What is Fundamental Analysis: Objective, Steps

You often hear successful investors talking about their investments in fundamentally strong companies. However, how does one conclude whether a company is fundamentally sound or not? This is where fundamental analysis comes into the picture. In this article, we will dive deeper to understand what fundamental analysis is, its objectives, and some of the key financial statements and ratios that you should look at while conducting fundamental analysis.

The Objective of Fundamental Analysis and Its Importance

Fundamental analysis refers to the analysis of a company to gauge its financial health, valuation, and market position. Fundamental analysis involves the study of key financial statements such as the balance sheet, profit & loss, and cash flow statements. It also utilises key ratios such as the price-to-earnings ratio, along with broader studies related to the market and industry in which a company operates.

The primary aim of fundamental analysis is to understand a stock/security’s intrinsic value and determine whether the security is overpriced or undervalued.

To understand why fundamental analysis is important, we must understand the objective of an investment. Typically, investors with a long-term investment horizon aim to invest in companies that can generate returns and wealth over several years. To do this, it is important to select the right companies and correctly assess them. This is where fundamental analysis comes into the picture.

• Fundamental analysis helps investors value a company. Through fundamental analysis, investors can compare the valuation of a company with its peers and also spot undervalued companies.
• Investors can use fundamental analysis to gauge the financial health of the company. Studying the financial results, balance sheets, and other key statements can help identify how and where the company stands financially.
• Fundamental analysis is also a key method to understand the business of a company, the industry outlook, and scope for growth, risks, threats, and market opportunities.
• With the help of fundamental analysis, investors can also get a better idea about the management and promoters of the company, governance standards, legal cases, and other factors that can help in the decision-making process.

Where to Find the Fundamentals of a Company

The first step of fundamental analysis is to gain access to key financial statements and reports about a company. The Securities and Exchange Board of India (SEBI) mandates companies to file and make key documents public on the exchanges on which they are listed.

Investors can find quarterly results, annual reports, corporate announcements, and other valuable company information on the websites of the respective stock exchanges. Similarly, you can also see the information on the company’s website.

Specific trading platforms or brokers also provide investors with access to key financial ratios and the earnings of a company.

How to Read the Annual Statement of a Company

The annual statement of a company is an essential report that provides shareholders and market participants with important information about the company. The annual report of a company typically has several sections that contain key data and information.

An annual report may include

• Financial highlights that go over the key financial metrics of the company.
• The management statement talks about opportunities, challenges, and the future trajectory of the company.
• Information about the company’s corporate governance.
• Detailed, audited financial reports.

As an investor, it is important to carefully go through all sections to spot any potential risk factors, challenges, or scope for growth. Additionally, examining the financial statements can give a clear idea of the company’s financial health. Although the highlights section can provide important information, the best approach would be to delve deeper to gain a better understanding.

Sections such as the business model, Management Discussion & Analysis (MD&A), and notes to account can help you understand the critical strategic context.

A Closer Look at Financial Statements

Let’s take a closer look at some of the crucial financial statements of a company.

Income Statement

The income statement of a company provides insights about the company’s revenues and expenses. It also states the gross and net profit or loss that the company recorded for a given quarter or financial year. It is an important statement that helps in measuring the financial performance of a company.

Balance Sheet

The balance sheet is one of the key financial statements that can help investors assess the financial health of the company. The balance sheet includes the assets and liabilities of the company, providing a representation of what the company owns and what it owes. It also includes information about the owner’s stake in the company.

Cash Flow Statement

The cash flow statement of a company records the inflows and outflows of cash from the company. The cash flow statement helps track the cash earned through business activities, investments, or financing. Investors can better understand the liquidity of a company through the cash flow statement. For investors, a positive operational cash flow is considered a solid indicator of business performance.

Quantitative and Qualitative Fundamental Analysis

Fundamental analysis can be divided into two main categories. Quantitative and qualitative analysis. Quantitative analysis refers to the analysis related to the company's financials. It involves the use of mathematical models or statistics to analyse the company’s financials.

Meanwhile, qualitative analysis refers to the analysis of non-quantifiable data. It is a more subjective way to analyse and understand various factors that impact the company.  

Both quantitative and qualitative analyses are essential. While quantitative analysis helps in understanding what is happening, qualitative analysis assists in determining the why.

Qualitative Fundamentals to Consider

Business Model

The business model of a company is one of the most common qualitative fundamentals that investors can consider. Investors can study the business model to understand how the company earns revenue, its customer base, and the market it operates in.

Competitive Advantage

Along with studying the company, it is also important to analyse its position in the market. Understanding the company’s differentiating factors can help investors spot competitive advantages or competing companies that can pose a risk.

Management Quality

A company’s management plays a crucial role in how the company operates in the short- and long-term. Investors should carefully research the company behind the wheel. Understanding the management and leadership's experience and history can provide insight into who is running the company and help identify any potential red flags.

