A Basic Guide To Fundamental Analysis

Many investors believe in long-term investing, therefore, they just buy and hold stocks. So, Fundamental Analysis of a business is a process of understanding the working of a business at its most basic i.e. fundamental financial level.

Or, in short, it helps investors to understand the basic premise on which the said business rests. Also, for investors it's a way to identify companies that are fundamentally strong in order to invest in them for the long term. This is done by looking at various fundamental indicators and parameters.

Usually stock investors are worried about overpaying for a stock because unlike grocery items, stocks do not come with a price tag. Instead, the price is based on its current market price.

For instance, let’s say you are buying shares of XYZ company for Rs 100. But as an investor, are you sure that you are not paying more than its true value? Well, the answer to this question is easy if you know how to do Fundamental Analysis.

What is the importance of Fundamental Analysis?

Let’s assume that you know the current market price of HDFC shares is Rs 780 per share. This price is the market price i.e. some seller must be asking for this rate to sell the stock.

So your job as a long-term investor is to buy the stock at a far lower price than the intrinsic value. So, if the true value of HDFC stock is Rs 900, buying it for Rs 780 is logical. On the other hand, if the true value of HDFC stock is Rs 700, buying it at Rs 780 is not a good deal for you.

Fundamental Analysis helps the investor to understand what is the true value or fair value of a stock.

If the current market price is lower than the fair value, also called intrinsic value, then the company/stock is said to be undervalued. And to the contrary if the current market price is higher than the fair value, then the company/stock is said to be overvalued. In a nutshell, this is the importance of Fundamental Analysis of a stock.

Components of Fundamental Analysis

Fundamental Analysis consists of three main parts:

Fundamental Analysis is an extremely comprehensive approach that requires a deep knowledge of accounting, finance, and economics.

What is the difference between technical and fundamental analysis?

Many investors are confused between these two terms. Fundamental Analysis of a company helps an investor to analyse the cash flow of a company based on the economy. It helps investors to decide if the stock of the particular company is actually worth buying.

Technical Analysis, on the other hand, focusses on internal market data such as price and trade volume.

Here is a table enumerating the key differences.

Basis of difference

Fundamental Analysis

Technical Analysis
Definition
Value calculated using various economic factorsUses price movements and patterns on charts to predict future price movements
Data FromEconomic reports, news events, industry statisticsChart analysis
Asset Bought(Sold)When price falls below (above) intrinsic valueWhen trader sees a price formation that has  a high probability of moving into profit in the near future.
Type of TraderUsually longer term position tradersGenerally swing traders and short term day traders
Time Horizon Often holding for days, weeks, or even monthsCan be long term, but most take positions for days, minutes, or even seconds
Concepts UtilizedReport expectations vs actual outcomes, current news events  compared  to historical eventsTrendlines, support & resistance(supply & demand), dow theory, price patterns

Types of Fundamental Analysis

Fundamental Analysis is broadly categorised into two categories: Qualitative and Quantitative. 

Qualitative Fundamental Analysis is subjective as it is based on the quality of something such as management, brand, products, financial performance, board, etc. For example, you feel the products of Hyundai Motors are better than those of Tata Motors. This is a qualitative opinion.

Quantitative fundamental analysis deals with numbers. The major source of quantitative data is extracted from the financial statements.

Both qualitative and quantitative fundamental analysis of a company are a must. You cannot do one at the expense of another.

Qualitative Fundamentals to Consider

There are three key qualitative fundamentals that analysts always consider when scrutinising a company stock. These include:

Business Model: What exactly does the company do? This isn't as straightforward as it seems. If a company's business model is based on selling burgers, is it making its money that way? Or is it just dependent on royalty and franchise fees?

Competitive Advantage: A company's long-term success is largely based on its ability to maintain a competitive advantage. For instance, Coca-Cola's brand name has the competitive edge over Pepsi. When a company can achieve a competitive advantage, its shareholders can reap benefits for decades.

Management: This too plays a crucial role as even the best business models are doomed if the leaders of the company fail to properly execute the plan. While it's hard for investors to meet and evaluate managers, one can certainly check the corporate website and look for the board members.

Besides, it's also important to consider a company's customer base, industry-wide growth, market share, competition, business cycles, etc. Learning about how the industry works will give an investor a deeper understanding of a company's financial health.

Quantitative Fundamentals to Consider

Financial statements disclose a lot about a company's financial performance. It helps investors to make investment decisions. The three most important financial statements are income statements, balance sheets and cash flow statements.

The Balance Sheet
The balance sheet represents a record of a company's assets, liabilities and equity at a particular point in time.

Assets = Liabilities + Shareholders' Equity

Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity.

The Income Statement
The income statement measures a company's performance over a specific time frame. The income statement deals with the incomes and expenses of a company during a given financial year. It classifies them into various parts based on their nature. Expenses are subtracted from incomes to arrive at the profit for the year.

Statement of Cash Flows
This statement specifically talks about the cash position of a company. It divides the company's activities into three categories—operating, investing and financing, and gives an account of the cash flowing in and out of the business on account of these.

  • Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets
  • Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds
  • Operating Cash Flow (OCF): Cash generated from day-to-day business operations

The cash flow statement is important because it's very difficult for a business to manipulate its cash situation.

What are the components of Quantitative Fundamental Analysis?

No. Financial RatioFormula
1Current RatioCurrent Assets / Current Liabilities
2Quick Ratio(Total Current assets - Inventory - Development Cost) / Current Liabilities
3Inventory TurnoverAnnual Cost of Goods Sold / Inventory
4Average Collection PeriodAccount Receivable / (Annual Credit Sales/365)
5Average Payment Period(Account Payable / Annual Purchase) * 365

6Total Asset TurnoverSales / Total Assets
7Debt RatioTotal Debt / Total Assets
8
Time Interest Earned
Operating Profit / Interest Expenses
9Fixed Payment Coverage Ratio(EBIT + Fixed Charge(Before Taxes) ) / (Fixed Charge (Before Taxes) + Interest)
10Gross Profit MarginGross Profit / Sales
11Operating Profit MarginOperating Profit / Sales

A few elements of quantitative fundamental analysis are:

i) Earning per share (this measures profitability): Earnings per share (EPS) is a company's net profit divided by the number of common shares it has outstanding. EPS indicates how much money a company makes for each share of its stock and is a widely used metric to estimate corporate value.

ii) P/E ratio: According to Wikipedia, the price-earnings ratio, also known as P/E ratio is “the ratio of a company's share price to the company's earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued.”

P/E = Share Price/Earnings per share

iii) P/B ratio: The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's current market price to its book value. P/B ratios under 1 are typically considered solid investments.

iv) Debt/Equity ratio: The debt-to-equity (D/E) ratio is calculated by dividing a company's total liabilities by its shareholder equity. These numbers are available on the balance sheet of a company's financial statements.

v) RoE ratio: The return on equity is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on assets minus liabilities.

ROE = Net Income / Shareholder’s Equity

These are among the few fundamental indicators that help you understand deeper about the company/stock.

Top-down vs. Bottom-up Fundamental Analysis

Fundamental Analysis can be either top-down or bottom-up. An investor who follows the top-down approach starts the analysis with the consideration of the health of the overall economy. By analyzing various macroeconomic factors such as interest rates, inflation, and GDP levels, an investor tries to determine the overall direction of the economy and identifies the industries and sectors of the economy offering the best investment opportunities.

Afterward, the investor assesses specific prospects and potential opportunities within the identified industries and sectors. Finally, they analyze and select individual stocks within the most promising industries.

Alternatively, there is the bottom-up approach. Instead of starting the analysis from the larger scale, the bottom-up approach immediately dives into the analysis of individual stocks. The logic of following the bottom-up approach is that individual stocks may perform much better than the overall industry.

The bottom-up approach is primarily concentrated on various microeconomic factors such as a company’s earnings and financial metrics.

Six steps while analysing fundamentals of a company

To begin with fundamental analysis, you should study following fundamental indicators:

  • Understand the company
  • Use the financial ratios for initial screening
  • Closely study the financial reports of the company. This includes balance sheets, income statement, cash flow statement, quarterly earnings, projected future earnings, etc.
  • Find the company's competitors/rivals and study them
  • Check the company’s debt and compare with rivals
  • Analyse the company’s future prospects.

Price to Earnings Method in Fundamental Analysis

This measure is a popular method of calculating Fundamental Analysis. To find the price-earnings ratio, divide the stock's current price by its earnings per share.

Price-Earnings Ratio = Current Stock Price/ Earnings per Share

Let’s understand this with the help of an example: 

If a stock is selling for Rs 28 now and its earnings last year were Rs 7 per share, the P/E ratio would be 4 (28/7=4). That means for every rupee the stock earns, investors are currently willing to pay Rs 4. 

However, investors also pay for future earnings. If the same Rs 28 stock is expected to earn Rs 10 a share next year, then the P/E ratio would be 2.8 (28/10 = 2.8). The idea is to find stocks with a significantly lower P/E ratio than others in its category. That category could be almost anything, from an industry group (i.e.; financial stocks) to high-yield securities, or many others.

What are the pros and cons of fundamental analysis?

Advantages

#1 Complete view of financial health of a company: Fundamental Analysis is very useful for a long term investment approach. Also, with stock fundamental analysis, you can evaluate the health and performance of any organisation through crucial numbers and major economic indicators.

#2 Helps in making a prudent investment decision: As an investor it helps you in making a better investing decision. It helps you gather the right information and make rational decisions.

#3 Predicts future: Fundamental analysis helps you to predict future price movement and gauge whether a stock is undervalued or overvalued.

#4 Helps detect red flags: Through fundamental Analysis, you can easily detect red flags about financial statements of a firm that serves as a warning about possible potential problems with the company and its stocks in the future.

Disadvantages

#1 Time consuming: In terms of disadvantages, Fundamental Analysis involves a lengthy and complex process so patience is key.

#2 Needs skills and knowledge: While analysing stock market fundamentals, one tends to count on assumptions, which could be right but if you have limited knowledge or are inexperienced, you may go wrong.

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