Understanding fundamental analysis for beginners: Fundamental analysis is the method of evaluating the economic and financial aspects of the market in order to determine the real value of an asset.
Fundamental analysis tries to understand and dissect the asset in a broader and deeper way.
The fundamental analysis argues that any macroeconomic variables like the status of the economy, inflation, interest rates, taxes, or any policies implemented by the government may have an impact on the asset
Typically, fundamental analysis begins at a macro level, when elements that control and impact the status of the economy are examined. Then the analysis goes on to the micro-level, where they focus on the growth of a single sector and examine company-specific aspects such as management composition, structural changes in management, and so on.
This is called the “top-down approach” method of analysis.
Why is Fundamental Analysis Important?
As said fundamentals help to find the real, fair, and intrinsic value of the asset, making sure we are not paying more than the value of the asset and helping us make wise investment decisions.
The intrinsic value of an asset is the measure of the asset’s actual value. If the intrinsic value of the asset is greater than the market value, it is a clear sign to buy the asset. If the market value is higher than the intrinsic value, the asset should be sold.
Fundamental analysis involves solid research and can be extensive, but it pays off the most. Fundamental analysis helps us discover good assets.
This article is all about fundamental analysis basics and key points of equity fundamental analysis.
Analyzing equity will help us recognize growth and value companies, which will help in the creation of wealth.
How to Do a Fundamental Analysis of a Company?
Fundamental analysis involves understanding the economic conditions (macroeconomy) of a country first and how they affect the business environment. You can also refer to the below video as well to find fundamentally strong stocks.
Economic Indicators while doing Fundamental Analysis for Beginners
GDP: A country’s GDP is an indicator of how well functioning the country’s economy is. It gives a picture of the spending and consumption of the population and the exports and imports of the country. Stable GDP growth is a good sign, indicating business growth.
Inflation: One thing we must keep an eye on is inflation. It should neither decline nor rise sharply but remain steady. Too much inflation can cause prices to rise, making it more difficult for people to buy, and therefore having a negative impact on consumption savings.
Interest Rates: Interest rates are a very complicated subject, but for the basic understanding of this article, we can tell that higher interest rates will negatively impact the economy. That is if the population starts saving more and investing less, which is a big problem for the economy and the flow of money, which should be productive.
Taxation: Taxation is a vast and dynamic topic. The effect of taxation will impact both consumers and corporate companies, Higher tax rates can feel like an imposition on the business and have a negative impact on their earnings, but on the other hand, taxation is the source of revenue for the country. Ideally, we have to check if the taxation policy is helping both the corporate companies and the country.
Policies: Policies are tools used by the government (fiscal) and the central bank (monetary) to regulate the economy. The fiscal policy helps in the growth of GDP and the regulation of taxation, while monetary policy helps in controlling inflation and interest rates.
We have to keep in mind that all these macroeconomic indicators are to be looked at to understand what phase the economy is in and make further investment decisions.
Research Qualitative and Quantitative Data of the Company
The next step of fundamental analysis is to research the company. There are two segments to the research on it, both qualitative and quantitative data.
Qualitative Segment in Fundamental Analysis for Beginners
Qualitative factors Things that cannot be calculated through numerical factors include
The business model of a company depends on understanding what the company does and what its products are in the market, how its products are helping the consumers, and how the company makes a profit in its industry. When we research the business model and the industry, we can understand what type of business it is.
An advantage over Competitors: To thrive in a crowded market, a firm must stand out. Every industry faces fierce rivalry, necessitating the use of a distinguishing feature to set it apart from its competitors. Create a moat around a firm to keep competitors away while allowing it to develop and profit. When a corporation gains a competitive edge, its stockholders might benefit for decades.
The flexibility of the Company: Established corporations use smart strategies to keep away competitors by creating several entry and exit barriers. Some strategies include lowering capital expenses, lowering manufacturing costs, employing predatory pricing, creating patents, improving advertising and marketing, and utilizing economies of scale.
Business Value and Innovation: a company’s overall market experience determines how well it can handle market pressure, and changes in the internal and external environment, and ultimately pave the way for future success. Values are always a secure pick in the market because they are a firm with a long history of success. A company’s major power is to innovate, constant product innovation will help in the company’s success.
Management and Corporate Governance: Most investors feel that the most significant factor in investing in a company is its management. It makes sense: even the strongest business strategy will fail if the company’s management fails to effectively execute the plan. While it is difficult for regular investors to meet and really evaluate management, you may look at the company website and review the resumes of senior executives and board members. Corporate governance refers to the policies in place inside a company that defines the interactions and duties of management, directors, and stakeholders. The business charter and bylaws, as well as corporate laws and regulations, establish and regulate these policies.
