Fundamental analysis is the centerpiece of investing in the stock market. Fundamental analysis of a stock does not only help in determining the health of a company but also managing portfolio. It is a tool which is used to make long-term investments in the stock market. By doing fundamental analysis, one can separate an excellent company from a junk company. Thus, it is recommended to do a fundamental analysis of stocks before investing in any company.
Fundamental Analysis vs. Technical Analysis:
Fundamental analysis refers to a method to do thorough research of a company carried out with the intention of making an investment. With this method, one can analyze the overall health of a company by analyzing its profit & loss statements, cash flow, balance sheets, Annual report and other publicly available data and documents. Once the investor finds such a company, he/she can invest in its stock and expect to benefit from the future growth of the business of the company.
Technical analysis involves analyzing charts of the past movements of a stock’s price and its trading volume over the different time periods. It involves understanding the patterns in the charts containing data of a stock’s price movement in the past. The investor following technical analysis is concerned only with the past prices and trading volume data of the stock. The investor is indifferent to whether the stock is a manufacturing, an agricultural or a financial services company.
Comparison between Fundamental Analysis and Technical Analysis:
Most of the successful stock market investors have followed the fundamental analysis. Fundamental analysis treats stock investment as a way of having ownership in a company’s business. This approach allows an investor to benefit from the enormous wealth, which is generated by owning a successful business over a long period of time. On the other hand, Technical analysis tries to predict the next ‘up move’ in a stock’s price and is indifferent to the company’s business.Selling a good stock only after one ‘up move’ in its price is not a winning decision in long term.
How to Check the Fundamentals of a Stock?
To find a fundamentally strong company. You can filter the healthy companies so that you can proceed to investigate further. If the company is not fundamentally strong, there is no need to learn more about its products/services, competitors, future prospects etc. An investor should focus on investing in stocks of companies which are:
1. Growing at a respectable pace
2. Have sustained profitability
3. Generating free cash flows
4. Conservatively financed [very low debt to equity (D/E) ratio: preferably debt-free]
5. Run by competent & shareholder-friendly management
Followings are trends and ratios that should be carefully noted in this step:
- Earnings Per Share (EPS) – Increasing for last 5 year.
- Sales Growth:– Increasing for last 5 year.
- Return on Equity (ROE)/(ROCE) – Should be greater than 15%
- Debt to Equity Ratio – Should be less than 1
- Price to Earnings Ratio (P/E) – Low compared to companies in the same industry.
- Dividend – Increasing for the last 5 years
Once you are confident that the company fulfills most of the criteria mentioned above, then study the financial reports of the company. The process of shortlisting companies is necessary so that an investor can focus his/her limited time and effort on a few targeted companies. Shortlisting companies before analysis helps an investor get maximum benefit out of his/her effort. This data is available in the public financial sources like screener/Moneycontrol etc.
READ THE ANNUAL REPORT OF A COMPANY
At the end of each financial year, every company is required by law to prepare a report for shareholders, which provides the details of performance of the company over the year. This report is called annual report. Annual report is the single most important source of information for an investor. An individual investor can get annual reports of any company from multiple sources. The Company website, Stock Exchange websites (BSE, NSE), and Financial Websites. These sources are free.
The detailed analysis of any company starts with reading of the annual report of the company. Annual report contains financial as well as non-financial information about the company. Both financial and non-financial information are equally important for investors.
The annual report contains almost entire financial data that an investor needs to form her views about the company:
A) The Independent Auditor’s Report:
Auditor’s report gives you a snapshot of authenticity of financial information that follows in the annual report.
B) Financial Statements:
These consist of three important sections: balance sheet, profit and loss statement and cash-flow statement.
c) Schedules/Notes to Financial Statements:
Schedules contain the detailed breakup of numbers shown in financial statements.
A) Communications from Promoters and Senior Management:
The communication of a company’s management to its shareholders is a very important source for judging the status of the company as well as the industry.
B) Directors’ Report:
Investor should analyse the current performance of the company by comparing it with the outlook presented by directors in past years in the annual report.
C) Management Discussion & Analysis (MDA):
MDA is another important section where management informs the shareholders about the business environment being faced by the company. The management informs the shareholders about the industry outlook, company outlook, opportunities, challenges, risks, updates on research & development, human resources etc.
Thus, we can see that the annual report is one such document that can throw light on the status of the company, provide information to gauge its potential of future growth and provide insight on the character of the management of the company. It is single most important document that every investor should read. While analyzing companies for first time investment, Investor should prefer reading annual reports going back as far as possible, preferably for last 5 to 10 years or more.
Learn what this company is doing which its competitors are not. Competitive advantage basically is something that adds value and, is unique to the firm. In simple terms, competitive advantage differentiates great companies from good companies. For example, Asian Paints outperformed all its competitors due to some unique capabilities that it developed over the years. The company has a wide distribution network, provides great quality products and has a very strong brand name. Thus, we can say that a firm with a competitive advantage(s) over its peers will create higher value and will be able to garner more respect from the market.
AVOID COMPANIES WITH BIG DEBT
Generally, too much debt is a bad thing for companies and shareholders because it inhibits a company’s ability to create a cash surplus. Big debts in a company are the same as the big hole in the Ship. If the hole in the Ship is not filled soon, then it won’t be able to cross the long sea and will definitely sink. While investing the companies check debt to equity ratio . Avoid companies with high debt to equity ratio.
CHECK FOR SHAREHOLDING PATTERN
If you are going to invest in some company’s stock then you need to know the shareholding pattern like – 1. What is the percentage of promoter shareholding? 2. What is the percentage of FII-DII shareholding? 3. What is the percentage of public shareholding? Generally, the promoter’s buying and share buybacks are signals of good company. However, we cannot judge the company’s future based on the promoter’s selling the stock. Please note, if the promoters are selling a lot of stocks continuously without explaining the reason, then it’s a matter to investigate further. Also check for Pledged Shares.
The management is the soul of the company. A good management can prosper the company to new heights. On the other hand, a bad management can lead to the downfall of the company. Hence, it’s really important to research carefully about the management of the company that you plan to invest. Here are a few points to check the efficiency of the Management.
Vision and Goals: Go through the Vision, Mission and Value statement of the company. Together, mission and vision guide strategy development, help communicate the company’s purpose to shareholders and inform the goals and objectives set to determine whether the strategy is on track.
Promoter’s Salary: The salary taken by the promoter/management of the company is one of the key parameters that can give critical insights into the management intentions.
Related Party Transactions: By studying each transaction in this section, an investor can conclude whether the promoters are benefiting from the company at the cost of minority shareholders. Related party transactions are provided by the company in annual Report.
These are the key points to consider while doing Fundamental Analysis. Hope, this post is useful to you. Keep learning and Happy Investing.
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