What is the fundamental analysis of stocks? A beginner’s guide

Introduction:

When considering stock investments, you aim to make smart choices, right? To ensure your decision adds value to your portfolio, it’s essential to analyze the market, the company, and all the details about its stocks. This analysis needs to be organized and focused to reach a valid conclusion. 

That’s where analysis methods come in—technical analysis and fundamental analysis. This article will explore one of these methods: the fundamental equity analysis. What is it? And how do investment advisory services use fundamental analysis? Let’s understand. 

What is Fundamental Analysis?

Fundamental analysis is important for investors and traders because it looks beyond short-term price changes to understand what drives a company’s performance. It helps determine a company’s true value by examining financial statements that reveal profits, liquidity, and financial health. This approach also assesses management quality, industry trends, and competitive advantages to estimate intrinsic value.

Through fundamental analysis, you can also answer the question, ‘How to find undervalued stocks with strong growth potential? Evaluating factors like market share and sales growth allows you to uncover long-term profit opportunities. Additionally, this analysis helps you spot overvalued stocks, enabling you to avoid poor investments. It becomes imperative during market volatility and economic uncertainty, guiding you to navigate risks effectively.

Fundamental analysis focuses on three main areas:

• Economic analysis: Examining broad economic indicators like GDP growth, inflation, and interest rates.
• Industry analysis: Studying industry trends, competition, and growth prospects.
• Company analysis: Reviewing financial statements, management quality, and competitive position.

Fundamental Analysis Vs. Technical Analysis:

As soon as we answer, ‘What is fundamental analysis?’, the immediate question is, ‘How is it different from technical analysis?’ 

Investors use two main methods to make market decisions: technical analysis and fundamental analysis. Both aim to predict market movements but differ in approach. Technical analysis focuses on past price data and patterns to make predictions, while fundamental analysis looks at factors influencing an asset’s value, such as financial statements and industry trends. Technical analysis is more suited for short- to medium-term trading, whereas fundamental analysis is often for long-term investments.

Fundamental analysis focuses on analyzing financial data, industry trends, and a company’s performance. Technical analysis, on the other hand, studies market psychology and trend charts to find the best entry or exit points. Fundamental indicators include revenue, expenses, and financial ratios, while technical analysis uses price data, RSI, and MACD to make predictions.

Tools of Fundamental Analysis:

A] Qualitative Analysis:

Qualitative analysis focuses on non-numerical factors influencing a company, like goodwill, demand, consumer behavior, market recognition, and brand value. It also examines the company’s management, their decisions, and the socio-economic impact of the company. Since this type of analysis is often subjective, it forms the first step in fundamental analysis. To assess a company qualitatively, several key questions need answers:

• How efficient are its operations?
• What is the quality of its management team?
• How strong is its brand value?
• Does it use any proprietary technology?
• What social initiatives is it involved in?
• What is its vision for the future?

Once you’ve considered these factors, the next step is quantitative analysis.

B] Quantitative Analysis:

Quantitative analysis focuses on the measurable aspects of a business. Its main source is financial statements. This method relies on data, reports, and statistics to understand a company’s financial health clearly. It involves looking at balance sheets, cash flow, debt, quarterly performance, and financial ratios. These elements help determine a company’s shares’ overall value and potential price. You also get a better understanding of how the business is performing. Let’s break down each element of the process.

1. Financial Statements:

When checking a company’s financial health, investors often focus on the three main statements.

• Profit and Loss Statement (P&L)  

Also known as the income statement, the P&L shows how much revenue a company earned during a specific period (quarterly, half-yearly, or yearly), its expenses, and its earnings per share (EPS). It helps you understand the company’s profitability by highlighting key figures like revenue, Profit Before Interest and Tax (PBIT), and net income for the current and the previous financial years. If these figures show growth, it’s a good sign. To gain a deeper insight, investors examine net and operating profit trends over the past 5-10 years.

• Balance Sheet  

A balance sheet is a synopsis of a company’s assets, liabilities, and shareholders’ equity at a specific time. It follows the formula:  

Assets = Liabilities + Shareholders’ Equity  

This statement shows what the company owes and what it owns. The balance sheet is analyzed in combination with financial ratios like debt-to-equity and return on equity to assess the company’s financial stability.

• Cash Flow Statement:  

The cash flow statement shows how money flows in and out of a business, helping you see how liquid it is. It breaks cash movements into operating, investing, and financing activities. One key measure here is Free Cash Flow, which tells you if the company is making more money than it’s spending. A positive cash flow suggests financial growth, while a negative one raises concerns.

Together, these three statements clearly show a company’s performance and financial health.

2. Annual Report and Investor Presentation:

An annual report is a detailed document companies share with shareholders yearly . It provides insight into the company’s operations and financial health and can be used to assess how the company performed over the year. The main purpose of an annual report is to offer transparency about the company’s activities. The main sections here include the business overview, financial highlights, industry overview, Management Discussion and Analysis (MD&A), Director’s report, auditor’s report, and debt information. This data helps investors analyze the company’s performance. 

An investor presentation, on the other hand, is a concise periodical overview of the company’s performance, growth opportunities, industry trends, and future plans. Not all companies offer these, but when they do, they’re helpful tools for quickly understanding the business and its outlook.

3. Financial Ratios:

A financial ratio shows a company’s financial health by comparing different figures from its financial statements. These ratios offer insights into performance and stability. They also help in comparing a company with its competitors. Additionally, analyzing the trend of financial ratios over the years can give you a clearer picture of how the company is performing. The ratios are categorized into the following categories-

1. Price Ratios:

Price ratios help you evaluate if a stock’s market price is justified based on its fundamentals. You can assess this by comparing it to industry averages and competitors to know where the company stands compared to its peers. The price ratios to consider are-

• EPS (Earnings per Share):  

EPS (Earnings per Share) tells you how much profit a company makes for each share of stock. The higher the EPS, the more money the company is earning.

