Library / MiyeeStockBuddy: The Complete Guide to Indian Markets
Part 3. Fundamental Analysis: Judging the Business
Fundamental analysis asks one question: is this a good business, and is the price sensible for what it is? Everything in this part is a way of answering it from published numbers, without meeting the management or visiting the factory.
3.1 The Core Idea: The Shop, Not the Price Tag
Suppose a shop earns ten lakh rupees a year, has no debt, and is offered to you for fifty lakh. You are paying five years of earnings. Now suppose an identical shop on the same street is offered for two crore. You are paying twenty years of earnings for the same ten lakh.
Neither number is right or wrong by itself. The question is what you believe happens next. If the second shop is about to open three branches and triple its earnings, twenty years of today’s profit may be cheap. If it is going to earn the same ten lakh forever, it is expensive. Every valuation argument you will ever read is a version of this.
The rule to remember You are buying a stream of future earnings. The price you pay decides your return just as much as the quality of the business does. A wonderful company bought at a foolish price is a poor investment, and this has been proved on Indian screens many times. |
3.2 The Three Statements, In Plain Language
Every listed company publishes three statements each quarter. Beginners are told to read them and are rarely told what each one is for. Here is the short version.
Statement | The question it answers | The trap in it |
|---|---|---|
Profit and Loss | Did the company make money this period? | Profit is an opinion shaped by accounting choices |
Balance Sheet | What does it own and what does it owe, right now? | A snapshot on one date, easy to dress up for that date |
Cash Flow | Did actual money come in or go out? | Hardest to fake, and therefore the most useful |
The profit and loss statement, from top to bottom
Read it as a waterfall. Revenue at the top, and each line takes a bite until what is left at the bottom belongs to shareholders.
Revenue 1,000 what customers paid less Cost of materials (520) raw material, purchases less Employee cost (140) salaries less Other operating expenses (120) power, freight, selling = Operating profit (EBITDA) 220 profit from the actual business less Depreciation (45) machines wearing out, not cash less Interest (35) the cost of borrowed money = Profit before tax 140 less Tax (35) = Net profit 105 what belongs to shareholders |
Two lines deserve attention. Operating profit, often called EBITDA, is what the business itself produced before the effects of borrowing and accounting. Net profit is what is left after the lenders and the government have been paid. A company can have a healthy operating profit and almost no net profit, and the entire difference will be interest. That is a company being run for its lenders rather than its owners.
The balance sheet, which must always balance
On one side sits everything the company owns: factories, stock, money owed to it by customers, cash in the bank. On the other sits how all of that was paid for: money borrowed from lenders, and money belonging to shareholders. The two sides are equal by construction, which is where the name comes from.
- Assets are what it owns. Watch the receivables line, which is money customers owe but have not paid. When it grows much faster than sales, the company is selling to people who are not paying.
- Liabilities are what it owes. Separate short term borrowings, which must be repaid within a year, from long term ones. A company with large short term debt and little cash is one bad quarter from a crisis.
- Equity is what remains for shareholders if everything were sold and every debt paid. It grows every year that profits are retained rather than paid out.
The cash flow statement, the one that is hard to fake
Profit is calculated. Cash is counted. A sale becomes profit the moment the invoice is raised, even if the customer never pays. Cash flow from operations only counts money that actually arrived.
Careful here If a company reports rising profits for three years while cash flow from operations stays flat or goes negative, something is wrong. Either customers are not paying, or inventory is piling up unsold, or the profit is an accounting construction. Almost every large Indian accounting scandal of the last twenty years was visible in this gap years before it was admitted. One number, checked once a year, would have kept you out of most of them: cash from operations divided by operating profit. Over three or four years it should average somewhere near eighty percent or better. |
3.3 The Ratios That Matter, and What Each Really Says
Price to Earnings: how many years of profit you are paying
The P/E ratio is the share price divided by the earnings per share. A P/E of 25 means you are paying twenty five rupees for every one rupee of annual profit, or twenty five years of current earnings.
Worked example A company earns 40 crore a year and has 10 crore shares outstanding. Earnings per share = 40 crore divided by 10 crore shares = 4 rupees per share. If the share trades at 100 rupees, the P/E is 100 divided by 4, which is 25. If the market later decides this company deserves a P/E of 30 and earnings are unchanged, the price becomes 120 without the business doing anything at all. That is what a re-rating means, and it is where a large part of multibagger returns actually comes from. |
A high P/E is not automatically expensive and a low one is not automatically cheap. A high P/E says the market expects strong growth; if that growth arrives, the shares can still do well. A low P/E often says the market expects trouble, and frequently the market is right. The cheapest looking companies on any Indian screen are usually cheap for a reason.
