What is Fundamental Analysis & How to Do It?
We think that the stock market is an easy place to make money. Right? Well, not really! Investing in the Stock Market is a prudent option but not an easy task for generating supplementary wealth, particularly in a changing interest rate scenario. Investing is becoming more accessible every day because of the technological advancement we witness every day. Do approach every stock trade but before you make a trade, you’ve got to build a case for why it’s a solid idea- and fundamental analysis must be part of that process.
The analysis- be it fundamental or technical, helps you decide whether a stock is a good investment or not. With proper analysis and the right investment, you can open a door to wonderful returns in the stock chosen. Eventually, your dream of making tremendous wealth may come true.
What is Fundamental Analysis?
Fundamental analysis (FA) is the process of evaluating a company's qualitative and quantitative factors to determine the actual value of the securities it has issued. FA comprises estimations based on various components related to stock, consisting of company financial statements, news releases, the global industry, competitor analysis, and more.
If the company's fundamental indicators unveil data that has a bad impact, this is likely to reflect the share price negatively. On the contrary, if it represents a positive data release, such as an outstanding earnings report, this can increase the stock price of that specific company.
Besides, it covers the analysis of the macroeconomic factors like the industry conditions, and the entire economy of the country.
Learn fundamental analysis of a stock in detail with our course on fundamental analysis.
Why Fundamental Analysis is Important
Most investors depend on the financial data available to make decisions while investing in stocks. It is so because the financial data illuminated in monetary contexts is the easiest way to judge success and predict the company's future.
With the means of comparison, it lets you determine who is outperforming in the market. We can judge only by comparing one thing with another. Making preferences without considering two or more alternatives is quite difficult.
FA is pivotal because it renders reliable and consistent information. With the help of FA, we can measure the intrinsic value of a security. DCF (Discounted Cash Flow) method is a common valuation process for determining a company's intrinsic value.
The DCF model considers a company's free cash flow and the weighted average cost of capital accounting for the time value of money. Such intrinsic value is then compared to the market value of the security. If stocks are traded less than the intrinsic value, then it is wise to buy the stock. In a nutshell, fundamental analysis teaches you the concept of value investing.
What are the Types Of Fundamental Analysis?
There are two types of Fundamental Analysis:
- Qualitative Analysis: It is concerned with the quality or character of something. It mainly consists of factors like the business model, competitive advantage, management analysis, and corporate governance.
- Quantitative Factors: It focuses on numbers found in reports such as financial statements, profit & loss statements, balance sheets, etc. It mainly includes factors such as balance sheet, income statement, and cash flow statement.
Fundamental Analysis vs Technical Analysis
Both FA and TA are used to analyze the stock’s performance. However, they differ from each other in several aspects as follows:
Fundamental Analysis Tools
Essentially, there are six types of fundamental analysis tools:
Earnings Per Share
Known as EPS, in short, Earnings Per Share is a highly valuable tool for conducting the FA. It defines the number of a company’s profits allotted to each outstanding stock share.
There are two formulas for computing earnings per share:
- Formula One:
EPS = Net Income / Total Number of Shares Outstanding
- Formula Two:
EPS = Net Income / Weighted Average of Shares Outstanding
It is also known as the P/E ratio. It allows you to look at the relationship between the stock price and EPS. It can provide you with an idea of the market expectations and the company’s value based on their earnings.
P/E Ratio = Market Value per Share / EPS
Price/Earnings-to-Growth (PEG) Ratio
It helps in determining the stock’s value while also considering the anticipated earnings growth. A few investors consider it a more robust indicator than the P/E ratio alone.
PEG = P/E ratio / Earnings Growth Rate (within a specific time period)
Price-to-Book (P/B) Ratio
The P/B ratio considers the current book value per share relative to the stock price. Book value is the company’s total assets minus outstanding liabilities. Mainly, this ratio could be an indicator of stocks that are undervalued.
P/B Ratio = Market Price per Share / Book Value per Share
Dividend Payout Ratio
Sometimes, this is simply known as the payout ratio. It can help you determine the number of dividends issued to shareholders pertinent to the net income of the company. Besides, it renders an idea of how much the company will pay shareholders to how much it’s keeping on hand. If the company is utilizing the retained fund for investing in future growth, a lower dividend isn’t a bad thing. In fact, it can let you have a better picture of the company.
