Fundamental analysis of a stock is a wholesome approach to measuring a security’s intrinsic value.
Remember teachers’ day of the 90s and 2000s? We would visit card shops and browse cards for our favorite teachers. There used to be so many teachers for whom we had to buy cards. So, with limited money and time, what did we do?
We used to spend the maximum amount of time and money on the card for our favorite teacher. We would look at a lot of cards, shortlist a few, then read them properly and check for grammatical accuracy, consider the aesthetics of it, check how good the envelope was, and then buy the best one. This is the fundamental analysis of a card.
This is what we need to do while looking at stocks. Investors need to look at the fundamentals of the stock before making a decision of buying them. What is the fundamental analysis of the stock, and how does it work? We have it covered for you.
Content:
- What is Fundamental Analysis of Stocks
- Types of Fundamental Analysis
- Qualitative Fundamental Analysis
- Quantitative Fundamental Analysis
- Advantages of Fundamental Analysis
- Disadvantages of Fundamental Analysis
- Difference between Fundamental & Technical Analysis
- Quick Summary
What is Fundamental Analysis of a Stock?
Fundamental analysis of a stock is a wholesome approach to measuring a security’s intrinsic value. This is done by taking into account several economic and financial factors. A fundamental analyst would look into anything that can affect the stock’s value. He/she would take several parameters like macroeconomic factors, the condition of the industry, the economic situation of the country, etc into consideration.
The idea behind all this analysis is to produce numbers that can be compared with a stock’s current value and determine if the stock is over or undervalued.
It is very important to make this analysis so that an investor can look beyond the daily stock movement and see the underlying fundamentals of the company. Simply put, a stock can shoot up due to any circumstantial factor for a day or two. However, in the long run, the same stock may not do so well as its fundamentals may not support growth.
Types of Fundamental Analysis
Broadly, fundamental analysis can be classified into two types:
- Qualitative Fundamental Analysis
- Quantitative Fundamental Analysis
Qualitative Fundamental Analysis
This approach is related to the overall nature and aspects of the stock that are not quantifiable. A company entangled in a legal battle will see its stock going down. On the other hand, a verdict in the favour of the company will push the stock up. This is how qualitative analysis works.
Quantitative Fundamental Analysis
This approach is all about numbers that can represent valuable information about the performance of the stock. Balance sheet, quarterly reports, etc. fall under this category.
Annual Report
Annual report of the company highlights the financials of the company in the given financial year. It also includes the management statement, outlook of the company, etc.
The three important components of the financial statement are:
- Balance Sheet
- Profit and Loss Statement
- Cash Flow Statement
1. Balance Sheet
The balance sheet tells about the assets, liabilities, and equity of the company at a given point in time. Assets are the resources that a company holds. Cash, real estate, machinery, inventory of goods, etc. fall under the category of assets. Liabilities are the debt of the company, while equity is how much money the shareholders have contributed.
Hence the equation becomes: Assets = Liabilities + shareholders’ equity.
If the value of liabilities and shareholders’ equity exceeds the value of assets, then the company is not doing well. Liabilities should never get so big that it starts tilting the scale in another direction. Investors can certainly look at the balance sheet to determine how the stock of the company would perform in the long run.
2. Profit and Loss Statement
The profit and loss statement of a company informs the investors about:
a. Revenue of the company
b. Incurred expenses of the company for revenue generation
c. Tax and depreciation
d. Earnings per share
a. Revenue: Revenue of the company details from where the company generates its revenue. It can be in form of sales, services, and other sources of income. A water purifier manufacturing company’s main source of revenue will be the sale of water purifiers. Also, the revenue generated by repairing them or selling some replaceable spare parts would also be counted as revenue.
b. Expense: The expense side of the profit and loss statement would tell an investor about how much money did the company spend. In the above example, for a water purifier company, the main expense would be of procuring raw material for manufacturing. Another avenue of expenditure is employee expense. This includes salaries, contributions to employee provident fund, and any employee welfare plan.
Then comes the borrowing costs. If the company has borrowed some money, it has to pay it back and thus gets counted under expense.
c. Tax and Depreciation: The profit before tax and profit after tax, commonly known as PBT and PAT, and the amortisation and depreciation are a few things that fall under expense as well.
d. Earnings Per Share: This indicates how much the company is earning from each ordinary share. If there are 100 outstanding shares of the company in the market, then we divide the profit after tax by 100 and we can arrive at earning per share number.
3. Cash Flow Statement
The cash flow statement broadly shows how much cash a company is actually generating. Taking the water purifier example here again.
Let’s say each purifier costs Rs 1,000. If the company sells 100 of them in a month, then it would have generated Rs 1,00,000 as revenue. But some of the customers may not have paid upfront.
Some may have bought those purifiers on credit. Let’s say half of those went on credit. Now, while the revenue of the company still stands at Rs 100,000, the actual money on the company’s account is Rs 50,000 only.
So how does this matter? At the end of the month, the company has Rs 50,000 in the account and it may have some urgent expenditure or debt to pay off. If that expense exceeds Rs 50,000 then the company will face a cash crunch.
This is the information the cash flow statement gives the investors. Investors can read this statement and see if the company is cash-strapped or not. A cash-strapped company is likely to face a tough time when a crisis arrives. And in such a situation, the stock ought to fall.
Advantages of Fundamental Analysis
- If the data is available, it can help in making sound decisions for short-term
- Helps in taking long-term positions on stocks
- Gives more than one set of data to look at for making decisions.
- Helps to understand the business in-depth
Disadvantages of Fundamental Analysis
- Highly time-consuming
- Very subjective as too many variables are involved
- Specific to a company or a sector
- Too dependent on what data the company provides
Fundamental vs Technical Analysis
While we have discussed what fundamental analysis is, technical analysis, in a nutshell, takes the stock data into account to make investments. A technical analyst looks at the historical price of the stock, returns, and volume of trades.
So here is the difference: Technical analysis is done mostly for short-term trading, while fundamental is done for long-term.
Buying and selling are done on the basis of trend lines, moving averages, etc in technical analysis, while in fundamental analysis, it is based on overvaluation or undervaluation of the stock.
Check out the detailed differences between Fundamental and Technical Analysis here.
We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, and hence we bring you the important topics and areas that you should know:
Quick Summary
- Fundamental analysis of a stock is a wholesome approach to measuring a security’s intrinsic value. This is done by taking into account several economic and financial factors.
- The idea behind all this analysis is to produce numbers that can be compared with a stock’s current value and determine if the stock is over or undervalued.
- Broadly, fundamental analysis can be classified into two types:
- Qualitative Fundamental Analysis
- Quantitative Fundamental Analysis
- Advantages of Fundamental Analysis: It can help in making sound decisions in short term and helps in taking long-term positions on stocks. It gives more than one set of data to look at for making decisions and helps to understand the business in-depth.
- Disadvantages of Fundamental Analysis: It is highly time-consuming and very subjective as too many variables are involved which are specific to a company or a sector and are too dependent on what data the company provides.
