An essential aspect of stock analysis is conducting a fundamental analysis of the company. This can allow you to assess the strength of the company and make an informed investment decision. Although this requires some effort, it is a great way to identify strong stocks that can withstand the test of time and offer stable returns despite the volatility in the market.
When we talk about the fundamental analysis of a company, we usually try to look at various ratios. These include the Price-to-Earnings or P/E ratio, Price-to-Sales or P/S ratio, Earnings Per Share or EPS, Debt-to-Equity or D/E ratio, Return on Equity ROE, etc.
While these ratios can offer an insight into the performance of the company, unless you don’t compare them to other companies in the same sector, it is difficult to assess if they are feasible investments.
Many professional equity analysts around the globe compare stocks of the same sector to conduct equity analysis. It is a quick and efficient way of highlighting stocks that are overvalued and those that can be included in the portfolio. While there are other ways of conducting this analysis, running a comparison with other companies from the sector is a preferred way of finding quality stocks to invest in. Let’s see how this can be done.
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The starting point of comparing stocks within the same sector is by pitching the standardized valuation metrics of one company against its peers. The process is simple:
- Choose one financial ratio (P/E, D/E, ROE, etc.)
- Find this ratio for the company that you are interested in
- Create a list of companies from the sector to which your chosen company belongs
- Find the selected ratio for all the companies in the peer group
- Analyze how the companies stack up
To make this simpler, allow us to explain using an example:
Let’s say that you want to run a sector-based analysis of HDFC Bank. You are interested in the banking sector and are considering buying the shares of HDFC Bank. Is it worth investing in right now? Let’s see how the ratios stack up.
- We will start our analysis using the P/E ratio.
- The P/E ratio of HDFC Bank on August 28, 2020, is 24.
- For the sake of comparison, let’s create a peer group consisting of ICICI Bank, Kotak Mahindra Bank, Axis Bank, and State Bank of India.
- The P/E ratios of these banks on August 28, 2020, are:
Similarly, let’s collate other ratios for the same group. We have:
|P/E ratio||P/S Ratio||D/E Ratio|
|Kotak Mahindra Bank||32.86||7.5||5.36|
|State Bank of India||12.26||0.77||15.57|
The hard work is done. Now comes the comparison. Before you get into that, it is important to understand these ratios:
- P/E ratio – A high P/E ratio means the stock is possibly overvalued since its price is high relative to its earnings. On the other hand, a low P/E ratio means that the stock is undervalued and can be a potential investment opportunity.
- P/S ratio – A high P/S ratio means investors are willing to pay more for each unit of sale. Hence, this can indicate an overvalued stock. On the other hand, a low P/S ratio can be a possible undervalued stock that you can consider.
- D/E ratio – A high D/E ratio means that the company is financing a large portion of its business through debt. This is an important ratio because it can help you understand if the company has high growth rates due to efficient business decisions or high debts.
Going back to our example, since we have selected five stocks as our sector representation, we will compare each of these ratios for HDFC Bank with the average across these five stocks. Hence, we can see that while the P/E ratio is at par with the average, the P/S ratio is very high. Also, the D/E ratio is way below the sector average. This means that HDFC Bank is perceived as a good investment avenue (explaining the high P/S ratio) and has low debts that make it a fundamentally strong company for investing.
You can include more ratios and/or stocks based on your requirements. While this takes care of the quantitative aspects, let’s turn our attention to the qualitative aspects for a comprehensive analysis of the stock. We do this by using two qualitative factors – leverage
Please note, the stocks mentioned above are not recommendations. Please conduct your own research and due diligence before investing.
Leverage and Profitability
These two broad-level factors can help you understand how you should assess a company with respect to its peers.
Let’s say that the company you plan to invest in has a Return on Equity of 80% whereas the sector average is 50%. This means that the company has displayed a better potential of converting its equity capital into profits.
There are various matrices that you need to consider before deciding how a particular company matches up to its peers. These include ROE, Return on Assets (ROA), Margins (gross, operating, and profit), D/E ratio, etc. You can follow the same process as explained above and list these numbers to run a comparative analysis.
Another important aspect that you must take into consideration is the Expected Annual Earnings Growth. While there are many ways to calculate this, we recommend investors to follow 3/4 investment analysts and try to determine an average figure. Pay attention to this parameter as it can affect the company valuation to a great extent. At the end of the day, investing in a company that has a high expected annual earnings growth with strong fundamentals makes financial sense.
What if the financial statements don’t highlight any significant difference?
There can be times when two or more companies in a sector have similar financial statements making it difficult to differentiate between them. This is when you need to start looking at the quality of management of all companies under comparison. Opt for companies that have a stable management team without frequent additions or deletions and depth to absorb a handful of key personnel resigning.
Competitiveness of the company
Porter’s five forces allow you to analyze the competitiveness of the company. This is important since the success of any business relies heavily on how the company manages its competition. Analyze this aspect by looking at factors like:
- The threat of new entry
- Threat of substitution
- Bargaining power of suppliers
- Bargaining power of buyers
- Competitive landscape
While analyzing a stock, it is important to get as many details about the company as you can. While the financial statements are a quick way to look into the financial strength of the company, ensure that you don’t ignore the qualitative and competitive aspects too.
Remember, unless you don’t compare a company with its competitors, you will not get the true picture. In the real world, this company is competing with others in the sector and leveraging its management team’s skills to succeed. If you can analyze and compare these aspects, then you can make more informed decisions.
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