So what is Fundamental analysis ? in this article we will discuss the fundamental analysis of stock and its all aspects.
Broadly there are 2 types of people in the Stock market. One of them is traders: who used to buy and sell stocks on the basis of their movement. Usually their time frame range from some minutes, hours, days to a maximum of a few months.
The other ones are Investors who used to buy and sell stocks of a company on the basis of the business. Here comes the role of Fundamental analysis.
What Exactly Meaning Of Fundamental Analysis Of Stocks?
Fundamental analysis is nothing but the analysis of business along with its financial performance of the business or company to determine the current valuation of such business/ company and also the potential of its future growth before making a decision of investment.
If a person wants to buy a stock, he has to understand which business or the company is doing well before investing money or whether the company or business going well in which he wants to buy a stock because of the simple reason that no person would invest money where it has a probability of loss.
This understanding or determining before investing money in any stock of a company is known as fundamental analysis.
Two Types Of Fundamental Analysis:
Fundamental analysis is a method of making Investment after analyzing the business and its financial performance in order to understand its current valuation and future growth potential.
Broadly it is divided into two types Qualitative and Quantitative.
Qualitative analysis is the form of analysis that can’t be done in the form of numbers or amounts, Such as:
To Understand the business model let’s see the concept of the “Circle of Competence” Model Given by Great Investor Warren buffet.
Do you understand the business model of HUL?
Yes, they make quality FMCG products, such as shampoo, soap, detergent, and Tea, etc. Maybe you use some products of them. What you think about the product is it good enough? If yes then it lies in your circle of competence.
They have a strong brand trusted by many allowing them to charge a premium price from their customers. how do you see HUL 10 years from now? Or let’s say how you see FMCG products demand in coming years.
As there is a growing demand for products and some players in the market that can compete with HUL, I think HUL will continue to be a market leader for the next 5 to 10 years.
Now let’s look at another business UPL.
Do you understand their business model? Not very clearly, but, they produce Agrochemicals and chemical intermediates. How do you see UPL 10 years from now?
It’s hard to say if they will remain market leaders 10 years from now as there are many other players like Kaveri seeds and Avanti feeds etc.
It depends upon you that which business model is much easier for you to understand Which Business model falls under your Circle of competence.
If one says that management is the most important criterion for investing in a company then it’s not incorrect. Even the best business model can be collapsed if the leaders of the company fail to properly manage the firm.
While it’s hard for retail investors to meet and truly evaluate managers, you can watch their meetings at Quarterly and annual results meetings also look at the corporate website, and check the resumes of the board members.
Now For Example, if a company says “We expect to see exponential growth in the coming years” but fails to answer “How?” better be careful with such companies, chances are they may not have any plans at all.
On the other hand, if a company says “We expect to be debt-free in the coming 5 years” and presents a concrete plan on how it is going to achieve them, you can trust the honesty of the management.
If you observe a successful business is always forward-looking in nature. A good business should have a futuristic approach along with forward-looking management. This helps the business to survive in a competitive environment.
For example, forward-looking management, Reliance Industries a leading Conglomerate company of India lead by the richest Indian Mr. Mukesh Ambani, understood earlier that Petrochemical business will not be sustained.
After a few years by now, that’s why they expanded not only into the retail and sales segment (by Reliance Retail) but also Telecommunications (by Reliance Jio) Because these businesses have a very high growth potential in the coming years.
One more thing that matters is the brand image of the Company in the market. If a Business have a great brand image it is easier for the business to expand, launch new products & services or win contracts.
For example again in the case of Reliance Jio, Since it was having a great pedigree and brand name of Reliance Industries. It was easier for it to expand and survive in its initial years.
One fact to be considered is that every person can have totally different perspectives toward a company’s business model, Brand Image or Product & services, etc.
If one develops a positive bias towards the company based on their positive experience with the company’s product or services, then at the same time another person may have negative biases based on their past experiences.
For example one would like to Invest in HDFC bank based on his good experience at the same time another person faced issues with the bank’s services, so he don’t want to invest in such management or Company.
