Unlike other items that we buy in life, for instance, groceries, stocks do not come with a fixed price tag. They are bought and sold by the traders at their current market value. This leaves us wondering whether we are paying the right amount for the stock or are overpaying to get it in our investment basket.
The confusion regarding the true value of a stock is solved by conducting the fundamental analysis of the stocks. Fundamental analysis is carried out by looking at the fundamental indicators. These fundamental indicator help traders to look at the business at the most basic level, i.e., the financial level.
Fundamental analysis helps in determining the financial health of a business by examining various ratios of the business. Thus, by the end of the fundamental analysis process, the trader gets the idea regarding what should be the ideal price of the stock under consideration.
What is the fundamental analysis of stocks in India?
Fundamental analysis is the process to find out the intrinsic value of a stock. Fundamental analysis, unlike technical analysis, combines the external factors and the internal factors like the financial statements and industry trends followed by a company. The intrinsic value of the stock does not change frequently.
It is the fundamentals of the company that derive the prices of the stocks up and down and hence help traders in determining the fair value of a stock.
Fundamental analysis is based on three different sets of data:
In fundamental analysis, short-term information about the company and the stock are avoided. Majority of people invest in the stock market with the purpose of investing for the long-term. It is suitable for investors who believe in buy and hold strategy.
Fundamental analysis helps identify the attributes of the company, and hence, the process of fundamental analysis requires an understanding of mathematics, business and accounting.
Types of Fundamental Analysis
Fundamental analysis is broadly classified into two categories- qualitative analysis and quantitative analysis.
Qualitative Analysis: Qualitative analysis, as the name suggests, is not driven by numbers and formulas. Quality is very subjective. Qualitative analysis is done individually by investors. This is primarily because quality aspects that are important for one investor might not be so important for the other investor. Under qualitative analysis nature of the company’s business, its corporate governance, the quality of earnings of the company and nature of its assets and liabilities are analyzed.
Quantitative Analysis: Quantitative analysis as a part of fundamental analysis helps in understanding the financial performance of a company. Numbers and formulas derive quantitative analysis. Once you have derived certain numeric values indicating the company’s performance, you can compare these values either with the performance of its competitors or with the past performance of the same company. Quantitative analysis is conducted using financial ratios and projected earnings of the company. Usually, it is the company’s balance sheet and cash flow statement that is taken into consideration while conducting quantitative analysis.
Importance of Fundamental Analysis
Fundamental analysis is important as it looks at various factors that have an impact on a company’s share price. Here are some reasons why fundamental analysis is important:
- It helps in evaluating the management of a company. A company’s management is its soul. Thus, the management of a company plays an essential role in the growth and development of the organization. Fundamental analysis helps in understanding the managerial structure of the company and to analyze how it has been performing over the years.
- No matter how good everything about the company is, in the end, what matters is the financial performance of the company. The fundamental analysis is an in-depth analysis of the financial performance of the company.
- Fundamental analysis also helps in finding out if the company is able to beat the competition in the industry. The financial values of one company are compared with the financial performance of its competitors. This is also important because if the company is not able to outperform its competitors, it won’t be able to survive for the long run.
- Fundamental analysis helps in determining the fair value of the company by cautiously analyzing its present and past performance. Fundamental analysis thus gives a clear picture to identify is the company is overvalued or undervalued.
- Fundamental analysis is important for evaluating the industry and the overall economy to find out its impact on the performance of a company. This helps in forecasting the movements that are likely to take place in the stock’s price. On this basis, it further helps in predicting future prices of the stocks.
Fundamental Analysis Tools
There are various tools that are widely used for fundamental analysis. These tools include:
- EPS or Earning Per Share: EPS or Earning Per Share is the amount of profit that is assigned to each of its stock by the company. The EPS value is calculated by dividing the total revenues of the company by the total number of outstanding shares. The income considered here is the income after tax. EPS represents the company’s health. A higher EPS value indicates higher returns for the investors.
- Price-to-earnings Ratio: One of the essential fundamental analysis tools, the price-to-earnings ratio reflects a company’s payouts compared to the stock prices. It is calculated by dividing the share price with EPS. A lower P/E ratio signifies higher returns for the investors. A lower P/E ratio signifies that the stock is undervalued and has the potential to grow in future.
- Return on Equity: It indicated the company’s efficiency to generate profits on its shareholder’ investment. The Return on Equity is calculated by dividing a company’s net earnings after tax by shareholders’ equity. A higher return on equity signifies that the company is more efficient.
- Price-to-Book (P/B) Ratio: Also known as the shareholders’ equity, P/B ratio is used to compare a stock’s book value to its market value. It is calculated by dividing the last closing price by the previous quarter’s book price of the stock. If the price-to-book value is less than one, then the stock is undervalued.
- Beta: It is the correlation of the stock price with its industry and is calculated by comparing the stock with the benchmark index. The value of beta is usually between -1 and 1. The beta value below 0 signifies that the stock is inversely correlated.
- Dividend Payout Ratio: Dividend payout ratio gives insight into what the company has earned and what portion of the earnings will be given out as a dividend. It is calculated by dividing the total dividend amount by the net income of the company.
- Dividend Yield Ratio: It indicated what the company is paying to its shareholders as a dividend in relation to its share price. It is always expressed as a percentage and is calculated by dividing the annual dividend of stock by current share price. It is important for investors looking forward to earning a good amount of dividend from the company.
Thus, for long-term investors, fundamental analysis is more important than technical analysis. It looks at both the qualitative and quantitative aspects affecting the performance of the stock in future.