Compare P/E against | Because | |
|---|---|---|
The same company’s own history | It reveals whether the market is paying more or less for this business than it usually does | |
Direct competitors | A private bank at 18 and another at 30 is a real question worth asking | |
The sector average | IT and consumer companies normally trade higher than cement or metals, and always have | |
Careful here Never compare P/E across unrelated sectors. A steel company at a P/E of 6 and a consumer goods company at a P/E of 60 is not evidence that one is cheap. Cyclical businesses look cheapest exactly at the top of their cycle, when profits have peaked and are about to fall. This one mistake has cost more Indian investors more money than any other ratio error. | ||
Return on Equity and Return on Capital Employed
ROE answers: for every hundred rupees of shareholders’ money in this business, how many rupees of profit does it produce each year? An ROE of eighteen percent means eighteen rupees. It is the closest thing to a report card on management.
ROCE asks the same question of all the capital in the business, borrowed money included. The difference between the two is where the useful information hides.
Two companies, the same ROE, very different businesses Company A: shareholders have put in 100 crore, there is no debt, and it earns 20 crore. ROE is 20 percent and ROCE is also 20 percent. Company B: shareholders have put in 100 crore, the company has borrowed another 200 crore, and it earns 20 crore after interest. ROE is still 20 percent, but ROCE is far lower because 300 crore of capital is producing that profit. Company A earns its return from the business. Company B earns it from borrowing. When interest rates rise, or lenders get nervous, Company B is in trouble and Company A is not. |
The rule to remember Look at ROE and ROCE together, over at least five years. A consistently high ROCE with low debt is the signature of a genuinely good business. A high ROE with a low ROCE is usually a warning that you are looking at leverage rather than quality. |
Debt to Equity: how much of the business belongs to lenders
This is total borrowings divided by shareholders’ equity. A ratio of 0.5 means fifty paise borrowed for every rupee of owners’ money. Under 0.5 is comfortable for most industries, over 1 needs a reason, and over 2 needs a very good reason.
The exception is banks and finance companies, whose entire business is borrowing at one rate and lending at a higher one. Their debt to equity is enormous by design, and judging them by this ratio is meaningless. For lenders, look at Net Interest Margin and at gross non performing assets instead.
Think of it like this Debt is a lever. It makes good years better and bad years catastrophic. A company with no debt survives a terrible two years and comes out the other side. A company with heavy debt gets one bad year, breaches a loan covenant, and the lenders take control of the outcome from that point onwards. |
Operating profit margin, and why the trend beats the level
Operating margin is operating profit divided by revenue. A margin of twenty two percent means twenty two paise of every rupee of sales survives the cost of running the business.
The level tells you what kind of business it is. Software and branded consumer goods run high margins because the product costs little to reproduce. Trading and construction run thin ones because they mostly move other people’s goods. Comparing across those is pointless.
The trend, however, is genuinely informative. Margins expanding for several years usually means the company has pricing power, meaning it can raise prices without losing customers. Margins contracting usually means competition has arrived or raw material costs are winning. Over five years, a company whose sales grow ten percent while margins expand is compounding far faster than the sales line alone suggests.
Cash conversion: profit on paper versus money in the bank
Divide cash flow from operations by operating profit, and average it over three or four years. Consistently above eighty percent means profits become money. Consistently below fifty percent means they do not, and you should want to know why before you invest.
The other numbers worth knowing
Measure | What it means | A rough guide |
|---|---|---|
Price to Book | Price against the accounting value of the assets | Useful for banks, misleading for asset light businesses |
PEG ratio | P/E divided by the growth rate | Below 1 suggests growth is not fully priced in; treat as a hint, not a rule |
Dividend yield | Dividend per share against price | High yield can mean a mature business or a falling price |
Interest coverage | Operating profit divided by interest cost | Below 3 is uncomfortable; below 1.5 is dangerous |
Working capital days | How long money is tied up in stock and receivables | Rising steadily means cash is getting stuck |
Free cash flow | Cash from operations less spending on assets | The money genuinely available to owners |
3.4 Reading the Annual Report Without Reading All of It
An annual report runs to three hundred pages and almost none of it needs reading in full. Five sections carry most of the information.
