What is Fundamental Analysis? How to do fundamental analysis of a stock? What is the difference between Fundamental analysis and Technical analysis?
If any of the above-mentioned questions stumbles in your mind then you are in the right place.
Let’s dive deep into the detailed guide.
What is Fundamental Analysis?
By deep down in the Fundamental analysis, you can gauge a stock’s intrinsic value via evaluating revenue and valuation factors. The end goal of fundamental analysis is to find if the stock is undervalued or overvalued when you are investing in the stock market for the long run.
What is the benefit of Fundamental Analysis of a company?
When you are looking for multibagger returns by investing in the stock market, you should not only exercise patience but also stick to a fundamentally strong stock that is able to deliver robust returns in the long run.
But how can you gauge which company is able to deliver robust returns in the long run?
Let’s make it clear with an example.
Suppose you want to buy an apple from the market and ask a shopkeeper the price of an apple. There are two options. The first one is the shopkeeper will ask you to pay 5 or 10 for a kg of an apple. But you know that one kg of apple should cost 7. Now, it’s time to investigate why the asking price is different. So, no matter at what valuation the apples are available, do investigate why they are available either at a stiff valuation or cheap valuation.
You will find the same scenario when you are about to trade a stock. Suppose you want to buy a share of Berger paints. When you type the share price of Berger paints you will find that Berger paints is currently trading at 773. The current trading price is what a trader asks to sell a share of Berger Paints that he owns. When your primary target is to buy a stock that will deliver robust returns in the long run then you need to own a stock at a much lower price than the intrinsic value of a stock.
Simply put, when the intrinsic value of Berger paints is 1000 then you should buy this stock as the stock is available at a discount than its underlying values. On the contrary, if the intrinsic value of Berger paints is 700 then it’s not worth buying since the stock is trading higher than its underlying values.
In a nutshell, fundamental analysis will tell you if you should own the stock at a much lower price than its underlying values or not.
What are the different types of Fundamental Analysis?
There are two components of Fundamental analysis namely Quantitative analysis and Qualitative analysis.
When you gauge the company by analyzing the Quantitative factors namely earnings, profit growth, free cash flow, you will find all these data in the financial reports i.e. income statement, balance sheet, profit and loss account, etc. By analyzing the quantitative factors of a company you will easily calculate if the company is trading higher or lower in respect of its underlying values.
But you can’t calculate the Qualitative Factors of a company right away by collecting the data from financial reports. The qualitative factors are the soft factors that aren’t easy to calculate. The Qualitative analysis of stock includes brand value, patents, business model, management, competitive advantage, and corporate governance to evaluate the company.
Though both the Quantitative Analysis and Qualitative Analysis cover the different aspects of a company, both are equally important to gauge whether the market price of a stock is trading higher or lower than its underlying values.
How to do Fundamental Analysis of a Stock?
Here is the exact 4-step process to do a fundamental analysis of a stock to find if the stock is trading lower than its underlying values.
- Step #1. Pick a sector that you have a complete understanding of.
- Step #2. Upside-down research of the Quantitative numbers.
- Step #3. Analyze the Qualitative factors of a company.
- Step #4. Invest in fundamentally intact companies across various sectors for the long-term.
Step #1. Choose a Sector
When you are hunting high and low for the best returns in the long run, then you should apply the top-down investing strategy.
How to choose a sector by applying the top-down investing strategy?
When you apply the top-down investing strategy you focus on how the macro-economic factors drive the stock market. After analyzing the economic factors, it is time to find what sectors or industries deliver robust returns historically. When you have found the specific industry that you have a complete understanding of, now it’s high time to pick the best stocks after making a detailed analysis of quantitative and qualitative factors.
Step #2. Upside-down research of the Quantitative numbers
When you are applying the top-down investing strategy to invest in the best stocks that are operating in the hottest sectors or industries, do check the 10 parameters before investing.
Parameter #1. Debt to Equity Ratio
The debt to equity ratio helps a retail investor to find what debt obligations a company has in comparison to its shareholder’s equity.
When a company’s total debt obligations is divided with its shareholders’ equity, the end result is the debt to equity ratio of a company.
By analyzing the debt to equity ratio one can find whether the company is delivering robust growth by pumping external capital or not. The D/E Ratio reveals whether the company is able to repay all the outstanding debts in the scenario of depressed earnings during a business cycle.
Banks and Non-banking financial corporations have a relatively higher debt to equity ratio as compared to the other sectors. When you have found that a bank has delivered robust growth by pumping external capital and the cost of the debt is marginally lower than the earnings, the stock is worth investing in.
Parameter #2. Free Cash Flow
Free cash flow will give a detailed snapshot of what’s left in the bank account of a company after deducting the capital expenditures from the sales. Simply put, free cash flow will help a retail investor to calculate the capital remains to declare dividends or offer share buybacks to cheer shareholders or to repay the creditors.
Free cash flow measures the efficiency of the management since it has taken into account how efficiently the company is generating sales by running a business operation. When a company has delivered robust earnings, the company may pay down the debts outstanding making it a debt-free company. When a company declares itself debt-free, you will witness a rise in dividend payments in the near future.
