Fundamental analysis is a method of evaluating a security in an attempt to measure its intrinsic value, by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts study anything that can affect the security’s value, including macro-economic factors such as the overall economy and industry conditions, and micro-economic factors such as financial conditions and company management. The end goal of fundamental analysis is to produce a quantitative value that an investor can compare with a security’s current price, thus indicating whether the security is undervalued or overvalued.
Simply FA is the study of numbers; involving company’s financial statements, industry reports, country’s economic figures such as GDP, GNP, inflation, unemployment, etc.. Usually fundamental analysts or researchers provide long complicated reports that probably no one really reads at least from front to cover. But it’s important to understand at least the most important ratios and figures in them. In this guide you’ll learn to scan them and quickly jump to the fruits of any financial research
Top Down Approach
There must be a hierarchy to your research; analysts usually work their way from top down. They can also work from bottum up but since upper levels affect lower ones so using top down is considered time and effort saving.
- Political Stability / Risk
- Laws / Regulations (freedom of entry & exit, benefits, etc.)
- Compare macro-economic figures.
GDP/GNP, interest rate, inflation, etc.. (look for potential growth or development in the selected economy). Look for markets with the greatest Opportunities and try to avoid those with Threats.
- Govt policies
- Contribution to GDP
- Profitability / Risk
- Industry Life Cycle – does it match the period of the required investment?
Reviewing several years of the company’s financial statements to evaluate its performance over a period of time. All factual figures are historic but used to project future earnings / performance.
The formal records of all financial activities of any entity or organization. There are 3 basic financial statements:
- Balance sheet : also referred to as statement of financial position or condition, reports on a company’s assets, liabilities and ownership equity at a given point in time.
- Income statement : also referred to as Profit and Loss statement “P&L” reports a company’s income, expenses, and profits over a period of time. Profit & Loss account provide information on the operation of the enterprise. These include sales and the various expenses incurred during the processing state.
- Statement of cash flows : reports on a company’s cash flow activities, particularly its operating, investing and financing activities.
PAR Value & Capital Increase
This is the initial stock price when the company first launched it’s IPO (Initial Public Offering). PAR Value = Issued Capital / # of Shares
Always compare to MP (Market Price). If PAR >MP and the company’s end of year results are profits not losses then this could be a possible opportunity
Example: OTMT was founded with 1 billion pounds over 100 million shares. Therefore its PAR Value is 10 pounds.
If OTMT is trading at less than 10 pounds; MP<PAR and at the same time it’s not making losses (it’s owner’s equity isn’t less than 1 billion) then from a fundamentalist perspective most probably it’s an opportunity.
When a company’s management decides to increase it’s capital (this is usually done when the firm’s financing a new investment) through shares offered in an underwriting as an option for current stockholders (maybe at PAR or PAR + PREMIUM depending on the general assembly’s decision) no matter what the MP is. However under-writings have significant effect on market prices. The market adjusts itself on the first day of trade of the extra shares in the secondary market.
Example: ORAS has very recently raised its capital almost 5 times. Each shareholder was allowed 4.9 shares @ 1 pound (PAR). Before the underwriting right the stock was traded @ 28 pounds. The next day it was trading at 7 and that believe it or not was 20% higher than the previous day!. If you owned 1 share which is 28, you’ll pay another 4.9 pounds for 4.9 shares (PAR = 1). Then you’ll have 5.9 shares for 28 + 4.9 = 32.9 divide by 5.9 = 5.58 pounds. That was the 28 of the earlier day!
KEY Ratios and Figures
How to measure the profitability?
EPS (Earnings Per Share) how much profit does each stock make
EPS = NI (Net Income) / # of shares
Example: X co. made $25M net profits last year, it has 50M listed shares. Whats the EPS or how much did each share make?
25 / 50 = $0.50
If the company is currently traded @ $5.00 (MP=5) that means it made 10% return.
When measuring any company’s profitability or returns, the first reference we go back to is the central bank interest rate. That’s the benchmark of any investment. If company X makes 10% return and banks give 12% interest on deposits then without any further analysis it’s clearly a waste. If banks give 8% then MAYBE its an opportunity. Why Maybe? Simply because other stocks within the same sector may be more profitable
EPS > interest = possible opportunity
Another Important Measure
Price / Earning Ratio
A measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a multiplier used for valuation: The P/E ratio has units of years which can be interpreted as “number of years of earnings to pay back purchase price”, a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.
P/E = MP / EPS
Example: ABC Co. has 500 000 listed shares and made 10m le profit last year. The stock’s traded @ 80 le. Calculate its P/E? 80 / (10’000’000 / 500’000) = 4 times
Meaning that if I buy ABC now and the company maintained its profitability constant I’ll earn my money back in 4 years.. Therefore as P/E decreases the stock becomes more attractive.
NOTE: P/E range differs from one market to another and one sector to another. So u can only compare P/Es of companies within the same sector.
Example: EFG Hermes (HRHO) vs. Pioneers Holding (PIOH) both in financial services. COMI vs NSGB (both banks). But you can’t compare an industrial co. like Ezz Steel (ESRS) to Telecom Egypt (ETEL) which is typically in the telecom industry. You will get misleading results. You can however compare MobiNil (telecom in Egypt) to Zain (telecom in Saudi Arabia); this will give you a general idea of which market trades at what P/E level. Which market is cheaper or more expensive
P/Es may also be used to compare the average of one country or economy to another. Example; in 2005 Egypt’s average P/E was 4-5 where in other neighboring countries like Qatar, UAE and Saudi Arabia they were trading at much higher P/Es (that reached 10 and above). That showed opportunity in the Egyptian market and soon after the market witnessed significant rises.
Also, comparing between sectors in general but different industries have different natures so its not necessary that agricultural firms are better picks than telecommunications just because they have lower P/Es.
Summary: P/Es in general give an idea of how cheap/expensive the stock, the sector or the market is. And hence how risky compared to others
EPS or the return shareholders make on their investments doesn’t necessarily get paid out!
PAYOUT is a ratio that differs from one company to another based on their internal strategy, stage in their industry life cycle and / or their current plans.
- Cash Dividend ( the amount paid out in cash)
- Stock Dividend ( a # of stocks given to current shareholders compensating their retained earning in the company’s capital increase)
How dividend’s affect the stock’s MP?
A simple discount’s made to the stock’s closing price the day before the payout with the value of the dividend to determine the following day’s opening price.
NOTE: These price adjustments are done while the session is offline, the stock is free to rise or drop due to market forces at normal trading hours
The dividend yield or the dividend-price ratio on a company stock is the company’s annual dividend payments divided by its net profits, or the dividend per share divided by the price per share. It is often expressed as a percentage.
Dividend Yield Per Share = Annual Dividend / MP
If Z company’s EPS is 10le and MP is 150le. Previous years’ records show that the company usually pays out 50% cash, 25% in stock and keeps 25% reserve. Then the dividend yield per share is 7.5/150 = 0.05 or 5%
NOTE: Many (Muslim) investors see dividends more appealing than interest on deposits due to (Shariaa Compliance plus) different companies pay out at different times of the year, so they have a chance to reinvest their earnings.
What happens with companies that do not pay dividends?
These are usually growth stocks. Based on their stage in their life cycle or if their management vision foresees potential growth or has an expansion opportunity they may require all earnings to be retained if not more capital to be raised to expand and accomplish their plans. These stocks tend to make capital gains where you your profits are summed up in the stock value and only realized when you sell.
These stocks often include the ones with higher risk and return probabilities.