Shareholding Pattern: shareholding patterns give the idea of who owns most of the company’s shares and who are its owners. Fundamentally, good companies have institutional investors, a good number of retail investors, and significant promoter holdings as their shareholders. Shareholding patterns indicate many things a good portion of Institutional holding can be good, especially if the investment is coming from foreign institutional investors and one more thing to keep in mind is that too much promoter holding in the company is also not a good sign.
Quantitative Segment in Fundamental Analysis for Beginners
The quantitative segment is the analysis of the company’s financial statements. This is the core part of the fundamental analysis process.
Financial statements are formal records of the financial activities and position of a company. They are prepared every quarter, and they give an insight into how the company is conducting business. They are presented in a standardized order, which helps everyone analyze and interpret them.
A financial statement has three major parts: an income statement, a cash flow statement, and a balance sheet. Using all these, investors can gauge the company’s financial performance over a period of time.
The income statement details a company’s earnings and spending over the course of a fiscal year. It divides them into different portions based on their nature. The profit for the year is calculated by subtracting expenses from income.
When reviewing the income statement, we should be concerned about the income and expense stability and future growth possibilities. Income from a company’s main business is used to evaluate it.
Although organizations gain money from other sources on occasion, these sources are not regarded as steady and fully illustrative of the company’s operations’ performance. In terms of expenditures, we should be interested in the types of expenses, their importance to the firm, the likelihood of their recurrence, and their role in boosting future revenues.
Cash Flow Statement
The cash flow statement is an important financial document because it has all the information regarding the cash inflow and outflow. Cash flow statements are very hard to manipulate, which makes them a good choice for some investors to give a lot of attention.
Cash flow Statements are classified into three types.
Cash flow from operations (CFO): Cash statements from day-to-day activities
Cash flow from investing (CFI): Cash statements from investing and selling off assets like buildings, computers, furniture, and manufacturing equipment.
Cash flow from financing (CFF): Cash statements pertaining to borrowing or paying back loans, debentures, bonds, and commercial papers.
The significance of the cash flow statement arises from the fact that, while a firm makes and spends a lot of money, as shown in the income statement, a lot of that money is non-monetary. Many of these flows include the expectation of getting or paying money in the future, although others do not. The statement eliminates this vagueness by specifying the sources and uses of cash. Companies are best positioned if they generate enough cash from operations to fund their investing activities. Using funds from finance operations to fund the other two indicates a rise in obligations.
This is an important financial statement. It discusses the company’s assets and liabilities. Unlike the income statement, the balance sheet displays the position of a company’s assets and liabilities at a certain point in time rather than across time.
Assets are resources that the business owns and controls, and liabilities are obligations that are to be paid back.
Assets = Liabilities + Shareholder’s Equity. This is a formula that represents the balance sheet in one go. This means that when all liabilities are paid off, all the assets will be owned by shareholders. Certain assets are required for a company’s operations to function successfully. These are paid for via liabilities (debt or equity). To be profitable, a company’s revenue from these assets must be greater than the amount necessary to repay the liabilities spent to acquire them.
From the information we obtain from the balance sheet, we should try to figure out the nature of the asset and how much income it can generate in the future.
Debt is a huge element that can have a negative impact on a company’s profitability. A company cannot perform well if it owes a lot of money. It is advised to avoid businesses that have a lot of debt.
All of the qualitative and quantitative information can be found in the company’s quarterly and annual reports.
Drawbacks to Fundamental Analysis for Beginners
Along with all the above benefits, the fundamental analysis also comes with a few cons –
Not for the Short Term: Fundamental analysis is not for the short-term investment gains, it does not indicate price action.
Long Process: Fundamental analysis is a time-consuming process. All investors have the same knowledge of the economy and finance.
Fundamental analysis does not work all the time. Like all investment strategies, there is a chance it might not work. We can determine the intrinsic value and it can be undervalued too, but there is no guarantee the stock price will rise because there are a lot of variables at play. You can enroll yourself in fundamental analysis courses to learn in detail.
To summarise, fundamental analysis for beginners is all about the intrinsic and real value of an asset. To find the intrinsic value of equity stock, we need to begin with macro-economic factors, do the industry analysis, and check the qualitative and quantitative aspects of the company to determine the value. This is quite a lengthy read, but understanding what factors come into play is very important.
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