Equity Analysis and Valuation
There are two parts to evaluating a stock for investment
1. Fundamental analysis:It is a study of “Financial statements” and information of a company to estimate the future returns from it. Financial statements include evaluating the revenue, expenses, assets, liabilities and other financial aspects of the company.This is useful in estimating the earning potential and hence the intrinsic value of the shares.
2. Technical analysis:It involves studying the prices of stocks rather than its intrinsic value. Technical analysis is a study of historical prices and market trends. Technical analysis is concerned with past trading data and what information the data might provide about future price movements.
Equity analysis thus requires both fundamental and technical analysis of stocks since one contributes to understanding the financial aspects and true valuation along with profits of the company whereas the other evaluates the price trends and forecasts future prices for making investment decisions.
Information for equity analysis is gathered from the following sources:
- Audited financial statements
- Analyst meetings, plant visits and interactions with the management
- Industry reports, analytics and representations
- Government and regulatory publications
Commonly used terms in Equity Investing
Price earning multiple: The price earning ratio or multiple basically calculates what the market is willing to pay for a share of a company based on its current earnings.It is computed as:
Market price per share / Earnings per share: Earnings per share is the profit after taxes divided by the number of shares. It indicates the amount of profit that is available, for every share the company has issued. Eg. A stock is currently trading at 50Rs/- a share and its earnings per share for the year is 5Rs/-.
P/E ratio would be calculated like this: 50/5= 10, the price earning ratio of this stock is 10 times which means investors are willing to pay 10 rupees for every rupee of earning. A company with a high P/E ratio usually indicated positive future performance and investors are willing to pay more for this company’s shares.
Price to book value (PBV): The PBV ratio compares the market price of the stock with its book value. It is computed as market price per share divided by the book value per share. The book value is value of the share in the books of the company i.e value of a company’s assets expressed on the balance sheet. Since the assets in company books is shown at its cost minus the depreciation and are not inflation adjusted, true realizable value of assets cannot be determined from books. Eg. If market price of the stock were lower than the book value and the PBV is less than one, the stock may be undervalued and vice versa.
Dividend yield ratio: The dividend declared by a company is a percentage of the face value of its shares. Eg. When the dividend received by an investor is compared to the market price of the share, it is called the dividend yield of the share.A 40% dividend declared by a company with face value Rs 10 of each share, the dividend amount is Rs 4 (10* 40%) on each share.
A security’s dividend yield can also be a sign of the stability of a company and often supports a firm’s share price. Normally, only profitable companies pay out dividends. Therefore, investors often view companies that have paid out significant dividends for an extended period of time as “safer” investments.
Risk and Return from investing in equity
Return: As we know the returns on equity investment are fluctuating and are received in periodic dividends and Increase in value of investment through change in share prices in secondary market. The equity market is highly volatile because large number of investors keep evaluating stocks and realigning their current investment position leading to fluctuating share prices. Since performance of companies can be evaluated based on its share prices, the company with increasing rate in share prices indicates profitability and vice versa.
Risk: The risk to an equity investor is that the future benefits are not assured or guaranteed, but have to be estimated based on dynamic changes in the business environment and profitability of the business.