The stock market is intriguing if you can dig deep into it. Are you wondering how to dig deeper into the stock market to realize its potential? If so, then Fundamental Analysis is the key tool for you.
In this article, you will read about the different aspects of Fundamental Analysis of Stocks. We will cover the basics as well as the deeper secrets of this tool which is the most efficient tool for investing in stocks especially for the long term.
In this article, you will read about various types of fundamental analysis, its basics, process, objectives or role, benefits, concepts of intrinsic value which is the most crucial thing in this process, and many other facts and concepts.
What is Fundamental Analysis? – Meaning / Definition
The basic Fundamental Analysis meaning is a method that is used for measuring the intrinsic value of a stock or security. It mainly depends on the economic factors affecting the business and its financials.
This process is not only limited to the company’s financial structure but it goes beyond that.
It includes the general economic scenario, the industry’s growth, and fall, along with the company’s organizational structure, management, and financials.
So, it is a complete study of a business venture to analyze its actual worth and then to measure its share’s intrinsic value.
It takes into account both macroeconomic and microeconomics factor at the same time. The notion behind this is to analyze the real price against the prevailing price in the market.
This gives the investor room for investment and the process will be discussed in the latter part of the article.
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What are the types of Fundamental Analysis?
There are two different Fundamental Analysis Types and they are quantitative and qualitative.
Fundamental Analysis Stocks that involve brand value, the financial performance of the company, management’s decisions, and other similar factors can be termed as a qualitative approach.
The quantitative approach includes numbers. It analyses the numbers in the financial statements and draws a conclusion about the price of the shares from there.
Though both the approach is different both are equally important in a complete analysis of a company’s share price.
Apart from these two, there are two different processes of fundamental analysis. One is top-down and the other is a bottom-up approach.
While the top-down approach looks into the macroeconomic factors first and then digs into the specific company, the bottom-up approach analyses the company first and then check the effect of the macroeconomic factors on the company’s performance.
What are the Basics of Fundamental Analysis?
For Fundamental Analysis Strategies, there are few Fundamental Analysis Basics which needs to be considered. These are primary factors which affect the analysis of the stock and they are –
- Company’s revenue and its structure
- Growth of the revenue over the years
- Profit made by the company in the past years
- Debt structure of the company
- Rate of Turnover
- Employee management and management’s approach towards its employees
These are six basic factors that are looked at while doing fundamental analysis of any security.
This is required to determine the intrinsic value of the stock and check whether it is rightly priced at the market or not.
How to start a Fundamental Analysis?
There are few basic steps to start this analysis and the steps are –
- For preparing the Fundamental Analysis Strategies, you first need to understand the company well
- The second step is to use financial ratios. The ratios are the primary source of information required for this analysis.
- Third step is to study the financial and annual reports of the company.
- The fourth step is also about reading the annual reports but of the rival companies’.
- Next step is to compare the company’s debt structure with its peers and rivals
- Finally, you need to analyze the prospects of the company to find out its worth.
The Role of Fundamental Analysis in Trading
The role of Fundamental Analysis in Trading is highly important. It is undoubtedly the best possible way to find out the real worth of any stock.
The role of Fundamental Analysis for Investment is basically to find out the intrinsic value of the stock based on the quantitative and qualitative sources of information.
This intrinsic value is required to compare with the current market price of the stock and take decision for investment.
So, if the market price is above the intrinsic value, the investor should sell or short the stock as the price in the long term is going to fall as the stock is overvalued and vice versa.
General Steps to Fundamental Evaluation
In this section, you will read about the Fundamental Analysis Steps in detail.
This section is sort of a Fundamental Analysis Guide with all the important attributes of the process that you need to be aware of to perform a financial analysis of your favorite stock.
Here we will be discussing the top-down approach mainly as it is the most followed approach across the globe.
So, in the top-down method of fundamental analysis, there are three general steps and there are sub-steps within them. It starts with the economic forecast and boils down to the company analysis.
Economic Analysis or Forecast
In the top-down process, the first step is always the evaluation of the economy in general. There are multiple sectors and industries with hundreds of companies in them which builds an economy in general.
This needs to be analyzed closely to begin fundamental research. The growth in the economy directly affects the growth of companies and their stocks in general with some exceptions.
There is a direct link of the interest rates prevailing in the economy with the stock market and bond markets.
So, it is highly important that you take note of the crucial aspects of the economy and then dig deeper into it.
Industry or Sector Analysis
After economic analysis, you need to get down to a few or one specific industry which seems more promising than the others in your analysis. It can be done by comparing the growth of certain industries that you prefer or as per your analysis.
