If you are looking to bag some multibaggers or invest in shares on a long-term basis, it is imperative for you to 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 if a particular stock is worth your purchase. One such method discussed in this article is fundamental analysis.
This article covers:
- What is fundamental analysis?
- Why is intrinsic value so crucial in making purchase decisions?
- How is fundamental analysis different from technical analysis?
- Who uses fundamental analysis?
- Types of fundamental analysis
- Quantitative fundamentals
- Qualitative fundamentals
- Pros of fundamental analysis
- Cons of fundamental analysis
What is fundamental analysis?
Fundamental analysis refers to a method that uses several relevant economic and financial factors to evaluate a share’s intrinsic value.
Intrinsic value meaning the investors pit it against the stock’s trading price and then decide if you want to go long or short, that is buy or sell it.
Why is intrinsic value so crucial in making purchase decisions?
There are 3 underlying assumptions of fundamental analysis:
- The market prices of stocks fail to reveal an accurate picture of a stock
- The value reflected by quantitative and qualitative analysis portrays a far better image of the same
- The share market will automatically discover the actual value of the stocks in the long run
In this case, instead of opting for a series of standard calculations, analysts opt for several complex models to find the stock’s actual value. In addition to that the assumption of stocks reaching their true value in the long run, the investor can use fundamental analysis to make significant gains over time.
How is fundamental analysis different from technical analysis?
Technical analysis uses statistics to evaluate a stock. An analyst combines the results from a plethora of data such as stock prices, past returns, trade volume, and more to understand the short-term movement of the equity share and the market. It inadvertently means that the data in contention here is short-term too.
If compared, the fundamental analysis considers information spanning years. Also, given its nature, technical analysis is useful for short-term trading, whereas it is primarily for long-term investments.
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 for gauging and improving the profit-making ability of an organization by streamlining its operations. It also helps them understand where they stand against the competition
Types of fundamental analysis
Fundamental analysis is all about harnessing data to make an investing decision pertaining to 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 be bifurcated into two categories – quantitative and qualitative. The former refers to the information in numerical form, whereas the latter pertains to the standard or nature of something.
They are only numbers. The analyst uses financial statements to make informed investment decisions. Here are the elements that form the base of quantitative fundamentals.
Cash flow statement
The cash flow is a statement that summarises the cash position of an entity. It bifurcates the cash inflows and outflows into 3 major categories:
- Cash flow from operations: It takes into account all the cash influx and outflows pertaining to the day-to-day business operations of the entity
- Cash flow from investing: A business invests in a lot of assets throughout a financial year. The cash flow from investing activities is a sum of cash paid for acquiring new resources and the proceeds from the sale of equipment, businesses, or other similar assets
- Cash flow from financing: It is a summary of all the cash paid and received from issuing securities and borrowing funds
Profit & loss statement
The profit & loss statement summarises the revenues, expenses, and profit generated by the company for a specific period.
The company’s balance sheet shows the company’s income, expenses, assets, and liabilities on a specific date. It also reveals the status of equity ownership and debt on a given date.
Unlike the quantitative fundamentals that are out in the world for everyone to see, the qualitative aspects are the more subtle characteristics of an organisation. Below are 4 main qualitative fundamentals to consider:
Management is the most critical part of a company. The way they go about their business will inadvertently decide the success or failure of the idea—the most innovative ideas flounder when it is given to them in the hands of incapable management.
The company charter and bylaws and its corporate laws and regulations define the corporate governance policies. These help the business in establishing its relationships between stakeholders, management, and directors.
The business model refers to what a business does and how it does it. A company needs to have a significant chunk of the inflows from its business model, and if it doesn’t, you are better off not investing in it.
It is what differentiates you from your competition. A competitive advantage can be a brand’s name, supply network, or ability to hire a quality workforce at a cheaper rate.
Pros of fundamental analysis
Here is why investors prefer fundamental analysis:
- It helps you find the probable long-term propositions to invest in the equity shares of choice
- It enables you to uncover companies that are underrated but possess valuable assets and a solid financial standing
- It has limited room for bias
- It helps you in detecting red flags before spending the money on the company
- It helps you get a thorough understanding of the business, including its crucial revenue and profit-driving aspects and those that need work
Cons of fundamental analysis
Even though being an efficient mechanism for finding the right equity shares, fundamental analysis has its share of criticisms:
- It ignores the herd mentality and focuses more on the intrinsic value aspect
- 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
Like any other investment strategy, the fundamental analysis does not guarantee a cent percent accurate result. But given its components, fundamental analysis often gets it wrong, especially if you are willing to go in on a long-term basis. Unlike the usual perception of it being useful only for experts, any investor can utilise it to understand their investment decision. But it can often be difficult for you to get a suitable base to conduct fundamental analysis.
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