Fundamental analysis of stocks is about the analysis of real data of a stock to find stock’s value. It is the best method to determine the health and growth prospect of company. In this method, stock’s revenue, profit margins, return on equity, future growth and other data are used to get company’s underlying value and growth prospects.
Fundamental analysis requires analyzing different financial, microeconomic and macroeconomic factors to determine the intrinsic value of a stock. It involves looking at the financial health of a company as well as taking into account the factors affecting its industry as a whole. For example, the factors determining the price of a stock like demand and supply gap and overall economy of the globe are taken into consideration.
If you want to do fundamental analysis of stocks, you need to pay close attention to the financial statements of the company. After all, it tells you about the health and growth prospect of the company.
Meaning of Fundamental Analysis:
Fundamental analysis of stocks is a method of stock valuation, in which intrinsic/real value of a stock is calculated by using financial and economic analysis. The analysis gives you a base to predict the movement of stock prices.
“Fundamental analysis takes into account both financial and non-financial information like Annual reports, the economic situation of the country where the stock is listed, Industry comparison, product demand of the company, government policies etc.”
It involves evaluation of a company’s qualitative and quantitative factors to answer questions like:
Is company making a profit?
Is revenue of the company increasing?
Has the company enough cash for expansion of its business.
Can the company repay its debts?
Can the company compete with their competitors?
And the most important, Is the company’s stock a good investment?
Why Fundamental Analysis is Important?
Fundamental analysis is a technique which is helpful in making investment decisions. Its basic importance lies in determining the intrinsic value of a security. It can then be compared to the current stock price and determined if the stock is overvalued or undervalued.
If the stock seems to be undervalued, then, it can be a wise decision to invest in it because it has more probability of appreciating over a period of time. Similarly, if a stock is overvalued, it might be time to pull money out of it as it has more probability of depreciating over a period of time.
If we look at examples in Indian stock market, we can find many fundamentally very strong stocks, which have made their investors extremely wealthy in a short period of time like TCS Limited, Infosys, Page Industries, Eicher Motors, Bosch India, Nestle India, TTK Prestige etc.
All the companies mentioned have given an approximate return of over 20% compounded annual growth return (CAGR) year on year for over 10 years. That means that if an investor had invested Rs 10 lakh, then, a rate of 20% CAGR would have made his capital Rs. 20 lakh in a period of about 3.5 years.
Source of information for Fundamental Analysis of Stocks
While going through fundamental analysis, you must have this information:
Annual reports of the company
Profit and loss account.
News related to the industry sector to which the company belongs or any economic reform.
Changes in regulations or laws that can impact the price of the stock
Who Uses Fundamental Analysis?
The people that use fundamental analysis on a regular basis and get benefitted by it are:
They buy and hold stocks of fundamentally strong companies with a long-term view and are not affected by the short-term volatility of the stocks.
Financial Advisors and Fund Managers
Their main role is to increase their clients’ money by advising them about investment opportunities arising in the market.
They are the ones that go for stocks that are currently underpriced in the market because of some reason but are actually fundamentally very strong.
What Strategy is used in the Fundamental Analysis?
According to a fundamental analyst, the market price of a stock moves towards its intrinsic value. If intrinsic value of a stock is higher than its current market value, the investor would buy the stock because investors know that the value of the stock will move towards its intrinsic value.
And if intrinsic value is below its current market price, the investor would sell the stock because the stock will move lower towards its intrinsic value.
The strategy of fundamental analysis sounds very simple, but it is quite technical if you want to get and analyze all data which is required to get the intrinsic value of the stock.
Fundamental analysts start with an analysis of overall present and future health of the company.
If the company has any ‘core competency’, which will help them to compete with their competitors. You must try to know about the brand positioning of the company. Like how the brands of the company are positioned in the mind of customers etc. This helps a company to survive for a long time in the market. Ultimately, it’s a strong point for valuation of a company.
How to do Fundamental Analysis of Stocks?
Let’s quickly look at some of the best & easy ways to perform fundamental analysis on stocks so that you can pick the selected ones for long-term investments:
#1 Initial screening of stocks with help of financial ratios:
First of all, initial screening of stocks is done, to find the right company to invest. You must take care of some important financial ratios of companies before taking a decision on investment. These ratios tell a lot about the financial health of a company.
“Benjamin Graham, popularly known as the father of fundamental analysis, made financial ratios very popular around the world. They are the most effective way of understanding the financial position of a company. Any financial ratio is calculated by dividing two numbers taken from the financial statements of a company.”
A ratio in itself does not imply much about a company but when compared with ratios of other companies of the same sector, tell huge tales of the financial standing of the company. There are numerous ratios which are broadly categorized into four categories.
Let us discuss the most common ratios and how they are calculated:
They assess the company’s liquidity position at any instant. That is, they measure a company’s ability to convert its assets into cash for paying off its obligations.
Current ratio = Current assets/Current liabilities
Quick ratio = Liquid current assets/Current liabilities
They assess the overall debt situation of a company.
Debt to Equity Ratio = Total debt/Total equity
Debt to Asset Ratio = Total Debt/Total assets
They assess the ability of a business to earn profits. They directly show the financial performance of a company. Let’s discuss the most commonly used profitability ratios.
Operating Profit Margin, also called EBITDA Margin tells about the efficiency of the company’s operating model.
Return on Capital Employed indicates the financial performance of the company taking into consideration the total capital it employed
ROCE = [Profit before income & taxes / capital employed]
They assess the overall efficiency of operations of the business in terms of ability to convert inventories into sales and sales into cash.
