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Fundamental Analysis of Stocks: Explained
Trading in stocks can be a rewarding experience. However, it comes with its own set of risks as well. This is why investors are regularly advised to evaluate the risks involved and carry out a fundamental analysis of stocks before trading in them. The term ‘fundamental analysis’ is a broad one that comprises several techniques and principles within it, all with the same objective of identifying the intrinsic market value of the stock. Let’s get to know the basics of fundamental analysis of stocks and their prominent pillars.
What is fundamental analysis?
If you want to define fundamental analysis in a single line – it is the process to identify the ‘real value' of an asset. As an extension, fundamental analysis of a company aims to identify the intrinsic value of its stock. It is one of the two primary methods of analysing stocks, the other being technical analysis. While technical analysis focuses on analysing price trends and patterns, fundamental analysis focuses on analysing the underlying financial and economic factors that drive a company's value. The result is then used to make informed buying, holding, or selling decisions.
Fundamental Analysis of a Company: Basics
The goal of fundamental analysis is to determine the fair value of a company's stock based on its financial performance and future growth prospects. By identifying undervalued companies (that is, their analysed fair value is higher than their current trading value), investors can potentially make profits by buying stocks at a discount and holding them until the market realises their true value. Similarly, by identifying overvalued companies (the stocks of which are trading at a price higher than their intrinsic value), investors can potentially avoid stocks that are likely to underperform in the long term.
At a high level, the process involves a thorough analysis of the company's financial statements, such as its profit & loss statements, income earned, balance sheet, and cash flow reports, to assess its financial health, profitability, and growth prospects. Additionally, fundamental analysis takes into account broader economic factors, such as industry trends, interest rates, and macroeconomic indicators like inflation and so on.
Types of Fundamental Analysis Techniques
There are two main buckets of fundamental analysis in the stock market. These are:
Quantitative analysis is an approach to fundamental analysis of a company’s stock that focuses on using numerical data and statistical methods to evaluate the financial performance of the company. It involves analysing various financial metrics, such as revenue, earnings, cash flow, and ratios, to identify trends and patterns that can help investors make informed investment decisions.
The key quantitative analysis techniques that are commonly used in the stock analysis include:
Ratio Analysessuch as price-to-earnings ratio (P/E ratio), price-to-book ratio (P/B ratio), return on equity (ROE), and debt-to-equity ratio (D/E ratio). By comparing these ratios to industry benchmarks and historical trends, investors can gain insights into the company's profitability, efficiency, and financial leverage.
Trend analysisis used to analyse various financial metrics, such as revenue, earnings, and cash flow, over a period of time to assess the company's growth potential and future prospects.
Regression analysisis used to identify the factors that influence a company's financial performance, such as macroeconomic indicators, industry trends, and competitive factors and forecast its future financial performance based on historical data.
Discounted Cash Flow (DCF) analysisis a technique that involves estimating the present value of a company's future cash flows and can help you assess whether the stock is overvalued or undervalued.
As the name suggests, the qualitative analysis focuses on the non-financial, intangible aspects that influence the performance of a company. It involves evaluating the company's management, corporate culture, industry trends, competitive position, risk factors, and other related qualitative factors that can affect the company's long-term prospects. Qualitative analysis is an important complement to quantitative analysis and together, they give you a holistic assessment of the company and its stock’s valuation.
Approaches for Conducting a Fundamental Analysis of a Company
Just like there are two types of fundamental analysis, there are two approaches to carrying out the process.
The top-down approach starts with an analysis of the broader economy and prevalent macroeconomic trends. This includes an analysis of factors such as gross domestic product (GDP), inflation, interest rates, and other economic indicators. By analysing these factors, investors can identify industries or sectors that are likely to perform well or poorly in the current economic environment.
One of the benefits of the top-down approach is that it can help investors to identify industries or sectors that are likely to perform well even in a weak economy. For example, the healthcare industry outperformed during the recent global pandemic. However, the top-down approach also has some limitations as it can be difficult to accurately predict macroeconomic trends and how they will impact individual industries and companies, and the approach can be time-consuming as well.
The bottom-up approach is the opposite of its predecessor. It begins with a fundamental analysis of the company’s performance while focusing on company-specific factors such as revenue growth, earnings growth, profit margins, and debt levels. The goal is to identify companies that are likely to perform well based on their financial health and growth prospects. Once promising individual companies have been identified, the analysis moves up to assess the broader industry and economic environment.
One of the benefits of the bottom-up approach is that it allows investors to focus on the specific characteristics of individual companies rather than being influenced by broader macroeconomic trends making the approach more efficient. While the approach can be useful for identifying promising companies with strong fundamentals and growth prospects, it may not be effective for identifying emerging industries or sectors that may be poised for growth in the future.
4 Steps of Fundamental Analysis
While the specific steps may vary based on the approach you use, typically, here are the critical steps involved in carrying out a fundamental analysis of stocks.
An assessment is conducted of the macroeconomic factors prevalent in the country. Industry dynamics, structure, and other influential trends are also considered. Thereafter, attention is paid to the products and services manufactured or offered by the company. The company’s vision, mission, goals, cost structure, revenue model, etc., are studied in this stage.
In this stage, the focus is narrowed down to the company’s financial health with an emphasis on the tenets of quantitative analysis. Financial information such as P&L statements, balance sheets, cash flow, key ratios (such as P/E, P/B, D/E), outstanding debts, and other liabilities are all thoroughly examined.
The third step draws from the qualitative analysis technique and focuses on non-financial aspects. Herein, attention is paid to intangible factors that influence the company’s performance, such as the company’s management, competition, business policies, ways of working, etc.
After conducting a holistic assessment and considering all qualitative and quantitative factors, the intrinsic value and growth prospects of a company are arrived at. Investment decisions are then made regarding the buying, selling, or holding of the company’s stock.
Fundamental analysis is a method of analysing stocks by examining the underlying economic and financial factors that impact the company. It involves analysing financial statements, ratios, and valuation techniques to determine the intrinsic value of a stock. This information can then be used to make investment decisions. Fundamental analysis is a crucial tool for long-term investors who seek to understand the true value of a company and its potential for growth.