Fundamental Analysis: The Long-Term Growth Indicator
Jun 01, 2018 | 17:31 PM IST
Jun 01, 2018 | 17:31 PM IST
Did you know, if had you invested Rs.50,000 in Eicher Motors in 2009, today (May 2018) your investment value would have been more than 6 Crore? Yes, you read it right--6 Crore! That's close to 13,000% absolute growth in less than 10 years. Who would have thought an automobile stock would give such astounding growth? Certainly not the technical analysts as they are quite short-sighted in terms of identifying growth potential. To gauge the growth potential of any company one needs to understand if the company has a sustainable business, good corporate governance and healthy financials. In the context of stock investment, the study of all these aspects of a company is called fundamental analysis.
Going back to the Eicher Motors example, it is quite likely that some fundamental analyst would have seen the potential in the company's financials and would have initiated a 'buy' call on the company. At the time the stock value was low, but the only factors which would have given confidence to the analyst must have been company's vision and its robust financials. Fundamental analysis lays the foundation for the long-term investment strategy.
What is Fundamental Analysis
Fundamental analysis is a method of examining a stock in order to determine its intrinsic value. The method involves examining economic, financial and other qualitative and quantitative factors of the corresponding company. The role of a fundamental analyst is to study anything and everything that can potentially affect the value of the stock in future. The ultimate objective of the fundamental analysis is to produce a conclusive commentary on the stock which proves whether the stock is undervalued or overvalued and it's growth potential with respect to its peer group and its competitive business advantage. Also, fundamental analysis takes into account factors like the overall economy and industry conditions, and microeconomic factors such as financial conditions and company management.
How To Approach Fundamental Analysis?
There isn't any defined method of approaching fundamental analysis. Though we can breakdown process in certain stages. Generally, analysts employ a top-down approach which initially takes into account the overall economy and then narrow down from industry groups to specific companies. It is important to understand as a part of the analysis process, that all information is relative. Sectors are compared against other sectors while companies are compared to other companies. Usually, companies are compared with others in the same group. For example, if an analyst selects automobile manufacturer like Tata Motors, then Tata Motors would be compared to another automobile manufacturer like Mahindra & Mahindra or Eicher Motors but not with an FMCG company like Nestle. This process is called peer group review.
Can Anybody Do Fundamental Analysis?
Yes, anyone who is willing to learn and put in a little effort can do fundamental analysis of stocks. To be honest, fundamental analysis is a tad difficult than Technical Analysis. Technical analysis is a study of trends and the general behaviour of traders. Whereas fundamental analysis is a more evolved method of analysis. However, the complexities of fundamental analysis are grossly exaggerated. There is this belief that only Chartered Accountants (CA) can carry out fundamental analysis. It's not true.
The First Step - Economic Outlook
First and foremost in the top-down approach would be an overall evaluation of the global economy. When the economy grows, most industry groups and companies profit and grow while in the economic downturn, most of the sectors and companies suffer. Most of the economists associate economic expansion and contraction to the level of interest rates. And interest rates are regarded as a principal indicator for the rise and fall of stock markets across the world. The correlation between stock prices and interest rates can be easily seen in index charts.
Let's take an example of a ship in the ocean. A ship is a company and the economy is the ocean. Now if the ocean is turbulent would it be a smooth sailing for the ships? Naturally, it won't. Similarly, whenever the global economy is going through a rough phase it makes it difficult for the businesses to function smoothly. Economic cycles play a crucial role in the fundamental analysis. In the top-down approach, the present state of the economy has to be evaluated first. Have a thorough understanding of the current economic situation give a perfect head start to the analysis process.
From The Economy To The Stock - The Journey Of Fundamental Analysis
As discussed, the process starts with the economic outlook. Then the analyst moves to the most prominent sector which stands to gain from the current economic situation. Once the sector is chosen, the analyst needs to narrow down the list of companies in the corresponding sectors before he/she undertakes the more detailed analysis. Analysts are generally interested in finding the leaders and the innovators within a group. The job is not just done to find the sector leaders but it's equally important to find businesses with have a competitive business advantage and innovative and sustainable enterprises. In a way, a company which with future-proof prospects.
The first task is to find the business with the competitive environment within the sector as well as the future trends. Later, focus shifts on how the companies fare with respect to market share, product position, and most importantly - competitive advantage.
Also, it pays rich dividends to find out who is the sector leader and how it will change the power of balance sector. The success of any company depends on having a competitive edge, be it marketing, technology, market share or innovation. A comparative analysis of the peer group within a sector also helps to determine the companies with an edge, and those most likely to keep it.
