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Fundamental Analysis: Sales & Earnings

Equity valuation is the most widely used metric while analysing a stock. The focus towards valuation is so popular that DIY investors overlook other important parameters to evaluate stocks. There is so much more to fundamental analysis than valuation ratios that is required to get a holistic view before investing. Let’s get a hang of few such parameters of fundamental analysis.


Note: Understanding the earnings report, balance sheet and annual reports is a topic I assume readers are familiar with. Nevertheless, interpreting these are fairly easy nowadays with the advent of FinTech Apps and tools which give you information at your fingertips without the need for you to hunt down these info and data.



Sales Growth


Sales, needless to say, is a basic parameter. Sales as a standalone figure isn’t usual for analysis, unless we add a time dimension to it. While analysing a business’s effectiveness, Sales should be on the rise YoY. A stagnant or negative Sales Growth can mean losing market share, unsuitable/undesirable products or poor adaptability to change in market needs. So, businesses should be shortlisted based on growth in sales.


To drill further into the sales data, investors can also calculate the rate of sales growth, which indicates acceleration in execution. Businesses operating in emerging themes generally show acceleration in sales growth as the products/services start getting traction. It can also mean, a business is expanding either geographically or its product/service catalogue which is contributing to the sales growth. In either case, this is a highly positive indicator for the investors. On the other hand, sales growth can be misleading if the growth was merely due to temporary sectoral macros which will not sustain long. Hence it is important to understand the cause of growth in sales to take a decision on it.



EBIT & EBIT Growth


EBIT which expands to Earnings Before Interests and Taxes is the operating profit of a business without deducting debt commitments and taxes. No investor would prefer to put their hard earned money on a business that is not profitable. Expanding into that, the chance of good returns increases when the profitability of a business increases. EBIT Growth provides that confidence to the investor. Growing profitability means the business is doing the right things on the operations front. In conjunction with Sales Growth, EBIT Growth can mean different things with different combinations.


EBIT Growth with stagnant sales indicates improving margins.This could be due to better utilisation of input costs or better inventory management. It would be fair to say the company has improved its efficiency, but lacking market penetration.


EBIT Growth with increase in sales indicates expansion through increased capacity, production etc.

Tip: A company that completed a CapEx (Capital Expenditure) on production would show increased inventory but unless it translates into sales and thereby increased earnings, the goal of CapEx is not met. Hence following a CapEx, check for EBIT and Sales Growth to re-evaluate your investment.


EBIT Growth with decrease in Sales could mean that the company's non-operating profit contributes to the earning growth and might not be sustainable. This could be a transitional phase for the business, but still the investor should be cautious about the growth the company is showing.



ROE & ROCE


Return On Equity (ROE) is a shareholder-centric profitability metric. It expresses profitability of a business in terms of the capital raised from shareholders, thereby its efficiency in unlocking value for it’s investors. Even though it’s a commonly used metric to evaluate a company’s efficiency in utilising the shareholder’s equity, this lacks another important parameter on which efficiency should be measured, i.e., Debt. A company could be increasing the profitability through high debt on top of a smaller equity base. This would tilt ROE on the higher side, but it could be considered as a risk for investors, if the debt levels are unsustainable.


Hence, a better alternative to ROE is Return On Capital Employed (ROCE), which calculates the return over capital available while servicing the debt and other liabilities. Including debt into the equation can help investors understand how leveraged the company is. A superior ROCE is better than superior ROE when comparing the company with its peers in the same industry. Like all other Quantitative metrics of fundamental analysis, these metrics should be compared with industry average or peers to shortlist the potential winners for your portfolio.



In the next article, I will cover debt, one of the most important aspects of Quantitative Fundamental Analysis.

Also, checkout the earlier article on how to interpret valuation ratios and other articles on fundamental analysis. Hope it helps you in your DIY investment journey!

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