• P/E (Price-to-Earnings) Ratio  

This compares a company’s EPS with its share price to show how much an investor can pay for Re.1 of its earnings. A high P/E ratio might indicate the stock is overvalued, while a low P/E ratio could mean it’s undervalued or less attractive.

• PEG (Price-to-Earnings Growth) Ratio  

The PEG (Price-Earnings-Growth) ratio shows how a company’s P/E ratio compares to its growth rate. It helps you see if a stock is priced fairly based on how fast the company grows. A PEG over 1.0 usually means the stock might be overvalued.

• P/B (Price-to-Book) Ratio  

The P/B (Price-Book) ratio compares a company’s market price to its book value. It helps you understand if a stock is priced fairly. The stock is generally considered reasonably valued if the P/B ratio is under 3.0. A ratio close to 1.0 might mean the stock is undervalued.

2. Profitability and Return Ratios:

Profitability ratios offer insight into how well a company generates profits. A higher profitability ratio compared to competitors can give a company a competitive edge. These ratios are valuable when comparing a company’s performance with its past results, immediate competitors, and industry averages. The main profitability ratios include ROA, ROE, and the Profit Margin.

• Return on Assets (ROA) provides a quick look at how effectively a company turns its assets into income. You can calculate ROA by dividing total income by total assets.
• Return on Equity (ROE) measures how well a company generates profits for its shareholders. It’s calculated by dividing total income by total shareholder equity. A higher ROE indicates that the company effectively uses shareholders’ investments to generate income.
• Profit margin shows how effectively a business converts its sales into profits. It is calculated by dividing net income by net sales. A higher profit margin means the company retains more profit from each sale, indicating better management efficiency.

3. Liquidity Ratios:

Liquidity ratios assess a company’s ability to meet its short-term debts without raising additional capital. Low liquidity ratios indicate a lack of cash reserves that can lead to serious problems during market fluctuations. You can go through the two liquidity ratios-

• Current Ratio

The current ratio shows how easily a company can pay its short-term debts without raising additional capital. It is computed by dividing current assets by current liabilities. What’s considered a “good” current ratio really depends on the industry and competition. Retail companies, for instance, often have higher ratios, while service-based firms usually show lower ones. 

If your current ratio is below 1, it may signal cash flow challenges within the year. A ratio of 1 is generally stable, indicating no immediate liquidity risks. While a higher ratio usually sounds positive, investors may see it differently, assuming the company is holding onto too much cash rather than reinvesting in growth or distributing dividends.

• Quick Ratio

The quick ratio is obtained by taking current assets, excluding inventory, and dividing that amount by current liabilities. This ratio is an extension of the current ratio and excludes inventory. Since selling inventory can take time, the quick ratio gives a clearer picture of immediate liquidity. 

4. Leverage Ratio:

Leverage ratios, or gearing or debt ratios, show how much debt a company uses to run its business. A lower ratio means the company relies less on borrowing but might also miss out on growth opportunities with higher leverage. 

One of the main leverage ratios to analyze is the debt-to-equity (D/E) ratio. This ratio compares a company’s total liabilities to its total equity. The ratio’s center point for interpretation is 1, which says for every rupee of equity, the company has a rupee of debt. 

The ratio is interpreted with respect to the scale (i.e., 1), peers, and the industry. A lower D/E ratio signals less debt and lower risk, which lenders and investors generally favor—companies with D/E ratios higher than their industry average may need help to secure additional funding.

C] Market Analysis:

You can choose from these two strategies to approach market analysis-

1. Top-Down Approach

This method starts with a broad view of the market, often described as a “30,000-foot view.” Here, you first assess the economy’s position in the business cycle, identify the current stage of the stock market, and consider macro factors that could signal a bubble or crash. 

Many investors also examine which sectors are expanding or contracting. They narrow their investment choices once they have a clear picture of the overall market. For instance, if you notice significant risks in student loans and pensions, you can focus on industries insulated from these issues or even short (sell) the stocks that will be most impacted. 

The main distinction here is that top-down investors don’t initially favor specific securities; instead, they develop a broad market view and select investments that align with that perspective.

2. Bottom-Up Approach

The bottom-up analysis begins with individual stocks or securities. Investors evaluate a company’s fundamentals before considering its industry or the overall market. 

This method is often favored by value investors like Warren Buffett, who believes a strong company will thrive regardless of its market environment. Bottom-up investors generally have a longer time horizon and concentrate on fewer stocks to gain in-depth knowledge, whereas top-down investors focus more on industries and macro trends. 

Bottomline:

Fundamental analysis can be applied to all markets, though it’s most common in stock and forex trading. It is useful for understanding market behavior, but it’s essential to consider various indicators together, not in isolation. 

This method doesn’t generate clear buy or sell signals on its own. Instead, it measures and compares the intrinsic value of securities to help develop a comprehensive strategy. It is also better suited for long-term investing, making it less effective for predicting short-term price movements. 

While fundamental analysis offers valuable insights, it should be part of a broader strategy, including stock screener. It requires thorough research and an understanding of multiple factors to make informed decisions. It can be a powerful tool for those willing to invest the time, but it’s important to remain cautious of the limitations and risks involved.

FAQs

Disclaimer Note: The securities quoted, if any, are for illustration only and are not recommendatory. This article is for education purposes only and shall not be considered as a recommendation or investment advice by Equentis – Research & Ranking. We will not be liable for any losses that may occur. Investments in the securities market are subject to market risks. Read all the related documents carefully before investing. Registration granted by SEBI, membership of BASL & certification from NISM in no way guarantee the performance of the intermediary or provide any assurance of returns to investors.