The crux of fundamental analysis is to identify the market price trend of a stock. The market price of any stock tends to go towards its real value which is its intrinsic value. A long term investor who uses fundamental analysis to decide to buy a stock looks at the market price of the stock and its intrinsic value. If the market price of the stock is less than its intrinsic value then he knows the market price will rise and trend towards its intrinsic value. So he will buy such a stock.

Once the market price moves above the intrinsic value then chances are less for the stock to rise further on its fundamentals. Hence, it is an indication to the investor to sell the stock.

How do you now find out the instrinsic value of a stock? The image gives a pictorial representation of how one should do this and the factors that are to be taken into account.

The first step is to examine the economy. You study the current and future overall health of the economy at the macro level. Then you come down to the next level that is the firm. You analyze the firm whose stock you wish to buy. The factors to be studied are management experience, history of performance, growth potential, low cost producer, brand name etc. You should also try to collect the maximum information about the company and its products. If the firm has core competency and fundamental strength then naturally the firm will be ahead of all other firms that are competing with it.

If the firm has a strong market presence and market share will improve its instrinsic value because selling their product will not require more costly efforts like media advertising, improving market share, etc.

The next step is to find out how quick the stock price is going to rise and how much it is going to rise. You should give importance to the percentage rise in the stock price. Stock ABC is trading at Rs50 is expected to rise to Rs.100 and stock DEF is trading at Rs.500 is expected to rise to Rs.550. You have Rs.5000 for investing. Say, both the stocks are fundamentally strong. Then in which stock would you invest?

Let us compare and see the results:

If you invest in stock ABC you can buy 100 shares and then realise Rs.10,000 on selling them (100 shares sold at Rs.100)
If you invest in stock DEF you can buy 10 shares and then realise Rs.5,500 on selling them (10 shares sold at Rs.550)
The increase in price is same but the return from stock ABC is more because the stock price is less and the percentage increase is more. You should give importance to the expected percentage of increase in the price and not on the actual amount of increase.

Fundamental analysts use different tools and ratios to compare all sorts of companies no matter what business they are in or what they do!

EPS: (Earnings Per Share)

The portion of a company's profit allocated to each outstanding share of common stock. The amount is computed by dividing net earnings by the number of outstanding shares of common stock. For example, a corporation that earned $10 million last year and has 10 million shares outstanding would report earnings per share of $1.

P/E Ratio: (Price/ EPS)

Also called its "earnings multiple", Price of a stock divided by its earnings per share. The P/E ratio may either use the reported earnings from the latest year or employ an analyst's forecast of next year's earnings. P/E gives investors an idea of how much they are paying for a company's earning power. An important notice here is that the P/E ratio is ultimately not an objective measure; a high P/E ratio might show an overvalued stock, or it might reflect a company with high potential for growth.

Dividend

Dividend is an amount of the profits that a company pays to people who own shares in the company. When a company earns a profit, some of this money is typically reinvested in the business and called retained earnings, and some of it can be paid to its shareholders as a dividend.

Book Value

The book value of an asset or group of assets is sometimes the price at which they were originally acquired ( historic cost ), in many cases equal to purchase price.

Growth Stocks

Growth Stocks in finance , are stocks that appreciate in value and yield a high return on equity (ROE). Analysts compute ROE by taking the company's net income and dividing it by the company's equity. To be classified as a growth stock, analysts expect to see at least 15 percent ROE.