FUNDAMENTAL ANALYSIS OF A COMPANY
INTRODUCTION
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 (FA) is a holistic approach to study a business. When
an investor wishes to invest in a business for the long term (say 3 – 5 years)
it becomes extremely essential to understand the business from various
perspectives. It is critical for an investor to separate the daily short term
noise in the stock prices and concentrate on the underlying business
performance. Over the long term, the stock prices of a fundamentally strong
company tend to appreciate, thereby creating wealth for its investors.
We have many such examples in
the Indian market. To name a few, one can think of companies such as Infosys
Limited, TCS Limited, Page Industries, Eicher Motors, Bosch India, Nestle
India, TTK Prestige etc. Each of these companies have delivered on an average
over 20% compounded annual growth return (CAGR) year on year for over 10 years.
To give you a perspective, at a 20% CAGR the investor would double his money in
roughly about 3.5 years. Higher the CAGR faster is the wealth creation process.
Some companies such as Bosch India Limited have delivered close to 30% CAGR.
Therefore, you can imagine the magnitude, and the speed at which wealth is
created if one would invest in fundamentally strong companies.
Here are long term charts of
Bosch India, Eicher Motors, and TCS Limited that can set you thinking about long
term wealth creation. Do remember these are just 3 examples amongst the many
that you may find in Indian markets.
TOOLS
OF FUNDAMENTAL ANALYSIS
The tools required for
fundamental analysis are extremely basic, most of which are available for free.
Specifically you would need the following:
1. Annual report of the company –
All the information that you need for FA is available in the annual report. You
can download the annual report from the company’s website for free
2. Industry related data – You will
need industry data to see how the company under consideration is performing
with respect to the industry. Basic data is available for free, and is usually
published in the industry’s association website
3. Access to news – Daily News helps
you stay updated on latest developments happening both in the industry and the
company you are interested in. A good business news paper or services such as
Google Alert can help you stay abreast of the latest news
4. MS Excel – Although not free, MS
Excel can be extremely helpful in fundamental calculations
With just these four tools, one
can develop fundamental analysis that can rival institutional research. You can
believe me when I say that you don’t need any other tool to do good fundamental
research. In fact even at the institutional level the objective is to keep the
research simple and logical.
IMPORTANCE OF FUNDAMENTAL
ANALYSIS
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.
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.
TYPE
OF FUNDAMENTAL ANALYSIS
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.
COMPONENTS
OF FUNDAMENTAL ANALYSIS
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
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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