How to perform Fundamental Analysis of a Company

Key points or sections to look for in an annual report:-

Management discussion and analysis
General shareholder information
consolidated financial statements (includes finances of the subsidiary companies as well), before reading this see if you can read the independent auditor’s report at the beginning, to see if there are any changes to the accounting policy for the given year.
Corporate governance (gives a brief about the Director’s background, shareholding pattern, director’s remuneration)

NOTE: Don’t spend time looking at the section where the share price of the company is discussed. As you are dealing with the company’s business and not the stock price.

NOTE: Skip the director’s report as we will be dealing with the financials at the end anyway.

P&L statement:-

Revenue for financial year – top line of a company
Expense for financial year
- Raw material cost
- Salary paid to employees
- depreciation and amortization
- interest payments
- electricity and rent
- power and advertisement
Tax for financial year
Profits for financial year

Other income for a company in a report maybe:-

Dividend income
Interest income

This is coming from non-operating activities.

Important formulas:-

Revenue – Expenses = Operating profits
Operating profits – Tax = Final profit
Final profit of the company -> Bottomline of a company(Profit after Tax)
Profit after Tax = Income – Expenses – Tax = Final profit of the company for that financial year

NOTE: Don’t just look at PAT(Final profit), also check Expenses and revenue.

NOTE: When checking the P&L statement always check the associated notes with it also. (Imp across all 3 statements, P&L, balance sheet and cash flow). Using the associated notes try to understand the nature of the revenue and expense part of the P&L statement.

Balance Sheet:-

While the P&L talks about how the company performed in a particular financial year, the balance sheet, on the other hand, discusses how the company has evolved financially over the years. -> contains data from all the years since the company has started.

Balance sheet consists of 2 broad sections:

Assets of the company -> non-current, current
Liabilities of the company -> non-current, current

Assets:-

Non-current -> ones which have a long term economic benefit for the company such as property, plant, machinery, etc.
- Intangible assets -> trademark, patent, certificate that the company holds.
- Financial investments -> government bonds, mutual fund investments.
Current -> ones which have an economic output in a 1 year time frame. -> finished goods which the company is ready to sell over the next year.
- Inventories, finished goods, trade receivables, payments from customers or vendors, or loans repayment

Total assets of a company = Current assets + non-current assets

NOTE: Heavier line items which have more money or the figure involved should be looked at more carefully.

Heavier line items can include(Go to associated note to get in detail):

Financial investments in non-current assets
Property, plant and equipment -> heavier line items

NOTE: Whenever you see a heavier line item you should always go to the associated notes and dig deeper into this.

Liabilities:-

Definition: Financial obligation of a company

E.g: A person who has taken a personal loan so this person has to return it someday hence its a liability.

Non current liabilities -> Can be fulfilled within a few years
- House loan: has a time period like 5-10 years, etc
Current liabilities -> Should be fulfilled within a year
- Credit card loans which one needs to repay every month then and there itself

Provisions in non current liabilities: Present in long term provisions section of the report

Current liabilities: Present in Other current liabilities section of the report, check associated notes

Equity liabilities: This has 2 parts

– Share Capital of the company: Money that the early promoters, investors put in to start the company. If a company raises more money in the future for some needs then this value will increase.

– Reserves and Surpluses: Contains the profits and cash flow coming from the P&L statement each year. Hence these funds or profits are marked by the company for certain projects or tasks and this is what this section represents.

Hence, the Balance sheet and P&L statement are connected in many ways.

This section might also be called (Equity liabilities)Other Equity and obviously check the associated notes.

Cash flow statement:-

Activities that a company does:

Operating activity
Investing activity
Financing activity

These activities either generate cash or consume cash.

Sum total of all 3 activities(Operating + Investing + Financing) -> Cash flow statement.

Operating activity:

Core operations of the company. E.g. – Bajaj auto: To manufacture and sell the bikes. Hence this activity either has to generate cash or consume cash.

NOTE: Any good company should be generating cash out of its operations.

Investing activity:

Investing new plant, acquiring machinery, sum total of capital expenditure that company carries out to grow the business.
This can also generate or consume cash.

NOTE: If it consumes cash, then it means that it’s reinvesting in itself.

NOTE: If it’s generating cash, then it’s probably selling one of its logistics or assets it owns therefore making money which will have a positive cash flow.

Financial activity:

Borrowing from banks or paying out dividends.

Positive: borrowing capital to fund working capital

Negative: repay loan taken from bank or paying dividends to shareholders.

Operating + Investing + Financial activity = Net cash flow(Imp statements -> one of the most imp for a company)

NOTE: If you want to do fundamental analysis first look at how the numbers in a cash flow statement are behaving only then do a further deep dive into the company. Always start with the cash flow statement when going for fundamental analysis, to see if you really want to go further with your analysis.

NOTE: If the operating activity is showing too much volatility then that will be a red flag for you. It should have stable numbers for this activity.

