The average investor, while dealing with equities would want to participate in investing in the asset class but may not understand the various terminologies that are used by advisors/experts.

This could result in making the investment without thoroughly understanding whether the same turns out to be a good decision. The branch of analysis which uses this terminology is called ‘Fundamental analysis’. Here’s some quick dope on few key terminologies which could give you the ‘gyan’ you need and set you on the right track whilst investing.

What is fundamental analysis?

Fundamental analysis involves reviewing the financial statements and its health, management, competitive advantages, future growth prospects etc., of a company. Typically, a study of historical and present financial data, with the goal to understand the company and arrive at a reasonable outlook of the same..  It includes Economic analysis, industry analysis, and Company analysis.

To know the soundness of the company, one needs to go through the financials of the company like profit and loss account and balance sheet. With the help of these we can find the financial performance of the company. We can know the Liquidity position, Leverage measures and measures of profitability etc.,

Let us take a look at how to calculate and take a decision on profitability ratios. In profitability ratios, we mainly concentrate on Operating margin, Net profit margin, Return on assets, Return on equity, Earnings per share, Price earnings ratio.

The operating margin: In simple words, it measures what proportion of a company’s revenue is left over after paying variable costs of production such as raw material, wages etc., it is an indicator of the control on its variable costs. A healthy operating margin is required for a company to be able to pay for its fixed cost, such as interest on debt etc. It is calculated as operating profit divided by Net sales.

Net profit margin: It measures company’s profits after taxes have been paid. It is also an indicator of the pricing policies of the company. Most companies work towards a certain % of net profit on the topline generated, based on various parameters / provisions towards costs & taxes and therefore with other items being constant, an increase in pricing of product / service could translate into increase in the bottomline (net profits). It is calculated as net profit divided by net sales.

Return on assets (ROA): It gives investor an idea of how effectively the management is utilizing assets to generate net-income. Higher the ROA better for the company because it means that the company is gaining more with little investment. It is calculated as net profit divided by Total assets.

Return on equity (ROE): This tells us about how much profit the company has made in relation to its total net-worth (Share Capital + Reserves & Surplus) of the Company. A company that has high ROE is more likely capable of generating cash internally. It is calculated as Net profit divided by net-worth.

Earnings per share (EPS): The portion of company’s profits allocated to each outstanding share holder. It serves as an indicator of a Company’s profitability. It is calculated as Net income divided by number of outstanding shares.

Price earning ratio (P/E): It is one of the most important number to look at, while taking investment decisions, particularly while investing in equities. It basically tells you, how much the market is willing to pay for the company’s earnings. It is calculated as current market price divided by Earnings per share.

Hope this brief enables you to get an idea on how to evaluate stocks; however, it is also suggested that if you do not have ample expertise, then do not indulge in this investment avenue without appropriate guidance!

e-mail: Anil Rego

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