This article will focus on fundamental analysis stocks and other important terms in details for beginners, including Definition, Importance, comparison with Technical analysis, stock picking guide and much more.
- Fundamental analysis is performed to identify and select stocks for long-term investment.
- It helps in estimating the intrinsic value (present value of the company’s future cashflows calculated using a discounted cash flow method) of the stock, which is deemed vital for long-term investment.
- The analysis is performed by evaluating the company’s financial statements viz Balance sheet, Income statement & Cash Flow statement. These statements help in acknowledging the past and current situation of the company that assists in forecasting the prospect of the company.
- Fundamental Analysis answers the vital question of “WHAT TO BUY?”
Why Fundamental Analysis important for long term investment?
- As Benjamin Graham quoted in his book Security Analysis, “Astute observers of corporate balance sheets are often the first to see business deterioration.” This is the most important reason why Fundamental analysis is a must do task, to see if the company can stay afloat for a long time.
Fundamental Analysis vs Technical Analysis
- Fundamental analysis focuses on the long-term period while technical analysis focuses on the short-term period.
- The former is majorly inclined towards stocks while latter is widely used in all asset classes.
- Fundamental Analysis determines the intrinsic value to evaluate if the stock is undervalued or overvalued, while technical analysis focuses on the right time to enter & exit the trade.
- Above mentioned are a few of the important differences between these two pillars of investment philosophy. Both techniques are equally great and one of these cannot be termed best.
How to select a stock
- To select a stock the best way is to use a top-down approach (structured method) wherein an investor first selects a sector that has been performing well then advances to select a stock that is performing well among its peers.
- This method helps in mapping the sector and the stock that has the potential of giving good returns over the long-term.
Evaluation of financial statements
- Financial statement analysis is the process of reviewing and analysing a company’s financial statements. These statements consist of Profit & Loss statement, Balance sheet, Cash flow statement, and statement of changes in equity (revaluation account).
- Evaluation of these statements aids us in acknowledging the efficiency, liquidity, profitability, and solvency of the company.
- It supports the analysis by providing us the past and present performance and by forecasting the future outcome of the company.
- There are two types of statement analysis- Horizontal analysis & Vertical analysis
Horizontal Analysis- To analyse the information of the financial statements, a base year is selected generally the first year and all elements of the base year are standardized to 1 and further growth or fall in the future years is calculated relative to the first year.
Vertical Analysis- It expresses all the elements of the statements in the percentage form. Vertical analysis standardizes the financial statement, eliminates the effects of the size of the company, and allows for comparison across companies. Most commonly, Sales/Revenue (for income statement) and Total assets (for balance sheet) are considered as the base value and other elements are calculated relative to them.
Calculation of financial ratios
- Financial ratios are calculated using various components of the financial statements and are considered very important for fundamental analysis. It helps us gain a deeper understanding of the health of the company which may not be apparent from just looking at the Balance Sheet.
- Amongst all the ratios, the three types of ratios mentioned below hold most importance as it deals with the important aspects of stock analysis.
- The elements used are both from the income statement and balance sheet. Below are the categories of ratios, which is calculated for finding if the stock is worth investing, or not.
- Liquidity ratios: This ratio aids in determining the company’s ability to pay short-term obligations like short-term debt, inventory, etc. A ratio above 1 is considered reliable. Below mentioned are the important ratios that must be calculated to check the liquidity ratio of the company:
- Current ratio = Current assets/Current liabilities (Here, Current assets includes cash, marketable securities, accounts receivables and inventory)
- Quick ratio (Acid test) = (cash + marketable securities + accounts receivables)/Current liabilities
- Cash ratio = (Cash + Marketable securities)/ Current Liabilities
- Solvency ratios: This ratio evaluates the company’s ability to fulfil its long-term obligations, which is an important factor for investors who wish to stay invested in the stock for a very long period. Below are the important ratios that must be calculated to know where the company stands in terms of long-term debt solvency. Generally, a ratio below 1 is considered good and reliable.
- Debt-to-equity = total debt/total shareholders’ equity
- Debt-to-capital = total debt/(total debt + total shareholders’ equity)
- Debt-to-assets = total debt/total assets
- Financial leverage = Average total assets/ Average total equity (Here, average means; the sum of the value of the beginning and end of the period divided by 2)
- Interest coverage = Operating Profit/ Interest payments (A lower ratio indicates that the firm will have difficulty in meeting its debt payments)
- Profitability ratios: It measures the overall performance of the firm relative to revenues, capital, equity, and assets and its ability to generate profits. It checks if the company is efficiently employing its capital or not. A ratio of 1 or higher is considered good. Below are the mentioned ratios that must be calculated:
- Net profit margin = Net income/revenue
- Gross profit margin = Gross profit/Revenue
- Operating profit margin = EBIT (operating profit)/Revenue
- Return on Assets = Net income/Average total assets
- Return on equity(ROE) = Net income/ Average total equity
- Activity or efficiency ratios: This ratio indicates how efficiently a company uses and employs its assets. Below are few important ratios that are to be calculated for analysing the company.
- Receivables turnover = Annual sales/revenue
- Days sales outstanding = 365/receivables turnover
- Payables turnover = purchases/average trade payables
- Number of days of payables = 365/payables turnover
- Inventory turnover = Cost of goods sold/Average inventory
- (Very important ratio for companies whose main business is manufacturing)
- Working Capital turnover = Revenue/average working capital
- DuPont approach is used to analyse return on equity (ROE). It decomposes the different drives of ROE.
- The different drivers of ROE represent financial leverage, asset turnover ratio, and profit margin.
- DuPont analysis aids in analysing which factor is helping the company grow and which is acting against its growth only to find out the pain point to fix it.
- DuPont analysis has two variants viz three-part approach and extended five-part approach.
Original three-part approach: This approach breaks down ROE into three parts, which helps in specifying the elements of ROE. The specified elements help us in acknowledging what drives the ROE higher or lower. A low ROE can be due to a lower profit margin or poor asset turnover or too little leverage.
Extended five-part approach: This approach further digs into the ROE formulae. It further divides the Net profit margin formula into three different parts, which consists of the tax burden, Interest burden & EBIT Margin. This explains that there are factors other than financial leverage that affects the Return on Equity.
- The breakdown has been shown below in the form of flow chart:
- The overall analysis facilitates us in determining if the stock is fundamentally strong or weak and if the business can sustain for a long period or not. This helps us in meeting the end goal of deciding if the stock is worth investing in or not.
- One thing that keeps fundamental analysis uncertain is the macroeconomic factor. It deals with the aggregate demand/supply and consists of GDP projections and results, budgets, employment levels, interest rates by the central bank, etc.
- Where Macroeconomic indicators are poor, it can have a negative impact on the valuation of stocks as market sentiment turns negative.
Companies with good fundamentals will certainly find out ways to tackle such situations and hence investment must not be pulled out in panic. It is advised to close the position of any stock only after thorough analysis, or after consulting an investment professional.