AN IN-DEPTH FUNDAMENTAL ANALYSIS
Welcome to the first chapter of our second module. We will start with the basics of fundamental analysis.
What is Fundamental Analysis?
Fundamental analysis is a holistic approach to study businesses or stocks before investing in them. Whenever you think of investing in a business, it becomes obligatory to understand and analyze that business from various perspectives. It is pretty essential for an investor to segregate the daily short term noise in the stock prices and focus on the underlying business performance.
The stock prices of a fundamentally powerful company tend to appreciate over the long term, thereby creating wealth for its investors. You will find many such instances in the Indian market.
To name a few, you can think of companies such as TCS Limited, Eicher Motors, Nestle India, Infosys Limited, etc. Each of these companies has rendered an average of over 20% CAGR (Compounded Annual Growth Rate) year on year for over 10 years. An investor may double his money at a 20% CAGR in roughly about 3.5 years.
Hence, the higher the CAGR faster would be the wealth creation process. Some companies like Bosch India Limited have rendered about 30% CAGR. Thus, you can wonder the magnitude and the pace at which wealth is created if one invests in a company that is fundamentally strong.
Qualitative and Quantitative Fundamental Analysis
While defining the word fundamental, it’s quite strenuous to stay specific as it can cover anything pertaining to the economic well-being of a company. Obviously, they include numbers such as revenue and profit, but they can also consist of anything from the market share of a company to the quality of its management.
Qualitative analysis is related to the quality or character of something. Mainly, it uses utilizes subjective judgment for analyzing a company’s prospects and value based on non-quantifiable information. This may include industry cycles, management expertise, labour relations, and strength of research and development.
In contrast with qualitative analysis, the quantitative analysis focuses on numbers found in reports such as balance sheets, profit and loss statements, financial statements, etc. To be more precise, it utilizes mathematical and statistical modelling, research, and measurement to understand behaviour. Usually, quantitative analysts represent a presented reality in terms of numerical value.
How does Fundamental Analysis Work?
Fundamental analysis particularly emphasizes on specific metrics or factors to determine whether a stock’s value is realistic or not. Below, we have mentioned a few metrics or fundamentals that can be used for analyzing a stock.
Earnings per share (EPS): EPS means earnings of a company for each share of stock issued.
Price-earnings (P/E) ratio: The P/E ratio of a stock compares the share price of the company to the earnings per share.
Projected earnings growth (PEG): This number evaluates one-year earnings growth of the stock.
Dividend yield: The dividend yield indicates the paid out share over a set time period of typically one year, in case a stock pays dividends to shareholders.
Price-sales (P/S) ratio: This expresses how the price of a stock compares to its company revenues.
Return on equity: Return on equity is the outcome of dividing the net income of the company by its shareholders’ equity.
Such kind of analysis looks inward rather than outward for assessing the quality of an investment. All of such metrics are quantifiable. This means you can eye on hard numbers and compare them before making any investment decision. There are some other metrics as well that you may wish to consider, though you can’t essentially assign a number to them. For example, you might measure the company’s value in the context of its brand visibility, the experience or quality of its executive board, the overall business model of the company, and its approach to corporate governance.
As fundamental analysis works on stocks, it can also be applied to bonds, mutual funds, or other securities.
So, this was all you needed to know about what fundamental analysis and how it works.
In the next chapter of the module, we will discuss why management analysis is so important.