Why Fundamental Analysis is Critical for Successful Investing by Praveen

Why Fundamental Analysis is Critical for Successful Investing by Praveen

1. What is Fundamental Analysis

Fundamental analysis is a comprehensive approach used by investors, financial analysts, and fund managers to assess a company's true worth and growth potential. By examining a wide range of financial and non-financial factors, this method seeks to gauge a company's overall health.

 

This analysis involves a deep dive into financial statements, requiring a keen ability to interpret various data points. Unlike strategies focused on short-term market fluctuations, fundamental analysis takes a long-term perspective, concentrating on a company's core fundamentals. It is crucial to note, however, that while this approach provides valuable insights, it cannot predict stock prices with absolute certainty, and investing always carries inherent risks.

 

Fundamental analysis aids investors in making informed decisions regarding when to buy, hold, or sell stocks. It hinges on a thorough understanding of financial statements, economic indicators, and industry dynamics. Staying abreast of the latest news and events that can impact a company's fundamentals is also imperative.

 

For instance, suppose a company's stock is currently trading at $100. After conducting extensive research, one analyst determines that its intrinsic value should be $104, while another arrives at a valuation of $106. In such cases, many investors may consider the average of these estimates, which suggests that the stock's intrinsic value is around $105. Investors often find these estimates relevant because they aim to purchase stocks trading below these fundamental values.

 

2.  IMPORTANCE OF FUNDAMENTAL ANALYSIS

Fundamental analysis plays a crucial role in helping investors make informed decisions about where to invest their money. Here are several key reasons why this method is essential:

·       Company Health Assessment: Fundamental analysis involves a comprehensive review of a company's financial statements, management team, industry position, and economic factors. This evaluation helps investors determine the financial health of the company, including aspects like liquidity, solvency, and profitability. Identifying these factors is vital for assessing potential risks associated with an investment.

·       Intrinsic Value Estimation: One of its primary goals is to estimate the intrinsic value of a company's stock, representing its true worth. By comparing this intrinsic value with the current market price, investors can pinpoint stocks that are either undervalued or overvalued. This insight creates opportunities for profitable investments.

·       Long-Term Investment Focus: Fundamental analysis is particularly valuable for long-term investors looking to hold assets over extended periods. It equips them with the tools to identify companies with strong fundamentals and growth potential, which are more likely to perform well in the long run.

·       Risk Management: By scrutinizing a company's financial statements, debt levels, and cash flow, investors can evaluate the associated risks. This information is crucial for making informed decisions and effectively managing risk in their portfolios.

·       Management Quality: Fundamental analysis evaluates the competence and track record of a company's management team. Experienced and capable leadership often correlates with better financial performance and strategic decision-making.

·       Competitive Position Analysis: It helps investors gain insight into a company's competitive position within its industry. Factors such as market share, competitive advantages, and industry trends provide valuable information about a company's long-term prospects.

·       Earnings Growth Potential: Investors commonly assess a company's historical earnings growth and its potential for future growth. Strong earnings growth can be a positive indicator for stock price appreciation.

·       Dividend Consideration: For income-focused investors who rely on dividends, fundamental analysis is indispensable. It evaluates a company's ability to generate consistent cash flow and distribute dividends to shareholders.

Stock Valuation Methods: Fundamental analysis offers various techniques for valuing a company's stock, including Price-to-Earnings (P/E) ratios, Price-to-Book (P/B) ratios, and Discounted Cash Flow (DCF) analysis. These valuation metrics aid in determining whether a stock is overpriced or underpriced in the market.

3.     CHECK FINANCIAL STATEMENTS

A company typically presents three core financial statements to convey its performance. Lets see the ITC Company Financial Statements.

 

3.1 PROFIT AND LOSS STATEMENT   

 

The financial document commonly known as the income statement goes by several names, including the profit and loss statement, P&L statement, earnings statement, and operation statement. It typically includes the following components:

 

·       Revenue: This section reports the company's earnings over a specific time frame, such as a quarter or a year.

·       Tax and Depreciation: It accounts for taxes paid and depreciation expenses, which reduce the company's taxable income.

