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Introduction to fundamental analysis
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.
To start trading, open a demat account with Nirmal Bang and get access to more details about stock markets and trades.
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.
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
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