Last Updated on Jun 15, 2022 by Nikitha
Though investing in stocks can be easy, picking the right company can be tricky. If you are looking to bag some multi-baggers returns or invest in shares on a long-term basis, you must use multiple lenses to gauge the company and its potential. You cannot depend on the daily changes in its stock market price. Your purchasing decision should come from something far more concrete. There are several methods that most long-term investors use in determining the worth of stock. One such method discussed in this article is the fundamental analysis of stocks.
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What is fundamental analysis?
The stock prices fluctuate daily. The current value of the stock may be undervalued or overvalued in the market. Investing by looking at the stock’s current price may not yield expected results. Thus, fundamental analysis comes into the picture.
Fundamental analysis is a method used to evaluate the health of a company. It uses financial and economic factors to evaluate the stock’s fair value or intrinsic value. It avoids short-term information about the company or the stock. The stock’s intrinsic value tells the investor whether it is a good deal or not. If the current market price is more than the intrinsic value, the company/stock is overvalued. If the current market price is less than the intrinsic value, it is undervalued.
Let’s consider an example to understand how fundamental analysis of stocks is used.
Alex is a stock market investor. He observes that a stock ‘A’ is trading at Rs 100. To find the intrinsic value of the stock he runs a fundamental analysis. He looks at all the financial statements, company’s performance, future prospects, etc. and analyses that the stock ‘A’ has a potential to grow up to Rs 150 by the next year. As the stock ‘A’ is currently undervalued, Alex makes the decision to buy the stock.
How to do a fundamental analysis of stocks?
The fundamental analysis of a stock involves a few essential steps as follows.
1. Consider financial ratios
A company’s performance is determined by the financial statements released by the company. As the first important step in the fundamental analysis of the stock, you can pick the critical financial ratios listed below and analyse them.
- Price to Earnings ratio (P/E) – the measure of valuation.
- Earning Per Share (EPS) – the measure of profitability.
- Price to Book ratio (P/B) ratio – the measure of a company’s valuation.
- Debt to Equity ratio (D/E) – the measure of indebtedness.
- Return on Equity ratio( RoE) – the measure of profit the shareholders will receive.
2. Understand the company
The next step after the financial ratios is understanding the company you are investing in. Get more insights on the company’s future goal, performance, and whether you should hold or sell the stock. The company’s website will give you a good understanding of the management, promoters, and other important information.
3. Analyse the financial results of the company
Once you have gone through the company details, the important step of the fundamental analysis is to review the company’s financials, like the balance sheet, cash flow statements and profit-loss statements. If there is an increase in the revenue/sales, net margin, and net profit in the last 5 yrs, it can be a positive sign. You should also review other financials like expenses, assets, operating costs, and liabilities.
4. Check the debts
The utmost important factor in the fundamental analysis is to check the debts the company owes. Though a company performs well, it can’t reward you if they have huge debts to clear. So finding companies having a lower debt-to-equity ratio is good. The ideal debt-to-equity ratio depends and varies across the sector.
5. Find the competitors
The company you intend to invest in should be performing better than its peers. It should have well-planned prospects, unique selling points, brand value, etc.
6. Study the future prospects of the company
Fundamental analysis of a stock is essential for long-term investments. In that case, reviewing the future prospects of the company is necessary. A company whose services or products will be in demand even after several years can be picked.
Types of fundamental analysis
Fundamental analysis is all about harnessing data to make an investment decision about stocks. When it comes to data, it can grow from a plethora of areas, and you can interpret them in several ways. So, fundamentals can bifurcate into two categories – quantitative and qualitative.
Quantitative fundamentals are all about numbers. The data is extracted from the financial statements of the company. In comparison, qualitative fundamentals are subjective based on the quality the company offers concerning the brand, services/products, management and competition.
Who uses fundamental analysis?
Even though most investors tend to utilise fundamental analysis, the parties likely to use it are:
- Value or long-term investors since it helps them find out the underlying value of the stock, growth potential, generate pricing targets, and ascertain whether the stock is worth the price they are paying
- Corporate managers and accountants use it to gauge and improve an organisation’s profit-making ability by streamlining its operations. It also helps them understand where they stand against the competition.
Pros of fundamental analysis
Here is why investors prefer fundamental analysis:
- It helps your long-term investment approach.
- It enables you to uncover underrated companies that possess valuable assets and a solid financial standing.
- It has limited room for bias.
- It helps you detect red flags before spending the money on the company.
Cons of fundamental analysis
When there are benefits, there are challenges as well:
- It takes into account years of data and can be time-consuming
- There are different techniques and models for each industry, which can feel cumbersome at times
- Financial statements, the basis of fundamental analysis, often do not present an accurate picture
- Analysing financial data can be a bit complicated
Fundamental analysis does not always guarantee success. It takes specific details of a company to derive an intrinsic value. In reality, the stock price is also influenced by several external factors, which can get overlooked.
Fundamental analysis vs technical analysis
Fundamental analysis and technical analysis are two important methods used by investors before trading in the stock market. Technical analysis takes a company’s past performance to predict the future price movements, while fundamental analysis takes economic and financial factors. Technical analysis is for short-term trading purposes where analysts consider internal data like stock price and volume.
1. Can we use both fundamental and technical analyses of stocks?
Fundamental analysis uses financial and economic data of the company for a long-term investment approach, while technical analysis takes the price and trading value for short-term trading. Depending on the investment period, you can use the approaches.
Tickertape Stock Screener can help you filter stocks based on critical metrics key for your investment decision-making. It encompasses filters like market cap, the sector to which the company belongs, PE ratio, technical indicators and more to ensure that you get a better insight into the company. Try out Tickertape Stock Screener today.
2. Should the fundamental analysis of stocks be used only by the experts?
No. The fundamental analysis of stocks is not limited to experts. Any investor can make use of this analysis before investing in stocks for the long term.