·       Earnings Per Share (EPS): The income statement often provides the EPS figure, indicating the portion of profit attributable to each outstanding share of stock.

·       Expenses: This segment details the costs incurred by the company in generating its revenues.

For a company to be considered successful, these three elements – revenue, tax and depreciation management, and EPS – should demonstrate positive trends. Analyzing these aspects provides valuable insights. Additionally, examining the historical trend in net profit and operating profit over the last 5-10 years offers a deeper understanding of the income statement.

3.2 BALANCE SHEET

A balance sheet serves as a snapshot of a company's financial health, capturing its assets, liabilities, and shareholder's equity at a specific moment. The name "balance sheet" derives from the fundamental principle that, at any given point, a company's total assets must precisely match its combined liabilities and shareholder's equity, maintaining a delicate equilibrium.

When a company's assets exceed its liabilities, it generally signals a positive indicator, prompting further assessment and consideration as a potential investment. Conversely, if the liabilities outweigh the assets, it often raises concerns and may deter investors, as it suggests potential financial instability.

For a more comprehensive evaluation of the balance sheet, financial analysts employ various key financial ratios, such as the debt-to-equity ratio and return on equity. These ratios offer deeper insights into a company's financial position and performance, aiding investors in making informed decisions.

3.3 CASH-FLOW STATEMENT

A cash flow statement provides a detailed account of how money flows into and out of a business, playing a crucial role in assessing a company's financial well-being. This statement primarily serves to analyze a company's liquidity.

The cash flow statement offers a clear picture of the net cash change, typically categorized into three main sections: cash generated from operating activities, cash utilized in investing activities, and cash involved in financing activities. This breakdown helps stakeholders understand how cash is managed within the company and is a valuable tool for evaluating its financial stability

3.4 ANNUAL REPORT AND INVESTORS’ PRESENTATION

An annual report is a comprehensive document that a company is required to share with its shareholders on an annual basis. It serves as a detailed account of the company's activities and financial performance throughout the year. Analyzing an annual report can offer valuable insights into the company's financial health and operations.

 

The primary purpose of a company's annual report is to provide transparent and public disclosure of its business operations and financial transactions over the preceding year. It typically includes various essential components, and for investors, paying attention to specific sections is crucial. These sections often encompass a business overview, financial highlights, Management Discussion and Analysis (MD&A), Director or Board's report, notes to accounts, auditor's report, Chairman's statement, and information on the company's debt situation. Thoroughly reviewing these elements can aid investors in gaining a deep understanding of the company's overall performance and financial position.

 

On the other hand, an investor presentation is a concise and informative resource that some companies provide to their shareholders. It offers a snapshot of key facts about the company, immediate growth opportunities in terms of sales, industry analysis, details about the management team, an overview of overall performance, innovations, future plans, and more. It's important to note that not all companies provide investor presentations, but when available, these presentations serve as a convenient and clear way for investors to comprehend the business and its prospects.

3.5 GROWTH OVER THE PERIOD OF 3 TO 5 YEARS

 Following the examination of financial statements and annual reports, the next step involves assessing the stock price growth over 3-year and 5-year periods. If a company has demonstrated positive indicators throughout the previous analysis steps, it often indicates a likelihood of an upward trend in its stock price over the same 3-year and 5-year timeframes.

In fundamental analysis, the focus consistently remains on the long-term trajectory of the stock price. This approach ensures that investors take into account not just short-term fluctuations but also the sustained growth potential and performance of the company over extended periods.

 

4.  FINANCIAL RATIOS

4.1 Profitability ratios 

 

a)     The PAT margin:-  or Profit After Tax margin, serves as a critical measure for evaluating a company's profitability. To calculate it, one deducts all expenses from the total revenue and expresses it as a percentage. This margin reflects the company's overall profitability and is determined by the following formula:

PAT Margin = (PAT / Total Revenue) * 100

 

b)     Return on Equity (ROE):- ROE is a pivotal ratio that evaluates the return shareholders receive on each unit of capital they have invested in a company. This ratio is instrumental in gauging a company's capacity to generate profits from the capital contributed by shareholders, thereby indicating its efficiency in delivering returns to its investors.

