Master class 2: Parameters of Fundamental Analysis of Stocks

25 Aug 2020  Read 1584 Views

Fundamental Analysis is the basic Analysis of a company's financial statements in order to evaluate its performance and financial health. It is important for an investor to understand the basics of the fundamental analysis of stocks of a company and know how to comprehend the figures reflected in the company's financial statements. The process of fundamental analysis of stocks can help in taking a well-calculated investment decision

This article talks about the parameters of fundamental analysis of stocks. The article covers Enterprise Value, its relation to the market cap, what is the P/B ratio, and how to use this value.

Market Cap

Market cap is a shorter and commonly used version of the term' Market Capitalization'. It means the total value of all the shares of a company combined. 

Mathematically,
Market Cap = Price of one share x Number of total shares issued by the company.

Market cap is a way of calculating the worth of a company. A higher market cap generally means a bigger worth of the company, while a lower market cap will indicate that the company is of lower worth.

In addition, sometimes, a company may also issue bonus shares or split the current shares. In such cases, the price of shares change. Yet, the market cap would remain constant in the absence of any other factor.  

However, this is not the only parameter. The company's actual worth depends on other factors, and the difference shows up in accounting practices. To know the actual worth of the company, one should understand its 'Enterprise Value.'

Enterprise Value

A company may have different ways of generating capital. It may sell equity to investors or may take loans from the bank, or do both. In any case, the entire amount is invested in building and running the company. Hence, the total amount of equity issued and the debt raised is combinedly known as its enterprise value.

For example, let's consider a company AJ Ltd. This company wants to expand. Its current market cap is ₹1000 (Market cap is specific to the total value of the shares issued). This is the value of the shares it has already issued. Now it also takes a loan of ₹200 for expansion. You would see that the total amount invested in this company is now ₹1200, where ₹1000 has come from shares, and ₹200 from debt. Hence, the enterprise value of AJ Ltd. is ₹1200.

Need easier access to these values of real companies in the market? Go to Ticker, type in the name of the company you wish to learn about, and voila! You have all the important figures in just a click!

Enterprise Value vs. Market Cap

One may get the ownership of the entire company if they are ready to buy all its shares. In order to buy AJ Ltd, you will get 100% shareholding if you spend ₹1000. However, you will still have to repay the debt of ₹200 that the company has already taken. This is the difference between market cap and enterprise value.

There are cases where enterprise value is quite high, but the market cap is low. It might mean that the company has primarily raised its capital through debt. Higher debt instead of equity means the company would be spending a large amount repaying this debt out of its profit. However, this depends on the repayment capacity of the company.

The Cash Component

There are certain cases where the company has raised capital by issuing the shares and has also taken some loan. Also, there might be a case when the company has a lot of cash reserves as well. Considering our previous example, AJ Ltd has ₹1000 as a market cap and ₹200 as a loan. Let's assume it also has a cash reserve of ₹500 but is not putting this money to any use. This amount shall be deducted from the enterprise value that we calculated in the previous example.

This result comes from the assumption that AJ Ltd has been holding cash reserves and couldn't find any suitable opportunity to put it in use for the business. In fact, it can also choose to use this cash to repay its debt. This would reduce its debt and hence, the enterprise value. As long as it is not contributing to the enterprise's operation, this component is deducted from the market cap.

Enterprise Value = Market Cap + Debt – Cash Reserve

A good cash holding shows that the company can not only repay its debts but also has the potential to expand further whenever needed.

This can be a sign of a financially healthy company, which can be an ideal investment. However, this obviously cannot be our only assessment.

Negative Enterprise Value

What if the company has more cash to hold than its market cap and debt put together? The enterprise value would be negative.

Going by the above formula, it will not be a surprise if you see a negative enterprise value. 

Let us now understand the meaning of negative enterprise value.

Suppose AJ Ltd has a cash reserve of ₹1500, a market cap of ₹1000, and a debt of ₹200. Today, if you want to own the entire company, you will have to pay only ₹1000 so that you get the 100% ownership of AJ Ltd. Once you own the company, you will have to pay the debt it has taken, but you will also get the ownership of any cash reserve it has. This means that you paid ₹1000 to own this company, paid ₹200 to repay its debt, and got ₹1500 from its cash reserves. So, in the end, you did not have to pay anything, rather got an amount of ₹300. So this '–₹300' is the enterprise value. Such companies indicate positive results and can encourage an investor to analyze the company further.

