Fundamental analysis of stocks is the most efficient and traditional method of analyzing securities. Especially, it is used to analyze stocks and the company at the most basic level to generate passive income in long term.
Do you know what is fundamental analysis of stocks in the stock market? Do you also know how to to fundamental analysis of stocks for better returns?
It is commendable if you can do fundamental analysis of stocks before investing. And if not! Then this post is for you which will give a new shape to your investment.
The stock market is for everyone and it gives every investor equal opportunity to take their returns. But it is surprising that most of the investors are not able to earn enough returns and even lose their money!
Because they don’t know what is fundamental analysis and do not use it before their investments.
If you don’t lay a proper fundamental analysis, you’ll regret later on your investments.
So let’s discuss this topic in depth.
What Is Fundamental Analysis?
Fundamental Analysis, the name itself indicates that this analysis is a method to find the real or intrinsic value of stocks, totally based on companies’ fundamentals. This is the analysis of companies health, financial performance and future outlook based on historical data and other financial parameters .
Good fundamental companies always give good results and good returns for shareholders in long-term. Yes, you must use it for long term investment and not for day trading or short term investment.
Note- for short term investment or day-trading you should prefer technical analysis.
Fundamental Analysis Example
You often use fundamental analysis in your daily life to estimate the usefulness of something. You can understand it by a simple example-
in Indian Culture, before the marriage of a girl, father of girl investigate so many questions about the boy to whom he wants to marry his daughter. He tries to know about the boy.
He asks many more questions like where did he study from childhood?, what is the other qualification? What job does he do?, etc. Why does he do this? He does this to know what his daughter’s future will be like with that boy.
He tries to analyze the future prospect of boy. Finally this way he comes to the decision whether that boy is suitable for his daughter or not.
Similarly, before buying shares, you should also do a basic analysis of that company so that your investment can become a boon in future.
Value Research: Goal Of Fundamental Analysis
Value research, in fundamental analysis, is often be used interchangeably. It is the core process and main goal of fundamental analysis. Actually, the current market price (CMP) of a stock may or may not be the true reflection of companies’ fundamentals.
Because many other factors like news, rumors, gossip, etc are added to the price. So it is difficult to say exactly what processes the market goes through in pricing the stocks.
However, there is a widely held belief in the realm of finance that the fundamental value of a stock is nothing but the present value of future benefits.
All stock valuation is based on fact that sooner or later, market will realize the true value of stock and rate it accordingly.
This is the price investors will be willing to pay for the stock, also referred to as intrinsic value or fundamental value. And in search of this intrinsic value, constant value research is done.
It is to estimate the true current price of the stock so that the future growth of a company can be forecasted.
Investing: Ultimate Goal Of Fundamental Analysis
The ultimate goal of fundamental analysis is to tell whether you should invest in a stock now or not. You can achieve this goal after getting the intrinsic value. Which is compared with a stock’s current market price in order to see whether the stock is undervalued or overvalued.
If the current market price is below the intrinsic value, the stock is deemed to be undervalued and you should invest your money to take a long position (buy) and the current market price is above the intrinsic value, the stock is considered overvalued and you should avoid investing in that particular stock.
Analyze Stocks Fundamentally
Being a good investor you should start fundamental analysis with market informations at three different levels –
1. at the level of the whole economy
It is often seen that when the overall economy of a country is good, the stock market also performs well. The expected change in the government or its financial policies is bound to effect the entire economy.
2. at the level of a given industry
Roughly, it has been seen that 50% of stocks rise and fall is directly related to the strengths and weakness of its industry group. News such as expected levies on a given set of commodities may affect only the relevant industry.
3. at the level of a specific company
Information about the health of the chairman of a company, or about a possible lockout or strike largely affects only the stocks of that company.
While the fundamental analysis at the level of a specific company can have as many steps, I will showcase you all those in 2 easy-to-follow steps to build a successful Investment.
Types of Fundamental Analysis
Two easy to follow steps consists of two major types of fundamental analysis.
- Qualitative Fundamental Analysis
- Quantitative Fundamental Analysis.
These two types of analysis are according to their names. One tells the fundamental quality of the company, the other gives a certain number to analyze the company.
How to do Fundamental Analysis of Stocks
Step 1: Qualitative Fundamental Analysis
As the name suggests, it only emphasizes on the selection of good companies. In this analysis you should pay more attention only on the value of a company and not on the price of its stock.
Management Processes
First of all, find out how the company is managed. One of the criteria to assess the company’s management is their past performance. You can check the growth rate of the company by looking at the sales, profits and other statistics of the last 4-5 years of the company.
It also tells about the management of the company. Has the company continuously adopted new technology, new products and new management methods?
There are differences between the managers of many companies. Or sometimes it can be a case of fraud related to company or management. You can search all these things on google.
Nature of Business
You should also find out whether the company has any specific capability or diversity. Diversity here refers to diversity in the company’s production and business, or to make and sell goods in other countries.
