.png){kind=small}
Introduction
Fundamental analysis is one of the most important techniques to make any worthwhile investment decisions about the Indian stock market. It constitutes the analysis of the financial health and performance of a company to project its intrinsic value and growth potential. In this article, key concepts, tools, and strategies of fundamental analysis will be explained concerning the Indian stock market.
> What is Fundamental Analysis?
Fundamental analysis is the method of analyzing the financial statements of a firm, economic indicators, industry trends, and competitive analysis, among other relevant aspects, to determine the intrinsic value of a firm's stock. Thus, identifying undervaluation or overvaluation of the stock gives the investor a lead to make decisions. In the Indian stock market, there are six basic steps for the fundamental analysis of a company. The six steps on how to analyze a stock follow:
Understand the Business
First of all, if you understand the business in simple terms—what the business is all about—then you can proceed further. Do something called "qualitative analysis." That means looking at non-numerical stuff.
Think of this as like going to a restaurant. You'd want to know its menu, who runs it, and who it competes with. Also, go to the website of the company and get a feel of what it does, what it stands for, and what its mission and vision are. something like reading about a restaurant and the values it espouses and what kind of experience you're in store for. This qualitative analysis allows you to get an intuitive sense of the business and its place in the markets, which sets up a base of some understanding before you dive into financial statements.
> Checking Financial ratios
One of the handiest ways through which both seasoned and new investors can pick promising companies from the stock market is by checking financial ratios. For a new investor who has never analyzed stocks, there is no need for your poring over complicated annual reports. You can easily find those ratios on finance websites. Here are some of the essential financial ratios:
EPS: Look for a company whose EPS has been trending upwards for the last 3-5 years. This will mostly be a positive sign that the company is actually earning more money per share.
Price to Earnings Ratio: Compare the company's PE to that of its industry peers. If it is low compared to theirs, then it might be really good.
Return on Equity: The average return on equity in the last 3 years should at least come out to be 15%. This will indicate that the company is using its shareholders' money efficiently.
Debt to Equity: It should not be more than 0.5. It will show that there is no overburdening of the company with debt.
Current Ratio: Look for a ratio higher than 1. This will tell you if a company has sufficient current assets to cover its current liabilities—a sign of financial stability.
Remember, these rules aren't cast in stone and may change with industry type, but they are good, general guides in evaluating the health of a company.
> Past financial statements
Financial statement analysis forms a very important part of fundamental analysis. To be able to do a good financial analysis, an analyst need not be a great accountant.
> Introduction to Financial Statement –
Balance sheet: It contains information regarding the financial position i.e. the assets, liabilities, and equity at the end of the financial reporting period.
Statement of profit and loss account: This is a statement that provides information about the financial performance of the company, that is, the income, expense, and profits for a given period.
Statement of changes in shareholders' equity: Shareholders' equity represents the funds belonging to shareholders. This may change due to various reasons like profits earned, dividends declared and paid, issuance of additional shares, buyback, and specific income/other comprehensive income.
Cash flow statement: The cash flow statement presents a summary of various sources and uses of cash.
> Competitors Analysis
Compare it with industry peers: Now consider the uniqueness of the company, the competitive advantage, cost and pricing control, brand repute, and future strategies. This would give you an idea about the company's relative position vis-à-vis its peers, similar to evaluating products for purchase in a store.
> Know the Debt of the Company
The next step in fundamental analysis is checking the total debt of the company. This will tell us what amount of money the company owes to others, such as creditors. They have to settle these before they can share their profits with shareholders in the form of dividends and pay interest on these to creditors or debenture holders.
Here's the deal: the more loans a company has to pay back, the less likely it is going to pay dividends to its shareholders. A good rule of thumb is that if the debt-to-equity ratio standing below 1 is an even better option of the company. This aids us in viewing if the burdening in debt of a company is at a manageable level; thus, being an attractive feature to investors.
> Future Prospects and Strategies
The future plans and strategies of the company will be a critical view towards making wise investment decisions. Never forget, the returns you look forward to depend on what lies ahead, not on what happened in the past. Consider companies whose products or services will be in demand a decade from now if you want to invest for long-term goals, such as FMCG, healthcare, or IT.
You can further get an idea about future prospects by developing financial models of a company. Compute the valuation, which gives the share's intrinsic value estimated for a time in the future and compare with the current value. In that way, you can judge whether to invest or not.
> Valuation Models
Some of the valuation models used in Fundamental Analysis are the Discounted Cash Flow model, and the Gordon Growth Model.
> Type of Fundamental Analysis
Fundamental analysis again comes in two flavors: Qualitative and Quantitative.
Qualitative analysis is about the quality of things like management, brand, products and financial performance. It's like giving an opinion whether Bajaj Auto has better products than TVS Motor Co. This is subjective.
Quantitative analysis deals with the numbers, data derived from financial statements. None of it is opinions; it's all hard facts.
Here's the exciting part: You need both. You can't pick one and ignore the other.
There can be two approaches to fundamental analysis: Top-down and Bottom-up. In the top-down approach, it normally starts from a big picture; for instance, it takes consideration of the economy as a whole, then goes ahead with a general industry, and finally to the stock. For example, while checking the stock of Maruti, you first look into the car industry on the whole.
In contrast, bottom-up analysis starts at the company level. You look at their strengths and then build your stock portfolio based on those strong picks. So, whether you start at the top or at the bottom, the end result of fundamental analysis is to make informed investment choices.
In a nutshell, fundamental analysis forms the core for making investment decisions. The financial health of the company, its position in the industry, and outlook and prospects may help an investor make a decision. Both qualitative and quantitative factors are part of the analytical process here. Plus, there is a top-down and bottom-up approach in this context. Therefore, fundamental analysis guides investors toward making wise long-term investments in the vibrant world of stocks.
Comments