Basics of Fundamental Analysis - 3 Pillars of Fundamental Analysis
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‘Only buy something that you’d be perfectly happy to hold if the markets shut down for 10 years’.
This quote by Warren Buffett perfectly captures the spirit of fundamental analysis. Great investors like Warren Buffett, Benjamin Graham and Peter Lynch have built fortunes using fundamental analysis.
But exactly, ‘What is Fundamental Analysis?’ or how does Fundamental Analysis work? Majority of us believe that fundamental analysis is only for experts. But this is not true.
We do fundamental analysis every day. This includes –
- Your mother deciding whether to buy ripe tomatoes or raw tomatoes.
- You deciding between IPhone 12 Pro Max and Samsung S21 Ultra.
- You deciding whether to eat a fruit or have panipuri.
The idea is to buy or invest in something for the long term. Raw tomatoes have longer shelf life. Fruits are good for long term health.
Fundamental analysis also helps you decide which stocks are worth investing for the long term. It is the study of a company’s long term prospects. It does not bother with what happens to a stock in 3-6 months.
[Read More: Best Long Term Stocks to Buy in 2021]
Fundamental analysis is more concerned with the company’s long term future. The aim is to find a stock’s real value. Also known as its intrinsic value.
Watch our Video on Fundamental Analysis and Learn How to Analyse Stocks.
https://youtu.be/eKntNyMDPOg
What is Fundamental Analysis?
Fundamental analysis is a systematic approach used to find a stock’s intrinsic value. It is done using qualitative and quantitative factors.
- Qualitative factors are quality of management, corporate governance etc.
- Quantitative factors include studying company’s profits, losses, cash flows etc.
Benjamin Graham is the father of ‘fundamental analysis’. He introduced the term in 1928. He observed that a stock’s value and its price in the market was different. This is contrary to Efficient Market Hypothesis (EMH).
EMH states that current stock prices reflect all ‘publicly’ available information. Hence it is impossible to beat the market. The concept of intrinsic value does not exist in EMH.
But investors like Peter Lynch and Warren Buffett have consistently beaten the market. This proves that intrinsic value does exist.
Fundamental Analysis & Intrinsic Value
The aim of fundamental analysis is to find a stock’s intrinsic value. But why is intrinsic value important? What does it tell you?
Let us understand this with an example. You want to buy a shirt. The shop keeper tells you its cost is Rs 1,000. You look at the shirts material, stitch, color, pattern etc. You decide that it cannot be worth more than Rs 700.
This Rs 700 is its ‘intrinsic value’. Intrinsic value of a company is simply its total assets minus total liabilities.
Let us apply the same concept to shares. The share price of Tata Consultancy Services Ltd (TCS) is Rs 3,100. You believe the stock will do well in the future. But feel the current prices are a bit ‘over’ valued. So, you wait for a fall to buy TCS at a discount.
The share price of TCS falls to Rs 2,800 after 1 month. You go ahead and buy the shares. You think you got a discount of Rs 300.
But what if I told you that the ‘intrinsic value’ of TCS is Rs 2,500.
Now, you have paid Rs 300 more for the stock! It is important to known a stock’s intrinsic value to avoid such situations. It will help you decide whether you are buying shares at a discount or paying extra.
- If Intrinsic Value is higher than stock price, the stock is undervalued.
- If Intrinsic Value is lower than stock price, the stock is overvalued.
Remember, stock prices generally revert to their intrinsic value in the long run. In the above example, suppose TCS is trading at Rs 2,000. Its intrinsic value is Rs 2,500.
- In this case, TCS is undervalued. So, you will buy TCS Ltd at Rs 2,000 as you expect it to revert to its intrinsic value (Rs 2,500).
- If TCS was trading at Rs 3,100 then you will sell it as it will revert to its intrinsic value (Rs 2,500).
This might sound easy, but finding a stock’s intrinsic value is difficult. It is obtained by merging both quantitative and qualitative aspects of a stock.
Types of Fundamental Analysis
Fundamental analysis is not limited to only studying a company’s balance sheet. There are two types of fundamental analysis –
Let us first understand qualitative fundamental analysis. What do you see in the below picture? A skull or a little girl playing in a garden?
The answer is both! Some might see a skull and others might see the girl. The picture remains the same but opinions change. Qualitative analysis is like this picture. It is subjective.
Qualitative Fundamental Analysis includes studying a company’s:
- Quality of management
- Corporate governance
For example: Should a business be managed by promoters or experienced professionals?
- Some investors might think a business is better off being managed by its promoters and owners as they have built it from the ground up and understand everything about the business.
- Other investors might believe the business is better off being managed by experts in respective fields. This will help the company take tough decisions and always be on top of the game.
Same situations, different conclusions.
This is why qualitative financial analysis is not solid science. It changes with every investor. But investment decisions cannot be made based on emotions. This is where ‘Quantitative Analysis’ comes into the picture.
Quantitative Fundamental Analysis is a study of a company’s finances. It involves studying:
Quantitative analysis is faced on formulas and ratios. It helps you find how the company has performed year on year. Whether the revenues are stable or not. Financial ratios play an important role in fundamental analysis. There are five types of financial ratios. We will each these ratios in detail later.
How Does Fundamental Analysis Work?
There are two approaches to fundamental analysis –
Let us understand how fundamental analysis works with this example. It is your best friend’s birthday. You decide to buy her a gift.
- You shortlist categories – Perfume, Clothes or Bags.
- You decide to gift her a perfume.
- You research on the best perfumes in the market based on smell and price.
- You finally decide to gift her a Dior perfume.
The above example is a top down approach to gifting.
Top down Fundamental Analysis first looks at macro-economic factors such as GDP, Inflation etc. It then looks at industries with high moats. Then it looks for companies with high profitability.
