Last Updated on Dec 14, 2022 by Anjali Chourasiya
Fundamental analysis is a holistic approach to understanding and studying a business. It helps in determining fundamentally strong companies. When you are planning to invest in a company for the long term, you must study it from various perspectives. Fundamental analysis also helps you determine a stock’s fair market value. But how? Let’s find out.
Table of Contents
What is fundamental analysis?
It is a method of evaluating the true value of a company or an asset. It does so by analysing the factors that could influence the price in the future. Fundamental analysis is in contrast with technical analysis. While fundamental analysis is the company’s financials, external events, influences, and industry trends, technical analysis derives the information from charts. The former is used for long-term investments, while the latter is usually used for trading.
Note: The true value of a company is also known as fair value and intrinsic value.
Importance of Fundamental Analysis
Fundamental analysis helps in determining the fair value of any stock. It also evaluates the health and performance of an organisation with the help of its financials and major economic indicators. Fundamental analysis of stock also helps in understanding the business model of a company, the working ways of the management, and its strengths and weaknesses. You can predict future price movements and determine if the stock is undervalued or overvalued.
Types of fundamental analysis
Fundamental analysis is divided into two categories:
Qualitative analysis
As the name suggests, qualitative analysis considers the qualitative factors of a company, such as goodwill, demand, consumer behaviour, company recognition in the broader market, competitive analysis, and brand value. It also aims to determine how the management is, the impact of their decisions on the market, and depicts their socio-economic position. Qualitative analysis is usually considered subjective.
Quantitative analysis
Quantitative analysis is related to the measurable characteristics of a business. Hence, the biggest source of quantitative analysis is financial statements. Quantitative analysis is about statistics, reports, and data. It considers statements, balance sheets, cash flows, debt, quarterly performance, and many financial ratios to understand the company’s overall financial health and determine the share’s price.
Difference between fundamental analysis and technical analysis
Fundamental analysis and technical analysis are far from each other. Let’s understand how.
| Points of difference | Fundamental analysis | Technical analysis |
| Meaning | It is a detailed examination of the factors that influence the industry, company, financial statements, competition, and more. | It includes the examination of charts for making predictions on the share price. It is data-driven and used to understand the patterns in the share price of a stock. |
| Function | Investment-related | Trading-related |
| Time-frame | long-term | short-term |
| Objective | To identify the true value of the stock | To identify the right time to enter or exit the market |
| Focuses on | Both past and present data | Past data only |
| Form of data used | Financial statements, economic reports, news events, industry statistics, management processes, etc. | Analysis of charts |
| Methodology | Examination of ongoing industry trends, economic outlook, competitor companies’ performance, and financial data. | Examination of the market psychology as well as price movements. |
| Indicators | Indicators used are expenses, revenues, assets, liabilities, debt-equity ratio, return on equity ratio, and so on. | Indicators used are price data, RSI, MACD, simple moving average, etc. |
Pros of fundamental analysis
- It is useful for the long-term investment approach.
- With fundamental analysis, you get information on where and when to invest in generating high earnings over a long-term period.
- Fundamental analysis includes both – qualitative and quantitative analysis. It helps in providing a complete insight into the company’s performance.
Cons of fundamental analysis
- It is a time-consuming process which requires multiple areas of analysis, making the process extremely complicated.
- The quantitative analysis is subjective because the data is not quantifiable.
Who uses fundamental analysis?
Even though most investors tend to utilise fundamental analysis, the people most likely to use it are:
- Value or long-term investors: It helps them find out the underlying value of the stock and growth potential, generate pricing targets, and ascertain whether the stock is worth the price they are paying.
- Corporate managers and accountants: They use it to gauge and improve an organisation’s profit-making ability by streamlining its operations. It also helps them understand where they stand against the competition.
Fundamental analysis methodology
Qualitative analysis
The first step in fundamental analysis is to analyse the company qualitatively. For this purpose, the answers to the following questions are determined.
- How efficient is the company in terms of operations?
- What is the quality of its key management personnel?
- How does the brand value of a company appear?
- Does the company use any exclusive (proprietary) technology?
- What socially responsible initiatives is the company undertaking?
- What is the company’s vision for the future?
After determining the answers to these questions and considering the answers are good, you move on to the next step.
Quantitative analysis
There are various factors that are analysed in quantitative analysis. Let’s look at all of them step-by-step.
Check financial statements
There are numerous financial statements of a company. However, there are three primary financial statements that a company presents to display its performance.
