Fundamental Analysis of Stocks

Are you wondering why a trader should worry about fundamental analysis when market sentiments and price performance largely drive stock prices? Then ask yourself the following questions :

Have you ever wanted to own a multibagger penny stock but failed to predict whether the penny stock (with hardly any history of high prices) will see growth in the long term or not? 

Do you have a problem being able to predict long-term stock prices based only on complex charts on past price movements?

Are you worried that the market trends based on which you invested in stock may be reversed at any moment?

If the answer is yes then it is time you started learning about fundamental research.

What is Fundamental Research?

Fundamental Research is a method of gaining actionable insights into companies and valuing their stock prices based not on the historical price movements but on the growth prospects of the underlying business. It involves analysing the financials, competitive advantages of the business, quality of the management and the competitive environment it operates in, among other factors.

The theory of fundamental research revolves around the fact that the market price of an asset may deviate from its fair value in the short term due to extraneous factors such as investor sentiment or market trends but will tend to move towards its real or intrinsic value over the long term based on the fundamental quality of the business model and its execution.

Sources of facts for fundamental analysis

The best sources for fundamental analysis are the following:

1. Draft Red Herring Prospectus (DRHP) –

   It contains financial statements, market analysis, business plans, details on the management and litigations of the company. DRHPs are a great place to start understanding a company from the scratch.

2. Market analyst reports –

   Usually available to only those customers who pay for these reports to the companies or internal teams that prepare such market intelligence reports

3. Annual, semi-annual and quarterly reports of the company –

   These reports keep potential investors updated on the recent events and measures that affect the growth of the company as well as general information on finances and management.

4. Newspapers and business magazines –

   These sources are usually more helpful in understanding key points and updates on both the company as well as different sectors and the economy in general.

What are the factors that analysts look for while analysing the fundamentals of a company?

Fundamental analysts believe that a firm’s fundamental factors are all reflected in the financial statements and are the true indicators of its earning potential and thereby, the future valuation of the securities. Some of the factors analysts may look at are-

1. Industry growth –

   sometimes an average company may see strong growth due to the growth of the market in general

2. Competitive advantage of the company and ability to gain and sustain market share –

   One must check the business model and strategy of the company and compare it to those of its competitors. Gaining market share often signals stock price growth.

3. Revenue and Profit growth –

   One must be very careful while checking this section – a company may have massive operations but still fail to be profitable, stagnating its growth over time. High earnings often trigger stock price growth. At the same time, a lot of companies choose to reduce profits by paying huge interest payments in order to avoid paying high taxes on profits. 

4. Quality of management –

   A strong management team with adequate experience, networks, vision and business style can push through all sorts of challenges. Their quality of management can be apparent from their stated objectives as well as track record in the current and previous companies.

5. Financial ratios –

   such as Quick ratio, Current ratio, P/E (Price to Earnings Ratio), etc. which give a clear picture of the financial health of the company – e.g. a company may be making large profits but it may not be enough to meet the liabilities on time due to a lack of liquidity. Such companies stand vulnerable to being wiped out in a single phase of a slowdown in the growth of either the company, the sector or the economy.

What is the significance of valuation in Fundamental research?

Valuation gives us the fair price at which the stocks should ideally be bought. It is based on the cash flows that the buyers are expected to earn over time. If the market price is above the fair price then the stock is said to be overpriced.

Difference between Fundamental Analysis and Technical Analysis

Fundamental analysis focuses on the underlying business – its financial health, business model, human resource management and competition etc. 

In contrast, technical analysis focuses only on the historical price movement and stock-related data points such as relative strength index, moving average, MACD etc. It has more to do with investor sentiments towards the company and the market in general – it ignores future events and trends related to the company’s growth in terms of revenue, profit etc. 

Conclusion

Now that you know about fundamental analysis, try reading up more on the stock market before opening a demat account and trading stocks yourself.