Once you have zeroed in on a company, a more specific scrutiny has to be initiated. Following are the factors that need to be watched closely.
Business Plan Of The Company - The business plan, model or concept is the bedrock upon which the future of the company is built. If the plan, model or concepts is weak, the company has little hope to succeed. While analysing a new business, an analytes tries to find answers to the questions like:
- Does its business make sense for the long-term view?
- Is it feasible?
- Is there a present market and a growing market for the future?
- Can the company stay profitable in the coming years?
In the same line, for established companies, the questions can be:
- Is the company heading in a clearly defined direction?
- Is the company a leader in the market?
- Can the company maintain leadership?
- Does the company have high dividend yield? And is it one of the high and regular dividend paying companies?
- Has the company, after a long run, lost its mojo?
Management Of The Company - What would be a good business plan in the hands of bad management? It would be a disaster. Even the best-laid plans in the most dynamic industries can go to drain with bad management. In order to execute a business plan, a company needs highly skilled management. One of the important steps of company valuation is to assess the management in terms of its capabilities, strengths and weaknesses. The reason analysts stress on good management is that a strong management has the capacity to change the fortunes of the company. They can turn a business plan into a highly profitable affair. A skilled and diligent management also maintains impeccable corporate governance which enforces discipline in all the aspects of the business. The important questions that every analyst must ask are:
- How skilled and experienced is the management team?
- Do they have a good track record?
- How long have they worked together?
- Does the promoter have any other business verticals? If yes, how are they performing?
- Is the management keeping up with all the legal and financial obligations?
Financial Analysis Of The Company - After scrutinising the qualitative aspects like a business plan, promoters profile and management competence, the next and final step is quantitative analysis.
The quantitative analysis simply means financial analysis of the company. This is the stage which tests the skills of a fundamental analyte. Here he/she has to examine the financial data of the company ranging as far back 10 years. All the balance sheets, profit and loss statements, cash flow statements, annual reports have to be perused. Financial data reveals the real face of the company.
All the financial documents of the public listed companies are attested by the Chief Financial Officer (CFO) of the company and are submitted to both the exchanges and SEBI. Therefore, it is safe to consider all the information in the annual report to be true.
Key Components of Fundamental Analysis
Once you get to the quantitative fundamental analysis you have to refer to various financial documents of the company. These documents can be easily found on the company's website under the 'Investors' tab. The same data is available on other financial portals but it is advisable to use the data acquired from the company's website.
Let's take a look at the key components of quantitative fundamental Analysis. Let me warn you, the amount of data and the inundation of numbers and jargons might intimidate a layman but be patient and watchful and you will be able to wrap your head around the concept.
Every listed company has to publish three financial documents to the public i.e. balance sheet, profit & loss statement and cash flow statement.
Meaning: A balance sheet is a report of company's assets, liabilities and shareholders' equity at a certain point in time.
What It Tells: A balance sheet gives a basis for calculating rates of return for the purpose of evaluating the capital structure of the company. The reason it is one of the most critical financial statement is that it gives a real picture of what a company owns, owes and the amount invested by the shareholders in a financial year.
Profit & Loss Statement
Meaning: The profit and loss statement (P&L) is the financial statement that sums up the revenues, costs and expenses incurred during a financial year or a quarter.
What It Tells: A P&L statement gives a clear information about a company's capability, or sometimes lack of it, to generate profit by increasing revenue, reducing costs or both. It gives a clear glimpse of how the company is utilising the funds and how it is reflecting in the bottom lines. A P&L statement is primarily used to recognise the profit-making elements and to identify and rectify the loss incurring elements. A P&L statement is also known as "income statement," "statement of financial results", "statement of operations, and "income and expenditure statement."
Cash Flow Statement:
Meaning: A cash flow statement is a financial statement that measures the cash utilisation of the company. It's a report of the cash generated, the sources of cash generation and how it was used by a company in a given period.
What It Tells: A cash flow statement accounts for company's cash generation and utilisation. It accounts for the sources and uses of cash into three categories: cash from operating activities, cash from investing activities, and cash from financing activities. The important point to note here is that a cash flow statement doesn't show the actual net income. Net income includes transactions that did not involve actual transfers of money. For example, depreciation is a noncash expense that is considered while calculating net income, however, it's not included in cash statements as there was no cash transaction involved. Cash flow statements are extremely critical for understanding company's cash management.