1. The auditor’s report. Look for the word "qualified" or any emphasis of matter. An unqualified opinion is normal. Anything else is the auditor saying, in the only language they are permitted, that something is not right.
2. Related party transactions. This lists business done with entities the promoters control. Large or growing amounts here deserve a very sceptical read. Money leaving a listed company for a promoter owned private one is the classic mechanism by which minority shareholders are quietly diluted.
3. Contingent liabilities. Debts that are not on the balance sheet yet, such as disputed tax demands and guarantees given for other companies. If this figure is large against equity, it is a real risk hiding in a footnote.
4. The management discussion. Compare this year’s promises against last year’s. A management that explains what went wrong and what they changed is worth more than one that reissues the same optimism annually.
5. The shareholding pattern. Covered next, and the single fastest quality check available to a retail investor.
Promoter holding and promoter pledging
Promoter holding is the percentage of the company owned by the founding family or group. Rising or steady promoter holding means the people who know the business best are keeping their money in it. Falling promoter holding over several quarters is worth investigating, though it is not always negative, since founders do have legitimate personal reasons to sell.
Promoter pledging is different, and it is one of the most useful warning signs available to a small investor. It means the promoter has borrowed money personally and given company shares as collateral. If the share price falls far enough, the lender sells those shares into the open market, which pushes the price down further, which triggers more selling.
Careful here High promoter pledging turns an ordinary market fall into a collapse, because the forced selling is mechanical and does not care what the company is worth. Several well known Indian companies have lost eighty percent or more in weeks through exactly this loop. The figure is published every quarter and takes thirty seconds to check. Treat pledging above a quarter of the promoter holding as a reason to demand a much better price, and pledging above half as a reason to walk away. |
3.5 What Multibaggers Tend To Have In Common
Nobody can identify these in advance with certainty. But the companies that multiplied ten times in India over the last two decades share a small number of features often enough to be worth knowing.
A moat that widens as the business grows
A moat is whatever stops a competitor with money from taking the customers. A trusted brand people pay more for. A distribution network reaching six lakh villages that would take a decade to rebuild. A regulatory licence. Switching costs that make leaving painful, which is why banks and enterprise software keep customers who complain constantly and never leave.
A long runway
A company with two percent of a huge and growing market can compound for twenty years. A company with sixty percent of a small and static one has already won and has nowhere left to go. Ask how big the opportunity is, not just how good the company is.
Profits growing faster than sales
If sales grow fifteen percent and profits grow twenty five percent, the business is becoming more efficient as it scales. Sustained over a decade, that gap is the difference between a good return and an extraordinary one.
A clean balance sheet
Almost every long term compounder went through at least one brutal downturn. Low debt is what allowed them to survive it and buy assets cheaply from competitors who could not.
Management that does what it said it would
Read three consecutive annual reports before buying. It costs an evening. A management that met its stated plans three years running has told you something no ratio can.
3.6 The Red Flag Checklist
None of these alone proves anything. Two or three together in the same company is a reason to move on and find another idea. There is no shortage of companies.
Warning sign | What it usually means | |
|---|---|---|
Profits rise for years while operating cash flow does not | Sales are being booked that may never turn into money | |
Auditor resigns before the term ends | The most serious single signal on this list | |
Receivables growing much faster than sales | Selling to customers who cannot or will not pay | |
Heavy promoter pledging | A price fall can become a forced, mechanical collapse | |
Large related party transactions | Money may be leaving the listed company through the side door | |
Frequent equity raising with no matching growth | Existing shareholders are being diluted to fund losses | |
Complex web of subsidiaries with no clear purpose | Complexity is often where problems are stored | |
A sudden change of accounting policy or year end | Comparisons with earlier years have just been broken | |
Very high dividend from a company that also borrows heavily | Borrowing to look generous is not generosity | |
The rule to remember Your first job is not to find the best company. It is to avoid the disasters. A portfolio of merely good businesses with no catastrophes beats a portfolio of brilliant picks containing two frauds, every single time, and it is far easier to achieve. | ||
© Vipin Nair. This guide is for reading online only. Copying, downloading, printing and redistribution are not permitted. For study and general reference; not legal, tax or investment advice.