In a growing economy, certain industries will bring more profits than others. To choose the specific industry for your investment purpose, you need to check the industry’s overall growth potential in the upcoming years.
How the industry is affecting the economy or its importance to the economy. Then you need to see the market strength or a number of companies in that industry and similar aspects.
Apart from these, you need to check the prospects of the industry as well. Innovations and technologies involved and getting developed in the industry.
Company Analysis as part of Fundamental Analysis
Finally, you come down to company analysis post industry analysis. Now you have analyzed the economy, chosen an industry.
Now you have to choose a company and its stock for investment from the industry you have selected.
For selecting a company out of the industry, the first step is to shortlist a few of them. You need to shortlist the companies on the basis of –
- Its prospects in terms of technology and innovation
- Its marketing standards
- Whether it has an edge over other companies or not?
- Market share
- Brand value
Analysis of the Business Plan
So, to begin with, you need to completely understand and observe the business plan of the company.
Every business has a plan for its prospects and growth projections. If not then you know what to do. So, check the business plan thoroughly.
Whether the business is demanding or not? Is it profitable or not? It is feasible or not? These questions need to be asked while choosing a new company.
For any established company, you need to know whether the company’s future goals are determined and defined or not in the business plan?
Whether it is a leader in the industry or not and similar questions which would help you verify the business plan of the company.
Then comes the management decisions. Yes, for fundamental research of stocks, you need to analyze the management decisions of that company.
You need to understand the strength and weaknesses of management. It will help you gauge their capabilities.
It is important for understanding the prospect of the company. The questions that you need to get answered by observing the management are –
- Whether management is efficient or not?
- Whether it can work as a team or not?
- It is comprised of experienced and talented people?
- Whether they have a track record or not?
- If yes, then how is their track record?
- Whether they deliver to their promises or not?
Financials of the company
After analyzing the management and its decision of the company, you need to check the financials which is one of the crucial parts of this research.
For financial analysis, you need to check the financial statements – profit and loss statement, balance sheet, cash flow statement along with other documents.
You need to find out the financial ratios to check their credibility, liquidity, and other aspects. Using financial analysis, you can derive the intrinsic value of the stock of the company.
If you found the intrinsic value of the stock to be above the current market price, then the stock is undervalued in the market.
This is the scope of investment. You can buy the share at this point as the market is going to boost the share’s price eventually with time.
Which are the Best Fundamental Analysis Tools?
Tools for Fundamental Analysis can include everything that is present and can be derived from the financial statements, management discussions, and business plan as you read above.
However, few financial tools are favorites of the analysts for this research. They are –
Earnings Per Share Or EPS:
Two of the basic financial information – one is earning of the company and the other is the total number of shares of the company but none of these two can individual tell you about the company’s performance.
But when you combine these two, it becomes one of the powerful tools for financial analysis. It is one of the most popular ratios which tells you about the company’s profit share for each of the stock.
EPS is calculated by dividing the net income or income after deducting dividends on preferred shares by the total number of outstanding shares of the company.
It is crucial for the investors as it helps them understand the wealth accumulation capabilities of the share of the company.
Price to Sales Ratio
It is used to recognize the price of the stock as compared to the revenue. It helps you understand the growth of the share price against the revenue generated in that year.
Price to Earnings Ratio
It is derived by dividing the price of the shares in the market (current sale price) by the earnings per share.
Price to Book Ratio or P/B Ratio
It is another important ratio that gives you an idea about the company’s stock price compared to its asset.
It is also known as Price to Equity Ratio. P/B Ratio is derived by dividing the latest closing price of the share by the book value of each share.
Return on Equity
It is derived by dividing the net income of the company by shareholder’s equity. It gives you the return generated on the equity of the company.
Dividend Payout Ratio
It gives you two important information – one is how much dividend is paid to the shareholders out of the profit of the company. Second is retained earnings of the company.
Apart from these few, there are many financial ratios and other tools which are used in Fundamental research.
What are the Objectives of Fundamental Analysis?
The objectives of Fundamental Analysis of Stock Market are –
- To predict the future price of the share of the company
- To do the valuation of the asset of the company
- In order to project the performance of the business
- To measure the credit risk
- To evaluate the management’s decisions
- In order to find the intrinsic value of the asset
Investing and Fundamental Analysis
Financial analysts perform Fundamental Analysis for Investorsand give their opinions about the shares and market.
Investors can perform financial research by themselves as well. Now, investing is the main motive for fundamental analysis, whoever does it, doesn’t matter.