Governance and Ethics

With the rising importance of a company’s governance practices, it is important to consider them while conducting qualitative analysis. A company engaging in unethical practices or companies that do not adhere to corporate governance norms can lead to severe problems for stakeholders.

Industry Outlook

While conducting a qualitative analysis, it is vital to be informed about the industry in which the company is operating. One should conduct an analysis of the industry to know opportunities for growth, market size, and potential risks.

Quantitative Fundamentals to Consider: Financial Ratios

Earnings-Per-Share (EPS)

The earnings-per-share is a key metric that allows one to know the amount of profit a company earns for each outstanding share of the company. It is calculated by subtracting the preferred dividends from the net income and dividing it by the total number of outstanding shares. A higher EPS means the company is more profitable.

Price-to-Earnings (P/E)

The P/E ratio is a key metric for valuing the company and comparing its value to that of its peers. The ratio measures the company’s share price to its EPS. A higher P/E ratio indicates that investors are paying a premium for the shares of the company, anticipating future growth.

Debt-to-Equity

The debt-to-equity ratio is a financial ratio that measures the amount of debt a company uses to finance its operations and assets. The higher the debt-to-equity ratio, the more the company relies on debt.

Return on Equity (ROE)

The return on equity is another essential metric used to gauge the financial performance and profitability of the company. It represents the returns generated against the total shareholder equity. The return on equity is obtained by dividing the net income by the total shareholders’ equity. Higher ROE indicates more efficient usage of the funds invested.

Current Ratio

The current ratio is obtained by dividing the total current assets by the total current liabilities. This ratio helps identify the company’s capability to meet its working capital requirements in the short term.

Other metrics such as Interest Coverage, Operating Margin and Price-to-Book (P/B) also help with quantitative analysis.

The 3 Layers of Fundamental Analysis

Fundamental analysis can also be divided into three distinct layers.

Economic Analysis

The economic analysis layer of fundamental analysis involves analysing various economic factors. It includes various factors that impact the micro- and macroeconomic environment. Some of the factors considered under economic analysis include the gross domestic product (GDP), interest rates, trade policies, and monetary policies. External factors such as government policies, geopolitical events, and taxes are also considered.

Industry Analysis

The industry analysis layer relates to the analysis conducted of a particular industry. When researching an industry, it is essential to consider its past performance, current situation, and future trajectory. Industry analysis also includes identifying major players, areas of growth, and key risk factors that can impact the industry.

Company Analysis

The company analysis layer of fundamental analysis includes a detailed analysis of a particular company. The company’s financial performance is assessed through financial statements and ratios. It also includes the analysis of qualitative factors such as the company’s competitive edge, the management, ethics, and governance.

Steps to Do Fundamental Analysis

Fundamental analysis can primarily be done through two approaches.

Top-Down Approach

The top-down approach of fundamental analysis includes analysing the broader environment first and working down to a specific company. In this approach, analysis begins with the economic and macro environment and then moves to an industry-specific analysis and finally ends with the company analysis.

Bottom-Up Approach

The bottom-up approach of fundamental analysis begins with the company, then expands to include analysis of the industry, and finally, the macro and economic environment.

Fundamental Analysis vs. Technical Analysis

Alongside fundamental analysis, investors and traders also utilise technical analysis in the decision-making process. Here is how the two differ from each other.

 Read more: Technical Analysis vs Fundamental Analysis

Example of Fundamental Analysis

Let’s take a look at how fundamental analysis is done with the help of an example.

• An investor wants to invest in Company ABC. Before investing, the investor wants to conduct a fundamental analysis of the company.
• In order to do that, the investor will access the financial statements and key ratios.
• Ratios like the P/E ratio and P/B ratio are benchmarked against competitors and the industry average to assess whether a company is overvalued or undervalued.
• Financial statements are studied to analyse the cash flow, EBITDA, assets, liabilities, and profitability.
• The investor will study the company’s business model and its position in the market to understand its competitive advantage.
• Fundamental analysis also calls for analysis of the industry the company is in, along with an analysis of the economic conditions and other factors like taxes and trade policies.

Pros and Cons of Fundamental Analysis

Pros

• Fundamental analysis is an effective way for long-term investors to analyse a company’s financials and value.
• Investors can make more informed decisions with the help of fundamental analysis, as it considers numerous internal and external factors.
• Through fundamental analysis, investors can spot undervalued companies that can be a valuable addition to a portfolio.

Cons

• Fundamental analysis requires thorough research and analysis, which can make it a time-consuming process.
• Since fundamentals are not completely quantifiable, emotions can influence decision-making.
• Reading and analysing financial statements and company fundamentals can be a complex process that can be challenging for investors who are not well-informed.

Conclusion

Fundamental analysis is one of the most valuable tools for investors as it not only helps in understanding what is happening within the company but also considers external factors such as industry trends and economic conditions. Using fundamental analysis can be extremely helpful for investors who are looking to invest in fundamentally strong companies for the long term.