What is the importance of fundamental analysis while picking stocks? To answer this question first we’ll have to understand what fundamental analysis actually is.
Table of Content…
- What is Fundamental Analysis?
- Why Should we do Fundamental Analysis of Stocks?
- Analyzing a Company’s Financials
- How to do Fundamental Analysis of Stocks?
- Good company vs Bad company (Fundamentals)
- Is Fundamental Analysis the Holy Grail for Investing in Stocks?
What is Fundamental Analysis?
Fundamental analysis is a strategy of analyzing relevant economic and financial aspects for calculating the inherent value of a stock. It encompasses everything that could influence the valuation of the stock, from macroeconomic factors such as economic circumstances and conditions of market to microeconomic factors such as the efficacy of the company’s management.
Why Should we do Fundamental Analysis of Stocks?
The answer for this is, we have to use our own knowledge in order to pick stocks, i.e., we have to build our own opinion and use our own logic to study how the fundamentals of a company are. If we follow these patterns, only then can we create ‘wealth’ – because in the stock market, without doing any research, we can surely buy stocks but cannot become true investors. We can even make small gains (10-15%) but won’t be able to create wealth in the long run. We also won’t be able to achieve ‘financial freedom‘ – which is the ultimate aim.
Analyzing a Company’s Financials
In Layman’s terms, fundamental analysis basically means to analyze the basic financials of a business. In this analysis, the most important thing is asking if the business is actually ‘profitable’ – because if the company isn’t profitable, no matter how much the stock price rises – it won’t matter, the stock price will eventually come back to where it should be.
As mentioned above, the most important thing in a business is earning profits – we’ll have to try to predict whether a business will remain profitable in the future or not, and if it’ll be profitable in the future, how much growth will be seen in the company. We then analyze what the chances of that company closing down are because if the company closes – all the money could be lost.
Consequently, we have to analyze how the company’s management performs and how they function – and whether they are planning for growth. We then have to analyze who the company’s competitors are, and how the company handles them.
Finally, when we plan to buy the company’s stock – we have to determine if it has cheap valuations or expensive valuations.
How to do Fundamental Analysis of Stocks?
When you search for a company (stock) to buy, don’t try to judge it by its share price and PE ratio at the beginning itself, because price should be discussed later. First, we should check the quality of a stock/investment – we should check if the share price and PE ratio are justifiable for that company. It can also happen that a company’s fundamentals are not that good, yet its price is rising – this happens a lot in the stock market.
We then have to look at the income statement of that company. An income statement refers to a Profit and Loss statement – this shows us how much profit a company has earned in 1 year and if no profit is visible, how much loss it is bearing – this statement gives a detailed breakdown of the profits and losses of a company.
Another important factor is revenue – which refers to the money the company has earned from its customers – by selling its products/services (and other investment activities). This isn’t the final act when checking a company’s financials; we have to include a lot of other costs that a company bears – such as the cost of raw materials, overhead costs, labor costs, and other such expenses, which the company has to deduct from its earnings/revenue.
This leads to net income – which is the actual profit of a company – due to which the company’s value increases in the long term.
Good company vs Bad company (Fundamentals)
Now let’s have a look at how a fundamentally bad company compares against a fundamentally good company, and how importance of fundamental analysis while picking stocks plays a role…
Fundamentals of a Bad Company
Taking an example, say, the revenue of company A in 2015 was 0, which means they sold absolutely nothing that year, and therefore their net income was negative that year – as the company has started, there will be fixed costs that have to be taken into account. If we look at company A’s FY 2020 financials, the company’s revenue has increased drastically, but its net income is still negative. Why? Because of the company’s EBIT (Earnings Before Interests and Taxes).
If, say, EBIT of company A in FY 2020 is 1000 crores, but after paying the interests, it is -100 (minus 100) crores – which implies that this company is completely in debt, and these sort of high debt companies are extremely risky. There are huge chances of such companies going bankrupt. Now, it is also possible that the company is reporting huge losses, but still, its stock price is flying high? Do people not see all the poor financials a company is reporting? The answer for this is very simple – SENTIMENTS. Such companies set unrealistic goals to lure people in towards their dream, and when the dream isn’t even close to being accomplished – people realize that the company is completely spurious and that is when the stock price takes a nosedive (crash).
Another way of seeing this is that, say, company A’s stock price is very high at the moment, and the company’s earnings are a joke at the same time – even if the company’s earnings grow, it won’t happen overnight as the company might have set targets of years way down the line. How many investors out there do you think will hold this stock for long-term, say, 10+ years? People who have invested in such stocks in the past year have invested only by seeing its rising price, and have no idea about its fundamentals because no true investor who actually believes in holding stocks for 10+ years would ever invest in such bogus stocks.
Warren Buffett has a saying for such companies…
“I don’t look to jump over 7-foot bars, I look around for 1-foot bars that I can step over”– Warren Buffett
In simple terms, it means to have realistic goals and expectations. This is one reason why new investors who have bought shares of such companies the past year won’t be able to hold them for the long term. These people have very weak confidence in such market conditions – one bad news and all these ‘investors’ will be in line to sell their shares. This is what a bubble looks like – a bubble that eventually bursts.
Benjamin Graham once quoted…
On a lighter note, if you run behind the crowd, things that happen with the crowd will happen to you. This is one reason why the stock market is infamous because maximum people invest in companies just by knowing its name and the hype surrounding it. But if you just open an annual report and study it, you are miles ahead of these 90% so-called investors.
That is why we should pick companies where we have researched for them, and not blindly follow the crowd.
Fundamentals of a Good Company
We’ll refer to it as company B. If we look at the financials of company B, its revenue in the past five years has almost doubled. For a company to grow, it should increase its sales and at the same time apply cost-cutting to its product – which helps in maximizing its profits.
Essentially, in order to increase profits, a company can do two things – 1. Sell more products by increasing revenue and/or 2. Increase profit margin on its products. If a company is able to capitalize on both these things simultaneously, it is heading in the right direction. This factor is visible in all the fundamentally good companies.
Also, company B has a greater revenue growth as compared to its peers (industry revenue) as the company’s management is efficient – the net income is growing at an even faster rate than industry. Concurrently, company B has increased its market share while competing with other established companies.
Another important aspect is dividends – company B has increased its dividend consistently over the past five years and has paid dividend even in uncertain times like that of 2020. This is why when you invest in fundamentally good companies – regardless of the market conditions, they tend to perform well in the long run.
You don’t have to worry or constantly update yourself with the stock prices of these companies in fear that they may go down over the years – their profits constantly increase and they pay their dividends to please the shareholders.
Is Fundamental Analysis the Holy Grail for Investing in Stocks?
The short answer for this is, No. There is no perfect formula or method to analyze a stock – stock market is much greater and complex than just simply analyzing the fundamentals of a stock and making money out of it.
Prices in the stock market are influenced by various other factors, people often use a combination of technical and fundamental analysis to have an in-depth idea of the intrinsic value of a stock. The key is to play the long-term game, the stock market has always gone up in value in the long run. With all the fluctuating prices and myriad of factors influencing a stock’s value in the short term, it is very difficult to nail your game in short runs – it is extremely difficult to time the market.
I would like to end it with an old investing quote…