However, another concept of enterprise value needs to be understood before making it a factor in the investment decision.

Have you read our previous Master Class: Learn the Basics of Share Market ?

Standalone vs. Consolidated Values

The enterprise value can be expressed in two ways. The company AJ Ltd. earns its revenue solely through its own operations; hence the values accounted would be called 'standalone.' 

Now assume AJ Ltd also invests some amount in a company VT. AJ Ltd has an ownership of 20% in VT. If VT earns ₹100, ₹20 from it goes to AJ Ltd as well. This would add to AJ Ltd's revenue, but it won't be considered as revenue from its operating activities but from its investment activities. Hence, values accounting a company's revenue through its investing activities would be called 'consolidated.' This happens mostly when some companies acquire other companies.

Their income statements are also referred to in a similar way - Standalone statements and consolidated statements.

In most cases, it is advisable to consider a company's consolidated financial statements to get a more accurate insight into its financial health.

P/B Ratio

P/B Ratio is the Market Price-to-Book value ratio. The price to book ratio is a financial ratio used to compare a company's current market price with its book value. It is a fundamental analysis parameter used by investors to identify potential investments. An ideal P/B ratio for a company to be considered as a solid investment should be under 1.

Mathematically,

PB Ratio = Market Value per share/Book value per share

Let us suppose there are 100 shares issued by AJ Ltd. The share of AJ Ltd is trading at ₹10 per share (market price). 

AJ Ltd owns assets worth ₹50000. This is the book value of the company. Since there are 100 shares issued, the book value per share is ₹500. The P/B ratio is 10/500 = 0.02.

Prima facie, it might appear that each shareholder would get ₹500 if everything is sold instead of ₹10 (market price), but it is impractical. The assets do not pay off much in distressing times. In addition, it might include an unsold inventory that is already having a hard time getting its buyers.

Moreover, book value is not a sound concept in every industry. It matters mostly in the manufacturing sector, where they have tangible assets. In the case of banks, they take the monetary deposits and lend to debtors, so there can be good use as the P/B ratio reflects their health as better.

In the case of industries like IT companies, the book value would be quite low, as less amount of infrastructure is needed to run the business. They provide service which cannot be valued like tangible products. Hence, book value is of less use here.

For instance, InfoEdge India Ltd has a P/B ratio above 10. InfoEdge is the company that runs Naukri.com and has a substantial holding in other IT companies like Zomato. This company doesn't need a huge infrastructure, unlike factories. Moreover, they don't produce any merchandise. They produce intangible software and generate services that apply them. Hence, their tangible asset might be limited to a couple of buildings. Yet, their prices are high because of their growth and earnings. High share price vs. low tangible asset value would further push the P/B value, unlike other industries.

However, it should be understood that the P/B ratio is not an absolute parameter. It is used to compare the companies within the same sector.

The Bottom line

The financial values of a company such as market cap, enterprise value, and P/B ratio are some of the initial important factors that should be considered while performing the fundamental analysis of stocks of a company. In most cases, it is often advisable to consider consolidated financial statements and figures of a company rather than considering its standalone values. Consolidated figures give a clearer and more accurate insight into a company's financial health. 

All the above figures are some of the most important parameters for a company's fundamental analysis of stocks. The proper interpretation and evaluation of these values will help in understanding what the company is up to.

To get a better understanding of the above topics with real companies and examples, you can refer to YouTube.
 

However, as important these values are, they hold lesser values if they are considered one at a time, or only one value is taken into account. It is important to evaluate all these and other important factors before doing the fundamental analysis of stocks and making a decision.

To understand more about the crucial drivers of an investment decision, jump ahead to the next blog of the series: In-depth Analysis of Dividend, face Value and promoter Holding

To read all Master Class series Click Here

About the Author: Vivek Tiwari | 66 Post(s)

Vivek Tiwari is a Software Engineer and a Data Scientist who hopelessly fell for Economics. His plans to move to Finance might now save mankind from his IITJEE selection story.

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