Seeing Beyond Mere Numbers: How Fundamental Analysis Drives Smart Stock Market Investments9 min read
Investing in the stock market can be quite a ride, filled with excitement and challenges. At times it can be daunting too. But we’ve got a magic mantra for you: fundamental analysis. You could even equate it to a Jedi mind-bending trick that helps you make smarter investment decisions. So, let’s dive into the nitty-gritty of how fundamental analysis can lead you towards success in the stock market.
Understanding the Real Value
Fundamental analysis is like a magic wand that reveals the true value of a stock. Instead of relying on fickle market sentiments or short-term price swings, you dig deep into a company’s financial statements. Balance sheets, income statements, and cash flow statements become your treasure map, to unearthing some hidden gems.
Qualitative vs. Quantitative Analysis
There are two aspects of fundamental analysis: qualitative and quantitative. Think of them as Batman and Robin, a dynamic duo battling the fluctuations of the market.
Qualitative Fundamental Analysis: This one is all about instinct. You evaluate the impact a company’s performance is likely to have in the future, like its business model, management team, and competitive advantage. You need to put on your best Sherlock Holmes hat; investigating industry trends, market conditions, and the overall market position of the company. The secret lies in analysing factors that numbers can’t capture.
Quantitative Fundamental Analysis: This when you want Einstein on his best day. You crunch numbers, analyse financial statements, and look at ratios. It’s all about cold, hard data and facts. You evaluate the company’s financial health, profitability, growth, and whether the stock is overpriced or a hidden treasure waiting to be discovered.
How To Implement The Fundamental Analysis of Stocks
Ready to don your analyst hat and roll up your sleeves? Here’s a step-by-step guide to conducting fundamental analysis:
- Get To Know the Company: Understand the company’s business model, their products and services, and how they make themselves profitable. With whom does the buck stop? Are they visionaries and how do they plan to realise their vision?
- Peek At Financial Ratios: Take a quick glance at financial ratios to weed out the losses from potential wins. Ratios like P/E ratio,the price/earning to growth ratio(PEG ratio) EPS, and ROE can give you a quick snapshot of a company’s health.
- Dive into Financial Statements: This is where the magic happens. Analyse the financial statements to understand the company’s financial health. Thoroughly check its balance sheet, income statement, and cash flow statement.
- Size up the Competition: Identify the company’s direct and indirect competitors. What sets the company apart? Do they have a competitive edge, What’s their ‘Brahmastra’ or if they have an army of loyal customers? Compare the company’s performance with its competitors to see if they have what it takes to win.
- Debt Detective: Check the company’s debt levels. Is it drowning in debt, or is it going full steam ahead? Too much debt can be a red flag, so keep an eye on it.
- Crystal Ball Gazing (figuratively): Analyse the company’s future prospects. What’s on the horizon? Are there any industry trends or market changes that could make or break the company? Use your crystal ball (figuratively speaking) to see where the company might be headed.
Stay in the Loop: Keep yourself updated with the latest news and updates about the company and its industry. You don’t want to miss any game-changing developments that could impact your investment.
Cracking the Code: Factors in Fundamental Analysis
Fundamental analysis provides several benefits to investors, enabling them to make informed investment decisions. Here are some key factor in fundamental analysis:
Evaluation of fair value:
Fundamental analysis helps investors assess the intrinsic value of a stock by analysing the company’s financial statements, industry position, and growth prospects. Fair value often relies on market-based information, such as recent transactions of similar assets or observable market prices. Evaluating the relevance and reliability of these inputs is crucial. Various valuation techniques can be employed to estimate fair value, including the market approach, income approach, and cost approach.
In January 2023, the share price of a reputed steel manufacturer was estimated at Rs. 114.60 per share, but it was trading at Rs. 109.20 at the time. This means that the stock was undervalued by about 4.8%. There could be a number of reasons for this, including falling steel prices, high debt levels, and slow growth in India. The undervaluing could also have been a result of the company’s investment in new technologies and its global reach. Source: https://www.alphaspread.com/security/nse/tatasteel/summary
Long-Term Investment Perspective:
Fundamental analysis takes into account a company’s financial health, management quality, competitive advantages, and growth prospects over the long term. By evaluating these factors, investors can assess the company’s ability to generate sustainable earnings and cash flows. This long-term perspective helps investors make informed decisions based on the company’s intrinsic value rather than short-term market fluctuations.