1. Profit and loss statement
The profit and loss statement is commonly referred to as the income statement, P&L statement, operation statement, and earnings statement. It usually consists of –
- The revenue of the company for a certain time period (quarterly or yearly)
- Tax and depreciation
- The Earnings Per Share (EPS) number
- The expenses incurred to generate the revenues
It gives you insight into a company’s profitability and articulates the company’s bottom line. There are various parameters in a P&L statement. Depending on the industry, we measure different parameters. However, the main parameters that we measure for all companies to check the profitability are revenue, Profit Before Interest and Tax (PBIT), and net income.
For a successful company, these three factors should always appreciate. After analysing these three factors, you can also analyse the trend in net profit for the last 5-10 yrs and operating profit to have a deeper understanding of the P&L statement.
2. Balance Sheet
A balance sheet displays a company’s assets, liabilities, and shareholder’s equity at a specific point in time. In a balance sheet, at any point in time, the total assets of a company should always be equal to the company’s liabilities, including shareholder’s equity. Hence, the name ‘balance sheet’.
If they are not balanced, there may be some issues, including incorrect or misplaced data, miscalculations, or exchange rate or inventory errors. Hence, in a balance sheet,
Assets = Liabilities + Shareholders’ Equity
A balance sheet tells what a company owns, what it owes, and what it is worth as a company. To determine if a company is worth investing in, we look at the total assets and total liabilities of the company.
If a company’s assets are higher than the liabilities, you can mark the company as ‘good for further assessment’. However, if the liabilities are higher, it is usually considered ‘not worth investing’. For a deeper analysis of the balance sheet, various financial ratios, such as debt to equity ratio, return on equity, etc., are used.
3. Cash-flow Statement
A cash flow statement shows the movement of money in and out of business. A cash-flow statement determines a company’s financial health. It helps you in analysing a company’s liquidity. The cash flow statement shows the net change in cash, which is usually divided into cash from operating activities, investing activities and financing activities.
For the analysis purpose, we check the factor ‘Free Cash Flow’. A positive cash flow indicates that the company’s assets are growing from where they started. In contrast, a negative cash flow indicates otherwise.
You can check all these financial statements of a company on Tickertape. Using the search bar, enter the company you wish to analyse. Click on ‘Financial Statements’ from the stock page to access the income statement, balance sheet, and cash flow.
Annual Report and Investors’ Presentation
An annual report is a comprehensive document that a company must provide to all its shareholders annually. It describes their operations throughout the year. You can determine the company’s financial health with the help of an annual report.
The intent of a company’s annual report is to provide public disclosure of its operations and financial activities over the past year. There are numerous components of an annual report. As an investor, you should look for the business overview, financial/performance highlights, Management Discussion and Analysis (MD&A), Director/Board’s report, notes to accounts, auditor’s report, Chairman’s statement, and debt scenario. The annual report provides valuable information which you can use to analyse the company thoroughly.
Investors’ presentation consists of facts about the company, immediate sales growth opportunities, industry analysis, management team, all-round performance, innovations, future plans and more. It is important to note that not every company provides investors presentations to its shareholders. Investors’ presentation is a brief, clear, informative resource to understand the business.
To get annual reports and investors’ presentations of a company, click on ‘Financial Statements’ of stock on Tickertape and scroll down to the bottom. You will get the company’s annual reports and investors’ presentations.
Growth over the period of 3 and 5 yrs
After analysing the financial statements and annual reports, you can analyse the growth in the share price of a stock for 3-yr and 5-yr periods. If a company has shown positive growth in all the previous steps, it is highly likely that it has had an upward trend in its stock price for the previous 3 yrs and 5 yrs. For the purpose of fundamental analysis, we always analyse the long-term growth of the share price.
Financial ratios
Financial ratios are helpful in determining the performance of a company. They are the best ways to analyse financial statements. Benjamin Graham, popularly known as the father of fundamental analysis, has made the use of financial statements popular. The ratios help in the competitive analysis of a company. Further, you can also analyse a company’s performance by analysing its financial ratios trend.
A. Profitability ratios
As the name suggests, profitability ratios determine the profitability of a company. The ratios reveal the performance of a company in terms of generating profits. They also convey the competitiveness of the management. There are various profitability ratios. For the purpose of fundamental analysis, here are four profitability ratios.
1. PAT margin
Profit After Tax (PAT) margin is calculated by deducting all company expenses from its total revenue. It identifies the overall profitability of a company. The formula to calculate the PAT margin is,
PAT margin = [PAT / Total revenue]*100
The higher the PAT margin, the better the profitability of a company. It is referred to as Net Profit Margin (NPM). It should be compared with the previous years’ trends or competitors to understand more deeply.
