We never make a purchase decision without first determining the commodity’s real value or true worth. We make sure that the benefits we will derive as a result of the acquisition in the coming future will outweigh the immediate loss that we have to incur in the form of payment. We do this exercise for the smallest of purchases, so much so that we even bargain with everyday vegetable and fruit vendors to align the price with its intrinsic value.
What is intrinsic value?
Intrinsic value forms the basis of the fundamental analysis of stocks. The term ‘intrinsic value’ is not limited to the stock market world, but it has many practical applications. In layman’s terms, we call this the ‘right price’ or ‘fair price.’ The complex analytical process of deriving a number that will represent the potential worth of an asset is called ‘valuation.’ There are several valuation models that you can use to value an investment.
The value of an asset is often subjective, i.e., what one person believes is the proper value of an asset might not be correct for another person. The same concept holds good for a stock in the stock market as well.
This is because the number of factors that affect the price of a security is so vast in number that it is humanly impossible to consider all of them, at the exact time, to arrive at the intrinsic value of the desired stock. A particular group of people would consider a unique set of factors that they understand correctly; however, a different group could combine other factors to arrive at the same stock’s value. Hence, behavioral consciousness and emotional bias have a drastic impact on the fundamental analysis of stocks. And that is precisely why, for the same commodity, there are both buyers and sellers.
How does one ‘fundamentally’ analyze a stock?
The first step in the fundamental analysis of stocks is understanding the happenings on a macroeconomic level – to get a holistic view of things. Having first studied the overall economy, analysts then gauge the strength of an industry within the economy. After that, they try to understand the performance of a company belonging to that industry. This can be referred to as the ‘top-down approach’ as it involves going from a macro level to a micro level.
As a part of the fundamental analysis of the stock market, we must analyze periodically published financial statements. This data is publically available for free and helps in computing meaningful ratios.
Why is a fundamental analysis done?
Fundamental analysis is done to find whether a stock is overvalued or undervalued. The study can lead to two types of recommendations – buying or selling the stock. When the result of the fundamental analysis of a stock is a buy recommendation, it means that the stock is currently undervalued. The stock is available at a bargain, and the possibility of a future price increase seems high. Valuation helps traders or investors in taking a position accordingly.
Fundamental Analysts believe that the value that they derive after studying a company’s financials is more accurate than the prices prevailing in the market. Hence, they assume that someday the market will reflect the accurate price of the security. And that is the entire game – identifying opportunities to buy securities at low prices and wait for the right time to sell them to make a profit.
What information should you consider?
Ideally, all the past and current information of a company should form a part of your analysis. Fundamental analysis does not only include analyzing numerical financial data. Incidents that could potentially impact the valuation of a company should also be considered. You can consider the following elements for your analysis:
1. Press releases of the company
2. Company in the news
3. The demand for a company’s offerings
4. Quality of management
5. Political conditions of the economy
6. Government behavior towards the industry
These factors might or might not have an immediate impact on the value of a company. However, it would help if you considered them.
What are the types of fundamental analysis?
Fundamental analysis of the stock market is a broad concept that includes a qualitative and a quantitative study.
Quantitative analysis refers to understanding numerical data. Turnover can be analyzed using the asset to turnover ratio, assets can be analyzed using quick ratio and current ratio, and profits can be analyzed using gross profit and net profit ratio. Computing ratios help in understanding where a company stands in comparison to the others in the same industry. Competition determines the long-term future of a company.
Qualitative analysis, on the other hand, is more subjective. It involves understanding the company culture that the top management has set up. It includes knowing how the employees are treated and whether they feel part of a family while working for their organization. Even though the business environment of an entity has no direct impact on the profitability of a company, it is arguably more important than big numbers. This is because employees are the ones running a company, and the more motivated the employees are, the better the company’s long-term growth prospects.
Fundamental Vs. Technical Analysis
Technical analysis is contradictory to fundamental analysis. In fundamental analysis, we try to arrive at the true worth of a company, which means that we believe that the current market price may not be an accurate representation. However, technical analysts believe that the market prices prevailing in the market are always correct. They argue that the market prices always take into consideration recent happenings. Hence, instead of fundamentally analyzing a security, they use charts to analyze price movements and trends and take a trading position based on their study.
Nonetheless, financial statements provide crucial data points about a company, and it is always a good idea to know about the market happenings.
Most of the tools essential for good research are available on the internet for free. For sound financial analysis, you will have to study the annual reports of target companies thoroughly. Understanding the transactions in the industry is also very important. Industry data is easily available on the internet. Daily news will help you make better investment decisions timely.