Fundamental Analysis

What is Fundamental Analysis?

Fundamental Analysis is a holistic approach to study a business. When an investor wishes to invest in a business for the long term, it becomes essential to understand the business from various aspects. 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, a fundamentally strong company’s stock prices tend to appreciate, thereby creating wealth for its investors.

Fundamental analysis is distinct from the other branch of equity analysis called technical analysis. There, not much attention is paid to the financial performance of the company. Investment decisions are taken based on patterns of the company’s historical share price.

Types Of Fundamental Analysis

Fundamental analysis (FA) is of two types — quantitative and qualitative.

Qualitative fundamental analysis is based on the quality of something such as management, brand, products, financial performance, board, etc.
The 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.

How to do Fundamental Analysis of Stocks?

1. Understand the company

It is very important that you understand the company in which you intend to invest. It will give you further insight as to how the company is performing, whether the company is taking right decisions towards its future goal, and whether you should hold or sell the stock. Visiting its website and learning about the company, its management, its promoters and its products is a good way to mine such information.

2. Study the financial reports of the company

Once you are done understanding the company, you should start analysing its financials such as balance sheet, profit-loss statements, cash flow statements, operating cost, revenue, expenses etc. You can evaluate its compounded annual growth rate (CAGR), sales and if the net profit has been increasing for the last 5 years, it can be considered a healthy sign for the company.

3. Check the debt

Debt is an important factor – one which can bring down a company’s performance. A security cannot perform well and reward you if it has a huge debt of its own. It is recommended that you avoid companies with huge debt. Always try to find a company to invest which has debt:equity ratio of less than 1.

4. Find the company’s competitors

The company you want to invest in must be one of the best among its peers. Try to find a company which is performing better than the other companies. It should have better future prospects, upcoming projects, new plant etc.

5. Analyse the future prospects

Fundamental analysis is most effective when you want to stay invest long term. Invest in those companies whose product will still be useful 15-25 years down the line.

6. Review all the aspects time to time

Do not invest in a company and forget about it. Stay updated about the company you have invested in. You should be updated about all its news and financial performance. Sell the security if there is a problem in the company.

Fundamental Analysis Tools

let’s take a look at some of the most important and easily understood metrics any investor should have in their analytical toolkit to understanding a company’s financials:

Earnings per share (EPS): Neither earnings nor the number of shares can tell you much about a company on its own. But when you combine them, you get one of the most commonly used ratios for analysis. EPS tells us how much of a company’s profit is assigned to each share of stock. EPS is calculated as net income (after dividends on preferred stock) divided by the number of outstanding shares.

Price-to-earnings ratio (P/E): Price of Stock divided Earnings Per Share

Projected earnings growth (PEG): The price/earnings-to-growth ratio, or the PEG ratio, is a metric that helps investors value a stock by taking into account a company’s market price, its earnings and its future growth prospects. Compare the PEG ratio to the price-to-earnings ratio (P/E ratio), a related measure that evaluates how expensive a stock is by comparing the company’s stock price to its earnings. The PEG ratio can provide a more complete picture of whether a stock is overvalued or undervalued.

The PEG ratio compares a company’s P/E ratio to its expected rate of growth, a key factor for assessing its value. A company that’s expected to grow its revenue, earnings and cash flow at a high rate is, all other things being equal, more valuable than a company with little growth opportunity.

Price-to-sales ratio (P/S): The P/S ratio values a company’s stock price as compared to its revenues. It’s also sometimes called the “PSR,” “revenue multiple,” or “sales multiple.

Price-to-book ratio (P/B): Also known as the “price-to-equity ratio,” the P/B compares a stock’s book value to its market value. You find it by dividing the stock’s most recent closing price by last quarter’s book value per share. Book value is the value of an asset as it appears in the books. It’s equal to the cost of each asset minus cumulative depreciation.

Dividend payout ratio: This compares dividends paid out to the shareholders to the company’s total net income, and it also accounts for retained earnings or income that is not paid out but rather held onto for potential growth.

Dividend yield: This is the yearly dividend total compared to share price. It’s given as a percentage. Divide payments per share in one year by the value of a share.

Return on equity: Divide the company’s net income by shareholders’ equity to find its return on equity.

Return on Capital Employed (ROCE): A profitability ratio, measures how efficiently a company is using its capital to generate profits. The return on capital employed metric is considered one of the best profitability ratios and is commonly used by investors to determine whether a company is suitable to invest in or not.

Debt-to-EBITDA ratio: One good way to gauge financial health is by looking at a company’s debt. There are several debt metrics, but the debt-to-EBITDA ratio is a good one for beginners to learn. You can find a company’s total debts on its balance sheet, and you’ll find its EBITDA (earnings before interest, taxes, depreciation, and amortization) on its income statement. Then turn the two numbers into a ratio. A high debt-to-EBITDA ratio could be a sign of a higher-risk investment, especially during recessions and other tough times.

Final Thoughts

There’s no one correct way to analyze stocks. The goal of stock analysis is to find companies that you believe are good values and great long-term businesses. Not only does this help you find stocks likely to deliver strong returns, but using analytical methods like those described here can help prevent you from making bad investments and losing money.