Fundamental analysis is done to evaluate securities by analysing its intrinsic value with the help of economic, financial, qualitative and quantitative factors. Also, fundamental analysts study microeconomic and macroeconomic factors. The aim of fundamental value is to provide a quantitative value so that an investor can use it to compare with security’s current market price and hence analyse whether security is overvalued or undervalued.
The fundamental analysis determines the stability or performance of the companies by going through key numbers and economic indicators. Fundamental analysts focus on identifying fundamentally strong companies and fundamentally weak companies so that they can decide whether to go long, that is, purchasing stocks and expecting its value to rise in future or companies that are strong or short, that is, to sell the stock and re-buying them when prices will be low for the companies that are weak.
HOW TO DO FUNDAMENTAL ANALYSIS
It is known that market price of a stock moves to its intrinsic value. Investors buy those stocks whose intrinsic value is higher than the market price believing that value of stock will move to its intrinsic value. However, fundamental analysis can be tricky and technical as there is lot of information and data that needs to evaluated to know about the intrinsic value of the stock. Thus, fundamental analysts begin with analysing the financial health and performance of a company. Below are few steps that investors can begin with to do fundamental analysis:
Initial Screening of stocks with Financial Ratios
To begin with, the initial screening of stocks is to be done in order to invest in a good company. Financial ratios tell a lot about a company’s stability. Hence, financial ratios must be looked through to make a decision about an investment.
A ratio can provide relevant financial information about a company when compared with other companies.
Below are some of the ratios used and how they are computed:
- Liquidity ratio
It measures the liquidity position of a company, that is, calculate a company’s ability to convert assets into cash for paying off its commitments and liabilities.
Current ratio– Current assets/Current liabilities
Quick ratio– Liquid current assets/Current Liabilities
- Leverage Ratio
It computes debt situation of a company.
Debt to equity ratio– Total debt/Total equity
Debt to asset ratio– Total debt/Total assets
- Price to Earnings Ratio (P/E)
P/E ratios compute the company’s current share price to its earnings per share. It shows if a company is undervalued or overvalued.
P/E ratio is used to evaluate the stability of a company by computing its profit. However, companies may raise their P/E ratio by adding debt, hence, P/E ratios of companies should be compared with their historical P/E, peers P/E, the average of market and industry P/E.
- Return on Equity
The end goal of any investment is its returns and returns on your investments entirely depend on the earnings of a company, that is, return on equity. It is inevitable that if a company earns a good profit then the investors will receive higher returns and vice versa. An ROE of 15-20% is considered ideal.
Learn about the company
The next step in fundamental analysis involves learning well about the company. There are crucial points that an investor must be aware of before investing in a company. Such as the performance of the company, management, and decisions about the company, its credibility and much more.
Go through the websites of companies and evaluate everything from their products, business, employees, visions to customers to make a decision about investing in a particular company.
Check the financial reports of the company
Analysing financial reports of a company is a essential step for understanding a company and making a decision for investment.
The financial reports that potential investors need to look at are-
- Annual reports– These reports are filed by public companies and can give exposure to all the key information of the companies. These are posted at the end of every year, 31st March and contains data for the entire year.
- Balance Sheets– A balance sheet shows all the assets and liabilities of a company for the given period. Analysing the debt and asset holdings of a company can tell about the stability of the company.
- P&L Statement– P&L statement provides information regarding the profitability of a company.
- Cash Flow Statement– Cash flow statement provide information regarding cash inflows and outflows during various activities and show the profitability of a company.
Debt of the company
Debt can affect the profitability, stability as well as the future of a company. Hence, one should look through the debt of the company before investing. Companies with huge debt may not provide good returns to its shareholders as debt hinders the financial stability of a company.
Before investing in a company, look for its peers and competitors to examine why the company you have chosen is better than others.
Look through the USP of a company by considering its current and future projects etc.
Lastly, look for the growth aspect of the company you have decided to invest in. Since you are willing to invest for a long term, you need to consider future prospects of companies and invest in those whose products are expected to stay in the market for years.