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Basics of Fundamental Analysis: Share market

In Fundamental Analysis, we need to check the accounts of the company to analyse its financial health. In fact, Fundamental analysis of the company is not limited to the balance sheet of a company, but it is wider enough to cover: –

  • Industry-specific analysis.
  • Company Specific analysis.
  • Competitor Specific analysis.

 Basic Terms used in Fundamental Analysis:-

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Some basic tips and Steps for fundamental Analysis:-

Industry Selection:- For making the investment we should choose the industry about which we are curious enough and we must have some knowledge about the Industry outlook, industry cycle, recent developments in the industry, major concern/risk factors of the industry, industrial growth rate, level of competitors, etc. To develop our understanding, we should read business magazines and business newspapers and journals. Every industry has ups and downs, there was a time when pharma stocks were at the top but there was also a time when pharma was hit hard, and it was the worst performer. Hence before making an investment decision we must have understood the industry-specific risk factors.

Company Selection:- For a good analysis, the company chosen should be older than three years so that all relevant data of past performance is available. For new companies, due to the unavailability of data on past performance, we may have to restrict our analysis to available data only. Further, we should choose a company that is big enough to avoid share manipulation by some group of traders. We know that the share price of a small company having only a few crores of market capitalisation can be easily manipulated by a group of traders. Hence, we should avoid such penny stocks.  Further risk factors related to the company must be understood before taking an investment decision and we should avoid companies with high risks like-

  • Risk of having only one or two big Customers/Suppliers.
  • Risk of non-availability of raw material for the final product of the company.
  • Risk of offshore business.
  • Currency exchange-related risk.
  • Highly leverages.
  • A high percentage of share pledges by the promoter.
  • Risk of a business model (like DHFL case)
  • Pending cases against the company.
  • High contingent liabilities or outside guarantees.
  • Competitor Disadvantages

Data collection: – We need to collect the financial data related to the company, industry as well as competitors of our company. This step is very important for fundamental analysis because final outcome depends on the accuracy of the data. We may collect data for three to five years. Some of the required data may be collected from financial statements, annual reports of the company, and business newspapers. On the basis of available data, we may need to calculate some data which is not readily available. The list of data required for analysis included the following:-

  • Sales value & compounded sales growth.
  • Profit After Tax.(PAT) & compounded profit growth
  • Operating profit & % of operating margin with sustainability with seasonal variation.
  • EPS
  • PE Ratio
  • ROE
  • ROCE
  • Book value
  • Intrinsic Value
  • Industry PE
  • Industry growth rate
  • Competitor PE.
  • Debt equity Ratio
  • Cash Flow
  • Share Holding pattern
  • Market cap & Free flow market cap

Perform Fundamental Analysis: – Based on collected data, we need to analyze the financial health of the company. A company showing poor financial health signs is rejected and A company with strong financial health is selected. Some indicators of the financial health of a company are enlisted below:-

Indicators of Week Financial HealthIndicators of Strong Financial Health
Reducing margins %Increasing/ Sustainable margins
Growth rate far behind industryHealthy Growth rate/ Growth rate more than Industry
High pledge % by promoters  Nil / very less pledge % by promoters  
Negative operating cash flows even after the initial setup period.  Positive & increasing operating cash flows.  
High Debt equity ratio / very high use of debt  Controlled use of debt.  
Alarming low level of interest coverage ratio  Healthy interest coverage ratio  
ROCE is below the risk-free rate of return  High ROCE.
ROE (return on equity) is below normal  High ROE.
Very High debtor daysFewer Debtor days (less than competitors)
Promoter selling stake aggressively.Promoters are holding consistently/ buy-back offers (company investing extra cash in own shares and reducing equity)
Sales are growing but operating cash flow is negativeHealthy cash flow.
Alarming low level of inventory turnover ratio.Healthy Inventory Turnover.

Selection based on intrinsic value: – Intrinsic value is treated as the true value of a share. The intrinsic value of a share can be arrived at by summing up the present value of all expected future cash flows. To calculate the present value, we need a discounting rate, we recommend using risk-free return, but some prefer to use WACC. Calculate the intrinsic value of the share and compare it with the current market price. Undervalued shares preferred and overvalued may are kept on the watchlist till the correction of prices.  

Mixing assumptions with Fundamental Analysis: – Ensure that company is growing at a sustainable growth rate which depends on many factors like industrial growth rate, technical advancements, etc. Find a growth rate of the company which is sustainable over your investment period.  Now we may try mixing our assumption with our collected data to find the expected share price of the company. We may find and fix the following assumptions: –

  • Sustainable growth rate (sales) over the investment period. (G)
  • Achievable operating margin % (M)
  • Expected interest & non-operating items (I)
  • Expected Tax rate (T)
  • Expected PE ratio (based on average of company PE & industry PE)

Find expected Share Price after investment period: – Expected share price of a company can be arrived at in the following manner: –

  • Find Expected Sales using the growth rate assumed at point 6 above.
  • Make adjustments in sales figures using data related to capacity addition or deletion (if any)
  • Apply margin % (M) to find out an operating profit.
  • Adjust expected interest and non-operating transaction (I) to arrive at PBT.
  • Reduce taxes (T) to arrive at PAT.
  • Calculate EPS (PAT/number of equity shares)
  • Expected share price = Expected EPS X Expected PE ratio

Some investor believes that if we invest our money just by checking the fundamentals, we will get immediate profit. But this is not true. There are many stocks that look fundamentally strong but their share price remains below intrinsic value for a long time. Just because of strong fundamentals, one should not hurry in making an investment. There are lots of other factors that need to be analysed but one cannot have all the information about all the factors affecting the share price of a company. Any information above industry, company, government policies and economy may substantially affect the share price. But don,t worry, there is one parameter that covers the factors and also covers the effect of all the available information. The name of that factor is “Share price”. The market price of shares is the result of all the factors and all the information affecting the share price. Hence if we analyse the market price itself then we need not analyse all these factors. The analysis based on share price movement is called Technical Analysis.

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