Parameter #3. Profit Margin
By analyzing the gross sales, total expenses, and net profit generated, you will find it difficult to calculate the profitability of a business across different economic cycles.
But when you analyze the Profit Margin of a company over a financial year you will find how much profit a company generates per rupee of sales after deducting operational expenses, interest payable on debts, if any, and applicable taxes.
Simply put, when a company delivers a 17% profit margin during the last financial year, it means that the company had a net income of ₹17 for each ₹100 of sales generated.
Do remember each sector has a different profit margin. Usually, the technology sector has a higher profit margin in comparison to the automobile sector. As an intelligent investor, do invest in a company that has a double-digit profit margin.
Parameter #4. Earnings per Share
The Earnings per Share (EPS) is calculated by dividing the company’s net profit in a financial year with its total shares outstanding.
By evaluating the Earnings per share you will find how much the company is making by issuing a common share.
When investors find that the company is able to deliver the present robust growth in the future, they are willing to pay a higher price to own that stock and thereby resulting in higher EPS.
Suppose, two companies operate in the same industry and they have delivered the same EPS in a financial year. Then in which company should you invest? Invest in the company that has fewer assets. The company with fewer assets is more efficient as the company utilizes the available capital quite efficiently to generate more profit.
Parameter #5. Dividend Payout
The Dividend-paying stocks provide a retail investor a regular and steady cash flow by owning the shares of a company that has a record of regular dividend payment.
The Dividend Rate of a company reveals what cash flow the retail investor will receive in a financial year from the stock that he owns. Invest in those stocks that have a track record of regular dividend payout and double-digit profit growth for the last 5 years.
Parameter #6. Return on Equity
To gauge the operational efficiency of a company, you will find Return on Equity a handy matrix.
Return on Equity is calculated once you divide the Net income of a company in a financial year with its’ Total Shareholder’s Equity.
Do remember different sectors have different Return on Equity. As a rule of thumb, don’t invest in a stock that has a lower ROE in comparison to its industry average. You should invest in the stock that has an ROE of 20% when the peer average is 17%.
Parameter #7. Return on Capital Employed
The Return on Capital Employed will help you to find how efficiently a company is generating profits by running business operations from its available capital.
The ROCE is quite helpful to analyze the performance of a company that has significant debt obligations when the company operates in the Banking and Telecom sectors.
Simply put, the ROCE helps you to find what amount of profit the company has made per rupee of capital employed after paying interest for debt obligations.
Invest in those companies that have a stable and soaring ROCE in comparison to those companies that have a volatile or deteriorating ROCE.
Parameter #8. Price to Sales Ratio
This ratio compares what retail investors are willing to pay for each rupee of sales or revenue generated by a company in a financial year.
The Price to Sales ratio can be calculated if you divide the current market price of a share with its per-share sales generated in a financial year.
Do remember when you compare two stocks as per the price to sales ratio, include stocks that are operating in the same sector. The lower the P/S ratio is, the higher the investment opportunity will be.
Parameter #9. Price to Earnings Ratio
To compare two companies’ valuations that are operating in the same sector or industry, price to earnings ratio is the key metric to gauge if the stock is overvalued or undervalued.
If the current market price of a stock is divided with its per-share earnings in a financial year, you will find the Price to Earnings Ratio.
In essence, the Price to Earnings Ratio will give you a detailed snapshot of how much the market is willing to pay per rupee of earnings generated by running a business operation either in the past or in the future.
When a company’s Price to Earnings Ratio is 35, then it can be assumed that the market is willing to pay ₹35 for ₹1 of current earnings.
In other terms, if the P/E ratio of a company is 7, then it can be assumed that it will take 7 years to earn back the initial investment when the company’s profit remains constant.
Neither a higher Price to Earnings ratio signifies that the company is overvalued nor a lower Price to earnings ratio makes a company undervalued. As an intelligent investor do consider in which sector the company is operating and whether the stock is available at lower P/E levels when compared to its peer companies.
Parameter #10. PEG Ratio
PEG Ratio is a handy one to evaluate the valuation of a stock. The Price/Earnings to Growth Ratio can be calculated by dividing the price to earnings ratio of a company with the expected earnings growth for a specific time horizon.
Since the PEG Ratio has taken account of both the Price to Earnings ratio and the projected earnings growth, you will find a clear picture of whether the stock is trading at a discounted price to its underlying values.
When the PEG ratio is less than one then the stock is possibly trading lower than its underlying values.
Parameter #11. Price to Book Ratio
When you divide the market price of a stock with its book value per share, you will find the Price to Book Ratio.
By analyzing the Price to Book ratio you will find what you are paying to own the shares of a company and what you will get after paying all the debts outstanding if the company goes bankrupt right now. It sounds like painting rock, to pinpoint a specific price to book ratio when you are hunting high and low for undervalued stocks.
Do remember, price to book ratio differs from one sector to another. As a value investor, you should pick a stock that’s P/B ratio varies between 1 & 3.
