Fundamental Analysis
Fundamental analysis is a method used by investors to identify the intrinsic value of a stock.
The current price of a stock may not reflect the actual value of the stock. The stock may be overvalued or undervalued in the market. Fundamental analysts study the underlying health of the company in order to find the intrinsic value.
This is done by using various qualitative and quantitative factors such as the company’s revenues, profit margins, return on equity, future growth potential and other metrics. The main purpose of this method is to identify companies that that are fundamentally strong in order to invest in them for the long term.
Many famous investors such as Warren Buffett and Peter Lynch use fundamental analysis to identify and select potential winners in the stock market.
Importance of Fundamental Analysis
The bedrock of investment, fundamental analysis helps you in better making an investing decision. Fundamental analysis of stocks helps you determine their fair value. Also, with stock fundamental analysis, you can evaluate the health and performance of any organisation through crucial numbers and major economic indicators.
Fundamental securities analysis helps you to predict future price movement and gauge whether a stock is undervalued or overvalued. At the same time, it helps you analyse a company’s strength and its ability to beat its competitors.
Fundamental analysis of stocks also helps in understanding the business model of a firm and the working of management, essential for making a prudent investment decision.
Tools used in fundamental analysis
Investors use a lot of different tools to determine the actual worth of a stock. This includes:
- Financial Reports (balance sheets, income statement, cash flow statement)
- Earnings (quarterly earnings and projected future earnings)
- Financial Ratios (Earnings per share, price to earnings ratio, return on equity)
Let’s take an example to understand how fundamental analysis is used to create wealth in the stock market.
Manoj is an investor in the stock market. He observes that stock ‘X’ is trading at Rs 30 in the market. Using fundamental analysis, he wants to know the intrinsic value of the stock. Look at the company’s financial reports, earnings ratios and overall health of the company, Manoj realises that the stock has the potential to grow to Rs 45 in the next one year.
This way, Manoj is able to identify the intrinsic value of the stock. Knowing that it is undervalued in the market, he makes a ‘buy’ decision to benefit in future.
Pros and Cons of Fundamental Analysis
Just like every other thing, securities analysis has its pros and cons. The advantages are:
- Helps development of a thorough understanding
Stock fundamental analysis helps in development of a rich understanding of the business where you are about to invest your hard-earned money. It helps you gather the right information and make rational decisions about the position to take.
- Limited room for biases
Investment decisions can go wrong due to cognitive biases. However, numbers at your disposal limits room for personal biases, essential for wealth creation in the long run. Rather than establishing entry and exit points, this analysis helps you take a long-term view of the markets.
- Helps detect red flags, if any
Through fundamental research and analysis, you can easily detect red flags about financial statements of a firm that serves as a warning about possible potential problems with the company and its stocks in the future. In the long-run, this prevents your wealth from being destroyed.
The cons of analysing stock market fundamentals are:
- Time-consuming and tedious
This is perhaps the biggest disadvantage of fundamental analysis of stocks. You need to analyse several areas, which makes the entire process tedious and time-consuming. At the same time, you need to periodically monitor all the financial data related to a firm and other economic indicators that may impact its performance negatively.
- Too many assumptions
Often while analysing stock market fundamentals, one tends to make too many assumptions and interpretations. These require skills, learning, knowledge and experience. Without them in your arsenal, you can go wrong with your analysis.
- Doesn’t take into account the herd mentality
Sometimes herd mentality and emotions result in bull and bear phases of the stock market and affect stock prices that may be missed during analysis. You may end up purchasing a fundamentally-sound stock at a wrong time and watch it going down or remain stagnant for a long period.
Conclusion
A bit of research and arithmetic is involved in fundamental analysis. But unlike general perception, it is not used solely by experts and professionals. Every investor can benefit from fundamental analysis in the market.
Source : Edelweiss