In 2008, the Indian stock market crashed following the global financial crisis. The Sensex fell by over 50% from its peak in January 2008. Many investors panicked and sold their stocks, fearing that the market would never recover. However, a few investors took a long-term view and continued to invest in the market. They believed that the Indian economy was fundamentally strong and that the stock market would eventually recover. These investors were right. The Sensex has since recovered and has more than doubled from its lows in 2008. This is a good example of how long-term investing can pay off. Source: Paytm Money
Identification of Growth Opportunities:
Fundamental analysis involves studying industry trends, market dynamics, and a company’s competitive positioning to identify growth opportunities. Investors analyse factors such as market size, demand drivers, technological advancements, and regulatory changes that could impact a company’s future growth prospects. By identifying companies with strong growth potential, investors can benefit from capital appreciation as the company’s earnings and market share expand.
In 2015, Infosys’s P/E ratio was around 15. This was significantly lower than the P/E ratios of other large IT services companies. Additionally, its FCF yield was around 10%. This was significantly higher than the FCF yields of other large IT services companies. This suggested that Infosys was undervalued in comparison to its peers. Based on these factors, it was possible to conclude that Infosys was undervalued in 2015. This information could have been used to buy Infosys stock at a discount and potentially generate significant returns. Source: https://companiesmarketcap.com/infosys/pe-ratio/
Risk & Red Flags Mitigation:
Fundamental analysis allows investors to assess the risks associated with investing in a particular stock. By analysing a company’s financial statements, investors can evaluate its liquidity position, debt levels, and ability to generate consistent profits. Additionally, examining key financial ratios such as debt-to-equity ratio, current ratio, and interest coverage ratio helps investors gauge the company’s financial health and risk exposure. Fundamental analysis also helps identify red flags such as declining sales, deteriorating margins, management issues, or accounting irregularities that may indicate potential risks.
In 2018, the Indian stock market was hit by the unearthing of significant financial irregularities, in which the Infrastructure Leasing & Financial Services company defaulted on its debt obligations. This led to a loss of confidence in the Indian stock market and a decline in share prices. In response to the high promoter shareholding, high debt levels and poor corporate governance in the companies involved, SEBI came up with new guidelines regarding increased disclosure requirements, enhanced monitoring of companies and increased penalties for violations.
Value Investing Opportunities:
Fundamental analysis is the cornerstone of value investing, a strategy that seeks to identify stocks trading below their intrinsic value. Investors using this approach, analyse a company’s financial statements, including the balance sheet, income statement, and cash flow statement, to determine its true worth. By comparing the company’s intrinsic value to its current market price, investors can identify undervalued stocks with the potential for price appreciation when the market recognises their true value. This approach allows investors to buy stocks at a lower prices and potentially earn higher returns over the long term.
A small-cap company that is engaged in the mining and beneficiation of iron ore has a strong track record of profitability. The company’s current share price is Rs. 100, which is significantly below its book value of Rs. 150. This means that the company is trading at a significant discount to its intrinsic value. Investors can look at quantitative factors like price to book ratio, earnings yield and dividend yield to consider an investment in this stock.
Macroeconomic Factors:
Fundamental analysis also takes into account macroeconomic factors that can impact a company’s performance. These factors include interest rates, inflation, GDP growth, exchange rates, government policies, and geopolitical events. By understanding how these macroeconomic factors influence industries and companies, investors can make more informed investment decisions. For example, a company operating in an export-oriented industry may be affected by currency exchange rate fluctuations, while rising interest rates could impact companies with high debt levels.
In 2014, the Indian economy grew at a rate of 7.4%, which was the fastest pace of growth in five years. This strong economic growth led to a surge in corporate earnings, which in turn, drove up stock prices. The Sensex rose by over 25% in 2014. One of the macroeconomic factors that contributed to the strong economic growth in 2014 was the government’s pro-growth policies. The government implemented a number of reforms, such as demonetisation (despite the debate over its impact) and the Goods and Services Tax (GST), which helped to boost economic activity.
Conclusion
Overall, fundamental analysis acts as a guiding compass for investors, providing insights into a company’s financials, growth prospects, and competitive advantages. It empowers investors to make well-rounded investment decisions based on a thorough assessment of a company’s fundamentals and industry dynamics. By embracing fundamental analysis, investors can navigate the stock market with greater confidence, of improving their potential for long-term success and wealth creation.
Disclaimer: Investments in the securities market are subject to market risks, read all the related documents carefully before investing. This content is purely for information purpose only and in no way to be considered as an advice or recommendation. Paytm Money Ltd SEBI Reg No. Broking – INZ000240532. NSE (90165), BSE(6707) Regd Office: 136, 1st Floor, Devika Tower, Nehru Place, Delhi – 110019. For complete Terms & Conditions and Disclaimers visit: https://www.paytmmoney.com. The securities are quoted as an example and not as a recommendation. Brokerage will not exceed the SEBI prescribed limit.