Parameter #12. Beta
To calculate the volatility of a stock in comparison to the overall market’s volatility, Beta is one of the key metrics to gauge the volatility often used by analysts. A Beta will give you a detailed snapshot of whether the stock is more volatile or not in comparison to the overall market.
A beta of 1.5 signals that the stock is 50% more volatile when compared to the market’s volatility. Simply put, when the market delivers a 20% return, the chances are higher that the stock will surge 30%. On the contrary, when the stock market corrects 20%, the stock may plummet 30%.
Simply put, High beta stocks are capable of delivering robust returns but are much riskier.
Step #3. Analyze the Qualitative factors of a company
You have done a proper analysis of a company on the basis of the numbers that you have got in its Income statement, Balance sheet, etc. Now it’s time to make a qualitative analysis of stocks that you won’t find in the balance sheet or income statement.
When you perform a detailed walk-through of Qualitative analysis, you will find the business model of the company, how efficient the company’s management is, if the company has a competitive moat, and the corporate governance of the company, etc.
Parameter #1. Business Model
The business model can be described as applying what mechanism a company generates profit. It’s worth considering what products or services the company offers to its target consumers and thereby generates a profit by running a business operation.
In other words, investigate what distinguishing features the company is offering that pulls the audience that makes the product or service the first choice to customers or clients and thereby keeps the competition at bay.
Parameter #2. Management of the Company
To evaluate the management of a company is a tuff job. It can’t be described as numbers since this is an intangible asset a company has. Simply put, there is no magic formula to gauge the efficiency of the management of a company.
Here are the few factors that you should pay close attention to find if the management is efficient enough to deliver robust earnings from the available capital.
- Who is sitting on the key positions namely CEO, COO, CFO?
- What are their educational qualifications and experience?
- For what tenure are they in the key positions?
- What are the previous employment records of the management?
Pick a stock after analyzing the above-mentioned points since the company that is operating in the hottest sector or industry can be doomed if the management of the company is not efficient enough to tackle adverse situations during a specific business cycle.
Parameter #3. Competitive Advantage or Competitive Moat
Competitive Advantage is a company’s ability to offer a specific product or service at a discounted price than its peer competitors. The competitive advantage gives a company to increase sales and competitors keep at bay.
Take the example of Amazon. It has a strong distribution network around the globe and competitive pricing has led the company to create a sustainable competitive advantage as compared to its peer companies.
You will find the same scenario when we take the example of Apple. The patent-protected technology, a strong distribution network, and lower operational expenses give Apple a competitive moat in respect of peer companies.
From the above examples, it is clear that the higher the competitive moat is, the higher the chances are of rising dividends to cheer the shareholders.
As a value investor, your primary goal is to find similar companies that have a competitive moat in their respective sectors and stay invested for the long run to get superior returns.
Parameter #4. Corporate Governance
Corporate Governance refers to a set of rules that are being exercised to run the firm, as set by the board of directors. When a company runs its business transparently and follows ideal work ethics with zero tolerance for illegal activities, the company is worth investing in.
The role of the board of directors is crucial when it comes to the preparation and exercise of a company’s corporate governance policies.
Step #4. Invest in fundamentally intact companies across various sectors
There are various sectors namely Banking and Financials, Consumer durables, Real estate, etc. They have delivered robust returns in comparison to the overall market. But that doesn’t mean you should include the companies that are operating in the consumer durables sector solely. Instead, as a smart investor do diversify your stock portfolio after investigating whether the fundamentals are intact and thereby include stocks across various sectors to minimize the risk profile.
Fundamental analysis helps a retail investor to find strong companies with robust fundamentals that will yield the best returns in the long run when you have owned a stock that is trading much lower than its underlying values.
FAQs regarding how to do fundamental analysis of a company
In which sectors should I invest?
When you are investing for the long run, pick a sector that will exist even after 100 years. For instance take the example of consumer staples, automobiles, etc. Apart from that, you should investigate whether the products or services that the company is offering now will be relevant after 50 years or not. Invest in those companies the products of which will be used even after 50 years.
How do I analyze the peer competition?
When you have picked a sector that you have a complete understanding of, now it is time to study the peer companies before you start investing in any company. You should find the answer why you are investing in that specific company and not in any of its peer companies. When you have found the company has delivered robust earnings, or the company has a sustainable competitive advantage, or has developed patent-protected products, has brand recognition, etc. then you are good to go.
What is the difference between fundamental analysis and technical analysis?
Fundamental analysis will help a retail investor to calculate the intrinsic value of a stock since it takes into account Quantitative factors namely earnings, valuations, etc., and Qualitative factors namely Brand value, competitive advantage, management, etc.
On the contrary Technical analysis has nothing to do with what is the intrinsic value of a stock. But it helps to identify patterns and trends after analyzing historical price movement and trade volume.
- Read also: How to do Technical Analysis of Stocks
Hope this article has helped you how to do fundamental analysis of a stock. If you have a doubt shot a question right in the comment sector so that I can help you in the best plausible way.