Last Updated on May 25, 2022 by Neera Bhardwaj
Short-term, medium-term and long-term investors typically look to buy a stock when it is undervalued – or selling at a price that is less than what their earnings justify – so as to increase the chances and the volume of earnings when they sell the stock eventually. Day traders do not pay attention to this type of “value investing” because they look to benefit from stock price changes that happen from minute to minute.
Besides the company’s earnings, investors might want to look at dividends a company is paying out, or its earnings as compared to the amount of shareholder equity it has, its sales , its debts and so on. The idea is to try and judge whether the stock price is worth the inherent value the company offers, in terms of the returns that the stock is likely to give, based on the financial health of the company.
Investors might also want to observe a company’s competitiveness in relation to its peers to evaluate whether its stock holds potential to deliver earnings to them in the long run. This is where fundamental analysis of stocks within the same sector comes into play to help you take informed decisions with regard to your investments. You might want to measure your stocks through the lens of what is known as Porter’s business model. Let’s find out more.
Table of Contents
Value investing approach
For instance, let’s say that an investor, Preeti, has decided that this is the moment to invest in AI and allied sectors. She is choosing between several companies that contribute and innovate actively in the AI technology space and have seen the same amount of earnings of about ~Rs. 20 cr. over the last three years. Company A, Company XYZ and Company B are on her list. Company XYZ is a stable brand, but Company A was recently in the news for some innovation that could propel its stock price. Meanwhile, Company B was in the news because its CEO is having an affair with a notorious celebrity and everyone is now questioning his decision-making abilities, even though he has brought the company a very long way. Company B’s stock price has tanked.
Preeti’s friends often discuss their investment plans and they are all telling her that Company A is the safest option. “Look how much its price has grown” they say. Preeti’s investment advisor tells her that Company B is the best option if Preeti is buying right now because of its low price. He explains that the company has a good P/E ratio compared to its peers.
How fundamental analysis overcomes knee-jerk reactions?
The financial advisor has used stock analysis to predict the stock’s ability to witness a stock price rise in the future. All three companies deliver about Rs. 20 cr. annual earnings. All three companies, he discovers upon research, have a similar amount of liabilities, all pay about the same amount of dividend.
But Preeti can get the shares of company B “at a discount” thanks to “bad news” surrounding the company that resulted in a share price drop. When the next quarterly report releases, investors will ideally get over the CEO’s headline making affair, and start investing in company B and its stock price will, according to the financial advisor’s predictions, rise at that point.
How to conduct your own fundamental analysis on stocks in the same sector?
Part 1: Fundamental analysis comparison methods using financial ratios
Assuming you have picked companies that have registered a similar volume of earnings and the same amount of borrowings and have paid out the same volume of dividend, here are a handful of easy-to-use ratios to compare stocks within the same sector. Even if the companies do not have the same amount of earnings and borrowings, you will still be able to evaluate them using these financial ratios.
Compare earnings using P/E ratio
The Price to Earnings ratio is an important metric in fundamental analysis that helps determine if the price you will pay for a stock is actually worth the earnings the company makes. P/E ratio, in simple terms, is the amount of money that investors are willing to pay when purchasing a share for every rupee earned by the company.
The formula for P/E ratio is as below:
P/E ratio = Earnings Per Share / Share Price
Here, earnings per share can be arrived at by another formula : Total Earnings / Total number of Shareholders.
Once you have the P/E value, compare the ratio of all the companies in the mix. The companies with lower P/E ratio are typically undervalued (or are selling at a discount), while the companies with a higher P/E ratio possibly have inflated prices that may be at risk of a price correction (which is a euphemism for price drop).
If a company has a negative P/E ratio, that should, however, be a cause for alarm because that usually happens when the earnings of a company is negative (read: company is loss-making).
Compare the price to book value of each company
The real value of a company, or its value if it were to shut shop today and repay all its shareholders after settling all its debts and paying off its liabilities, is known as its book value.
The formula for P/B ratio is as below:
P/B ratio = Market price / Book value
You’ll be able to get the book value easily enough. Deduct the borrowings/ debt/ liabilities of the company from the value of the company, or its present worth, and then add the asset value to the amount.
