What is Fundamental Analysis?

"The stock market is filled with individuals who know the price of everything, but the value of nothing." — Phillip Fisher

 

Introduction

 

The price of a stock consists of both the fundamental aspects and the speculative aspects. The fundamental aspects tell us the value of the stock and the speculative aspects tell us the sentiment in the market about the stock at a particular period of time.

 

Now, fundamental analysis helps us gauge the intrinsic value of the stock, what this essentially means is that by the help of fundamental analysis you can determine the true value of a stock and then buy if the stock is undervalued (the value of the stock is greater than the price at which it is trading) and sell if it is overvalued (the value of the stock is less than the price at which it is trading).

 

A lot of successful investors including Warren Buffet, Charlie Munger, Phillip Fisher have made fantastic returns by this simple concept. 

 

During this blog discussion, we will explore the introductory note over fundamental analysis that includes fundamentals of a company, financial ratios, role of an investor and many more.

 

Fundamental Analysis

 

Basically, Fundamental Analysis is a way to analyse a company based on several key aspects which are known as its fundamentals. It is used mainly for making long term investments in the equity market (stock market). Long term may refer to a few months or several years. 

 

Since, there are speculative aspects present in the short term, it is intuitive that a stock takes some time to move towards its intrinsic value. An investor catches this move.

 

It should be noted that technical analysis (which takes into consideration various statistical trends and patterns recurring due to the speculative practices and psychological aspects) is far more efficient than fundamental analysis in the short term.

 

 

Fundamentals of a company

 

As it can be observed by looking at any business that a business is affected by a vast variety of factors both internal factors including capital structure, management, labour etc and external factors including tax rates, rules and regulations, foreign investors etc.

 

Broadly, these factors, referred to as fundamentals can be classified into two categories:

 

1.  Qualitative factors

 

These fundamentals are related to the standard or quality of the company and includes factors such as:

1.  Business Model

2.  Organization Structure

3.  Competitive Advantage

4.  Management, etc.

 

 

2. Quantitative factors

 

These fundamentals are related to the numerical aspects of the company and include factors such as:

 

1. Revenue

2. Expenditure

3. Dividends

4. Cash Flow, etc.

 

There are quite a few sources to analyse these aspects of a company. These include the investor reports and investor presentations which are usually made available quarterly and include the management discussion, financial statements, etc. and the news provided by unbiased sources. 

 

A lot of screening applications and websites are also available on the internet which act as unbiased sources of information required for fundamental analysis.

 

(Suggested blog: An Introduction to Financial Analysis)

 

4 Types of Financial Ratios

 

Financial ratios are numeric ratios derived from the financial statements of a company (which includes the balance sheets, income statements and cash flow statements). 

 

They form an integral part of the quantitative analysis of a company and help an investor determine the financial health of the company by providing an investor with an outlook of the performance trend of the company.

 

These ratios are divided into 4 major categories:

 

1. Profitability Ratios

 

These ratios reflect how much profit was made with respect to how much was put in to generate that profit.

 

• PAT Margin = PAT (Profit After Tax) for the Year / Total Revenue. 

• EBITDA Margin = EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) / (Revenue - Other Income)

• Return on Equity (RoE) : Net Profit / Shareholders’ equity

• Return on Assets (RoA) : Net Profit / Total Assets

• Return on Capital Employed (RoCE) : EBIT (Earnings before interest and taxes)  / (Total Assets - Current Liabilities)

 

 

2. Operating Ratios

 

These ratios correspond to the management of the company and are important to judge how well the company can make money.

 

• Fixed Asset Turnover = Net Sales (or Revenue) / Average Fixed Assets

• Working Capital Turnover = Net Sales (or Revenue) / Average Working Capital

• Total Asset Turnover = Net Sales (or Revenue) / Total Assets

• Inventory Turnover Ratio = Sales / Average Inventory

• Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable

 

 

3. Leverage Ratios 

 

These ratios show how much “opened up” a company is and correspondingly signify its financial health and sustainability.

 

• Debt ratio = Total Liabilities / Total Assets

• Interest Coverage Ratio : EBIT (Earnings before interest and taxes) / Interest Expense

• Debt to Equity Ratio = Total Debt / Total Equity

• Debt service coverage ratio = Operating Income / Total Debt Service

 

 

4. Valuation Ratios  

 

These ratios put the stock price in perspective of the company’s financials.

 

• Price to Earnings (P/E) : Market price / Earnings per Share

• Price to Book Value (P/B) : Market price / Book Value per Share

• Price to Sales (P/S) : Market price / Sales per Share

• Price to Cash Flow (P/CF) : Market price / Cash Flow per Share

 

These financial ratios, specially the valuation ratios serve as a benchmark for investment purposes and are used by a lot of investors.

 

There are no pre-defined or empirical values set for these ratios and there is no standard answer to the relative weightage of all these ratios. A good practice is to look at the change in these ratios with time (either quarter-wise or yearly) of a company or an industry and get an idea of the overall trend of the movement of the company or the industry.

 

It is advisable to compare the financial ratios of a company with the financial ratios of its sector which may act as a benchmark for a particular period of time. It should also be noted that the relative impact of all these ratios is highly subjective and is subject to a lot of factors including the company’s sector, business model, future plans, etc. and therefore, it can be hazardous to blindly follow these ratios at all times.

 

(Recommended blog: 5 Elements of Financial Analysis)

 

 

What is the Role of an investor?

 

The role of an investor is to create a model which takes into consideration all the fundamental aspects (both the qualitative and quantitative), provide them suitable weightage and arrive at the intrinsic value of the company and the share of that company. Then this value is used to initiate buy or sell orders which ultimately result in profitability. 

 

Since, there are a lot of market participants, the success of an investor is solely attributed to his analysis which provides him an edge in the market. 

Different investors give different weightage to different fundamentals of the company (based on their understanding of the company and experience) and take into consideration a myriad of aspects before finally reaching the intrinsic value.

 

As an example Warren Buffet, considers the following basic principles or tenets as part of the initial process of his overall fundamental analysis process:

 

1. Business Tenets:

 

• Is the business simple and understandable?

• Does the business have a consistent operating history?

• Does the business have favorable long-term prospects?

 

 

2. Management Tenets:

 

• Is management rational?

• Is management candid with its shareholders?

• Does management resist the institutional imperative?

 

 

3. Financial Tenets:

 

• Focus on return on equity, not earnings per share.

• Calculate “owner earnings.”

• Look for companies with high profit margins.

• For every dollar retained, make sure the company has created at least one dollar of market value.

 

 

4. Market Tenets:

 

• What is the value of the business?

• Can the business be purchased at a significant discount to its value?

 

Next time you look at a company for investment, try thinking about these basic principles. This simple exercise will definitely help you cherry pick the best stocks out there.

 

 

Conclusion

 

There are a lot of concepts involved in fundamental analysis. Even though the basics remain the same and the ratios like the profitability ratios, leverage ratios, operating ratios and valuation ratios comprising the quantitative aspects and parameters like management, competitive advantage, etc. comprising the qualitative aspects are looked upon by almost all the investors, the relative weightages, broader market trends and most importantly discipline separate one investor from the other.

 

(Also check: Petroleum Industry and Financial Analytics)

 

Fundamental analysis might look easy after reading this blog and arguably it is easy. But any risk taken in the markets should be well justified and accepted and this is possible only if the fundamental analysis done is robust and systematic.