Fundamentals of Stock Market: Tutorial-3

Types of Analysis:
The methods used to analyze securities and make investment decisions fall into two very broad
categories: fundamental analysis and technical analysis. Fundamental analysis involves analyzing the
characteristics of a company in order to estimate its value. Technical analysis takes a completely different
approach; it doesnt care one bit about the value of a company or a commodity. Technicians (sometimes
called chartists) are only interested in the price movements in the market.
Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand
in a market in an attempt to determine what direction, or trend, will continue in the future. In other words,
technical analysis attempts to understand the emotions in the market by studying the market itself, as
opposed to its components. If you understand the benefits and limitations of technical analysis, it can give
you a new set of tools or skills that will enable you to be a better trader or investor.
In this tutorial, well introduce you to the tools of fundamental analysis. Its a broad topic, so well just
cover the basics, providing you with the foundation youll need to understand more advanced concepts
down the road.

Tools of Fundamental Analysis:

Fundamental analysis is the process of looking at a business at the basic or fundamental financial level.
This type of analysis examines key ratios of a business to determine its financial health and gives you an
idea of the value its stock. Many investors use fundamental analysis alone or in combination with other
tools to evaluate stocks for investment purposes. The goal is to determine the current worth and, more
importantly, how the market values the stock. This article focuses on the key tools of fundamental
analysis and what they tell you. Even if you dont plan to do in-depth fundamental analysis yourself, it will
help you follow stocks more closely if you understand the key ratios and terms.
The basic tools are:
1)

Earnings per Share EPS

2)

Price to Earning Ratio (P/E Ratio)

3)

Projected Earning Growth PEG

4)

Price to Sell P/S

5)

Price to Book P/B

6)

Dividend Payout Ratio

7)

Dividend Yield

8)

Book Value

9)

Return on Equity

No single number from this list is a magic bullet that will give you a buy or sell recommendation by itself,
however as you begin developing a picture of what you want in a stock, these numbers will become
benchmarks to measure the worth of potential investments.
1) Earnings per Share EPS:

EPS = Net Earnings / Outstanding Shares

Using our example above, Company A had earnings of Rs100 and 10 shares outstanding, which equals
an EPS of 10 (Rs100 / 10 = 10). Company B had earnings of Rs100 and 50 shares outstanding, which
equals an EPS of 2 (Rs100 / 50 = 2).
So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS.
The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it
doesnt tell you whether its a good stock to buy or what the market thinks of it. For that information, we
need to look at some ratios.
2) Price to Earning Ratio (P/E Ratio)

P/E = Stock Price / EPS

For example, a company with a share price of Rs 40 and an EPS of 8 would have a P/E of 5 (Rs40 / 8 =
5).
The P/E gives you an idea of what the market is willing to pay for the companys earnings. The higher the
P/E the more the market is willing to pay for the companys earnings. Some investors read a high P/E as
an overpriced stock and that may be the case, however it can also indicate the market has high hopes for
this stocks future and has bid up the price. Conversely, a low P/E may indicate a vote of no confidence
by the market or it could mean this is a sleeper that the market has overlooked. Known as value stocks,
many investors made their fortunes spotting these diamonds in the rough before the rest of the market
discovered their true worth.
What is the right P/E? There is no correct answer to this question, because part of the answer depends
on your willingness to pay for earnings. The more you are willing to pay, which means you believe the
company has good long term prospects over and above its current position, the higher the right P/E is

for that particular stock in your decision-making process. Another investor may not see the same value
and think your right P/E is all wrong
3) Projected Earning Growth PEG:

PEG = Price per Earnings / (projected growth in earnings)

