Most people wanting to enter the stock markets would have encountered the word “Fundamental Analysis”.
This tool is one of the most essential tools if we want to create a fortune in the markets. This tool is not just important for people already in the markets but also who aspire to be entering markets soon.
Therefore in this article, we will discuss and highlight the tenets of Fundamental Analysis.
In this article
What is Fundamental Analysis?
Fundamental Analysis tends to find the intrinsic value of a company based on various parameters.
These parameters as mentioned below are studied in detail in order to arrive at a particular viewpoint. (i.e. whether a stock is undervalued or overvalued based on fundamentals)
It includes analyzing the economy as a whole. This encompasses both the domestic and global macro indicators such as GDP growth, inflation, interest rates, reserves, fiscal balance etc;
It pertains to the sector which the company is present in. For example, we are analyzing a particular bank say HDFC Bank Ltd. Then the sector that we would analyze would be BFSI (Banking, Financial Services and Insurance).
Carrying forward our example of HDFC Bank Ltd., the industry we are talking about is private banking as HDFC Bank is a private sector bank.
For analyzing a company in detail, we should look at all the key financial metrics such as return on equity, net profit margin, growth in sales, earning per share to name a few. We also have to reflect on key valuation ratios such as price to earnings, enterprise value to EBITDA (Earnings before Interest, Tax, Depreciation & Amortization) etc.
There can be a host of other ratios.
Investors can take a top-down approach or bottom-up approach to carry out fundamental analysis for a company.
Top-down approach includes following the pattern highlighted above i.e.
Or the investors can take a different path which is just the opposite called bottom-up approach.
In this approach, the investor starts with analyzing the company in question first and then goes on to analyze the various other parameters. (Industry followed by sector followed by economic analysis)
We hope that by now you have a fair idea of how fundamental analysis works.
However, let us look at a particular example to get the concept crystal clear in our minds.
Fundamental Analysis example: HDFC Bank Ltd.
We have taken HDFC Bank as the example. This is because it is one of the most fundamentally sound companies we can think of in the Indian markets.
Let us first analyze the economy of India.
Our country today stands at a strong footing as compared to the world economy. The GDP growth rate is robust at around 7.3 percent (as expected for Fiscal 2020 by International Monetary Fund). The inflation is under the radar of RBI and is also expected to stay the same as oil prices have corrected.
Other metrics too are solid such as reserves. We also need to figure out economic indicators which are specific to our sector.
In BFSI, the indicators can be credit supply, amount of bad loans from each sector etc. This will simplify our task and give us a bird’s eye view of the sector in question.
Coming to the BFSI sector, we know that for any economy it is the most instrumental part.
This is because credit flows through this sector. BFSI includes public sector banks, private sector banks, Non- Banking Financial Companies, Insurance companies etc.
The sector felt a jolt post the IL&FS crisis.
However, steps have been taken by both the government and Central Bank to repose faith in the economy. But it is facing the twin problems of recovering from the crisis and the NPA war. Therefore, the sector can be considered in a grey zone at the present moment.
The industry which in our question is private sector banks has been performing well (exception Yes Bank and few others where there are corporate governance issues).
We have to delve deep into various events that have occurred in that particular industry to form an opinion on the same. Say what was the impact of IL&FS on private sector banks? How has the NPA scenario been for the last few quarters? We need to constantly ask these questions and be as sure as possible before jumping in to buy a company.
Finally analyzing our company HDFC Bank Ltd. The key financial metrics we can use for analyzing the performance of a financial institution are as follows:-
- Growth in loans & advances;
- Net Interest Margin (In percentage terms);
- Net Interest Income (Growth);
- NPA (Both gross and net. Net NPAs are arrived at by deducting provisions from Gross NPAs);
- CASA ratio (Current Account and Savings account);
- Provision Coverage ratio;
- Retail loan growth;
- Capital Adequacy ratio;
For valuation metrics we can look at Book value per share, Price to book etc. One more important element to consider is the management. Companies such as HDFC Bank, TCS, L&T and Maruti Suzuki have delivered exceptional results. This is because they have been backed by solid management apart from the factors that have been in support.
(Note: Investors should note that ratios for analyzing a bank or financial institution are completely different as compared to companies in other sectors. The key financial metrics for companies in other sectors are net profit margin, revenues growth, EPS, dividend yield, ROE, debt to equity, ROA, EBITDA margin. Also, no ratio can be in isolation. Meaning we cannot form an opinion just by looking at one particular ratio. All ratios must, therefore, be given proper weight.
Companies like people also need cash to keep going. Therefore, analyzing the cash flow also becomes instrumental.
There are also industry-specific ratios we need to be aware of. For example while analyzing an oil & gas company we have to look at throughput output, Nielsen Composite Index. Similarly, for a cement company, we can look at the geographic spread, EBITDA/tonne etc. There can be a host of other solvency and financial ratios)
After all analysis, the end goal is to produce a quantitative value so that we can compare the security’s current price to what our estimates are.
This way we would be able to clearly tell whether the stock is undervalued or overvalued. Therefore, having the core belief that prices do not accurately reflect all available information is one of the characteristics of a fundamental analyst. This way they are able to capitalize on perceived price discrepancies.
Fundamental analysis is used mostly for stocks. However, we should also note that this tool can be used for other types of securities as well.
Say, for example, we can perform fundamental analysis on a particular bond’s value. This can be done by analyzing the key economic factors such as interest rates, the general condition of the economy, inflation rate, the central bank’s stance during policy meetings etc.
Investors would also be glad to know that mavericks in the markets such as Warren Buffett, Charlie Munger adopt this methodology to pick stocks. It is through this tool they have created such massive amounts of wealth for themselves for their investors.
Fundamental Analysis vs. Technical Analysis
Both these techniques are used by investors to make investment decisions in the market. However, the approach followed in both is different. Let us look at the key differences for each:-
|Fundamental Analysis||Technical Analysis|
|Investment decision is reached by analyzing the economic, sector and financial factors||Investment decision is reached by analyzing the historical stock movement. Thereby the future price of the stock is predicted|
|It is a long-term approach||It is used by traders for short-term|
|It makes use of financial statements such as annual reports, earnings reports, brokerage reports etc.||It uses price movements charts for analysis|
|This methodology also incorporates key market happenings||It focuses primarily on the past performance of the stock|
Therefore, we can easily say that fundamental analysis offers a more holistic picture than technical analysis. This is because analyzing a company fundamentally involves delving deep into each angle. On the other hand, technical analysis is only dependent on past price movements of the stock to arrive at a future value.
Can you become a Fundamental Analyst?
It is a common misconception that only qualified Chartered Accountants; Certifies Financial Analysts can become masters in stock picking.
However, this is not true at all.
Any person, who has the will, has requisite data and knows to analyze the key points (from annual reports, earnings reports, sector reports etc.) can excel in stock picking. It is also a rigorous process.
Disclaimer: the views expressed here are of the authors and do not reflect those of Groww.