Fundamental analysis 101

You must be wondering why i am writing so many posts about money?You must also have noticed that my posts are jumbled up. I have done that on purpose. It may not be perfect but i always try to introduce a concept when it is relevent. Like i can't tell you the similarity between magic poker and stock market without telling you that money is created out of nothing in stock market just like in the magic poker. So before I wanted to start about stock market i wanted to divide companies into categories so that i can discuss their profitablity and future prospects. Those categories are given in the Money 5. Later we will slowly build on those categories and learn what we can as investors and enterpreneurs. But that will be later, first we will talk about valuing a company with an example. Something that is at the very heart of fundamental analysis.

Fundamental Analysis is about valuing a company according to its future growth prospects and by deeply studying the balance sheet, cash flow etc.
It lies more on the concept that when you buy a share, you buy it because of the company that share represent and not because you think it will rise in the next 6 days or your broker told you to buy or your uncle told that it is a good stock. We will unravel this as we go along. Lets start with an example.

A fictional example set in say 1990s: One day a boy working at a shop observes that there is a government office on the other side of the road. Being a government office, people have to wait very long for everything. In this he spots a perfect opportunity to sell coffee to these people. Since these people are waiting, they will go for a time pass.What is a better time pass that he could offer than a cup of coffee. Easy to make. Low investment. So this boy asks his owner to lend him some money and tells him his plan. The owner gets impressed and gives him the money. The boy buys a espresso coffee machine and gets to business. He starts to charge 3 ruppes for a cup, which costs him 2.5. So he is making 0.5 Rs on every cup. Suddenly his demand picks up and in no time he finds himself selling 100 cups everday i.e. 50 rupees profit. He works for few months and returns his loan to the owner and starts to save. One day I visit this office and finds the boy's business model very appealing. Now the question is, how much should I offer to buy his business. I calculate 50 profit * 300 days = 15000 Rs/ year.Then I predict that this business is not going to last more than 5 years because government offices will get computerized by then. No one will wait then.Since I liked the kids gusto, I thought I would give him 1/3 rd more so that he won't refuse. I offer that kid 15000 * 5 = 75,000 + 25000= 1,00,000 for his business. But to my surprise the smart kid refuses the offer. (Why? lets see).

The boy has more plans about his business. He hires another boy and starts to produce 150 cups of coffee and realizes that this is the average demand at that office. Then he starts to replicate his model at other government offices every 4 month. He uses his saving which he had accumulated from before to buy another coffee machine. After say one year he has 3 coffee shops producing average 150 cups per day. Since he is hiring people so say his profit reduces to 40 paise per cup. So he is earning Rs 60 per day, with 3 shops he is earning 180 per day. So now even if his business doesnot expand( since he can go inter city with his plan) he can earn 54,000 per year(300 working days) for the next 4 years( before the computerization takes place). That is 2,16,000.Well my 1,00,000 offer pales to this figure in comparison.

You see what I missed. I missed the growth prospect of the business.In stock market the price of shares is similiar to the worth of the company. So if you are buying a share in that company then you are actually valuing that company. And so the growth of a company becomes very important. Now lets assume his comapany has 100 shares. I offered

1,00,000 for 100, i.e 1000 per share. Based on his current daily earning I had calculated 15000 profit per year. i.e. 150 Rs per share.

So now i will introdoce one of the most important terms in fundamental analysis. P/E or PE ratio. This means price is to earning ratio, i.e. Price divided by earnings. Lets calculate the PE ratio of that boy's company based on your offer. Price of share according to your offer is 1000 and earning is 150. 1000/150 is 6.66. So according to your offer the PE of the company is 6.66. If I had offered 2,00,00, i.e. 2000/share then it will be 2000/150 = 13.33. Savvy.

So if next time you see PE ratio next to a share price then you can calculate the earning per share (EPS) ,equal to profit per share, by dividing share price by PE ratio. Try this if you are new to this.