ROE is calculated using the following formula:

ROE = (Net Income / Shareholders' Equity) * 100

a)     Return on Capital Employed (ROCE):- ROCE is a valuable metric for evaluating a company's efficiency in utilizing its capital, encompassing both equity and debt, to generate profits. This ratio offers insights into how effectively the company deploys its resources for profitability.

The calculation of ROCE involves dividing the Profit Before Interest and Tax (PBIT) by the total capital employed:

ROCE :- PBIT / Total Capital Employed

 

4.2 Leverage ratios

 

a) Debt-to-equity ratio :- The debt-to-equity ratio is a key metric in fundamental analysis, commonly known as the risk ratio. This ratio quantifies the proportion of a company's total debt relative to its shareholders' equity, providing insights into its financial risk profile.

To calculate the debt-to-equity ratio

Debt-to-Equity Ratio =

 Total Debt / Shareholders' Equity

 

b) Interest coverage ratio:- The interest coverage ratio, also known as the debt service ratio or debt service coverage ratio, offers valuable insights into a company's ability to meet its interest payment obligations on outstanding debt. This ratio assesses the duration, often measured in quarters or years, for which a company can sustain interest payments using its current earnings.

The formula to calculate:

Interest Coverage Ratio =

 (EBIT) / Interest Expense

 

4.3 Operating ratios

 

a) Working Capital Turnover Ratio :- The working capital turnover ratio is a metric that quantifies how effectively a company utilizes its working capital to generate revenue for its day-to-day operations. This ratio, often referred to as "net sales to working capital," assesses the company's efficiency in generating revenue relative to its working capital.

The formula for calculating:

Working Capital Turnover Ratio =

Revenue / Average Working Capital

 

b) Total assets turnover:- The total assets turnover ratio serves as a metric that gauges a company's proficiency in generating revenue relative to the total assets at its disposal. This ratio is a measure of how efficiently a company utilizes its assets to produce revenue and is typically calculated on an annual basis.

The calculation:

Total Assets Turnover Ratio =

 Operating Revenue / Average Total Assets

 

 

4.4 Valuation ratios

 

1.Price to Earnings ratio (P/E ratio):-

The Price-to-Earnings (P/E) ratio stands as one of the most widely used and renowned financial ratios in investment analysis. This ratio scrutinizes a company's share price in relation to its earnings per share (EPS). Given its widespread popularity, it's often referred to as a "financial ratio superstar."

The P/E ratio plays a pivotal role in assessing whether a stock is currently trading at a valuation that is undervalued or overvalued in the market. The calculation of this ratio is

P/E Ratio =

Market Value per Share / Earnings per Share

 

2. Price to Sales ratio (P/S ratio):- The Price-to-Sales (P/S) ratio is a financial metric that evaluates a company's stock price in relation to its total revenue. This ratio provides insights into the price investors are willing to pay for each unit of sales generated by the company. In essence, it helps assess the market's valuation of a company based on its sales performance.

The P/S ratio is calculated

P/S Ratio =

Current Share Price / Sales per Share

 

3.EV/EBITDA ratio: - The EV/EBITDA ratio is a financial metric that combines Enterprise Value (EV) and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) to assess a company's financial valuation. Enterprise Value represents the total value of a company, including its debt and equity components, making it a comprehensive measure of its overall worth.

The ratio is used to determine how many times an investor would need to pay EBITDA if they were to acquire the entire business. In essence, it gauges the multiple at which EBITDA is valued in the context of acquiring the company.

The formula for calculating:

EV/EBITDA Ratio ­=

 Enterprise Value (EV) / EBITDA

5.     CONCLUSION

When considering long-term investments, the initial and fundamental step is conducting fundamental analysis. While this process can be comprehensive, it lays the foundation for your long-term investment strategy. Therefore, it's essential to invest time in comprehending a company's financial statements, assessing its historical stock performance, and evaluating critical financial ratios.

REFERENCE

 ·      Security Analysis

·       Fundamental Analysis for Dummies

·       Business Analysis And Valuation: Using Financial Statements.

. https://www.tickertape.in/blog/a-step-by-step-guide-to-fundamental-analysis