E.g: Cash from operating activity: 34428

Cash from investing activity: -52279

Cash from financing activity: 17570

-> So, 34-52=17 Cr -> So it has reinvested in itself

17,750 * 8/100 = 1405.62 -> interest rate of loan -> each year

So, in 2019 this company has operating activity cash at 703 Cr. So, -1405-703=700 Cr in negative-> This is a big red flag. And you should probably not consider investing in such a company. Hence, the cash flow statement alone tells you so much and whether you should look at the company for investment.

E.g: cash from operating profit: 177678

cash from investing activity: -51295

cash from financing activity: -62996

-> From 177678 , 51295 is being used. so you have about 120000 left and also from that about 62996 is also being used and is probably being paid as dividends to the shareholders. How do we know that it’s giving it to shareholders and not using it to repay debt, because it has 60000 surplus leftover cash from operating activities. It is not needed to pay cash from here and there.

Connection between the P&L, balance sheet and the cash flow statement:-

None of the 3 should be viewed in isolation
In the P&L statement, the bottomline which is the Profit after tax flow straight into the Reserves & Surplus section into the Balance Sheet.
In Assets side, the balance sheet states the cash position of the company. This number comes from the cash flow statement, the last line which is the net cash and flows to the assets specifically into the current assets side of the balance sheet.
The P&L has the yearly depreciation number which is in the expense section and flows from here to the accumulated depreciation of the balance sheet.
The Balance sheet on the Liabilities also states the borrowings of the company which flows to the finance charges stated in the P&L of the company which is the interest that company pays on the borrowings present in the balance sheet.

E.g – 1000 Cr borrow, 100 Cr – Finance charges, then company has effective borrowing rate of 10%.

Key sections to look for in a P&L statement:

Revenue
Expenses heavy items (why so much?, what is the expense?)
Effective tax rate
PAT

Key sections to look for in a Balance sheet:

Borrowings – heavy -> leveraged and may not sustain with change in business cycle
accounts receivables
Cash available at hand or bank – how much money or cash or capital they have if any bad situation turns occurs such as covid.

Key sections to look for in a Cash flow statement:

Cash flow from-
- Operating, investing and financing activity.

Financial ratios:-

Metrics which help you understand the financial health of a company.

There are 3 categories:

Profitability ratios
Leverage ratios
Valuation ratios

Profitability ratios:

Help you understand how the company and business is expanding and helps to pay dividends and show how competitive management is.

It includes:

Operating margins
PAT margins
Return on equity

Leverage ratios:

How much debt or loan the company has taken to run its operations.

Also known as solvency ratios – The ratio measures the operational efficiency of the business considering or according to the debt they have taken.

It includes:

Interest coverage ratio
Debt to equity ratio

Valuation ratios:

Compares stock price to the valuation of the company – to know how cheap or expensive the company’s stock is.

Price to Sales ratio
Price to Book ratio
Price to Equity ratio

Important Calculations:

