What is Fundamental Analysis?
Let us begin by understanding what fundamental analysis is. In short, fundamental analysis is a method used by investors to identify the intrinsic value of a stock. Every asset has an intrinsic value and in the case of equities, the intrinsic value is captured by future cash flows. However, future cash flows are only one part of fundamental analysis. To understand the real fundamental analysis meaning, one has to look at net asset value, management quality, and other intangibles too. The total of all this will answer your question on what fundamental analysis is in the share market.
A quick word on why we focus so much on fundamental analysis in the share market. Firstly, it helps us get an idea of what stock is worth; now that may or may not be the market price. Secondly, fundamental analysis is a logical approach to investment decisions based on value. You may be wrong in the short term but are more likely to be right in the long term. That is where stock fundamental analysis assumes importance for analysts and investors alike.
Understanding Fundamental analysis
To understand what fundamental analysis is in stock markets, let us go back to a basic question, how do you decide whether a stock has to be purchased or sold. You see if the industry is healthy, then you see if the economy overall is healthy and finally you check if the company is healthy. The fundamental analysis captures whether the company can capture the business advantages in the industry, whether it has a unique product, how is its distribution network, how it is taking on competition etc.
Let us first look at fundamental analysis meaning. Fundamental analysis broadly encompasses Quantitative fundamental analysis and qualitative fundamental analysis. For example, the quantitative fundamental analysis considers profits, debt in the balance sheet, growth, P/E ratio, P/BV ratio, Price / Cash flow ratio, EV / EBITDA ratio, etc. Quantitative fundamental analysis is about numbers and data that can be quantified.
Then we come to qualitative fundamental analysis, which is more qualitative. This is equally important when it comes to stock fundamental analysis. The qualitative approach looks at factors like how the company takes on competition, how it builds entry barriers in business, quality of management, corporate governance standards, etc. In reality, stock fundamental analysis focuses on both quantitative and qualitative aspects. It is normally the quantitative factors that drive growth in price but it is normally the qualitative factors that drive the valuation or P/E ratio of the stock.
Let me now turn to some of the merits or advantages of fundamental analysis.
- First and foremost, fundamental analysis enables a thorough understanding of the company, its strengths, and its weaknesses and challenges. Fundamental analysis helps an investor make rational decisions.
- Fundamental analysis meaning is all about being unbiased and objective. When you use a fundamental analysis approach to valuing a company, it is based on a rational story and hence personal biases, likes and dislikes don’t come into the picture.
- The great Warren Buffet once said that fundamental analysis of a business is all about identifying the red flags. These are the danger marks that tell you not to buy a particular company or stock. To that extent, fundamental analysis acts as a warning system.
Let us also look at some of the key resources that are used in the fundamental analysis of stocks.
- The most important document in any fundamental analysis is the annual reports of the company. This includes the income statement, balance sheet, and cash flows. You get a clear understanding of what the company earns, what it owns, what it owes, and what it generates.
- The second important aspect of fundamental analysis is ratio analysis. This includes ratios that look at profitability, debt servicing, liquidity, solvency, the efficiency of operation, return on capital, etc. These ratios help you to identify where the problem points in the company.
- ROE analysis is part of the ratio analysis but it warrants separate discussion in any understanding of fundamental analysis. Here the return on equity is broken up into different parts to evaluate what is exactly driving the profitability and the valuation of the company in the market.
- Static earnings are one part of the stock. The other part is the quarterly results announced by the company from time to time. Each quarter, you get an update on how the company is performing and no fundamental analysis is complete unless these quarterly numbers are closely analyzed.
- Channel checks are one more important source of information in fundamental analysis. For example, an auto company may claim that it produced 20% more cars but a dealer check would tell you if its cars are in demand. The same is the case with FMCG products with short shelf lives.
It is only when all the above steps are combined that you have a veritable fundamental analysis model for companies.
Components of fundamental analysis?
There are different ways to look at the components of fundamental analysis. We will not get into the steps, but broadly fundamental analysis can be top-down or bottom-up. For example, an approach of evaluating the economy first, then the industry it operates, and finally, the company is an example of a top-down approach to fundamental analysis.
On the other hand, evaluating a company directly and then ratifying it with industry and economy level factors is an example of a bottom-up approach. Normally the top-down approach to fundamental analysis is more popular in large-cap stocks while bottom-up is more popular in mid-cap and small cap stocks.
The fundamental analysis must also be looked at as distinct from technical analysis. For example, fundamental analysis looks at the company's financials and qualitative factors to evaluate if the company is attractive. Technical analysis focuses on charts and patterns to evaluate whether to buy or to sell. In reality, traders and investors use both. They use fundamental analysis to identify buying and selling opportunities and use technical analysis to identify the entry and exit levels.
What is delivery trading?
Delivery trading is about buying a stock and holding it for some time in your Demat account. India is currently in the rolling settlement system so if you buy or sell a stock then you must close the position the same day for intraday trading. If you don’t do that, then it becomes a delivery trade. But that is delivery trading from a very theoretical and process perspective. Let us look at delivery trading from the standpoint of fundamental analysis.
The idea of fundamental analysis is that to be profitable in equities, it is essential to take delivery and hold for long periods. You make big profits when you buy and hold for a long time of say 3-5 years. That is the essence of delivery trading.
How to invest in stock markets?
To invest in stock markets, you start by opening your trading account with a broker and also your Demat account. That is the starting point. The most important aspect is that you must research and understand stocks before buying them. After all, a well-informed decision is always more valuable than a decision taken at random.
Once you have decided to trade, do your research on stocks and zero in on the stock. Then look at charts if the level is right. Also, look at factors like management quality and what the media is talking about the stock. You finally get a much better product and a much better investment decision.
Frequently Asked Questions Expand All
Intrinsic value is the fundamental value of a stock based on future cash flows, industry attractiveness and qualitative factors like management, corporate governance etc. It is used as a basis for investors to decide whether the stock is under-priced or overpriced.
There are a number of factors that go into impacting the fundamentals of the company. For example, factors like profitability, operating income, leverage, solvency, liquidity etc. In addition, qualitative factors like management, corporate governance, competitive strength etc are also key determinants of fundamental value. Apart from all these factors, many macro factors like inflation, interest rates and the competitive levels and innovation in the particular industry also are material.
Fundamental analysis helps to arrive at a likely value for the stock based on future cash flows. It enables us to see if there is margin of safety in the investment decision. It is not just enough for the stock to be under-priced but it has got to be substantially under-priced. Today fundamental analysis is used not only by analysts and investors but also by investment bankers looking for potential M&A targets.
For fundamental analysis, there are a variety of automated tools you can use. You can use automated screeners; you can use ratio sorting and you can also use spread sheets to do a what-if analysis under various conditions. All these can be important tools for fundamental analysis.