P/B ratio works similarly to P/E ratio in the sense that the lower the value, the better it is, but a negative P/B ratio may not be ideal.
Compare the price to sales of each company
For companies that may or may not be profitable, but more specifically in situations where companies are neck-to-neck when it comes to the other ratios, price-to-sales ratio can be used to decide which company holds better potential based on their recent performance.
The price to sales ratio indicates how much money an investor will need to pay for purchasing one share of the company against the amount of sales the company has generated per share.
The formula for P/S ratio is as below:
P/S ratio = Market capitalization / Total sales of the past 12 mth
A price to sales ratio of less than 1 is seen to be very desirable, and for the most part investors are satisfied with a P/S ratio of 1 or 2. Anything more than that might mean that the stock is overvalued.
Compare using return on equity, with a focus on debt:equity proportions
ROE holds the company’s net income against its shareholder’s equity to get a true idea of how its earnings fare against the price the shareholders are paying for shares at present.
The formula to calculate ROE is as below:
ROE = Net income / Shareholder’s equity
Compare the ROE of the companies in the sector. An ROE of anywhere between 15% and 20% may be considered optimal. The higher the ROE the better. You can also compare a company’s present ROE to its own past ROE to see whether ROE is progressing or diminishing. A diminishing ROE should be cause for concern because it means that the company is using more money to generate the same amount of profits. A progressing ROE means that it is making more efficient use of investor capital.
ROE should be used in tandem with the D/E ratio or Debt to Equity ratio.
The formula for D/E ratio is as below:
D/E ratio = Total liabilities / Shareholder’s equity
The D/E ratio will tell you how the share price fares against the liabilities of a company. Some companies might display a seemingly positive ROE but that might just be the outcome of a far higher debt to equity proportion. If you were to total its debts and shareholder capital, the company’s earnings might not seem as strong. Using ROE and D/E ratios together can help you maintain a balanced view.
Part 2: Competitive analysis using Porter’s business model
With the financial ratios, you are able to tell which stock in a given sector comes at the most value-for-money price right now against its past sales and earnings, its present book value and shareholder equity and so on.
But since you will be holding the stock in the future, you obviously also want to predict how the company linked to the stock will fare in the future. This might be suitably achieved by measuring a company’s competitive edge. Porter’s business model for competitive analysis, works very much like a SWOT (strengths, weaknesses, opportunities, threats) analysis that you might be familiar with. There are five components to this assessment, as follows:
- Supplier power equation: How easy is it for the company’s suppliers to drive up prices. Are there sufficient suppliers in the market for the company to pick a new supplier if the existing supplier’s pricing becomes unprofitable?
- Buyer power equation: How easy is it for the company’s customers to drive down prices? This will be linked to the following two points.
- Competition and product density: All of us are aware of how demand-supply economics work. If the company’s product is replicated by countless competitors, then product differentiation becomes a challenge, price becomes the only differentiator, and profitability could take a hit.
- Substitution threat: If the company’s product is in danger of being substituted or replaced by a new product or due to innovation or the advancement of technology. Investing in such a company might not be a good idea. For example, imagine buying shares of the top CD manufacturer just before iPods became a thing. It would not be an ideal investment even if the company was the best-in-class or the leader in its sector.
- New entrant threat: Existing players in a sector stand to have a smaller market share when a new player enters and carves out a niche for themselves. It helps if the company linked to your stock has a patent in its favour, or some other factor that sets it apart from any new entrant.
The takeaway
You can always find out whether a stock price is selling at a premium or at a discount, or at a justified price, using financial ratios that compare its price to its financial health. If you time your investment such that you buy at a discount, you increase your chances of reaching your earnings target, and doing so more quickly. Do not forget to also conduct a competitive analysis of the company because you not only want to know if it is a leader in its sector, and if its present price is worth it; you also want to know what potential it has in the competitive landscape ahead. A 360-degree view on stocks you intend to purchase must include all these key measurements, evaluations and comparisons.
