Fundamental Analysis: Make Informed Decisions in Stock Market
Beginners in the stock market often make the mistake of ignoring investment research. They often choose securities based on ‘word of mouth.’. Fundamental and technical analysis is something that builds your bas for informed decision-making. While technical analysis helps you understand the price direction, fundamental analysis allows you to find the intrinsic or fair value of a security. Let us discuss more about fundamental analysis here
What is Fundamental Analysis?
Fundamental analysis allows investors to find a fair or intrinsic value of a security. It factors in economic, financial, and other factors to find the fair value of a security. Economic, financial, and other factors can affect a security’s value in the market. It is the investor’s responsibility to find the impact of these factors on the security, and make informed decisions. This type of analysis also collects information regarding the financial performance of the company or the issuer.
Let us say you want to purchase stocks of a public company. How would you know the intrinsic value of the stock in the market? Are you overpaying or underpaying for the stock? These questions are answered through fundamental analysis. You find the fair value of the stock and compare it with the current market price. A range of metrics like P/E ratio PEG ratio, debt-to-equity ratio, and consumer price index are used for this. Financial statements of the company/issuer are also analysed to determine the intrinsic value of the security.
Types of Fundamental Analysis?
Qualitative fundamental analysis includes both quantitative and qualitative factors. When considering factors like management efficiency, brand recognition, and board diversity, it is called qualitative analysis. These factors do not involve numbers and represent the quality of anything. For instance, you might feel that the quality of the products of a company is better than that of the others. However, it does not guarantee that the financial performance of the company is better than the others in the market.
Quantitative fundamental analysis, on the other hand, involves numbers, ratios, and other metrics. The financial statements of the company help determine the qualitative factors. Investors must use both qualitative and quantitative analysis to make informed decisions.
It can also be divided into two categories based on the approach. When considering the industry sector before getting into company specifics, it is called top-down fundamental analysis. On the other hand, bottom-up analysis considers the company first before researching the industry sector. While you can follow any approach, do not forget to consider both quantitative and qualitative factors for your analysis.
Importance of Fundamental Analysis?
When you purchase an asset, you always want to pay the right or fair price. You don’t want to overpay for the asset. However, you will be glad when you get your hands on an undervalued asset, as you can sell it for a higher price. This analysis helps identify the right price for a given security, thus preventing you from overpaying.
For instance, let’s say you want to purchase stocks of a popular company named ‘X.’. The current market price of stocks of X is Rs 300 per share. However, the price is high due to word of mouth and investor expectations in the market. After doing its fundamental analysis, you discover that the fair value of stocks of X is Rs 200 per share. The actual price can be lower than the market price due to poor management, pending debts on the company, higher PEG ratio, and many other reasons. You might have failed to discover that the stocks of X are overvalued in the market without doing such an analysis.
Let us take another example of an undervalued asset in the market. Let’s say you discover stocks of another company at a rate of Rs 100 per share. However, the fair value of the stocks is higher because the issuer has strong fundamentals. Choosing such an undervalued stock can create chances of capital appreciation in the future. While it can be performed on different securities, it is mostly used for stock research. Beginners in the stock market must understand what is fundamental analysis as this will help them make better decisions and build a strong portfolio.
How Do You Calculate Fundamental Analysis?
Now that you have understood the meaning of fundamental analysis let’s find about the calculation part. As discussed above, fundamental analysis helps determine the fair value of the stock. At the end of the analysis, you will know the intrinsic value of a security in INR or any other desired currency.
You can make better decisions by knowing the fair value of the security. When the market value of a security is more than or equal to the intrinsic value, you must consider waiting. However, do not forget to pounce on undervalued assets having more intrinsic value.
The calculation part will change for determining different financial metrics. For instance, consider the P/E or Price-to-Earnings ratio used in fundamental analysis. It is evaluated by dividing the current market price per share by EPS ( Earnings Per Share) Similarly, the formula is different for calculating the PEG ratio, ROE (Return on Equity), and other ratios/metrics.
How to Start a Fundamental Analysis?
Before you start the fundamental analysis of stocks, it is essential to understand the key metrics. Financial metrics and ratios will allow you to screen companies and choose the best ones. You can use the P/E ratio, PEG ratio, or any other metric for initial screening. After the initial screening, you must collect more information regarding the selected companies. You can use the financial statements of selected companies to gather more information. Financial statements will allow you to determine the financial position of the selected companies. You must compare a company’s performance with its competitors for more insights. Investors also analyse the company’s future prospects to make informed decisions.
Market makers often have to hold securities to improve the liquidity and trading volume. Since they are at risk by holding securities, they are allowed to earn from bid-ask spreads. The difference between the bid and ask prices is the profit for them. There is always a risk of non-execution on both sides of an order. When both sides of an order cannot be executed, they might not make a profit.
Investors relying on technical analysis usually start their research with charts. On the other hand, fundamental analysis involves studying a company’s financial statements.
In a Nutshell
Fundamental analysis is a crucial part of investment research. You can determine the intrinsic or fair value of an asset in the market. You can be sure of not overpaying for an asset. Investors also rely on technical analysis to predict the future price movements of an asset. Both fundamental and technical analysis are a must in today’s investment scenario, where market conditions change constantly. You tend to make better and more informed decisions with high-end investment research.