Top down approach involves:
- Economy Analysis
- Industry Analysis
- Company Analysis
Bottom up Fundamental Analysis is the exact opposite of Top Down analysis. Here, we start by analyzing a company, then the industry and finally the overall economy. Top Down approach is more popular among investors and analysts.
{Read More: Learn How to Choose Stocks for Investments]
Three Pillars of Fundamental Analysis
Every company functions in an environment which shapes its future. This environment influences the stock’s intrinsic value. Hence, economic analysis is an important part of fundamental analysis.
Economic Analysis is a study of the following factors.
1. Gross Domestic Product (GDP): GDP is the total value of goods and services produced in an economy. In a growing economy, GDP is high and companies post higher profits. Whereas during recessions, profits fall leading to unemployment, lower spending etc. A steadily growing GDP is good for business.
2. Inflation: High inflation reduces investor’s purchasing power. This reduces the overall demand in an economy. Low demand means less revenue. When companies earn less it directly affects investor sentiments. This is evident in lower stock prices.
Inflation is equally disruptive for companies as well. When inflation rises, cost of raw materials increases. Companies cannot keep on raising their prices as it will affect demand. High cost of production reduces profit margins. This again affects stock prices.
3. Interest rates: When interest rates are high, businesses are forced to borrow money at high rates. This increases the cost of capital reducing company’s profitability. When companies post less profits, its share prices are directly impacted.
When interest rates are low, businesses borrow money cheaply and cost of capital reduces. This drives demand and increases company’s profits. Investors are eager to invest in companies with high profitability. This increases its share prices.
4. Economic & Political Stability: A stable political environment is important for businesses. Companies can work in the long term only when there is stable political climate in the country. For example: Investors prefer investing in companies based in USA, UK than politically unstable countries like Syria or Iran.
Industry Analysis
Companies belong to an industry. Infosys, Tata Consultancy Services (TCS) belong to ‘Information Technology’ industry. So which industry should you invest in? How should you analyse a particular industry?
Here are factors that Investors should consider while analyzing an industry.
1. Demand Supply Gap: The demand for any product grows at a steady rate. But its production increases with time. At a particular point, there is an oversupply.
- Oversupply reduces a product’s demand which decreases a company’s overall profitability.
- High demand and low supply increases the price of the product. This leads to higher profitability for the business and investors.
Ideally you should invest in companies with marginal demand supply gap.
2. Competitiveness in the industry: Extreme competition can bring down a company’s future earning potential. Hence it is important to invest in companies with ‘economic moat’. Industries with high moat have high barriers to entry, high cost of production etc. This keeps competition to a minimum.
Example: Telecom industry has high entry barriers in terms of spectrum cost, set up costs etc. Similarly FMCG, Pharma, airlines also have high entry barriers. Whereas clothing industry has relatively low entry barriers.
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3. Evergreen Companies: With advancements in technology, products are getting out of fashion quickly. In 1990s, everyone owned a Walkman. Today, mobiles have replaced Walkman. Floppy disks are replaced by cloud storage!
Investing in industries with a high replacement rate is not recommended. Investors should invest in ‘evergreen companies’. These are companies whose products will never go out of use. Like FMCG, Pharma etc.
[Read More: Best Pharma Stocks to Buy in India]
4. Government Regulations: There are certain industries which are heavily punished by the government. These include Alcohol, Cigarette industries etc. ITC, United Breweries Ltd are such stocks. A change in regulation or taxation can heavily impact such companies. This can lead to substantial long term loss for investors. Hence, investors need to be careful while investing in such industries.
5. Production Factors: Cost of raw materials and labor is an important part of industry analysis. An industry with a history of labor strikes should be avoided. High cost of production is another key aspect while analyzing an industry. Every product has a fixed cost and a variable cost.
Higher fixed cost = more time required to break even. Example: Airline Industry
Lower fixed cost = easy to break even. Example: IT Industry
Ideally, investors should invest in companies with lower fixed cost and fewer labor strikes.
Company Analysis
The final pillar of EIC is ‘Company Analysis’.
- Economic analysis shows the growth prospects of the entire economy.
- Industry analysis shows which industry is more profitable.
- Company analysis shows which company is most attractive.
In company analysis, investors focus on future earnings potential of a company. Company analysis is performed using:
Difference between Technical and Fundamental Analysis
Fundamental and technical analysis provide answers to two very different questions.
- Fundamental analysis tells you ‘what’ to buy.
- Technical analysis tells you ‘when’ to buy.
The question of ‘when to buy’ arises when you are trading in the market, not investing.
Technical analysis is for traders. It does not bother with a stock’s intrinsic value. Technical analysis focuses on when to enter and exit a stock. Whether the stock is good, bad or ugly is not too important for them.
Hence traders should prefer technical analysis. Investors looking to create long term wealth should focus more on fundamental analysis.
We have created a dedicated playlist for technical analysis. Learn everything about technical analysis here.
https://youtu.be/BrzKg6P7Kx8
How to Perform Fundamental Analysis?
Fundamental analysis is not just for analysts with fancy degrees. Everyone with basic understanding of finance can practice fundamental analysis. You will need the following tools for fundamental analysis –
- Company’s annual reports. This is freely available on company’s website.
- Access to competitors and overall industry data.
- Access to news of your shortlisted companies and industries.
All these tools are freely available. So, Fundamental analysis can be done by everyone. The difficult task is trying to understand what these ratios mean. We will explain you all major types of financial ratios and their implications in the coming articles.
This concludes the basics of fundamental analysis. If you are interested in investing in best ‘fundamentally’ chosen stocks then open a FREE Samco Demat account today and get access to the best long term stocks in India.