Fundamental Analysis

TABLE OF CONTENT

What is Fundamental Analysis and How Your Stock Investments Can Benefit ?

Fundamental analysis is a process of understanding the workings of a business at its most basic i.e. fundamental financial level. This is done by looking at various fundamental indicators and parameters. Fundamental Analysis of a business helps understand the basic premise on which the said business rests.

One of the biggest worries of any stock investor is that they are overpaying for a stock. Unlike grocery items or dishes in a restaurant, stocks do not come with a fixed price tag. You buy a stock based on current market price for the trade. What is the true value of a stock? For example, if you are buying HDFC Bank shares at Rs 2200, are you paying more or less compared to its true value. The answer to such questions can be received if you do fundamental analysis.

Fundamental analysis examines the key ratios of a business in a way to determine its financial health. So, at the end of the process, you a fair idea of what should be the price of company's stock. This tells you whether your purchase price was more or less. As a thumb rule, always remember that when you buy a stock at its fair value or less than that, you stand to make profits because the market price always is more than fair value.

Introduction to fundamental analysis

Fundamental analysis is a method of evaluating the intrinsic value of a stock. This form of analysis combines external events and influences, as well as financial statements and industry trends. Remember the intrinsic value/fair value of a stock does not change everyday. To understand what is that fair value, you should take the help of fundamentals, which are what drives prices up and down.

Fundamental analysis uses three sets of data. One, historical data is used to know things were earlier. Two, publicly known information about the company including announcements made by the management, and what others are saying about the company. Three, information that is not known publicly but is useful i.e. instances of how management handles crises, situations etc.

Fundamental analysis is a way to avoid short-term information about a company/stock. Every day there is some news on stocks. While these information may form the basis of trades, not everyone in the stock market is a trader. Many people believe in long-term investing. They want to buy and hold stocks.

Fundamental analysis helps you identify attributes of companies. The process of fundamental analysis will require you to understand a bit of mathematics, business and accounting basics. Along with this, you will need to have some common sense of how the company operates, the industry/sector and other things that can be imbibed from various documents.

When you buy a banana from the market, you pay a price that you think is right. If a fruit seller asks you to pay Rs 50 for a banana is that right? In the same way, if a banana is available for 50 paise is that right? You know that one dozen of bananas should cost Rs 40-50. So, per banana cost is about Rs 4. So, if the banana is available at a steep discount or steep premium, there must be valid reasons why the asking price is such. When you go to buy a stock, for example Infosys, you know the current market price is Rs 780 per share. This price is only the market price i.e. some seller must be asking for this rate to sell the Infosys stock.

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 Infosys stock is Rs 900, buying it for Rs 780 is logical. On the other hand, if the true value of Infosys stock is Rs 700, buying it at Rs 780 is not a good deal for you.

Fundamental analysis and various stock fundamental reports tell the investor what is the true value or fair value. Hence, you know whether you are entering a good deal for the buyer or the seller. If the current market price is lower than the fair value, also called intrinsic value, then the company/stock is said to be undervalued. 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.

All good stock brokerages have their research desk. The research desk contains analysts who do fundamental analysis of stocks they cover. A fundamental report of a company/stock covers these in detail and so these are among the benefits of fundamental analysis.

These reports are usually 5-10 pages long. They discuss the company's financial results, give data on the company's historical profit & loss as well as balance sheet. There is also a valuation view provided so that investors can know how much are they paying for the stock given its prospects. Some charts and graphics are also present in each fundamental report.

At Nirmal Bang, you can get free fundamental reports of stocks. By reading them, you can understand what is Nirmal Bang recommendation and what is the target price for the stock.

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Many investors are confused between two terms - technical analysis and fundamental analysis.

Fundamental analysis of a company seeks to make a studied guess on the cash flows of a company based on how the economy, industry and the company will perform. Once this is done, the investor gets an idea of what the company/stock is actually worth.

Technical analysis, on the other hand, is very different. It focusses on internal market data such as price and trade volume. The focus of technical analysis is on identifying patterns and trends that will repeat so that the trader can capitalize on them.