Operating profit margin = EBITDA(total income – total expenses)/revenue
- E.g: BAJAJ auto -> 31443.2 – 25072.6 = 6692.1 = EBITDA
- Operating profit margin = 6692/31443.2 = 0.210 = 21%(operating profit margin)
PAT margins = PAT number(bottomline or Profit after Tax)/Total income
- E.g: Bajaj Auto -> 0.165 = 16.5%
Return on equity: Helps the investor assess the return shareholder earns for every unit of capital invested.
- Measures company’s efficiency or ability with which company generates profits from each unit of shareholder’s equity.
- Bajaj auto -> Return on equity = Net profit(bottomline)/total equity = 0.24 = 24%
- Higher the ROE, better the company
- NOTE: also do make sure that the company doesn’t have debt, as this can cause a decrease in the ROE numbers.(red flag)
- ROE should be at least 25% of a good company
If PAT margins and EBITDA margins are trending upwards then profitability margins should also be stable(if not then it’s a red flag)
Interest coverage ratio:
- How much company is earning with the interest burden that it has.
- It determines how efficiently a company repays interest on its outstanding debt.
- Suppose income = 400, interest = 100, available funds = 300 -> this means that the company has enough funds to pay or service its debt.
- Finance costs = is low as it does not have any short term or long term borrowings
- Interest coverage ratio = EBITDA number/interest obligation or finance cost = 14.8(example) -> this means that the company is earning 14 times more than the interest obligation which is a really good thing. Especially if the company has some debt it’s always good if the company then has a higher interest coverage ratio number. Lower the number riskier it is for the investor.
Debt to equity ratio:
- Debt/equity
- If Debt to equity ratios is 1, then this value shows equal debt and equity
- Higher than 1 indicates more leverage or debt which can be a red flag
- Lower than 1 indicates or shows a bigger equity base as compared to the debt of company
- Bajaj auto has no debt.(in example)
- E.g. -> long term debt = 4000, short term debt = 1500, total debt – 5500, D/E ratio = 5500/21000 = 0.25 -> lower than 1 better and larger equity base
Debt to asset and financial leverage ratio:
- When there is debt on a company, pay close attention to all the leverage ratios as it can reveal any hidden stories.
Valuation ratios:
- How cheap or expensive stock is trading. We use this information to make an investment decision.
Price to sales ratio:
- Compares stock price to sales per share.
  - Current Share price of the company/sales per share
  - First we need to calculate sales on a per share basis.
  - Sales per share = (total sales)/(number of outstanding shares) = 29,112*10^7/28900000 = sales per share = 1007.32
  - Now, current share price = 3780/1007.32 = 3.75 -> Every 1rs or sales the stock price as of today the stock price is valued at 3.75 times the sales.
  - No ideal number for this.
  - Compare this number with its peers to get an idea of how cheap or expensive the stock is.
  - E.g. -> company A and company B are identical and sell the same product in the market.Company A -> Revenue: rs. 1000, PAT: rs. 250, Profit margin: 25%. Company B -> Revenue: rs. 1000, PAT: rs. 150, Profit margin: 15%
  - This means that company A sales is more valuable than company B, Hence if company A is trading at a higher price than B then this is probably justified because of its higher PAT margin.
  - NOTE: Whenever you find that the price to sales ratio is on the higher side then always check the PAT margin to see and make sure why this is.
Price to book value:
- Book value: the amount of money left on the table after the company pays off all its obligations.
- Tangible assets -> Liabilities
- What is the min value the company receives upon obligation. -> book value
- Book value = total equity/total outstanding shares
- E.g: Bajaj auto = 21662*10^7/28900000 = 749.55 per share
- Price to book => Share price/book value= 3780/750=5 -> high ratio indicates that the firm is probably overvalued with respect to the company’s equity or book value.
- NOTE: Low value of this ratio indicates that the firm is probably undervalued with respect to the company’s equity or book value.
Price to earning ratio:
- Most popular ratios used by investors and analysts.
- For this, we have to first calculate the earning per share for this.
- Earning per share = EPS = PAT/total outstanding shares
- E.g: Bajaj auto = EPS = profit of year = 5211*10^7/28900000 = 180.37 rs.
- We can use this to calculate Price to Earning -> 3780/180.37 = 20.96 = price to earning we can say is 20x
  - This means that for every unit of profit of Bajaj Auto the market participants are willing to pay 20 times more to acquire the share.
  - E.g. -> 5000/180 = 27.72 -> if the share price of the company increases in a stable manner and EPS remains around the same then we can say that the Price to earning ratio increases.
  - We can check this index also to see how cheap or overvalued the market is at the current moment.
  - NOTE: check on nse website to get Price to Earning ratio of nifty and estimate how cheap or expensive the market is trading at.

NOTE: Don’t look at the financial ratios of a company in isolation, always compare these with the peers of the company which will give you how the company is performing in its particular sector.

NOTE: Don’t only look at the financial ratios for investment purposes. Take a holistic approach and take into consideration the quantitative and qualitative aspects as well and then take a decision.

How to value a company?

Relative valuation

3 ways in which you can value a company:

Intrinsic valuation of a company which involves the Discounted Cash Flow analysis Model(DCF)(common tool)

It considers: Free cash flow available for company
growth rate of cash flow
Risk
The model incorporates all this and then gives you a sense of how cheap or expensive the stock is.

Relative value technique -> Investors mostly use this when they cannot use the intrinsic valuation technique to value a company.

Company does not have positive free cash flow -> then intrinsic value cannot be made then relative valuation is done.
In this technique we take the peers of the company and look at various parameters like Cashflow, price to sales, price to book, debt to equity ratios to see how one company is priced with another and can use this to check how cheap or expensive the price is trading for investment.

Option based valuation

This technique depends on an event.
E.g. -> suppose there is a pharma company which has applied for a patent, the value of this company will be unlocked when the patent is approved right.
To value this company only if the event happens then we can value the company, then the option based valuation comes into play but this is pretty complex and you should for now only focus on the first 2 techniques.

Fundamental investing checklist:-

Look at the gross profit margin – >equal to 20% -> higher the margin higher than it is a sustainable moat in the business
Revenue
All check the EPS, and it should grow inline with the net profits
Also the debt should be sustainable if it has debt check the interest coverage ratio so as to know if the company can get through this debt phase and go through this and any difficult future times also.
Return on equity – Pay attention to this -> ROE more than 20-25% Is pretty good
Also check debt is manageable and ROE shouldn’t be driven by a higher leverage on the balance sheet.

NOTE: Check business diversity also if it has multiple business interests, and multiple verticals then watch out for this, as generally multibaggers are those which have 1-2 products or product lines and they do it exceptionally well.

NOTE: be reasonable with expectations -> maybe years of negative returns then see positive after some time, but important is to stay invested and check good companies and have belief in that company.

Good books to read:-

The little book of valuation by Aswath Damodaran

The little book that builds wealth by Pat Dorsey