Fundamental analysis and technical analysis are two common ways to sort and pick stocks. How and when to use them can be a matter of personal style, but each has its strengths.
Fundamental analysis attempts to identify stocks offering strong growth potential at a good price by examining the underlying company’s business, as well as conditions within its industry or in the broader economy.
Technical analysis, on the other hand, bypasses the underlying company’s fundamentals and instead looks for statistical patterns on stock charts that might foretell future price and volume moves.
If you are looking to bag some multibaggers or invest in shares on a long-term basis, it is imperative for you to use multiple lenses to gauge the company and its potential.
When investing for the long term, you cannot solely depend on the daily changes in its stock market price. Your purchasing decision should come from something far more concrete. There are several methods that most long-term investors use in determining if a particular stock is worth your purchase and one of the most effective ways is fundamental analysis.
What is Fundamental Analysis?
Fundamental analysis is a method used by investors to identify the intrinsic value of a stock.
The current price of a stock may not always reflect the true value of the stock / performance of the company. The stock may be overvalued or undervalued in the market. Fundamental analysts study the underlying health of the company in order to find the intrinsic value.
This is done by using various qualitative and quantitative factors such as the company’s revenues, profit margins, return on equity, future growth potential and other metrics. The main purpose of this method is to identify companies that are fundamentally strong in order to invest in them for the long term.
What are the Different Types of Fundamental Analysis?
There are two main types of fundamental analysis –
- Qualitative: a study that involves brand value, management decisions, the financial performance of the company over a given period, and other similar factors.
- Quantitative: an analysis that is more number-based and considers the company’s financial statements and derives the share value from these observations.
Though the approaches are different, they are equally crucial for a comprehensive analysis of a company’s share price. Fundamental analysis can also be done with a top-down or bottom-up approach:
- The top-down approach looks into the macroeconomic factors first and then digs into a specific company.
- The bottom-up approach analyses the company first and then checks the effect of macroeconomic factors on the company’s performance.
What are the Basics of Fundamental Analysis?
Before conducting fundamental analysis of a stock, you need to consider a few basic factors.
These factors are –
- Company’s structure and revenue
- Company’s profits over the years
- Revenue growth over the years
- Company’s debt
- Corporate governance
- Rate of turnover
- And more
Analysts look at these factors while conducting a fundamental analysis of any security and determine its intrinsic value.
How to Do Fundamental Analysis of a Stock?
While there is no single standard method to perform fundamental analysis ( stock trading is not as straightforward as solving a mathematics problem), you can certainly follow broad guidelines as you build your instinct and processes with experience. It is also important to understand that the same information may reflect different perspectives for different industries and stocks. Here are some key steps to start that you should learn to begin performing fundamental analysis of your target companies:
- Understand the company, its operations, business model, etc.
- Use the financial ratios for initial screening (see our blog here for detailed knowledge on financial ratios)
- Closely study the financial reports of the company.
- Find the company’s competitors/rivals and study them.
- Check the company’s debt and compare it with rivals.
- Analyze the company’s prospects.
EPS, P/E ratio, P/B ratio, Debt/Equity ratio and RoE ratio are among the few fundamental indicators that help you understand deeper about the company/stock.
1. EPS: Earning Per Share (EPS) is a measure of profitability.
EPS = Net Profit of The Company/ Number of Outstanding Shares
The higher the earnings per share, usually the better is the financial performance of the company, and in principle the better the stock should perform.
What is considered as a “good” EPS depends on a variety of factors, including but not limited to the recent performance results of the company, the performance of its competitors, and importantly, the expectations of the market participants/analysts. It may happen that even after reporting a growing EPS, the company’s
stock can drop in price if the markets were expecting an even higher number.
Similarly, a shrinking EPS might still lead to a price surge if analysts were expecting an even worse result. It is important to always judge the EPS in relation to the company’s share price, such as by looking at the company’s P/E (as explained below) or earnings yield.
2. P/E Ratio: Price to Earnings Ratio (P/E ratio) is a measure of valuation.
The P/E ratio shows whether a share of stock pays well compared to its price.
P/E = Price of Stock/ Earnings Per Share
Hypothetically, for XYZ company the price/share is Rs.100 and the stock pays Rs.10 earnings per share. The P/E ratio of the stock is Rs.10.
Lower the P/E ratio, higher is the earnings which in turn makes the stock a profitable deal.
If the P/E ratio is too low as compared to the competing firms, this might mean that the stock could be undervalued, and has good potential for a future price rise.
3. P/B Ratio: Price to Book ratio (P/B), is a measure of valuation for banking and financial companies.
P/B = Price of Stock/ Book Value of Stock
Imagine if a company is worth Rs.100 crores and has 5,000,000 shares outstanding, it will have a book value/share of Rs.200.
If its stock trades at Rs.800/share, then the P/B ratio comes to be 4.
P/B ratio greater than 1, means the stock is growing at a faster pace than its book value suggests. P/B ratios equal to more than 100 are often seen in high growth stocks.
4. RoE Ratio: Return on Equity Ratio (RoE), is a profit measure that can be generated with the money that has been invested by its shareholders.
RoE = Net Income of company/ Shareholder’s equity
ROE is generally displayed in percentage. Higher the earnings per share, the healthier the company, so better the stock is likely to perform.
Pros and Cons of Fundamental Analysis
Just like every other thing, fundamental analysis has its pros and cons. The advantages are:
- Helps development of a thorough understanding:
Stock fundamental analysis helps in the development of a rich understanding of the business where you are about to invest your hard-earned money. It helps you gather the right information and make rational decisions about the position to take.
- Limited room for biases:
Investment decisions can go wrong due to cognitive biases (see our blog here for detailed knowledge on cognitive biases and how you can avoid them while participating in the stock markets). However, crude numbers at your disposal limits room for personal biases, essential for wealth creation in the long run. Rather than establishing entry and exit points, this analysis helps you take a long-term view of the markets.
- Helps detect red flags, (if any):
Through fundamental research and analysis, you can easily detect red flags about financial statements of a firm that serve as a warning about possible potential problems with the company and its stocks in the future. In the long-run, this prevents your wealth from being destroyed.
The cons of analysing stock market fundamentals are:
- Time-consuming and tedious:
This is perhaps the biggest disadvantage of fundamental analysis of stocks. You need to analyse several areas, which makes the entire process tedious and time-consuming. At the same time, you need to periodically monitor all the financial data related to a firm and other economic indicators that may impact its performance negatively.
- Too many assumptions:
Often while analysing stock market fundamentals, one tends to make too many assumptions and interpretations. These require skills, learning, knowledge and experience. Without them in your arsenal, you can go wrong with your analysis.
- Doesn’t take into account the herd mentality:
Sometimes herd mentality and emotions result in bull and bear phases of the stock market and affect stock prices that may be missed during analysis. You may end up purchasing a fundamentally-sound stock at the wrong time and watch it going down or remain stagnant for a long period.
Like any other investment strategy, the fundamental analysis does not guarantee a cent percent accurate result. Unlike the usual perception of it being useful only for experts, any investor can utilise it to understand their investment decision.
Now when you are very well aware and know how to take the first steps towards the fundamental analysis of any stock, consider making your first (or next) investment with ShareIndia.
Disclaimer: Any Advice or information in the post is general advice for education purpose only and is not responsible for generating any trading profits for anyone, please do not trade or invest based solely on this information.