This is the major limitation of the qualitative analysis that it consists of an emotional factor.
It is the analysis of the company related to information that can be shown in numbers and amounts. Understanding the numbers is the most important part of Quantitative analysis. It is consists of
The balance sheet also referred to as the statement of financial position, reports the financial position of a business at a point of time. This information is reported at a point of time, It is based upon the accounting equation and reports the assets, liabilities, and equity of the business.
At all times Assets = Liabilities + Equity (A = L + E) on the balance sheet and in the accounting system. Companies issues balance sheets quarterly and annually. As an Investor one should read the balance sheets of the company and do his personal analysis.
An income statement is a sheet of information that presents the revenues, expenses, operating profit, and net profits generated by the business in a particular time period.
The income statement is also known as the Profit And Loss (P&L) statement.
In general business use, the term ‘cash flow’ refers to the flow of cash in and out of the business and the ability of a business to have cash in hand to pay its financial obligations. A good Cashflow predicts the good financial health of the business.
The cash flow statement describes how much real cash is in the hands of a business, It is easy for businesses to manipulate the P&L statement but they can’t manipulate the cash flow statement.
Check The Financial Ratio During Fundamental Analysis Of Stocks
Price To Earning Ratio(PE Ratio)
The price-to-earning ratio (PE Ratio) is the measure of the share price relative to the annual net income earned by the firm per share.
PE ratio shows current investor demand for a company share. A high PE ratio generally indicates high demand because investors believe that the business will continue to grow in the future.
In this case, the stock may be overvalued because everyone is willing to pay a premium for the stock, and because of which the price of the stock continues to rise.
At the same time, a low PE ratio doesn’t mean a bad company but indicates a share at discount. Or perhaps investors are not optimistic about the future growth of the business that’s why investors are not willing to pay a premium for the stock. In this case, the stock may be undervalued
The PE ratio has a history of years, which can be interpreted as the number of years of earnings to pay back the purchase price.
Debt To Equity Ratio
The debt-to-equity ratio shows the relationship between a company’s total debt and its total equity. It Indicates how much of the company’s equity is in debt or simply of Loan.
Generally, debt to equity ratio less than 1 is considered safer whereas a more than 1 is considered dangerous. The debt-to-equity ratio is a key measure for investors looking to a company’s financial health.
If a company has a huge debt or debt to equity ratio is greater than 1, it reflects that a company is not performing well. It is advised to ignore the company having heavy debts.
Return On Equity (ROE) Ratio
The Return on Equity ratio measures the rate of return that an Investor receives on their shareholding in the company. Return on equity signifies how good the company is in generating returns on the investment it received from its shareholders. Generally, a 15% plus ROE ratio is considered good.
Price To Book (P/B) Ratio
The price-to-book ratio (P/B ratio) measures a stock price against a company’s book value its fundamental worth. Generally, a PB ratio less than 1 Indicates an undervalued share price of the stock and vice versa.
The point to be considered is “Quantitative analysis requires analysis of the hard- facts of the company because all the information are facts and can be understood in the form of numbers. So, Every Investor will have a common perspective on the Company.
Concept Of Intrinsic value
Even after doing all the analysis one is confused if this is the right price to buy the stock or is it still overvalued? Here comes the role of intrinsic value.
The intrinsic value of a stock is called its true value. It is the value of the stock at its lowest. This means from this point of time there are very rare chances of it’s crashing. It is very hard to find a stock that is trading at its intrinsic value but if one does it, it provides an upper edge in Investing.
With this above discussion, we can definitely reach to a conclusion that the fundamental analysis can be clearly understood as the analysis of health as well as the growth of the company because it is an evaluation of qualitative as well as the quantitative factors of the company.
This analysis gives the idea of whether a company is earning profits, whether it is repaying debts, whether the stock of the company is a good investment, or whether the company possesses enough capital for expanding in the future.
With all this, it can also be inferred, at last, that it becomes pretty easier to decide whether to make an investment or not with the process of fundamental analysis of a stock. Performing this analysis of Indian stocks is not that difficult, it may definitely take time but as the saying “good things take time” makes it worth it.