For example, a stock with a P/E of 30 and projected earning growth next year of 15% would have a PEG
of 2 (30 / 15 = 2).
What does the 2 mean? Like all ratios, it simply shows you a relationship. In this case, the lower the
number the less you pay for each unit of future earnings growth. So, even a stock with a high P/E, but
high projected earning growth may be a good value. Looking at the opposite situation; a low P/E stock
with low or no projected earnings growth, you see that what looks like a value may not work out that way.
For example, a stock with a P/E of 8 and flat earnings growth equals a PEG of 8. This could prove to be
an expensive investment.
A few important things to remember about PEG:
- It is about year-to-year earnings growth
- It relies on projections, which may not always be accurate
4) Price to Sell P/S:

P/S = Market Cap / Revenues

or
P/S = Stock Price / Sales Price per Share
Much like P/E, the P/S number reflects the value placed on sales by the market. The lower the P/S, the
better the value, at least thats the conventional knowledge. However, this is definitely not a number you
want to use in isolation. When dealing with a young company, there are many questions to answer and
the P/S supplies just one answer.
5) Price to Book P/B

Value investors use these indicators besides earnings growth. One of the metrics they look for is the Price
to Book ratio or P/B. This measurement looks at the value the market places on the book value of the
company. You calculate the P/B by taking the current price per share and dividing by the book value per
share.

P/B = Share Price / Book Value Per Share

Like the P/E, the lower the P/B, the better the value. Value investors would use a low P/B is stock
screens, for instance, to identify potential candidates.
6) Dividend Payout Ratio:

You calculate the DPR by dividing the annual dividends per share by the Earnings per Share.
DPR = Dividends Per Share / EPS
For example, if a company paid out Rs1 per share in annual dividends and had Rs3 in EPS, the DPR
would be 33%.The real question is whether 33% is good or bad and that is subject to interpretation.
Growing companies will typically retain more profits to fund growth and pay lower or no dividends.
Companies that pay higher dividends may be in grown-up industries where there is little room for growth
and paying higher dividends is the best use of profits (utilities used to fall into this group, although in
recent years many of them have been diversifying).
Either way, you must view the whole DPR issue in the context of the company and its industry. By itself, it
tells you very little.
7) Dividend Yield:

If you are a value investor or looking for dividend income then there are a couple of measurements that
are specific to you. For dividend investors, one of the telling metrics is Dividend Yield. This measurement
tells you what percentage return a company pays out to shareholders in the form of dividends. Older, wellestablished companies tend to payout a higher percentage then do younger companies and their dividend
history can be more consistent.
You calculate the Dividend Yield by taking the annual dividend per share and divide by the stocks price.
Dividend Yield = annual dividend per share / stocks price per share
For example, if a companys annual dividend is Rs1.50 and the stock trades at RS25, the Dividend Yield
is 6%.
8) Book Value:

One way to determine a companys value is to go to the balance statement and look at the Book Value.
The Book Value is simply the companys assets minus its liabilities.
Book Value = Assets Liabilities
In other words, if you wanted to close the doors, how much would be left after you settled all the
outstanding obligations and sold off all the assets. A company that is a viable growing business will
always be worth more than its book value for its ability to generate earnings and growth.
Book value appeals more to value investors who look at the relationship to the stocks price by using the
Price to Book ratio.
To compare companies, you should convert to book value per share, which is simply the book value
divided by outstanding shares.
9) Return on Equity:

Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings.
You calculate ROE by dividing Net Income by Book Value. A healthy company may produce an ROE in
the 13% to 15% range. Like all metrics, compare companies in the same industry to get a better picture.
While ROE is a useful measure, it does have some flaws that can give you a false picture, so never rely
on it alone. For example, if a company carries a large debt and raises funds through borrowing rather
than issuing stock it will reduce its book value. A lower book value means youre dividing by a smaller
number so the ROE is artificially higher. There are other situations such as taking write-downs, stock buy
backs, or any other accounting slight of hand that reduces book value, which will produce a higher ROE
without improving profits.
It may also be more meaningful to look at the ROE over a period of the past five years, rather than one
year to average out any abnormal numbers.
Given that you must look at the total picture, ROE is a useful tool in identifying companies with a
competitive advantage. All other things roughly equal, the company that can consistently squeeze out
more profits with their assets, will be a better investment in the long run.

