Skill Sheet: What You Will Learn Here
- How to read financial statements?
- Dispelling myths around fundamental analysis of stocks
- The core, approaches and enablers
- The pros and cons of fundamental analysis
Let’s begin this chapter by studying the basics, literally, because that’s what fundamental analysis of stocks means.
One of the meanings of 'fundamental' is the 'basic or most important aspect on which other things depend'. 'Analysis', as you know, is the process of studying or examining something in an organised manner. 'Fundamental analysis' in the world of finance or investments means 'analysis of the financial health of a business, the competition and the industry it belongs to and its macro-economic environment'. This involves an in-depth financial statement analysis.
It’s not rocket science
While the term is a mouthful, fundamental analysis of stocks gets easier as you begin to identify the business that interests you and the investments you will make in an organised manner.
You would definitely want to know where your money is going, right? Therefore, getting yourself organised right at the start shouldn’t be too difficult. While fundamental analysis is a process with many elements to it, developing an understanding gets simpler over time. It helps develop objectivity and cuts down random impulses, therefore enabling you to make informed decisions at the right time. A detailed financial statement analysis is the first step of fundamental analysis.
The difference between price and value
Fundamental analysis of stocks is the method employed to understand the worth of a company, otherwise known as the intrinsic value. It involves estimating a company's:
- Ability to remain in business
- Growth and future cash flows
- Future profits and asset creation
A computed or perceived value based on quantitative variables and qualitative aspects of the business, intrinsic value must not be confused with price. Price can be lower than the value – undervalued - or higher - overvalued. To put it in Warren Buffet’s words, "Price is what you pay, and value is what you get".
There are many methods to arrive at the intrinsic value of a company. We shall discuss this in the chapter on valuation.
Fundamental analysis is a tool for investors, lenders, rating agencies, the government and industry bodies alike. While lenders use fundamental analysis of stocks to assess if the company will be able to pay back loans, rating agencies use it to rate the company that seeks to raise money.
Approaches to Fundamental Analysis
Fundamental analysis can be approached in two ways:
Top-down: This approach involves primarily arriving at the prospective investment in a company by analysing the macroeconomic factors such as policies, inflation, interest rates, etc. Thereafter, a sector that has better prospects based on macro data will be selected. And finally, a company from the sector that has better value will be chosen for investment.
Bottom-up: This is the opposite of the top-down approach. Here, the intrinsic value of the targeted company is derived by reading through its financial statements and understanding its business model, qualitative aspects - management, corporate governance, competitive edge etc. The sector dynamics of the company are then evaluated, followed by macroeconomic variables, before choosing the company for investment.
Financial Statement Analysis: The Core of Fundamental Analysis
All corporate plans and performances are expressed in numbers, which are organised and presented as financial statements. These financial statements are evaluated to assess the present and future performance of the company to arrive at its intrinsic value. The financial statements are available in the public domain as companies are mandated to file their financial statements with various authorities such as the Registrar of Companies (ROC), stock exchanges, Reserve Bank of India (RBI), Securities Exchange Board of India (SEBI) as well as on their websites. A financial statement includes the following:
- Balance sheet
- Profit and loss account
- Cash flow statement
- Ratio analysis
Let’s take a brief look at what these different elements of a financial statement are:
The Balance sheet is a part of the financial statement that highlights the financial position of a company at a given point in time. It shows the company’s shareholders' fund, borrowings and other liabilities, as well as its assets.
Assets = Shareholder’s fund + external liabilities
This is how a balance sheet is expressed as an equation
The Profit and Loss statement in a financial statement highlights the operational aspects. It contains the revenue generated and the profit or losses made during the accounting period. It also contains the earnings per share, a key indicator for the shareholders that conveys how much a shareholder earned during the year. Dividends paid and retained earnings also form part of this financial statement.
The cash flow statement is the most important of financial statements as it conveys the actual cash flows of the company in terms of operations, investments and financing activities. The accounting standards insist on the accrual method, where transactions are made even if there is no receipt or payment of cash. The cash flow statement helps in gauging the actual amount of cash generated from operations.
Ratio analysis is the most important diagnostic tool to monitor or check the health of a company. It is used to assess a company's profitability, the efficiency of asset utilisation as well as financial and operating risks. Apart from this, valuation ratios that employ the market price of a company as an element reveal how much value the market is assigning to the company. Ratios are arrived at by using the elements of the profit and loss account, balance sheet and cash flows.
We shall discuss this in detail as we go further.
Pros and Cons of Fundamental Analysis
The primary advantage of fundamental analysis is objectivity. Subjectivity, gut feeling, rumours and gossip are all relegated as it brings in disciplined thinking. It helps in arriving at the fair value of a company, which may be either more or less than the current market price, thus helping in decision-making.
The major disadvantage is the analysis of financial statements is a tedious process involving a lot of studies. Sometimes, relying on historical data for investment may not be a sound decision. Fundamental analysis involves assumption-based calculations that may prove inaccurate, including forecasting certain elements of the financial statements such as profits. It is used only for long-term investment purposes.
Points to remember
- Despite being a long-drawn process, fundamental analysis cannot be ignored in the context of long-term investment.
- Making an informed decision is important when one is employing his or her capital
- Price trends are helpful for short-term trading. But fundamental analysis is crucial for long-term investing.