InventoryTurnover = Cost of goods sold / Average inventories
Accounts payable turnover = Net credit purchases / Average accounts payable
Working Capital Turnover = Revenue / Average Working Capital
Price-to-earnings (P/E ratio):
P/E ratio measures a company’s current share price to its earnings per share. It shows how much a stock investor is paying for each rupee of earning. It also shows if the company is overvalued or undervalued.
Generally, P/E ratio is useful for the valuation of stable and mature companies which earns a profit. You must always keep in mind that a company can easily boost its P/E by adding debt. So, it’s better to use past earnings for calculation of P/E.
If you want to know about the ideal P/E, you should compare current P/E of the company with its historical P/E, peers P/E, the average of market and industry P/E. Suppose, a company with 18 P/E may look expensive when compared to its historical P/E but can be a good buy if Peers P/E is 19 or 20, an average of market and industry P/E is 21.
Return on equity (ROE):
The main purpose of any investment is return. How much you will get from your investment depends on the earning of the company i.e. return on equity. If a company is earning a good profit, investors will also be benefited.
It helps to compare the profitability of the company in the same industry. Generally, ROE between 15-20% is considered good, though a high ROE is expected from a good growing company.
Price- to- book value (P/BV Ratio):
This ratio is used to know that if a company goes bankrupt and repays it’s all debts, then what value will remain with them.
It compares company’s market value to its book value.
The ratio shows how much debt is involved in the business of the company by promoter’s capital. A low debt-to-equity ratio is considered better.
Again, a company with low debt- to- equity ratio is assumed to have more opportunity for expansion due to fund-raising.
Price/earnings growth ratio (PEG):
As you know that a fast-growing company has higher P/E ratio. One can think that the company is overvalued. So, P/E ratio divided by estimated growth rate gives a result that if high P/E is justified or not.
It can be compared to competitors with different growth rate.
#2 Know about the company:
The second step of fundamental analysis of stocks is to understand the company which you have selected for the investment. If you have little knowledge, you can’t decide about the performance of the company. Whether the company is performing well or not?
What is going on inside the company?
What will be the effect of a change in management of the company? Whether the company is taking the right decision towards its future goal. And lastly, whether you should hold or sell the company.
Go to the home page of the company and check everything, like products, business, customers, geography, mission, vision etc.
If you are satisfied, then move forward to next step of the investigation. Else, just ignore.
#3 Check the financial reports of the company:
After knowing all about the company, you should move forward to study financial reports of the company. Study of financial reports in a fundamental analysis of stocks is a most important step.
Financial reports include Profit & loss account, Balance sheet and cash flow statement.
The balance sheet is reviewed to understand the financial condition of a business, as of a given period. The income statement is used to understand the profit or loss of a business within a given period. Whereas, Cash flow is used to understand the flow of cash as of a given period.
Annual reports play one of the most important roles in the fundamental analysis of any stock. They are filed by all public companies which contain all the key information about the company. These are published by the end of the year and includes data up to March 31st of that year.
They are huge documents and going through the entire annual report can be an extremely tedious process.
A balance sheet is a way of representing a company’s assets and liabilities or a particular period of time. Different constituents of a balance sheet can be understood by the picture posted below:
Analysis of different items is necessary to know the overall health of the company. For example, too much and too little debt in the balance sheet, both are areas of concern. Too much debt means high financing costs and thus, reduced profitability. Too little debt might mean that the company is not taking steps for expanding itself. Thus, a right balance is required everywhere.
The P&L gives us the detailed picture of the profitability of the company. The constituents of the P&L statement can be seen in the picture below:
All the heads in P&L statements should be seen on a corresponding comparative basis. For example, revenues for the 3rd quarter of 2017 should be compared with revenues for the 3rd quarter of 2016.
Cash Flow Statement
This statement provides a detailed report on cash flows through various activities of the company. It gives a good idea about the liquidity or cash flows of a company which predict the profitability of the company. The constituents of the cash/funds flow statement can be seen in the picture below:
#4 Check the debt of the company:
Beforeinvesting, you must check the debt of the company.Debt is one of the biggest factors which can change whole future of the company. You should always avoid companies with huge debt. Because a company with huge debt can’t reward its shareholder. Their huge debt can deteriorate the performance of the company.
#5 Find the peers of the company:
If you are deciding to invest in a company, then you should find the company’s peer first. And, check that why you are not choosing its peer. What is the unique thing which is making your selected company better in comparison of its peer?
Yes, Unique selling proposition (USP) of a company makes it different from their competitors. Try to find out USP of the selected company, upcoming projects, future prospects, new assignments etc.
#6 Analyze the future prospect:
At last, try to analyze the growth prospect of the company. If you want to invest in long-term stock then always pick those companies whose products and services will be in demand for long-term like 15 years or more. Because these criteria will help to survive the company for long-term and ultimately it will give long-term profit to investors.
Summary: How to do fundamental analysis of stocks
Here is a quick summary of how you should be going ahead with the fundamental analysis of stocks. In case of confusions, feel free to check the article above for more information.
Initial screening of stocks by analyzing financial ratios.
Study about the company. It’s mission, vision, management, products & services etc.
Detail analysis of financial reports of the company i.e. balance sheet, profit and loss sheet and cash flow.
Study the debt of the company
Know about the competitors.
Finally, analyze the future growth prospect.
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