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8 Fundamental Indicators for stocks

ICICIdirect 8 Mins 17 Nov 2023

Investors have welcomed the new Samvat on a positive note. Many of you would be starting your financial journey, while some may restart with all the learning from the previous Samvat. How can you do better at stock picking? One way to start picking the right stocks is through fundamental analysis. 

Stock analysis is a crucial aspect of successful investing, and while technical analysis focuses on price trends and patterns, fundamental analysis delves into the financial health and performance of a company. Fundamental indicators are key metrics that provide insight into a company's underlying strength, growth potential, and overall value. 

In this article, we will explore some fundamental indicators essential for stock analysis.

Indicator 1: Earnings Per Share (EPS)

EPS is an indicator that represents the portion of a company's profit allocated to each outstanding share of common stock. It is calculated by dividing net earnings by the number of outstanding shares. Let us consider a company named XYZ Ltd. that reported a net profit of Rs 10,00,000 for FY23. Now, XYZ Ltd. has 1 lakh outstanding shares of common stock.

Earnings Per Share (EPS) Formula:

  • EPS = Net Profit / Number of Outstanding Shares
  • EPS = Rs 10,00,000/1,00,000
  • EPS = 10​

A rising EPS is considered a positive sign, indicating a company's profitability. Investors often compare a company's current EPS to its historical performance and industry peers.

Indicator 2: Price-to-Earnings Ratio (P/E)

The P/E ratio is another widely used valuation metric that compares a company's current stock price to its earnings per share. It provides insights into the market's expectations for a company's future earnings growth. Mathematically, it is expressed as:

PE = Market Price Per Share / Earning Per Share

Assume a company has a share price of Rs 500 and EPS of 10. In this case, PE would be 50.

A high P/E ratio may suggest that investors have high expectations for future growth, while a low P/E ratio might indicate undervaluation. However, it is crucial to compare P/E ratios within the same industry for a more accurate assessment.

Indicator 3: Dividend Yield

The dividend yield is the annual dividend payment divided by the stock's current market price. It measures the return on investment from dividends.

Companies that consistently pay dividends are often considered stable and financially sound. However, a high dividend yield could also signal a lack of growth opportunities or financial distress.

Indicator 4: Book Value

Book value is the net asset value of a company, calculated by subtracting liabilities from assets. It represents the theoretical value of a company's equity if all assets were sold and liabilities paid off. You can use the price-to-book ratio (P/B) to compare a stock's market value to its book value. A P/B ratio below one (1) may suggest the stock is undervalued.

Indicator 5: Debt-to-Equity Ratio

The debt-to-equity ratio compares a company's total debt to its total equity, indicating the proportion of debt used to finance operations.

A high debt-to-equity ratio may indicate higher financial risk, as the company relies heavily on debt for financing. However, industries like utilities or real estate often have higher ratios.

A D/E ratio of 0.5 for a company X indicates that it uses 50% debt and 50% equity to finance its assets. Lower D/E ratios are mostly considered less risky as they suggest a lower reliance on debt for financing. A higher D/E ratio might indicate a higher financial risk, as the company uses more debt to finance its operations.

Indicator 6: Revenue and Revenue Growth

You can also examine a company's total revenue and growth over time, as it is crucial for assessing its market share and competitiveness. Consistent revenue growth may indicate a healthy and expanding business. Analyzing revenue in conjunction with profit margins provides a more comprehensive picture of a company's financial health.

Indicator 7: Free Cash Flow

Free cash flow represents the cash generated by a company's operations after capital expenditures. It reflects the company's ability to invest in growth, pay dividends, or reduce debt. Positive free cash flow is considered a positive sign, indicating financial flexibility. Negative free cash flow might signal financial challenges or aggressive expansion.

Indicator 8: Return on Equity (ROE)

The last parameter is ROE. However, it is one of the most important fundamental indicators. ROE measures a company's ability to generate profit from shareholders' equity. You can find the value of ROE by dividing net income by shareholders' equity. A high ROE suggests efficient use of equity capital, while a declining ROE may indicate less effective management or increased financial leverage. ROE is calculated as below: 

  • ROE = (Net Income / Shareholder Equity) * 100

Let us assume a company with a net income (Profit After Tax) of Rs 10,00,000 and Shareholder equity of Rs 50,00,000. In this case, ROE will be (10,00,000 / 50,00,000) * 100 - which equals 20%. It means that for every rupee of shareholders' equity, the company generated a return of 20 cents in net income.

Before you go

Fundamental analysis is a powerful tool for investors like you who seek a comprehensive understanding of a company's financial health. While these fundamental indicators provide valuable insights, it's essential to consider them in the industry context, economic conditions, and the company's overall strategy. A well-rounded approach, combining fundamental analysis with other methods, can help you make informed decisions and navigate the dynamic world of stock markets.

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