Dividend Payout = Net Income / Dividends Paid
It determines the ratio of the annual dividend pertinent to the per-share price. Typically, high yield follows high dividends. So, this can be a sign of high earnings. Obviously, this isn’t the case always- it could be because of the reason that stock is actually losing value.
Dividend Yield = Annual Dividend / Current Share Price
Return on Equity (ROE)
It’s a method of evaluating a company’s performance based on its shareholder’s equity and net income. With ROE, you can determine whether the company is effectively using its assets for generating profit or not.
Return on Equity = Net Income / Average Shareholder Equity
How Do You Perform a Fundamental Analysis?
In case you are wondering- what’s the process of fundamental analysis, then you must follow the six simple and essential steps as described below:
Step 1: Employ Financial Ratios for Preliminary Assessment
It’s strenuous to read the financials of over 5,500 stocks listed on the Indian Stock Exchange. A better approach is to first shortlist the best companies based on specific criteria. Then, study the screened companies individually to pick the one that suits your choice. You can use several financial ratios such as PBV ratio, P/E ratio, CAGR, ROE, Dividend Yield, Current Ratio, etc.
Again, calculating them one-by-one would be a time-consuming task. So, you can use different websites such as Moneycontrol, Tickertape, Screener, etc. for readymade financial ratios.
Step 2: Investigate and Perceive the Company
After screening, the next step is to understand the company which is crucial. It is so because if you don’t understand the company, you won’t be able to figure out whether it is performing good or bad or if it’s making the appropriate decision towards its future goal or not, and more. Moreover, you will also come to know how it is doing as compared to its competitors. Most importantly, you will know whether you should hold the stock or sell it off.
You must know about its founders/promoters, products/services, competitors, management efficiency, etc. The simplest way to find all such info is to visit the company’s website and read out ‘About’, ‘Products’, ‘Board of Directors’, ‘Mission and Vision’, etc. If you find them appealing, you can move on with it.
Step 3: Analyse the Company’s Financial Report
Now that you have understood the company and found it impressive, the next thing you need to do is to check its financial report. It covers the company’s Balance sheet, Profit & loss statements, and cash flow statements.
As a thumb rule, you can consider the net profit, revenue/sales, and margin increasing for the last five years a healthy sign. Then, you must also examine other financials like expenses, operating costs, assets, liabilities, etc. You can easily find the financial reports of the company on Moneycontrol.com or Screener.
Step 4: Examine the Company's Debt
One of the biggest factors to check prior to investing in a stock is the company’s total debt. If the company is under a huge debt, it can’t perform well and reward its shareholders. It must repay the debt along with interest on the borrowed money before anything else. In short, you must ignore companies with huge debts. According to the thumb rule, you must invest in stocks with a debt/equity ratio of less than one.
You can use this ratio either during the stock’s initial screening or while reading the company’s finances. Additionally, other red flags can be consistently declining profit/margin, pledging of shares, and low liquidity.
Step 5. Identify the Company’s Competitors
Before investing, it’s always wise to study the company’s rival and determine what this company is doing that its peers aren’t. You can find the list of the company’s competitors on the Screener website. Just enter the company’s name and you will find the peer comparison. Study the competitors well. Further, you must answer the question of why you aren’t investing in any of its competitors. Your answer must be convincing one like Competitive advantage, Unique Selling Point (USP), Brand Value, future prospects, more.
Step 6: Examine Company's Future Prospects
Often, good investments are based on the company’s future potential/aspects rather than their current situation. Investors seek good returns from their investments in futures. Hence, always invest in a company having strong long future prospects. Pick companies whose products or services will be still used twenty years from now.
Investing in a pen-drive or CD making company with no long term prospects won’t be a wiser move at all. Cloud drives are evolving at a fast pace which will make such products obsolete with time.
Fundamental analysis lets you make informed and intelligent trading decisions. If you want to get a clearer picture of the stock you’re going to trade, you need to scrutinize the company offering the stock. Moreover, you must have a close look at the company’s earnings, news/happenings, and evaluate its overall health. Basically, such an analysis is suitable for long-term investors.
Obviously, the FA shouldn’t be the final deciding factor alone but you must combine it with technical analysis. Technical analysis will help you through stock charts and price action. Spying on securities from various angles, you can make yourself better informed and primed to sniff out hot stocks.
In case you have any questions related to the described topic, do let us know in the comment section. We will get back to you sooner!
For more in-depth detail on the fundamental analysis of stock, we suggest you go for our free module on fundamental analysis. We have covered a lot of related things in different chapters.
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