Fundamental Analysis: Attractiveness of the industry, Financial Ratios, Book and Market values
In the first part of the article, we got acquainted with fundamental analysis and studied the first stage of fundamental assessment – the analysis of macroeconomic indicators. In the second part, we will focus on industry attractiveness levels and financial ratios.
Step №2: Analysis of the attractiveness of the industry
The industries are analyzed depending on their investment attractiveness and liquidity. Here are the sectoral types of investment attractiveness:
- Crisis industry: its feature is a great drop in production.
- Depressive industry: stagnant, development prospects are either lacking or unclear.
- Stable industry: the growth of the industry can be described as stable and promising, and its performance is above the national average.
- A promising industry has the potential for development and investments under clear, targeted comprehensive programs. Its feature is a small volume of production, but in the future investments may pay off.
- A growing industry is in the growth stage and has high profitability. The enterprises of the industry steadily make profits, so the volume of production grows.
- Cyclical industry: the return and risk of investments in stocks of companies in this industry depend on the economic cycle phase. In general, these are industries that produce means of production, as well as durable goods.
- A seasonal industry is characterized by an irregular output of products due to the season, climate, and demand for products.
The investor’s task is to identify the most promising sector of the economy and invest accordingly in the shares of the companies. The higher the liquidity of a stock, the faster an investor can get income. If the liquidity of the financial asset is low, then it is more difficult to sell or buy shares vice versa. For the convenience of analysis stock indices are used. As a rule, this type of indicator is calculated for the most significant sectors of the economy. For example, the S&P 500 Information Technology for evaluating the information technology sector.
Step № 3: Analysis of the company and securities
Assessing the value of a company, an investor studies profit, dividends, growth rates, the ratio of debt and equity capital. Also free cash flow is calculated, the return on equity is analyzed and the company’s growth rates are predicted. Moreover, the company’s activities, its reputation, technologies used in production, as well as company management are examined. All financial indicators of the company are compared with those of competitors, as well as with the industry averages.
There are two types of company values, which most often don’t coincide. These are book and market values. The last one is conditioned by the ratio of supply and demand. The most attractive for investors is the situation when the market value of the company is lower than the book value or the real value of the assets. Then the company’s shares can be considered undervalued. In this case, investors expect that the share price will rise, as it will tend to the book price.
In the book “Analysis of Securities” by Graham and Dodd, which we mentioned in the first part of the article, the following idea was formulated: “The value of a share depends on its prospects in the future.”
Furthermore, we will consider the financial ratios in more detail. Since companies represented on the stock market are from different industries, with different scales of activity, different reputations, it’s rather difficult to compare them with each other.
The financial ratios simplify the life of investors. As they allow, using a single scale, not only to determine the real state of affairs of a particular company, but also to compare its financial performance with others.
Here are the most popular multipliers:
- P / E (Capitalization to Net Profit Ratio) allows us to calculate how many years it will take for an investment to pay off while maintaining the current profit of the company. The ratio was proposed by Graham and Dodd as an estimate of the fair value of the shares. The value of the indicator is usually in the range of 7 to 30. The indicator below the range indicates the undervaluation of the company’s shares and attracts investors.
- P / S (Capitalization to Revenue Ratio) shows how much the investor pays per unit of revenue. A coefficient value less than 2 is okay. A value less than 1 indicates underestimation.
- P / BV (The ratio of capitalization to the company’s capital; the ratio of the market price of a share to the value of assets per share) makes it clear what the investor will get in case of bankruptcy of the company. A value greater than one indicates that if the company goes bankrupt, then there will not be enough funds to pay off debts for all shareholders. A value less than one, on the contrary, shows that, in case of bankruptcy, all shareholders will be paid their shares.
- EV (Capitalization of the company + debt liabilities – available cash) is the fair value of the company.
- EV / EBITDA (The ratio of the company’s value to pre-tax profit) shows the period of time for the unspent depreciation, interest and taxes, the profit of the company to pay off the cost of acquiring the company. The multiplier is similar to the P / E, but more reliable for comparing companies. The evaluation procedure is the same, the lower the value, the better.
- EPS (The ratio of net income to the number of common shares): the growth EPS rate is used for the analysis (the percentage of the current indicator to the past). Often, a sharp decline or rise in profits will cause a stock price movement.
- ROE (net profit to equity) shows how much profit a unit of equity capital brings, thereby you can judge the efficiency of the company.
Thus, fundamental analysis is based on the study of macroeconomic indicators, sectors in order to choose the most promising option, the state of an individual company and on the study of securities separately.
Novice investors need to clearly distinguish between market and book value of assets. It’s usually better to buy those assets that are currently undervalued by the market since they are likely to rise in price. You can choose a company using financial ratios that allow you not only to assess the state of the company, but also to compare it with competitors. Soon, MonInvAI will add additional fundamental analysis indicators for even more accurate forecasts.
