Get a cup of coffee. And let’s understand what these stock market veterans talk about fundamental analysis.Let’s start with the basics;
What is fundamental analysis?
Let’s break up this thing Fundamental + Analysis.
Fundamental - It is nothing but forming the base, from which everything else develops.
Analysis - which means the act of drawing down the conclusion.
When it comes to investing, the meaning of fundamental analysis is nothing but understanding business at a greater depth and building a perspective on the business model. Fundamental analysis also includes finding the stock’s intrinsic value and concluding if it is undervalued or overvalued. Holistically, the health of the company is seen by elemental analysis.
We got the gist of what is fundamental analysis; let’s understand it furthermore.
How to understand the fundamentals of the business?
Like any analysis, Fundamental analysis has tools. Let’s come to the tools used for fundamental analysis.
1. Annual Report:
The annual report gives sufficient information about the company and the sector. It provides information about the significant cost drivers and revenue drivers for the company and its initiatives for the situations they faced during the previous Financial Year.
Understanding Profit and Loss statement and Balance sheet helps in understanding the business that happened during the past year and even on a quarterly basis how did the company perform and Comparison with previous years revenue, Costs, EBIDTA, and PAT. All these show the company’s performance and where it is lagging.
For example, if the Company’s P&L statement shows negative EPS for the current year, this doesn’t mean the company didn’t perform well. We need to check each line item if it shows it has some extraordinary expense for the current year, such as specific tax, etc. However, that doesn’t determine the performance of the company.
Even looking at cash flows helps to understand if the business is healthy or not. Good operating cash flows can be considered as good for the company. So, understanding P&L statements and Balance sheets are pretty important. Based on these statements and previous years of data, we calculate essential ratios of the company, such as
a. Liquidity Ratios:
These ratios help determine the company’s ability to pay its short-term debt obligations. Ratios such as current ratio, quick ratio, cash ratio, etc. takes balance sheet elements into consideration like existing assets and current liabilities.
b. Profitability Ratios:
This is the most important ratio to evaluate a company’s ability to generate bottom line (profit) relative to revenue. These ratios are net profit margin, gross profit margin, and EBIT margin.
c. Leverage Ratios:
This helps us to indicate business-level debt incurred by a business entity. Ratios such as debt to equity and debt to asset help us to draw an inference.
d. Efficiency Ratios:
This shows the company's ability to effectively employ its resources, such as capital and assets to produce income. This is also called turnover ratio, which includes inventory, account payables, account receivables turnover ratio.
These ratios help in understanding the growth and change happening in the business Structure over the years.
2. Industry-related data:
You will need industry data to see how the company under consideration is performing concerning the industry. Essential information is available for free and is usually published on the industry’s association website.
3. Access to the news:
Daily News helps you stay updated on the latest developments in the industry and the company you are interested in. Good information aggregators such as Pvot can help you stay abreast of the fundamental understanding of personal finance and fundamentals.
4. MS Excel:
It can be extremely helpful in fundamental calculations.
How to find a desired company for Investment?
In the process of fundamental analysis, before finding the ideal company, we need to find the sector to see potential over the next few years. Let’s say we are interested in FMEG Sector (Fast moving electronic Goods). In India, FMEG Sector has good growth potential and aims to grow at 12 percent CAGR for the next five years.
After Finalizing the Sector, we can find companies like Havells, V-Guard, Crompton Greaves,& Hitachi.
To know which company would be better for investment, we can get a basic idea of which entity is doing good in the sector by doing a Market and Income approach analysis. Moreover, calculating the cash flows and critical ratios mentioned above for all the firms helps understand the firm's business structure and margins. It is essential to identify the threats for the sector and company.
The essential parts and other materials in this sector are imported from China. With the present situation between the two countries, if the government levies heavy import duties for Chinese items, it will impact the company margins.
Understanding threats the sector faces and finding the best company can overcome these threats to grow further.
