Fundamental Analysis of Stocks

Fundamental Analysis of Stocks

Investing in a company without proper research can be risky. Fundamental analysis is a guide that helps investors understand the actual value of a company. The fundamentals help us analyse the business model, financial health, management, and scope for expansion of a business, etc. and to determine if a stock is reasonably priced or not. This provides investors with a chance to make rational judgments on the basis of facts rather than speculations.

Objective of Fundamental Analysis 

The goal of fundamental analysis is to discover the actual value of a share. This real value is what the company is truly worth, based on its fundamentals and future, not just the current market price. By contrasting this intrinsic value with the stock's current price, you can see if it is cheaper than it ought to be (a good time to buy), or more expensive than it deserves to be. The underlying belief is that, eventually, price and actual worth will match. This is different from technical analysis, which uses charts and past prices to try to guess what happens next. People who do fundamental analysis think the market sometimes acts based on feelings or noise, which gives smart investors a chance to buy at good prices. The idea is to purchase/sell shares of a company at a price that profits or protects you from future price movements.

Where to Find Fundamentals of a Company

An investor can get a company’s basic information from many places but we can trust details only from the company’s office or reliable government sources. 

Company Filings: All listed companies are required to file operational and financial reports to stock exchanges and regulatory authorities. These filings comprise annual reports,  quarterly updates and statements from top management of the company. Through these filings, useful information on different aspects of the company is provided. 

Company Website: Listed companies have a special investor section on their websites. Here, you will find financial reports, news, and recordings of calls where company leaders talk to investors. These help in making people know how well the company is doing.

Financial Information Platforms: There are many online platforms and financial apps today that compile a lot of company information in one platform like financial statements, ratios, historical performance. These sites are a great source for first stage research, but investors always need to cross-check the data against official company reports and regulatory filings to get accuracy and completeness. 

Inclusions of the Annual Statement 

The Annual Report is the comprehensive paper used in fundamental analysis. It gives a full picture of the company’s financial health. Important parts are:

Financial Statements: This part has three sections

✔  The Balance Sheet represents the Assets owned (what does the company own) and Liabilities and Shareholder's Equity owed (what the Company owes) at a point in time. It shows how strong the company is when competitors are compared with it.

✔  The Income Statement shows how much revenue the Company earned and spent (expenses) over time to determine if it is profitable. 

✔  The Statement of Cash Flows will explain the real cash flows moving in and out. 

Management Discussion & Analysis (MD&A):  A vital component of a company’s annual report on finances, giving details of its performance, results, and future outlook.

Auditors’ Report: A report by an independent audit firm that checks if the financial statements  are true and fair. A good report from a reputed third party, means you can trust the data.

Notes to Accounts: These notes help an investor understand how the company earns and spends money. Here, details about how the company keeps accounts, its loans, and legal matters are listed. 

How to Read and Infer Annual Statements 

To read financial statements you need to understand the story behind the numbers. Here are the areas to look at and focus on. 

Check the current ratio.  In the case that the company owes more than it owns, it is riskier. The debt-to-equity ratio reveals a company’s ability to pay its short-term obligations. If liabilities exceed assets, the company is riskier and vice versa. 

From the Income Statement: Look for steady growth in sales and profits over time. If profits are falling, maybe costs are rising or competition is high. Growth in sales is important but profits must also be substantial for a healthy and fundamentally strong company share. Check profit margins, as a strong margin is a positive indication for long term profitability.

From the Statement of Cash Flows: This shows the monetary health of the company. A company may show profits but have no cash, which is a warning sign. Cash that is generated from a company's main business is a positive sign for inventors to invest in the particular stock. It shows the business can support itself and grow or pay even dividends. 

Look for Consistency: Always check all three statements together. If something doesn’t match, look deeper. Also read the Director’s Report to know what the leaders are saying about the company’s goals and problems. It helps the investor in understanding the reason for various changes and the leadership’s commitment towards future growth.

Qualitative Fundamental Analysis 

In this section we discuss things that cannot be counted in numbers. It studies non-financial factors that help a company grow. These are often the company’s competitive advantage or “moat.” 

Business Model: How is revenue generated by the company? Is the way its working strong and can it grow? Generally, a business that receives monthly payments (i.e. subscription-based) is more sustainable than a business that relies on selling single-use products.

✔ Brand Moat: A strong brand can allow a company the opportunity to charge a premium for their service or product. This may happen due to monopoly or greater market share etc.

✔ Network Effect Moat: The value of the product enhances as more people use it. For instance, a social platform becomes more valuable when your friends also use it. 

✔ Cost Advantage: It shows the company’s ability to produce at lower costs than its competitors. Large retailers do this effectively with its size and structure.

✔ Switching Costs Moat: In case it is costly and/or difficult to switch to a competitor, the company is somewhat protected. For example, switching accounting software might require effort and cost.