2. Return on Equity (ROE)
It is a critical ratio that assesses the return earned by the shareholders on every unit of capital invested. ROE is useful in measuring the company’s ability to generate profits from the shareholders’ investments. It represents the efficiency of a company in generating profits for its shareholders. It is calculated as,
ROE = [ Net income / Shareholders’ equity ] * 100
To calculate the shareholders’ equity, subtract a company’s total liabilities from its total assets. You can get this information from the balance sheet.
Shareholders’ equity = Total assets – Total liabilities
High ROE signifies good cash generation by the company, conveying a good performance by management, whereas low ROE indicates otherwise. ROE of a company can also be compared with its competitors and past years’ trends to get a better understanding.
3. Return on Assets (ROA)
It is a profitability ratio that measures the profitability of a company in relation to its total assets. It shows if the company is using its assets efficiently to generate profits. To calculate the ROA, divide a company’s net income by its total assets.
ROA = Net income / Total assets
The higher the ROA, the more efficient management is in utilising the economic resources. Both ROE and ROA reflect how well a company utilises its resources. However, there is one key difference which is the way they treat a company’s debt. ROA captures how much debt a company carries as its total assets include all kinds of capital. On the other hand, ROE leaves out all the liabilities and only measures the return on a company’s equity.
If a company has more debt, its RoE would be higher than its ROA.
4. Return on Capital Employed (ROCE)
It is useful in understanding how well a company is utilising its capital to generate profits. It takes into consideration all kinds of capital, including debt. To calculate ROCE, divide Profit Before Interest and Tax (PBIT) by the total capital employed.
ROCE = PBIT / Total capital employed
Where the total capital employed = Equity + short-term debt + long-term debt
PBIT is also known as Earnings Before Interest and Tax (EBIT). You can find this information in the income statement of a company.
A higher ROCE suggests efficient management in terms of capital employed. However, a lower ROCE may indicate a lot of cash on hand as cash is included in total assets. As a result, high levels of cash can sometimes skew this metric.
B. Leverage ratios
Often referred to as solvency ratios, leverage ratios measure a company’s ability to sustain its day-to-day operations in the long term. It measures a company’s financial health by determining its ability to meet its long-term debt obligation. Let’s look at two leverage ratios that will help us determine the potential company to invest in:
1. Debt-to-equity ratio
It is one of the prominent ratios in fundamental analysis and is often referred to as the risk ratio. The debt-to-equity ratio calculates the weight of a company’s total debt against total shareholders’ liabilities. It is calculated as
Debt-to-equity ratio = Total debt / Shareholders’ equity
Where the total debt = short-term debt + long-term debt + fixed payment obligations
A value of one on this ratio signifies that there is an equal amount of debt and equity capital. A higher ratio (more than 1) indicates higher leverage, whereas a lower than 1 signifies a relatively bigger equity base with respect to debt. The maximum acceptable debt-to-equity ratio for many companies is between 1.5-2 or less. For larger companies, debt to equity ratio of 2 or higher is acceptable. Ultimately, an ideal debt-to-equity ratio varies across companies based on the sector they belong to.
2. Interest coverage ratio
Often referred to as the debt service ratio or the debt service coverage ratio, it gives insights into how easily a company can repay the interest on its outstanding debt. The interest coverage ratio determines the time (typically number of quarters or years) for which interest payment can be made with the company’s current available earnings. It is calculated as
Interest coverage ratio = EBIT / Interest expense
The lower the ratio, the more the company has a debt burden. The company’s ability to pay back the debt is questionable when the interest coverage ratio is only 1.5 or lower. The analysts usually prefer an interest coverage ratio of 2 or more.
C. Operating ratios
Often referred to as activity ratios, they measure the efficiency at which a business can convert its assets into revenues. Operating ratios help us understand the efficiency of a company’s management. Profitability ratios convey the company’s efficiency, which is generally determined by measuring the operating ratios. Hence, it is difficult to classify these ratios.
1. Working capital turnover
To run a company’s day-to-day operations, working capital is required. The working capital turnover ratio measures how much revenue a company generates for every unit of working capital. It is commonly referred to as net sales to working capital. The formula to calculate it,
Working capital turnover ratio = Revenue / Average working capital
The higher the working capital turnover ratio of a company, the better sales it can generate in comparison with the funds they have used to execute the sales.