Investing is generally meant for the long term. In the long-term, investors expect his or her investments to grow, right?
Generally, investments are made with a goal in mind and there should be certain financial goals behind each investment. It is necessary to make wise investment decisions.
So, the investor wants the investment to grow and how it can grow? If you invest at a price that is lower and at the time of selling the investment, it should increase by a good margin, right? This is the purpose of fundamental analysis in investing.
It helps you find the right entry point in the market when the price is low and has enormous potential to grow.
What is the importance of Fundamental Analysis?
The Fundamental Analysis of Shares helps you get to the fair price of the share. The price of the share of a company is not always rightly trading in the market.
Often it is either overpriced or underrated. The importance of fundamental research analysis lies in this due fact only.
It is important to find the right price of the stock before investing, right? Fundamental research of the company helps you find that price.
Fundamental Analysis (FA) vs Technical Analysis (TA)
So, to jot down a few points for Fundamental Analysis vs Technical Analysis, we have –
- While FA helps in understanding the financial performance of the company, TA helps in observing the patterns of the share price movement of the company.
- FA uses financial statements for making future predictions while TA uses historical price movements and patterns.
- Investors for long-term investment use FA and traders who trade daily mainly use TA.
- Finally, FA depends on management’s decisions, company announcements, while TA solely depends on the charts and price movements.
Where can you get the Fundamental Report of a company/stock?
For Fundamental Analysis of Company, you need to carry on Fundamental Analysis of Report. But where can you find these reports? It is not that tough as you may be thinking.
If you have a Demat and trading account with a good brokerage house, you will get all the reports on their trading platforms only. The brokerage houses have research departments and services from where you can derive these reports.
Apart from that, you can get annual reports, financial statements of the company from the company websites as well.
Then there is individual research organization for conducting financial research, you can buy reports from them as well.
How to read the Annual Report of a Company?
The basic Fundamental Analysis Source is the annual reports of the company. For Fundamental Analysis of Annual Report, you need to understand the following from the report –
- Last ten years of financial highlights.
- Decisions taken by the management and also need to analyze that decision
- You need to read and understand the report provided by the director/s of the company.
- Corporate governance report as well
- Company announcements and notices
- Annexures as well.
The Concept of Intrinsic Value in Fundamental Analysis
One thing that has come up time and again in this article till now is the Intrinsic Value of Shares.
So, what is this intrinsic value of the shares? Why is it so crucial for fundamental research and investments? Let us find out here.
Intrinsic value is the price of the share of the company which is not affected by the demand and supply of the share market. It means that this price is purely derived based on the financials and other aspects of the business itself.
To make it simpler, the intrinsic value of a share can be referred to as the right value of the share.
It is because the current market price of the share is affected by many other factors apart from the business’s operations and performance.
This is why the current market price cannot be taken as the right valuation of a share of a company.
Intrinsic value can be derived by means of financial analysis and research and there are no certain formulae of doing that.
You need to follow the above-mentioned steps as we have discussed to derive the value. This is mainly for the valuation of shares which is highly important for investment.
Pros of Fundamental Analysis
The Fundamental Analysis Benefits are –
- It helps in predicting the long-term trends in the market. It is generally used for long-term investment as it can help you understand the future price of the stock.
- Fundamental Analysis helps you find good companies for investment. The company’s have the potential to grow in the future.
- It helps in analyzing one of the most important but intangible factors that are Business Acumen. It is highly beneficial in investment analysis as it can tell you about the future of the business.
- Fundamental Analysis helps you understand the economy, industry, and then the company which helps you wisely predict the price knowing all the risks and rewards of your investment.
Criticisms of Fundamental Analysis
There are few Fundamental analysis Criticism as well and they are –
- It is time-consuming. For conducting fundamental research, you need a lot of time. Accumulating all the information from the business plan to the financials and finding out ratios and analyzing and reading each of the reports takes a lot of time which may defer the investment on time.
- In fundamental analysis, it is important to research as per the industry or the company. Your approach needs to be different for each of the company and industry and that is difficult to understand which approach to be adopted.
- The valuation is based on financials provided by the company itself. It can be biased as the company can alter its financials to increase or decreased its share prices.
Fundamental Analysis – Conclusion
So, Fundamental Analysis can be referred to as the most in-depth research analysis technique for investment purposes.
It helps in finding the true value of the share though it is time taking. It helps in predicting the future price of the shares using the financial information of the company.
In long-term investment, there is no other option than to conduct a fundamental research analysis.
It uses different financial tools and derives the intrinsic value of the share with which the current market price needs to be compared and then investment decisions need to be taken.
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