What is Fundamental Analysis ?
Stock market has its own typical jargons which are confusing for layman to understand. What is fundamental analysis, what is technical analysis, what is the difference between fundamental analysis and technical analysis are common questions for a first timer in the markets. Let’s decipher them one by one
What is Fundamental Analysis?
Knowing the intrinsic worth of the company is the end goal of fundamental analysis. But for doing the same many inputs are required some of them being the past financial data of the company, a broad understanding of the future growth prospectus, it’s industry background, economic cycles and political ecosystem, interest rates, inflation, currency reserves, tax regime etc. All the inputs are used to derive the true worth of the company. Some use discounted cash flow to arrive at the true worth of the company and some use net asset value etc. While some use price to earnings multiple (P/E) or price to book value (P/B) as the evaluating criteria to know the true worth for comparison with price quoted on the stock exchange. If the price is higher, the stock is costly or overvalued and if the price is low or undervalued there is value in the stock which can be bought for future gains. If the stock is overpriced it may be sold to book profits.
Practical Approach to Fundamental Analysis
There is tons of material on how to do fundamental analysis but the short cut is to listen to what the richest man who has made billions using fundamental analysis has to say. ”Both our operating and investment experience cause us to conclude that ‘turnarounds’ seldom turn and that the same energies and talent are much better employed in a wonderful business purchased at a fair price than in a poor business purchased at a bargain price” - Warren Buffet • Investment is not an exercise in hopes or expectations, it is also not about fantasizing the future based on some events or news or tips, but it is all about realistic assessment of the present by verifying the past track record, and then estimating a future, based on probability. • Successful Investments are just like marriages, one sees the past history, the track record, with focus on understanding the present and then envisioning a future, but nonetheless future is always uncertain, but because, decisions are taken on the basis of facts present on hand, more often than not, they are sound. The same is true for Investments too. True wealth creating companies are wonderful today, and not, will become wonderful tomorrow or the typical turnaround cases.
Inputs for using fundamental analysis: The 3 most important things to watch out for;
• Creation of economic profits, meaning generating returns over and above cost of capital. Companies generating return on capital above 15% are generally considered good for investments • Debt equity ratio is the measure of riskiness of the company during economic down turns. In general a debt equity ratio in excess of 2 is considered risky subject to certain exception of capital intensive industries. • Implicit growth in the revenues and profitability of the company is a perquisite for long term stock price appreciation of the company. When fundamental analysis doesn’t work: For analyzing stocks for the short to medium term fundamentals may not work as demand and supply of the stocks will be the main force driving the stock prices. In such cases it is better to chase price action with trailing stops The difference between technical analysis and fundamental analysis is the time horizon. While technical analysis uses only prices as input as it is assumed that everything is discounted in the prices whereas fundamental analysis takes as input all factors which potentially can impact the value of the company. Stock prices running ahead of the fundamentals at times may not have rational valuations to justify the prices as insiders may well be ahead in knowing the true fundamentals. In such cases it is better to chase price action with trailing stops. Promoters’ deliberate attempt to hide facts, misrepresent data and fudge accounts may lead to arriving at wrong value of the stock dehors of reality.
A practical guide to start fundamental analysis:
• Read the annual report of the company in particular the director’s report and management discussion and analysis popularly known as MDA • Check the growth in profitability of at least previous 5 years to understand the growth rate, higher the rate better for the stock. • Check the debt equity ratio of the company since last five years, a decreasing debt equity ratio for an indebted company would be encouraging. Lower the debt equity ratio the safer it is for investors. • Valuation parameters like P/E, Price/Sales and Price/Book value should be compared vis-à-vis its past record of last five to ten years to know the high and low band of the valuation within which the company had fluctuated in the past. Such comparison will help to understand whether current valuation is at the lower or upper band of the historical valuation.
Fundamental Analysis Reference Books:
• Intelligent Investor by Ben Graham • Fundamental Analysis for Investors by Raghu Palat
How is Samco helping customers do fundamental analysis
Samco Securities, one of India's leading discount brokers provides 4 resources to help investors in fundamental analysis
- Samco Stock Ratings - Ratings have been assigned to over 1000+ companies on the basis of fundamental analysis and the inherent strengths of the companies.
- Samco Data Bank - A consolidated data summary of companies financials to aid fundamental analysis.
- Samco CO Risk Adviser - To aid risk management of a stock portfolio.
- Samco CO Pledge Monitor - To understand the promoter pledge for various companies outstanding shares.