Just having all the important qualities required to succeed as a day trader won't help;
proper selection of stocks for day trading is equally important. Generally day traders fail
because they don't select a proper stock for day trading.
Certain rules that can help you in selection of stock for day trading are discussed here.
These rules can be digested quickly to help you avoid the biggest pitfalls in trading.
These rules include:

Trade liquid stocks

Avoid unpredictable (chaotic) stocks

Trade stocks with good correlation

Move with the trend

Research

1. Trade liquid stocks

It is often said that liquidity is like oxygen to traders; without it, they are dead. Thus
liquidity is the first and most important rule while selecting a stock for day trading.
A liquid stock is one, which has a high average trading volumes, so that it can be bought
or sold in sufficient quantities without causing much impact on the prices.
It is advisable to day trade strictly in liquid shares less liquid stocks helps a trader buy or
sell large quantities of shares without any problem of there being no buyers or sellers.
While it could be argued that illiquid volatility also creates opportunity through rapid
price change, statistics prove that volatile shares move the most in the least amount of
time. Therefore, most opportunity dissipates while downside risk looms.
However, this is not a hard and fast rule, as the amount of liquidity depends on the
quality of your trade.
Suppose you buy few shares, say 50 to 100 shares, then shares with average trading
volume of 50,000 to 75, 000 will suffice, whereas if you buy few hundred or thousand
shares then you need a stock with average trading volume of few lakh shares.

Some of the examples most liquid stocks include Reliance Industries, SBI, Infosys,
ONGC etc.
2. Avoid unpredictable (chaotic) stocks
Generally it is seen that stocks that are trading with low average daily volumes or stocks
where some big news is soon expected, tend to trade in a highly unpredictable manner.
Sometimes even after an important announcement -- which may be either good or bad
(like big order, good results, bad results, plant shutdown etc) -- the stock may trade in a
chaotic manner. So it is advisable to avoid such chaotic stocks.
Some of the mid caps, and most of the small caps especially those in S, T and Z group
are chaotic stocks; better not to trade them from intraday point of view. They also have
very low volume thereby increasing their unpredictability.
3. Trade stocks with good correlation
It is advisable to trade in stocks that have more in correlation with major indices and
sectors. That is if the index or a sector moves up the stocks belonging to that index or
sector also moves up and vice versa.
Stocks that track and trade in correlation with the group (sector) to which they belong
are more readable & reliable, so that if any good/bad news comes in, affecting the sector
as a whole, then you can depend on the stock to move in the manner as the overall
sector is expected to move.
For instance, if the Indian rupee strengthens against the US dollar then all IT companies
depending on US markets get adversely affected.
A stronger rupee means these IT companies will earn less from their exports. Conversely
rupee weakening against the dollar leads to increase in their export earnings.
4. Move with the trend
It is always easier to swim along the river rather than across it. Always remember this
thing while day trading.
If we are in a secular bull run, then it is advisable to find stocks (sectors) that are going
to rise, rather than finding stocks (sectors) that are going to fall.
Similarly if we are in a bearish phase, then it is advisable to find stocks (sectors) that are
going to fall, rather than finding stocks (sectors) that are likely to move up.

5. Research
Quality research is the key to success. However, it is generally observed that day traders
hardly do any research.
First, identify an index (like the BSE Sensex or the NSE Nifty) that fits your style of
trading and then identify sectors within this index that appeal to your interest. Next step
is to create a significant list of stocks within each such sector. Note that stocks in the
sector need to be leader of that sector, and should be most tradable.
Daily analyse these stocks technically to decide whether they will move up or down the
next day. You also need to find out a particular stock's key levels of support and
resistance. Is the stock overbought or oversold? Has volume been showing any
significant changes?
Also study the fundamentals of the companies and try to know when they declare their
quarterly results. Studying how a particular stock moves on the day before the result,
when the result is announced and after the result helps a day trader understand how the
market reacts to results.

