Fundamental Analysis and Financial Ratios

Jul 12, 2024

Learn Stock Market from Scratch: Video 5 by The Wall Street School

Overview

This video focuses on understanding how to gauge the financial health of a company using fundamental analysis. This involves using various financial ratios and analyzing industry competition.

Key Concepts

Fundamental Analysis

  • Warren Buffet's Philosophy:
    • Price vs. Value: "Price is what you pay, value is what you get"
    • Key investment goals: price appreciation and dividends

Dividend-Paying Companies

  • Examples of high dividend-paying government companies:
    • NHPC, NTPC, Indian Oil, Hindustan Zinc, Bharat Petroleum, Vedanta, PTC, REC, ONGC, HPCL, Coal India
  • Importance of retained earnings for value creation:
    • Companies should retain earnings only if it creates an equal or higher amount of market value.

Financial Health Analysis

  • NHPC Example:
    • Dividend yield: 7.41%
    • Sales doubled over 10 years, but profits remained flat
    • High debt
  • *Coal India vs. Hindustan Unilever Analysis:
    • Coal India provides high dividends but creates negative value per retained rupee.
    • Hindustan Unilever: Significant value created per retained rupee while also paying high dividends.

Financial Ratios and Their Importance

Profitability Ratios

  • Gross Profit Margin (GP Margin): Gross Profit / Sales
  • Operating Profit Margin: Operating Profit / Sales
  • Net Profit Margin: Net Profit / Sales

Liquidity Ratios

  • Interest Coverage Ratio (ICR): EBIT / Interest
  • Debt Service Coverage Ratio (DSCR): EBIT / (Interest + Short-term Debt)

Efficiency Ratios

  • Asset Turnover Ratio: Sales / Assets
  • Return on Equity (ROE): Net Profit / Total Shareholders Equity
  • Return on Capital Employed (ROCE): EBIT / (Debt + Equity)

Practical Examples

Comparison Between Companies

  • Grasim vs. Crompton Greaves:
    • Differences in ROCE due to efficiency in using capital.

Investment Strategies

  • 1984 Letter from Berkshire Hathaway:
    • Focus on value creation per retained dollar.
  • Good, Great, and Gruesome Businesses:
    • Great: Businesses with enduring moat
    • Good: Businesses needing large capital but yielding satisfactory returns
    • Gruesome: Rapidly growing businesses requiring high capital but earning little return

Real-World Examples

  • Amara Raja Batteries: Major capital expansion without corresponding sales growth
    • Result: Stock prices remain flat despite initial hype
  • Snowman Logistics: High capex with low asset turnover ratio
    • Conclusion: Company needs high capital for minimal sales growth; stock prices decline.

Profit vs Cash Flow Analysis

  • Estimating the true health of a company by examining cumulative net profit vs. cumulative cash flows over time.
  • ITC and Hindustan Unilever: Healthy alignment between net profits and cash flows.
  • PC Jeweller and Manpasand Beverages: Discrepancies indicating potential financial issues.

Summary

  • Focus on financial ratios to understand company health.
  • Compare profitability, solvency, and efficiency ratios to make informed investment decisions.
  • Real-world examples show the importance of proper fundamental analysis.
  • Understand the broader financial health beyond just high dividend yields.

The next video will delve deeper into understanding business moats and further analysis strategies.