New investors/ beginners should always invest their money only in companies of specific caliber.
Companies’ Environment
The industrial, business and economic environment around the company has a great impact on the company. So you should understand all these things.
India is an agricultural country, the industry also accelerates when the crop production is good. Monsoon estimates should also be considered. You should also pay attention to inflation due to which the cost of production increases.
This also requires attention to the profit loss to companies.
International Competitiveness
Now the whole world economy is connected to each other. In such an environment, only those companies will be able to survive internationally which can compete with competition in international markets or cheap imports coming into their country.
For this, you should look at the company’s exports. Also, industry level factors like industry growth and it’s business cycle, market share, regulatory authorities have significant impacts on the company of that industry.
Step 2: Quantitative Fundamental Analysis
This analysis gives you many precise measurable tools. By using these tools in comparison, you can come to an investment decision with greater accuracy. These may be in the form of Financial Statements and Financial Ratios.
Financial Statements of an Annual Report of a company is the biggest source of quantitative analysis.
Annual Report
The Annual Report of a company is an official publication. It is an audited and reliable document to describe the company’s activities, operations and financials over the past year. It is published by the end of each financial year.
The Annual Report is the best source to get information about the company for potential investors like you and the present shareholders. It contains many sections, highlighting certain aspect of the business like operating and financial highlights, financial statements, auditor’s report, etc.
Financial Statements
Financial statements are one of the most important sections of the Annual Report. It is a written report, audited by loyal agencies to ensure accuracy. There are three financial statements, named as–
- Balance Sheet,
- Profit & Loss statement and
- Cash Flow statement
These financial statements are available in two form-
- Standalone financial statement- contains the financial numbers of only the company in consideration.
- Consolidated financial statement- contains the company and its subsidiaries financial numbers.
You can use standalone numbers or consolidated numbers as per your requirement or according to the structure of the company.
Note- Next we will describe all these financial terms with their practical implications.
Balance Sheet
A balance sheet is a financial statement that shows the position of a company.
It describes a company’s assets, liabilities and shareholders’ equity at a specific point in time. The balance sheet is based on the fundamental equation: Assets = Liabilities + Equity.
If you want to find future prospects of any company, then it is very important for you to evaluate its balance sheet over a span of 5-6 years at least. It provides a basis for fundamental analysis. You can compute different financial ratios here.
From here you get to know how the financial health and stability of the company is.
Profit and Loss Statement
P&L Statement is also known as Income Statement. It mainly focuses on the revenue of the company for a given period (yearly or quarterly) and the expenses incurred to generate the revenues. Revenue is referred as the top line of the company.
Why should you analyze profit and loss statement?
It gives an idea of what the future prospects of the company will be. It shows the health of the business operations. The trend of the company’s business cycle is also visible by profit and loss statement.
It tells whether the company’s business or the company’s net sales or net profit is increasing or not? viz, the company is in a growth story or in a downward story.
Important Elements of P&L Statement
The values of all important elements of profit and loss statement like net sales, net profit, employee Cost, consumption of Raw materials and PBIT (Profit Before exceptional Items and Tax) should go up with time except interest.
Cash Flow Statement
The Cash flow statement (CFS) is also an important financial statement which gives you a picture of the true cash position of the company. It is described under three main activities – operating activities, investing activities and the financing activities.
Liabilities are directly proportional to the cash level and assets are inversely proportional to the cash level. The cash flow statement reflects the company’s performance in how well the company generates cash to pay its debt obligations etc.
Financial Ratios
Financial ratios are derivation of financial statements. It was made more popular by Benjamin Graham, the father of fundamental analysis.
Financial ratios help explain the results, and allow comparisons with previous years and with other companies in the same industry. Comparison gives you a very good sense.
But never use only a single fundamental ratio. You must use these ratios in combination since single ratio alone is not a magic bullet.
Financial ratios can majorly be grouped under 4 different categories, namely-
1. Profitability Ratios,
2. Leverage Ratios,
3. Valuation Ratios and
4. Operating Ratios
Despite, here we will describe all these important ratios without further classification for your better understanding.
P/E Ratio
P/E ratio is the ratio of price of share to the earning per share. It is also known as “Price-Earning Ratio”.
P/E Ratio Formula
PE Ratio = Price of share/ EPS(ttm)
Here, it is important to know what is EPS and TTM.
EPS
EPS is earning per share. It is calculated by taking a company’s net earning and dividing by the numbers of outstanding shares of the stock the company has.
EPS is a great way to compare earnings across companies, but it doesn’t tell you anything about how the market values the stock.
That’s why fundamental analysts use the P/E Ratio, to figure out how much the market is willing to pay for a company’s earnings.
TTM
Trailing Twelve Months (TTM) is a term used to describe the past 12 consecutive months of a company’s performance data.
Meaning of P/E Ratio
P/E ratio gives you an idea of the stock performance to the industry performance. For example- auto sector is industry and Tata Motors, TVS, Hero Moto Corps are the company of this industry.