The Above principles might help find good investment opportunities. Markets are subject to risks proper evaluation before the investment is required.
Types of Fundamental Analysis:
A. Top-Down Approach
- Economic Analysis:
Gross Domestic Product (GDP), growth rates, inflation, interest rates, exchange rates, productivity, and energy prices play an important factor in fundamental analysis.
- Industry/Sector Analysis:
This website has some interesting data points on every industry published by the government available for free.
- Company Analysis:
Company's financial statements Analysis
Analyzing current valuation
B. Bottom-Up Approach
- Company Analysis:
Analyzing valuation of the company
Financial statements Analysis
- Industry Analysis
- Economic Analysis
Parameters to be considered Quantitative analysis
Parameters to be considered for Qualitative analysis
- Management performance and experience
- Competitive advantage
- Business model
Financial Ratios that you should be familiar with:
These ratios are compared to their competitors or industry measures, ratios in isolation will not convey much.
Price to earnings ratio (PE):
This ratio tells how much the market is willing to pay for every rupee the firm earns. Example: Finolex Industries’ price to earnings is 15x, which means for every rupee the company makes in context to EPS, the market is willing to give 15 rupees.
Annual value of dividends received relative to the market value per share of security. Example: Finolex Industries pays out 5 rupees annual dividend the dividend/ share price gives you the dividend yield. Let’s assume today’s market price is 180, then 5/180 * 100 = 2.77%.
Return on equity (ROE):
It shows the firm’s ability to turn equity investments into profits. Example: Let’s say the founder invested 1000, and the company is generating 140 as income. So 140/1000 = 14% ROE. This ratio takes only equity into account.
Return on Capital Employed (ROCE):
This ratio measures how efficiently a company uses its capital (equity + debt) to generate profits. Example: Let’s say the company borrowed 200 and invested equity of 1000, Generated an operating income of 180. So 180/1200= 15% ROCE.
Price to book:
This ratio evaluates a company’s current market value relative to its book value. Book value comes from an excess of assets over liabilities.
Different types of investment styles
1. Buy and Hold
Investors believe in active steering between 'good' companies and which an investor will grow with the company.
2. Contrarian investors - Howard Marks style of investing
These investors distinguish themselves by a 'short term 'approach; the market is a voting machine and not a weighing machine. Own decisions are made because of which signals from the market are ignored.
3 . Value investors - Warren Buffet style of investing
They restrict their attention to undervalued companies, and they believe that these companies will not collapse quickly. The value is determined based on a Fundamental Analysis.
The process of fundamentals more often sticks to following three approaches:
In this approach, we look for similar companies with similar cash flows. Also called relative valuation, Trading comps and trans comps are performed using this approach
Pure approach, we project the growth rates we give the terminal value considering the going concern based on some strong assumptions.
This approach looks at the cost of replacing the asset. This is prominently used in the real estate sector. There were instances where the land bank for the real estate company had a value of 6000 crores. However, the company was trading at 2,600 crores! Health companies can be reviewed using the market and income approach, where generally distressed companies or Capex heavy businesses use the asset or cost approach of valuation.
Let's take an example and demonstrate the Income approach of valuation. This is also called Discounted Cash Flow method (DCF) of valuation.
Company Name: Finolex Industries Ltd.
According to the income approach based on the inputs like WACC, Terminal Growth rate, the company’s growth rate, etc. Based on the Discounted cash flow method, Finolex’s intrinsic value of the company is 137.
Fundamental Analysis is used to make long-term investments. Investment in a company with sound fundamentals creates wealth. Using Fundamental Analysis, one can separate an investment-grade company from a junk company. All investment-grade companies exhibit a few common traits. Likewise, all junk companies exhibit common characteristics.
Disclaimer: Wantedly, in the income approach, we considered 2020 as the last year of the data. As it is not the investment recommendation nor advice. It is just to show how every input comes together in the income approach of valuation.