Invest what you can afford to lose

Intra-day trading carries more risk than investing in stocks. Invest only the amount that you can afford to
lose. An unexpected movement can wipe out your entire investment in a few minutes. In January 2009,
the Satyam Computer scrip fell more than 80% from Rs 188 to Rs 31 in one day. If it is a leveraged
position, you could lose more than you invested.

Choose highly liquid shares

Day traders must square their positions at the end of the trading session. This is easy if you are trading in
large-cap, index-based stocks, which are very liquid and get traded in large volumes every day. Don't
dabble in mid-cap and small-cap shares, where the traded volumes are not very large. You could end up
holding shares that have no buyers at the end of the day.
Trade only in 2-3 scrips at a time
It's prudent to diversify your portfolio when you are investing in stocks, but when it comes to day trading,
confine yourself to just 1-2 stocks. You can have up to 8-10 large-cap, index-based stocks on your watch
list, but don't trade in more than 2-3 stocks at a time. Stock movements need to be tracked closely by the
day trader and you won't be able to monitor more than 2-3 stocks at a time.
Research watch list thoroughly
Read up on the 8-10 stocks on your day trading watch list. You should know about all forthcoming
corporate actions (stock splits, bonuses, dividends, result dates, mergers, etc) as well as technical levels
of the stock. There are websites, such as http://www.khelostocks.com/calcPivotPoint.html, where you can
feed in the price (high, low and closing) to know the resistance and support levels.
Fix entry price and target levels
Before you buy, fix your entry price and target level. The psychology of the buyer changes after he has
bought a stock, which could interfere with his judgement and nudge him into selling too quickly even if the
price moves up marginally. This might cost him the opportunity to fully gain from the upside. If you set
yourself a price target and adhere to it, your psychological frame will not change.
Use stop losses to contain impact
A stop loss is a trigger for selling shares if the price moves beyond a specified limit. It helps the buyer limit
his losses in case the share belies his expectations and moves down (or up). Suppose you buy 20 shares
of Reliance at Rs 940 each and set a stop loss of Rs 920. If the share falls to Rs 920, your shares will be
sold. In this manner, your losses will be curtailed even if the share drops to Rs 900. A stop loss takes the
emotions out of the decision to sell.
Don't be an investor
Day trading and investing are like chalk and cheese. Both involve buying shares but the factors
considered are completely different. One takes into account technical data, while the other looks at its
fundamentals. Don't try mixing the two. Often, if an intra-day bet goes wrong, the buyer does not book his
loss, but takes delivery of the shares and then waits for the price to recover. This can be a costly mistake
because the shares were bought with an ultra short-term horizon. They may not be worth investing in

Book profits when targets are met

Greed and fear are the two biggest hurdles for the day trader. Just as he should not flinch from booking
losses when the trade goes wrong, he should book his profits when the shares reach his target. If he feels
that there is more upside to the stock, he should reset the stop loss. Suppose you invest at Rs 100 for a
target of Rs 110 and set a stop loss of Rs 95. If the price goes up to Rs 110 but you are bullish, raise the
stop loss to Rs 108. This will reserve some of the profit.
Don't fight the market trend
Even the most sophisticated analysis cannot predict which way the market will move. All technical factors
may be bullish but the market may decline. Technical factors only point to the likely movement of the
market, they don't guarantee it. If the market movement is not as per your expectations, don't try and be a
contrarian. You may end up losing more.
Small is beautiful
While stock investments can yield stupendous returns, be content with small gains from intra-day trading.
Day traders get a leverage of almost 3-4 times their investment, so even if your stocks go up by 3%, you
would have earned 9-12% on your investment. In any case, it's rare for large-cap stocks to move by more
than 5-6% in a day. Even if you get a return of 10-12% on your capital, it's not bad for a day's work.