✔ Management Quality: The leaders’ skill and honesty matter a lot. Successful leaders drive the growth of the company through the decisions that they make. 

Quantitative Fundamental 

In this section we will talk about the numbers in the financial report that help us make an informed choice of stocks . Ratios are simple tools to compare a company’s different parts.

Valuation Ratios: 

o P/E Ratio (Price/Earnings): The relationship between the stock price and the profit (per share). A high P/E means people think it will have high growth.

o P/B Ratio (Price-to-Book): It tells how the stock price compares to the company’s net worth. A number under 1 may mean the stock is cheap.

o P/S Ratio (Price-to-Sales): Good for companies not making profit yet but have strong sales. 

• Profitability Ratios: The profitability of the company is reflected by these ratios. ROE is a measure to know how effectively shareholders' equity is used to generate profit
• Liquidity Ratios: Liquidity ratios can indicate whether the business can pay all short-term debt.  The current ratio indicates whether a company has sufficient cash to settle the payment.
• Efficiency Ratios: An efficiency ratio is a financial statistic that measures a Company’s efficiency in leveraging its assets and resources for revenues and profits. 
• Solvency Ratios The solvency ratios are a measure of a company’s fiscal health. From here, one can know if enough cash is being made by a company to cover its long-term liabilities. In case this ratio is below 1.0, it is an indication that  the company could take on risk when paying off its debt.. 

Steps involved while doing Fundamental Analysis 

Here is how to effectively perform a full fundamental analysis step-by-step: 

1. Macro Analysis: Start with the big picture. Look at the whole economy—like GDP, inflation, and interest rates. This shows the market situation. A good economy helps companies grow, while a weak one can slow them down.

2. Industry Analysis: Now look at the industry. Is it growing or shrinking? Is there tough competition? Apply Porter's Five Forces to evaluate the strength of the industry and how the company fits into it. 

3. Company Specific Analysis: This is the most important part. 

• Qualitative Assessment: Evaluate the company by looking at its business plan, management team and any other differentiating characteristics.

• Quantitative Assessment: Look at the company's numbers and ratios to determine if they align and complete the picture of the business.

• Find True Value: By utilizing the DCF or other model, determine a company’s true value based on projected future earnings.

•  Make a Decision: Determine whether you would like to buy, sell or hold a position based on the company’s current stock price and its true value.

The 3 Tiers of Analysis Approach

Think of fundamental analysis as looking at a company from three levels: 

1.    Macro (Economy) Level: 

This is broad  top down perspective. What is the state of the national and world economy? 

2.     Industry Level:

 The mid-level perspective is this one. How is the industry doing? What are the major trends? 

3.     Company-Specific Level:

This is the closest view. You look at the company's financials, products, leaders, and advantages to get a full picture of its health.

Advantages and Disadvantages of Fundamental Analysis 

A Simple Example of Fundamental Analysis 

Let us say you are analyzing a company called Sunrise Limited that sells solar panels: 

• The Big Picture (Macro/Industry): the government is backing clean energy companies, and certainly that is why solar companies are growing so fast. 
• Company Specifics (Qualitative): Sunrise Limited has smart and experienced management. Additionally, the company has a niche patent that affords them an edge over most green companies.
• Financial Figures (Quantitative): Year-over-year sales are increasing at a rate of 20%. The company has a P/E ratio of 15, lower than the average of 25, which suggests the company may be valued lower than other companies. There is low debt and the company makes strong cash profits from its core work.
• Final Thought: The Performance, experienced management, and valuation continue to be the justifications for our long-term investment. 

Frequently Asked Questions -  (FAQs)

1. What is fundamental vs. technical analysis?

The actual worth of a company can be known by Fundamental analysis. As regards Technical analysis, charts and historical prices are studied to predict what will happen next. 

2. How should the beginning be made as a beginner?

First, it may be found out what is done by the company. Next, the reports and ratios should be examined to understand its financial condition. A comparison needs to be drawn with other similar companies.

3. Can fundamental analysis predict stock prices?

No. It doesn't inform you about short-term prices, but it lets you discover the actual value of the stock in the long run.

4. Is it only for long-term investors?

It is ideal for the long-term, but even short-term traders can utilise it to better understand company news.

5. Can a strong business have a low-value stock?

Yes. Occasionally, the market behaves illogically. That's when a shrewd investor can get a bargain.

Conclusion

Fundamental analysis is a powerful tool to evaluate the bigger picture for long-term growth.  It preps up the investor on the company basics and gives a fair idea whether it is a sound investment at the given price.  Although it's time-consuming, it arms you with the information to make intelligent decisions. It prevents you from getting caught up in market mania and staying on top of real business quality. Simply put, it makes you think like a business owner, not only a trader.