P/E ratio is expressed as a multiple (X). Whenever you buy a stock, you pay a premium to buy a share and this premium is called as P/E ratio.
In fundamental analysis, you should not judge the current market price (CMP) of the share, you should judge the P/E ratio and then decide whether the stock is undervalued or overvalued.
Higher the P/E ratio, more people are convinced to pay high for that stock expecting higher growth in coming future.
Forward P/E Ratio
Forward PE Ratio = Price of share/ Estimated EPS
where, EPS (Earnings per Share) = CAGR% of EPS (last 3 years)
Price of Share = Current market price (CMP)
CAGR
Compound Annual Growth Rate (CAGR) is defined as the rate of return that for an investment to grow from its present value to its future value, assuming the profits were reinvested at the end of each year.
Formula of CAGR
CAGR = [Future Value÷Present Value]1/n – 1
where n= no. of years
Here, you can put Basic EPS values for different years as a present value and future value given under the heading of EPS Before Extraordinary in a yearly results for calculation of CAGR.
Meaning of Forward P/E Ratio
In forward P/E ratio, estimated EPS is used. Because, here you have to estimate how much a share of the company can grow in 3 or 5 years.
To find estimated EPS, you need CAGR in %. i.e., you have to multiply CAGR value by 100.
After finding out the value of Forward P/E ratio from its formula, you can determine whether the stock price is undervalued or overvalued.
If Forward P/E ratio < current P/E ratio → stock is said to be undervalued;
Forward P/E ratio = current P/E ratio → stock is said to be fair valued;
Forward P/E ratio > current P/E ratio → stock is said to be overvalued;
Note- In the case of mid cap and small cap stocks, you should also consider one another factor known as margin of safety.
P/B Ratio
P/B ratio stands for price to book ratio. It is the ratio of price of a share to the book value per share. This tells us whether company’s stock price is trading at a premium or at a discount.
The higher the P/B ratio the higher price the market is willing to pay for the company above its assets. It is more useful to value investor than growth investor.
P/B Ratio Formula
P/B Ratio = Price of Share/ Book Value per Share
where, Book Value per Share = (Total Assets – Total Liabilities)/ Total Shares Outstanding
Price of Share = Current market price (CMP)
Book Value
According to the company’s balance sheet, the value of the share is called the book value of the share. It is also called as Shareholders Fund or Shareholders Equity or Net Worth.
It is the difference between total assets and total liabilities. You can also find it by adding reserves and equity capital of a company.
ROE (Return on Equity)
It is the ratio of net income to the shareholders equity. It is used as a general indication of the company’s efficiency, in other words, how much profit it is able to generate given the resources provided by its shareholders.
ROE = Net Income/ Shareholders Equity
Book Value = Shareholders Equity = Net Worth
Net Income = Net Income for that Finance Year
If you look for companies whose ROE is high and growing and the P/B ratio is either decreasing or growing very slowly in the same timeframe, then it is most likely to become a multi bagger stock.
EV/EBITDA Ratio
It is an important financial ratio. It stands for the Enterprise Value (EV) to the Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) ratio.
EV determines the company’s total value while EBITDA measures a company’s overall financial performance.
EV = (Market Cap + Debt) – Cash Equivalent
EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
You should use this ratio to compare companies within the same industry. A common practice of deciding the valuation of a stock:
| EV/EBITDA Ratio | 0 (zero) | 6 to 10 | 15 | >20 |
| Your Decision | Avoid | Perfect | Fair Valued | Over Valued |
PEG Ratio
PEG stands for Price/Earnings to Growth. It is the ratio of P/E ratio to the estimated EPS growth rate for a specified time period.
PEG Ratio = PE Ratio/ Estimated EPS Growth Rate
where, P/E ratio in TTM and Estimated EPS Growth Rate= Average EPS Growth Rate
It permits you to determine stock’s value, similar to the P/E ratio, while it also taking into consideration the company’s earnings growth. A common practice of deciding the valuation of a stock for different segments:
| Large Cap | Mid Cap | Small Cap | |
| GOOD | 15% | 40% | 100% |
| Average | 10% | 20% | 40% |
Sources of Fundamental Analysis
Company’s own website, Financial Newspapers, Magazines and the Financial websites like money control are the major sources where you can get all information to analyze fundamentally a stock.
Pros And Cons of Fundamental Analysis
With every good thing, some evil is also possible. Fundamental Analysis is also not untouched by it. Manipulation in the financial data by the company may be possible in rare cases. Also you can think that Fundamental Analysis is time-consuming.
But in my opinion, you can make huge money by analyzing the company potential growth. In fact , you may be the second Warren Buffet, the richest person on the earth without running any business.
This is the fundamental analysis. Learn and do it yourself. Contact me if you have any difficulty. Try to follow this Stock Market Calculator to set long-term goals of a stock, which I am going to generalize.
I hope you liked this post, and maybe it will help you build your new successful portfolio from today. Your comment will be awaited!!