Here is a table enumerating the key differences.

Factor Fundamental analysis Technical analysis
  • What is
  • Calculate stock real value
  • Predict future price movement
  • Done with the use of
  • Financial data, company and sector information
  • Price, trading volume data
  • Time horizon for analysis
  • Long term
  • Short term
  • Suitable for
  • Investors
  • Traders

If you want to do fundamental analysis of a company, you can start by reading the annual report of the company. Always read the latest annual report and then look back at what the annual report said a few years ago.

As the name suggests, the annual report is a yearly publication. It is available online on the company's website and stock exchanges. It is sent offline to the shareholders. The annual report captures the yearly data and developments for the financial year end.

Annual reports usually provide all the fundamental indicators that you want to know as an investor. As an investor doing fundamental analysis of a company, you should look at the following sections of the annual report

  • Financial highlights
  • Management discussion & analysis
  • 10 year financial highlights
  • Director’s report
  • Report on corporate governance
  • Notices
  • Annexures (if any)

Once you read the annual report, you have taken a small step in the overall process of fundamental analysis for the company/stock. With full knowledge, you can begin your successful investing journey

The types of fundamental analysis are divided into two separate categories: qualitative and quantitative. Qualitative fundamental analysis is based on the quality of something such management, brand, products, financial performance, board etc. Qualitative analysis is a subjective opinion. For example, you feel the products of Bajaj Auto are better than those of TVS Motor Co. This is a qualitative opinion. Quantitative fundamental analysis adds numbers. The major source of quantitative data is extracted from the financial statements. It is not subjective. Both qualitative and quantitative fundamental analysis of a company are a must. You cannot do one at the expense of another.

The process of fundamental analysis can also be done in two different ways: top-down and bottom-up. Investors using a top-down fundamental analysis of a company start by looking at macroeconomic factors before working going into the individual stock. For instance, if they are looking at Maruti stock, they will look at automobiles and passenger car sector before going into the company specifics. However, bottom-up fundamental analysis is done by first looking at individual companies and then building a stock portfolio based on their specific advantages.

Fundamental analysis, as explained earlier, tells you the true value of a stock.

This intrinsic/fair value of a company/stock is the present value of all expected future cash inflows (or earnings) from that company/stock. This is what the process of fundamental analysis achieves.

The fair value represents the potential price of a company. If the market value is the same or lower than fair value, then you should buy the stock and wait. Use a fundamental report to get the fair value.

A few elements of quantitative fundamental analysis are EPS, P/E ratio, P/B ratio, Debt/Equity ratio and RoE ratio. These are among the few fundamental indicators that help you understand deeper about the company/stock.

  • Earning Per Share is called EPS. This is a measure of profitability.
  • EPS = Net Profit of The Company divided Number of Outstanding Shares
  • Price to Earnings Ratio is called P/E ratio. This is a measure of valuation.
  • P/E = Price of Stock divided Earnings Per Share
  • Price to Book ratio is called P/B ratio. This is a measure of valuation for banking and financial companies.
  • P/B = Price of Stock divided Book Value of Stock/Company
  • Debt to Equity ratio is called D/E. This is a measure of indebtedness.
  • Debt to Equity Ratio = Total Liabilities of the company divided Total shareholder’s equity
  • Return on Equity Ratio is called RoE. It is a profit measure that can be generated with the money that has been invested by its shareholders.
  • Return on equity = Net Income of company divided by Shareholder’s equity

There are 5-6 steps that you need to follow to analyse the fundamentals of a company.

  • Understand the company first
  • Use the financial ratios for initial screening
  • Closely study the financial reports of the company.
  • Find the company's competitors/rivals and study them.
  • Check the company’s debt and compare with rivals.
  • Analyse the company’s future prospects.

By studying such fundamental indicators, you begin in a good way.

The advantages of fundamental analysis are

  • Very useful for long term investment approach
  • Gives a complete view of financial aspects of a company

The disadvantages of fundamental analysis are

  • Financial data is required and cannot be analysed by all
  • Involves a lengthy and complex process so patience is key

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