2. Total assets turnover
This ratio indicates a company’s ability to generate revenues with the given amount of assets. It is a ratio of the total sales or revenue of a company to its average assets. The total assets turnover ratio is calculated annually. It is calculated as
Asset turnover ratio = Operating revenue / Average total assets
A higher total assets turnover ratio conveys that a company is using its assets efficiently to generate more sales, whereas a lower ratio indicates a company’s inability to use its resources effectively.
This ratio tends to be higher in certain sectors. For example, sectors like retail usually have small asset bases but higher sales. Hence, they have the highest asset turnover ratio. Conversely, sectors like real estate and utilities have large asset bases, thus, low asset turnover.
D. Valuation ratios
Valuation ratios measure a company’s worth. It analyses whether a company’s current share price is perceived as its true value. It compares the cost of security with the perks of owning the stock. Let’s explore some valuation ratios.
1. Price to Earnings ratio (P/E ratio)
It is a popular ratio that analyses a company’s share price to its earnings per share. Due to its popularity, it is often called a ‘financial ratio superstar’. It helps in determining if a stock is undervalued or overvalued.
P/E ratio = Market value per share / Earnings per share
To determine if a stock is undervalued or overvalued, the P/E ratio of that stock is compared with other stocks of the same industry and/or with the sector P/E. A high P/E ratio could mean that the stock price is relatively higher than its earnings and possibly overvalued. In contrast, a low P/E ratio might indicate the stock’s price is low relative to earnings and perhaps undervalued.
2. Price to Sales ratio (P/S ratio)
It compares the stock price of a company to its revenue. It helps in determining how much an investor is willing to pay per rupee of sales. The formula for the P/S ratio is
P/S ratio = Current share price / Sales per share
Where the sales per share = Total revenues / Total number of shares
It is better to compare the P/S ratio of similar companies in the same industry to get a deeper understanding of how cheap or expensive the stock is. The higher the P/S ratio, the higher the valuation of the company. Conversely, a low ratio indicates the stock is undervalued.
3. EV/EBITDA ratio
Enterprise Value (EV) measures a company’s total value. It is compared with a company’s EBITDA to determine how often an investor has to pay EBITDA if they were to acquire the entire business.
Similar to the P/E ratio, the lower the EV/EBITDA, the lesser the company valuation. A high EV/EBITDA signifies that a company is highly likely to be overvalued. This ratio is used in comparison with other companies in the same sector. Hence, cross-sector comparison won’t be helpful. It is commonly used to figure out what multiple a company is currently trading at.
Conclusion
Fundamental analysis is the first step you take when you are looking for long-term investments in assets like stocks. It is an extensive process but provides you with your potential long-term investment plan. Hence, take your time in understanding the financial statements, stock growth of a company, and evaluating the crucial financial ratios. Tickertape is your complete destination for fundamental analysis. From getting financial statements to ratios, adding stocks to the watch list, to investing in them directly, everything can be done here. Start your investment journey now!
FAQs
Can we use both fundamental and technical analysis of stocks?
Fundamental analysis uses financial and economic data of the company for a long-term investment approach, while technical analysis takes the price and trading value for short-term trading. Depending on the investment period, you can use the approaches.
Should the fundamental analysis of stocks be used only by the experts?
No. The fundamental analysis of stocks is not limited to experts. Any investor can make use of this analysis before investing in stocks for the long term.
How to do a fundamental analysis of stocks?
Fundamental analysis is a holistic approach to understanding and studying a business. It helps in determining fundamentally strong companies. Here’s how to do it in brief.
– Understand the company, their business model, management structure, and so on.
– Use financial ratios like PE ratios to evaluate the company.
– Study the financial reports of the company.
– Find the competitors and study them. Look for competitive advantages in the company.
– Check the company’s debt and compare it with rivals.
– Analyse the company’s future prospects.
– Review all the aspects from time to time.
How to get a Tickertape Pro membership?
To become a Tickertape Pro Member and enjoy various benefits, you must-
– Log in to Tickertape
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– Select the plan that suits your needs
– Make the payment
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Read these articles to get a better understanding:
– How Tickertape Makes Investing Easy and Rewarding
– How To Use Tickertape Stock Screener To Discover Stocks? – A Complete Guide
– Introducing Mutual Fund Screener: Find the Right Fund for Your Financial Goals
– Market Mood Index (MMI): Time Your Investments Better
As an insatiable reader and learner, I’ve spent the last two years exploring the world of finance. With my creative mind and curious spirit, I love making complex finance topics easy and fun for everyone to understand. Join me on my journey as we navigate the world of finance together!
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