In a world dominated by fluctuating markets and rapid price changes, how can investors determine the real worth of an asset? The answer lies in fundamental analysis—a method that goes beyond market noise to uncover the intrinsic value of stocks, bonds, currencies, and commodities. By diving deep into financial statements, economic indicators, and key qualitative factors, fundamental analysis empowers investors to make informed decisions based on the true potential of an asset, rather than short-term price movements or market sentiment.
Fundamental Analysis! Wow that sounds… brainy? So let us break it down in simple words.
The Fundamental Analysis can be done using top down or bottom up approach. In a top- down approach, investor begin by evaluating the overall economic health. By examining macro- economic factors like interest rates, inflation, GDP and identify industries or sectors with favorable prospects, Subsequently analyze company in these promising sectors.
1. Quantitative company analysis
Quantitative financial analysis is a key component of fundamental analysis, focusing on numerical data and financial metrics to evaluate a company’s performance, financial health, and growth prospects. Unlike qualitative analysis, which looks at non-numerical factors (like management quality or industry trends), quantitative analysis uses objective, measurable data to assess a company’s underlying value.
This type of analysis examines financial statements, key financial ratios, and market data to gauge profitability, liquidity, solvency, and efficiency. Investors use these quantitative tools to determine whether a company’s stock is overvalued, undervalued, or fairly priced, and to predict its future performance.
The Financial statement analysis involves the following:
– Balance sheet Analysis:
This statement records a company’s assets, liabilities, and equity at a particular point in time.
It shows investors the financial structure of a company, listing down what a company owns and owes, thus helping to determine a company’s real worth, Compare a company’s debt levels with its assets, equity, and earnings. These are used to evaluate the likelihood of a company staying afloat over the long haul by paying off both long-term debt and the interest on that debt. This is evaluated by using solvency ratios. Examples of solvency ratios include:
- Debt-equity ratios.
- Debt-assets ratios.
- Interest coverage ratios.
– Cash flow Analysis:
This is a very important financial statement, as it shows the true cash or liquidity position of a company. It provides information on the cash inflows and outflows over a period of time.
It is difficult to manipulate the cash position of a company; therefore it is used as a concrete measure of a company’s performance.
– Income statement analysis:
Under fundamental analysis focuses on evaluating a company’s profitability, cost management, and overall financial performance. Key components of the income statement include:
Revenue, cost of goods sold (COGS), gross profit, operating expenses, operating income (EBIT), net income: final profit after all expenses, including taxes and interest, leading to earnings per share (EPS) and efficiency of operations by management.
This can be evaluated using the following ratios:
- Profit margin ratio.
- Return on assets.
- Return on equity.
- Return on capital employed.
- Fixed Assets Turnover Ratio.
- Working Capital Turnover Ratio.
- Total Assets Turnover Ratio.
- Inventory Turnover Ratio.
- Inventory Number of Days.
2. Qualitative company analysis
They are key to evaluating a company, though they are more challenging to analyze since they are subjective and not quantifiable. These factors can either positively or negatively impact the company, with some having a greater influence than others. Assessing the extent of their effects can be difficult.
Examples include customer satisfaction, pending litigation that could harm the company’s reputation, changes in management, and relationships with key vendors, and ownership of new technology that offers a competitive advantage.
A popular technique used in qualitative analysis is known as SWOT analysis. SWOT stands for Strengths, Weaknesses, Opportunities, and Threats, this offers you an insight into a company’s competitive position and its ability to navigate future challenges.
3. Industry Analysis
Industry analysis is a tool used by businesses and analysts to evaluate the competitive landscape of an industry. It provides insights into key factors such as supply and demand trends, the level of competition within the industry, its standing relative to emerging industries, future prospects considering technological advancements, the credit system in place, and the impact of external factors on the industry.
Fundamental analysis by industry analysis involves evaluating a company’s position within its industry to assess its growth potential and risks. Here’s a concise approach:
- Define the Industry: Identify the industry and its key segments.
- Growth Trends: Analyze historical growth, future projections, and key drivers.
- Competitive Landscape: Assess industry competition using frameworks like Porter’s Five Forces.
- External Factors: Consider economic conditions, technological changes, regulations, and social trends affecting the industry
- Innovation and Risks: Assess technological advancements and industry-specific risks (cyclicality, geopolitical, environmental).
4. Economy Analysis
Economy analysis in fundamental analysis focuses on key macroeconomic factors that impact a company’s performance like GDP growth, interest rates, inflation unemployment
Consumer confidence, exchange rates, government policies, global economic trends.
5. Valuation Analysis
Valuation is a key aspect of fundamental analysis, used to determine the intrinsic value of an asset, comparing it to its market price. Common valuation methods include:
- Discounted Cash Flow (DCF) Analysis:
A method that estimates the present value of a company or asset based on projected future cash flows, adjusted for time value of money.
- Price-to-Earnings (P/E) Ratio:
Compares the market price of a stock to its earnings, helping investors assess whether a stock is overvalued or undervalued.
- Comparable Company Analysis:
Involves comparing a company’s financial metrics with those of similar companies in the same industry. Market value ratios are used to evaluate the share price of a company’s stock. The valuation ratios help us develop a sense of how the market participants value the stock price. These ratios help us understand the attractiveness of the stock price from an investment perspective. The point of valuation ratios is to compare the price of a stock viz a viz the benefits of owning it. Like all the other ratios we had looked at, a company’s valuation ratios should be evaluated alongside the company’s competitors.
- Price to Sales (P/S) Ratio.
- Price to Book Value (P/BV) Ratio. and
- Price to Earnings (P/E) Ratio.
Conclusion:
Fundamental analysis evaluates an asset’s intrinsic value by examining financial health, market conditions, and economic factors. It helps identify under-priced or overpriced assets, manage risks, and make long-term investment decisions. However, performing fundamental analysis can be challenging and for many retail investors as it requires expertise, time, and passion. In such cases, investing in mutual funds provides a realistic alternative, as fund managers handle the analysis, offering diversification and professional oversight. Mutual funds allow investors to benefit from fundamental analysis without doing it themselves, Invest Smarter with Mutual Funds: Leave the Analysis to the Experts!
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The article is authored by Mr. Sahil Chichiria from Team RichVik.