Fundamental Analysis is important from the perspective of investing. To Start Fundamental Analysis you need to learn the process, its models, implementation & more.
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Process to Start Fundamental Analysis – DHF Model
Fundamental analysis requires you to analyze the security’s intrinsic value by taking into consideration all the factors such as news, financial statements, macroeconomic factors, etc.
There are various methods of implementing fundamental analysis, out of which the most commonly used is the Discounted Cash Flow (DCF) model.
However, while implementing the DCF model, it is important to note that there are many assumptions taken into consideration.
Therefore, if the assumptions are not backed by sound logic, the model might not reveal the true intrinsic value of a security.
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To Start Fundamental Analysis – 1st Step is DHF Model
Let’s take a look at the drawbacks & affects of DHF Model on the fair value calculation:
Application of Forecast:
The discounted cash flow method requires the analyst to predict the future cash flow in the company and the business cycles that the company might witness.
Predicting the future accurately is something beyond the capabilities of human beings. Therefore, there is always a certain degree of approximation due to which the results might not always be accurate.
Terminal Growth plays a major role:
Terminal rate is the expected rate at which the cash flows in the company are expected to increase. Ideally, it is said that the termination rate ranges between the rate of inflation and the growth rate of GDP.
However, the DCF model is highly sensitive to Terminal Growth Rate. This implies that even a minor change in the terminal growth rate can change the final output, which in this case, is the value of one share.
Since the DCF model is primarily based on assumptions, the analyst must modify it after certain intervals.
This is because as time passes, we get to see more accurate information regarding various factors, and then that data needs to be replaced with the assumed values.
For instance, the analyst might consider a certain expected revenue, but the reports suggest a greater revenue.
In this case, the present value has to be replaced with the new data to get a more accurate model.
Long Term Focus:
If you are an investor who is looking for a short-term investment, say one year, then DCF is not the appropriate model for you.
This is because the DCF model is designed for a broader perspective, and therefore it is focused on long term investing.
DHF Model is the 1st step, if you want to Start Fundamental Analysis.
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Conservative Assumptions in DHF Model
To Start Fundamental Analysis you should also understand regarding conservative Assumptions in DHF Model.
The above-mentioned drawbacks depict how assumptions can change the DCF model drastically.
If you are willing to overcome these drawbacks and minimize the risks of your model failing, we would recommend you to go with conservative assumptions.
The conservative assumptions which can be taken while making a DCF model are:
The FCF Growth Rate:
The FCF, also known as free cash flow growth rate, should not be more than 20% year over year. This is because it is close to impossible for most companies to sustain an FCF of over 20% every year.
In case the company is new and belongs to a sector with a high growth rate, the FCF can be close to 20% but not more than that.
Number of Years:
As discussed earlier, the DCF model is designed for those who are looking for a long-term investment opportunity. Therefore, it is generally said that taking a longer time frame may lead to better results.
However, it is important to note that it might lead to more errors. Hence, we suggest you create a DCF model by taking a time period of around ten years.
Stages of DCF Valuation:
If you have ever made or come across a DCF Model, you would know that it is divided into stages. The DCF model is divided into parts because it is difficult to predict the future accurately.
Therefore, it is generally recommended to divide the model into two parts. The first part or stage depicts the near future that is nearly 3-4 years with a growing FCF rate, while stage 2 depicts the time after that with a lower FCF rate.
Terminal Growth Rate:
As we saw earlier, the DCF model is highly sensitive to the terminal growth rate. While we cannot predict the terminal growth rate accurately, we suggest you keep it as low as possible.
In our opinion, you should keep it at around 4%; anything lesser than that would do.
Start Fundamental Analysis with Margin of Safety Concept
If you are an avid reader, you must have read the book “Intelligent Investor” written by Benjamin Graham. The concept of margin of safety was introduced in the same book.
No matter how accurate your assumptions are, there is always a scope of your model not matching the reality.
To insulate yourself against this and ensuring that your model is close to reality, you implement the margin of safety. The concept says an investor should buy the stock when it is available at a discount to the intrinsic value.
This means that if XYZ stock’s intrinsic value is 110, and you adjust a buffer of 10, the lower intrinsic value comes to be 100, so you should buy it at 70.
The 30% difference between the intrinsic value and buying price was the discount calculated at intrinsic value. This is done to minimize errors to the least possible extent and attain maximum accuracy.
Some people might believe that following such a conservative approach might not be correct. To some extent, it is true, as we are reducing the intrinsic value by a significant amount.
However, this is the only way to protect you from any unexpected change that might affect the price of the stock.
If a stock is trading at 400 and your buy value after adjusting the margin of safety is 200. So if the price drops to 200, you can be confident that the stock is a must buy at that level as you have kept a significant margin.
However, you might not get to see stocks undervalued to this extent in a normal market. But, if you find an opportunity in the bearish market, you must take it.
When to sell a Stock? – Concept to Start Fundamental Analysis
The DCF model and margin of safety approach guides you through calculating the perfect buy price of a security, also known as an entry point.
However, it is also important to know when you should sell your security i.e., the exit point. Since trading and investing is all about the right entry and exit, it is important to know when to book profits.
In the previous lessons, we learned the basis on which we buy a stock i.e., the investable attributes.
In the case of fundamental analysis, we buy a stock after ensuring that it fulfills our investing checklist. This implies that one should not buy a stock only because the price has dropped.
It is important to ensure that the stock has all the investable attributes you need, and it matches your checklist.
Therefore, if you are buying a stock keeping in mind the investable attributes, you should hold it till the attributes hold true.
For example, due to the Covid-19, the entire economy saw a downside, and almost every stock crashed.
This does not mean you buy all of them since they are at lower prices; you must pick stocks and ensure that they match your checklist criteria.
Similarly, if a particular sector is recovering, some stocks from that sector might shoot up. But you should hold them till the investable attributes are fulfilled as the prices might increase further.
Number of Stocks in your Portfolio
To Start Fundamental Analysis you should know how many stocks you should have in your portfolio.
There is no upper or lower limit to the number of stocks you can have in your portfolio. When it comes to portfolio management, every investor has a different mindset.
Some might believe that creating a diversified portfolio helps in hedging the risk.
This is because if a particular sector does not perform well, you might earn greater returns from another sector.
However, some people say that keeping yourself confined to a single sector helps in focusing on that sector. This can help in the thorough analysis and picking up stocks that have huge upside potential.
We would suggest you keep your portfolio short but diverse. This means you should pick up a few stocks from all major sectors to build your portfolio.
This will provide ease of management as you won’t have to keep track of a lot of stocks. At the same time, it will help you in hedging yourself from unexpected risks.
Start Fundamental Analysis – Summary
Fundamental analysis is mostly about thorough research reading financial statements, calculating accounting ratios, making models, etc.
Therefore, you should also pay attention to qualitative and thorough research. At the same time, one of the main techniques of profitability in the market is controlling your psychology.
While investing, keep a long-term approach in mind, and set reasonable targets.
The market is volatile, you might be able to earn 100% returns in a week, but you might end up losing it all if you are not patient.
Just keep your compound annual growth rate reasonable, and the money will flow in.
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