem beneficial to a firm, if revenue growth is at the expense of profitability and cash inflow, it may be detrimental to the firm.

Analyzing Profit and Profit Margins

Profit is the balance remaining after a company accounts for all its expenses. Operating profit, EBITDA, profit before tax and profit after tax are some of the types of profit that are analyzed by investors.

Profit margins are the ratio of profit to revenue. Using the example from above, if profit is ₹10 and revenue is ₹100, the profit margin is 10%.

While assessing profit margins, the focus is on the long term and compared to similar companies. Improvement in profit margins over time can be due to several factors like better price realization, change in product mix or better control over costs. Conversely, deterioration in profit margins can be on account of increased competition, poor control over costs or adverse changes in the mix of products sold.

It is also necessary to understand the nature of profits. Improvement in profits may be on account of improved operational performance of the business or due to non-recurrent gains. Improvement in profits due to the sale of a business may not adequately reflect the true health of the business.

Earnings Per Share (EPS)

Earnings per share (EPS) shows how much profit a company generates for each share of common stock. It is used in determining the price/earnings ratio.

Trends in EPS over a period of time are important for investors. One year’s EPS in isolation should not be considered. There are several company activities that may result in a change in the number of shares outstanding. These include equity issues, mergers, buy backs, stock splits, and other activities.

EPS may increase as a result of an increase in profits or a reduction in the number of shares. It should be analyzed in conjunction with other financial statement items, especially profit and cash flow.

Cash Flow Analysis

While profit and cash flow are related, there are instances where a positive profit margin is reported and cash flow from operations is negative. Keep in mind, profits do not always equate to cash.

Operating cash flow is cash inflow generated by a business’s primary functions and activities, i.e. selling and delivering a product or service. Carefully reviewing operating cash flow in relation to a company’s profitability will aid an investor in determining cash flow support for previously reported profits.

A negative cash flow can be temporary and supported by long term benefits to the business, i.e. an increase in equipment to support future business growth. Long term debt can also negatively impact cash flow and increase cash outflows.

Profit versus cash flow

A persistent gap between reported profits and operating cash generation deserves further investigation, although differences can also arise for legitimate business reasons.

Basic Financial Ratios for Stock Investing

Financial ratios let users compare and analyze data across different time periods and companies. The best ratios for a particular company depend on a number of factors and can vary from industry to industry.

Price-Earnings Ratio (P/E Ratio)

The price-earnings ratio shows what the market is valuing a stock for relative to the earnings per share. A stock with a P/E ratio of 20 indicates the market is valuing the stock at 20 times earnings per share.

A high P/E ratio may indicate the stock is undervalued and may appreciate in the future. Alternatively, a high P/E ratio may indicate that the stock is overvalued. The same analysis may be done for a low P/E ratio.

There are no concrete rules for what constitutes a good or bad P/E ratio. It is best to compare the ratio against that of similar companies, consider historical trends, and analyze expected earnings growth.

Price to Book Ratio (P/B Ratio)

The price to book ratio shows the market valuation (or market cap) relative to the book value. This ratio may be more applicable to financial services companies.

In companies with a heavy asset base, this ratio may be applicable. In a company with a light asset base (or no assets), this ratio may not be applicable.

ROE

Return on Equity (ROE) shows the return generated by a company for the shareholders. It is calculated as:

ROE = Net Profit/Average Shareholders’ Equity x 100

A company may increase its ROE by using more debt in the capital structure of the company. While debt can increase the ROE, it increases financial risk.

ROCE

Return on Capital Employed (ROCE) is the return generated by the operation of the business and shows how the business utilizes the capital. It is similar to ROE but uses Capital Employed instead of Equity.

ROCE shows how the business is operating and should be analyzed with financial ratios to show the business’s liquidity.

Debt-to-Equity Ratio

The debt-to-equity ratio shows how much equity a company has compared to the amount of debt. Using a significant amount of debt to fund the business can be risky. If a company experiences a slump in business and earnings, the interest payments on the debt become an even greater financial burden.

It is critical to evaluate a company's debt in relation to debt in its industry. Banks, utilities, and other service companies, for example, may have significant differences in their levels of debt and other financial resources.

Current Ratio

The current ratio shows the level of a company's liquidity by comparing current assets to current liabilities. Some financial analysts place too much emphasis on this ratio. In fact, it may not be relevant to a particular company. For some companies, it may be normal to have current liabilities exceed current assets.

How to Analyse a Company's Balance Sheet

Balance sheets are a way for companies to show their assets, liabilities and share equity at a specific date in time. Balance sheets are an excellent resource for potential investors to see how the company finances and utilizes it’s business resources.

Some important features of balance sheets include:

• Cash and cash equivalents: Being liquid is very important for a company and cash equivalents can aid in financial flexibility.

• Receivables: Sudden increases in receivables can be a red flag.

• Inventory: Changes may reflect growth, supply-chain requirements or slower-moving stock.

• Borrowings: Examine total debt, maturity profile and interest burden where relevant.

• Net worth: Provides a broad measure of shareholders' accounting equity.

