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An Introduction to Fundamental Analysis

On what basis do you make a decision to buy or sell a stock?

Is it based on what you hear from the so called experts on the TV, or you listen to your broker’s advice? Or is it your friends you turn to for stock ideas and tips?

The only way to make the right buy and sell decisions for the equity market is through fundamental analysis.

This article explains what fundamental analysis is, and explains the parameters that are considered during fundamental analysis so that you can do your own analysis before buying or selling a stock!

In “An introduction to Technical Analysis”, we saw that the only factor deciding a stocks price is the future profitability of the company.

And the factors that influence this future profitability are the basic factors like the economy, the sector in which the company operates, the company’s investments, its profitability, etc.

Technical Analysis doesn’t consider these factors – it considers only the historic price and volume data. Therefore, it is not the right tool to decide a shares future price movement.

So, what is the right tool? You guessed it right – it is Fundamental Analysis.

What is Fundamental Analysis?

Fundamental Analysis is the study of the basic factors affecting a company’s operation and its future profitability. By evaluating these factors, fundamental analysis attempts to derive the intrinsic value (or the true underlying value) of a company’s stock.

This includes a study of the above mentioned factors (the economy, the sector in which the company operates, the company’s investments, its profitability, etc.), as well as an analysis of the company’s financials: The profit and loss account, the balance sheet, and the cash flow statements.

Fundamental Analysis does not take into consideration any past price movement of the stock.

Principles behind Fundamental Analysis

Fundamental Analysis relies on two theories:

The Efficient Market Hypothesis

This theory states that the markets are efficient: Information pertaining to a company is equally available to all participants of the market, and these participants make the buy and sell decisions based on this available information.

It believes that no information remains hidden from the participants – there is no “insider information”. Thus, all participants make informed decisions.

The Random Walk Theory

This theory says that prices of stocks do not follow any pattern. The share prices move randomly depending on the information received by the market from time to time.

Implication of these theories

When combined, these theories imply that markets price stocks correctly, based on the information currently available. Also, the markets would continue to price stocks correctly in the future, based on the information available at that time.

But at times, the markets do not behave “efficiently”. During these times, stocks trade at prices way above or below their intrinsic values.

If an analysis of the available information is done, and projections are made about the future data, the fair price of a stock can be determined with reasonable accuracy. By comparing the prevailing market price of a stock with its intrinsic value (or its fair price), buy and sell decisions can be made.

Technical Analysis versus Fundamental Analysis: A quick comparison

Technical Analysis studies the past price and volume movements of the stock to predict its future price. The assumption is that stocks repeat the price patterns formed in the past.

(To know more about Technical Analysis, please read “An introduction to Technical Analysis”)

Fundamental Analysis considers the basic factors affecting a company, and predicts the price of a stock based on that.

Therefore, fundamental analysis is a much more reliable tool to calculate the future price of a company’s shares.

Factors Considered in Fundamental Analysis

Following are some of the factors that are considered during fundamental analysis:

Financials of the company

This involves the study of financial health of the company using the various financial reports, like the profit and loss account, the balance sheet, and the cash flow statements.

State and direction of domestic economy

This is a study of the country’s economy in which the company operates. If the economy is growing fast, the probability of the company growing fast is greater.

Similarly, if the economy is facing a slow growth, the chances of the company growing fast are lesser.

State and direction of world economy

Since all the economies of the world are intertwined, any positive or negative development even in foreign economies has an implication on companies in other countries.

This is especially true if the good or bad development is in a country that has lots of customers or suppliers of a company.

Thus, fundamental analysis of a company also involves the study of the world economy.

Currency and commodity price movements

Most companies use commodities like coal, metals and crude oil as their inputs. Any change in the price of these commodities has an implication on the profitability of the company.

Similarly, any change in the exchange rate of currencies also has an impact on companies that import their raw materials or export their products.

Interest rate movements

Companies borrow money to invest for their expansions. Also, consumers borrow money to buy products.

Thus, if the interest rates are high, the borrowing cost of the companies would increase. Also, consumers would borrow less resulting in lesser sales for the company.

Therefore, interest rates also have an impact on the profitability, and therefore, the stock price of the company.

The sector in which the company operates

Apart from the economy on the whole, the sector in which the company operates also needs to be considered. If the sector is not growing, the company’s profitability would be likely to fall in the future.

For example, let’s say you are studying a company that manufactures radios. Now, since the sector (Radios) is shrinking, the company would not be able to increase its profits even if the economy is booming.

Competition in the sector

If a company operates in a sector that has no competition, it can charge high prices and earn more profit.

But if the company competes with many other companies for the products it sells, its pricing power would be limited, and therefore, the possibility to earn higher profits would also be limited.

Entry barriers in the sector

An entry barrier is something that can prevent the entry of new competitors in a sector. This can be license cost (For example, in telecom), technology (Eg. in manufacture of LCD TVs), high capital requirement (Eg. In power generation), etc.

If a company operates in a sector that has high entry barriers, the possibility of new competition emerging in the future is less, and therefore, the company’s profitability would not get adversely affected.

On the contrary, if a company operates in a sector that has low or no entry barriers, new competition can come up fast, thus negatively impacting the company’s profitability.

The company’s investments and future expansion plans

If the company regularly invests its profits for expanding into new businesses or for creation of more capacity in the existing business, the chances of earning more profits in the future increase.

How the outcome of Fundamental Analysis is utilized

After studying all the basic factors affecting a company, the fundamental analyst comes up with the intrinsic value of the company’s shares. This is the “fair price” of the stock, and it is price that the stock should be ideally trading at.

Due to the imperfections in the market, the stock may not be trading at this price.

If the market price of the stock is less than the intrinsic (or fair) value of the stock, the stock can be bought. The expectation would be that the stock would ultimately trade at its fair price, and thus, a profit can be made.

(Do you know that stocks or shares give the best returns in the long run? Please read “Stocks – The winning bet for the long term” and “Equity Investment is Risk Free – Here’s the Proof” for more)

Similarly, if the current price of the stock is more than the intrinsic (or fair) value of the stock, the stock can be sold. Again, the expectation would be that the stock would ultimately trade at its fair price. Thus, a loss can be avoided.

Fundamental Analysis and Target Price

There is another way in which fundamental analysis can be used: many times, a fundamental analyst studies a company and the factors affecting it, and comes up with a price at which the stock should be trading in the future. This is called the “target price” of the stock.

Buy and sell decisions can be made comparing this target price with the prevailing price of the stock.

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