• Contingent liabilities: These can represent potential future obligations and should be understood before making an assessment.

Investors should always look over the notes at the end of the financial statement, and take into account the accounting policies of the company.

How to Evaluate Stock Valuation

Usually, after analyzing a company's industry, competitors, and businesses to identify its financials, investors can decide if a company's equity is fairly valued.

A metric that measures valuation is the price to earnings ratio (P/E), price to book (P/B) ratio, cash flow, dividend yield, and/or EV/EBITDA. Cash flow and dividends tend to be more indicative of valuation in cyclical industries.

A stock's P/E can indicate a stock's overvaluation relative to its peers; however, this may not be case if one of the companies is more financially levered, in which case, EV/EBITDA may be more appropriate.

Other factors must be considered as well. The payoff may not be worth the risk if the stock has rapidly increasing earnings and is, therefore, valued at a premium. Conversely, investors may expect that the stock of a company with slower earnings growth will continue to grow at its current rate and, thus, purchase the stock at a valuation that may seem high relative to the company's earnings.

Fundamental Analysis vs Technical Analysis

These approaches are not necessarily mutually exclusive. An investor may use fundamental analysis to understand the business and valuation while using technical analysis to study price behaviour. Neither method can guarantee future returns.

A Step-by-Step Fundamental Analysis Checklist

1. Understand the business: Identify the company's products, customers, geography, revenue model and major competitors.

2. Study revenue: Review several years of sales growth and identify the main growth drivers.

3. Examine profitability: Check operating margins, net profit and whether earnings growth is sustainable.

4. Review EPS: Understand earnings per share and any changes in the share count.

5. Check cash flow: Compare operating cash flow with reported profits and examine capital expenditure.

6. Analyse the balance sheet: Review debt, cash, receivables, inventory, net worth and contingent liabilities.

7. Calculate or review key ratios: Consider P/E, P/B, ROE, ROCE, debt-to-equity and liquidity ratios as appropriate for the sector.

8. Compare with peers: Look at comparable companies rather than judging a ratio in isolation.

9. Assess valuation: Ask whether the current price already reflects optimistic growth expectations.

10. Review risks: Consider competition, regulation, debt, customer concentration, cyclicality, governance and other company-specific risks.

For additional context, investors can consult official exchange disclosures and company filings. NSE provides financial information and disclosure resources, while SEBI publishes investor-education material and regulatory information.

Common Mistakes Investors Should Avoid

Looking at only one ratio

A low P/E does not automatically mean a stock is undervalued. Similarly, a high ROE does not automatically mean a company is high quality. Ratios need context.

Ignoring debt

Strong revenue and profit growth can be less reassuring when accompanied by rapidly rising leverage or significant refinancing requirements.

Confusing profit with cash

Accounting profit does not necessarily equal cash available to the company. Working capital and capital expenditure can materially affect cash generation.

Comparing unrelated businesses

Financial ratios differ significantly between industries. A valuation that looks high for one sector may be normal for another.

Using historical valuation without considering future growth

A stock may trade above its historical average because business fundamentals have changed. Conversely, a historically cheap valuation may remain low because earnings prospects have deteriorated.

Ignoring corporate governance

Financial statements should be considered alongside promoter holdings, related-party transactions, auditor observations, pledges where applicable, capital allocation and other governance disclosures.

Where to Find Information for Fundamental Analysis

Investors can obtain company financial information from annually published company reports, and information provided quarterly to the exchange. Companies may make various regulatory disclosures to the exchange. However, management may also provide its assessment of the company’s performance in presentations to investors. Management’s assessment, however, should be analyzed in the context of the information provided in the financial statements.

Investor resources available on the NSE website promote use of available information, assessment of investment opportunities, and the need to transact investment through authorised intermediaries. SEBI, on the other hand, provides a range of resources to foster financial literacy and invest in securities.

Prospective investors may wish to consult Explore Stock Investment for information on stock market investing in India.

Can Fundamental Analysis Predict Stock Prices?

Not directly. Fundamental analysis provides clues about the company’s operation, financial condition and value. However, this information alone won’t help you determine the stock price.

The stock market consists of investors who bid and ask based on a forecast of future events. These can be changes in the company’s financial condition, competitive environment, the economy or interest rate environment, just to name a few. Therefore, even the best company in its industry can trade at a declining price based on expectations of the marketplace.

So, what is the use case of fundamental analysis? The answer is to evaluate whether you are purchasing a stock at an appropriate price, relative to the company’s potential earnings power.

Conclusion

Fundamental analysis of stocks involves evaluating a company’s financial and non-financial statements to gain a deeper understanding of a company and its stock. Factors including revenue, net income, cash flow, EPS, and balance sheet items provide differing elements of a company.

Conducting thorough fundamental analysis enables an investor to evaluate elements including the company’s financial performance and risks, as well as competitive and industry environment and management and governance. Investors should keep in mind that analysis of this nature provides no guarantees and returns are always at risk.

The information in this article is for educational purposes only and is not an investment recommendation. Individual investors should do their own research and make their own investment decisions. Investors should evaluate the risks involved and seek the input of a financial professional if they deem it necessary.