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Analysing Company Fundamentals

Fundamental analysis evaluates a business's financial health by examining key ratios and indicators to understand its actual value. This helps investors determine if they're overpaying for a stock. Unlike fixed-price items, stock prices vary, and fundamental analysis provides insight into whether a stock's market price is fair. By buying stocks at or below their fair value, investors can potentially profit as market prices often exceed fair values.

The Importance of Fundamental Analysis

Fundamental analysis is crucial for long-term investors to determine whether a stock is undervalued or overvalued. Just like knowing the fair price of a banana helps you avoid overpaying, understanding a stock's intrinsic value helps you make informed investment decisions. Fundamental analysis reveals the stock's actual value, ensuring profitable investments.

Types of Fundamental Analysis

Fundamental analysis is divided into qualitative and quantitative categories.

Qualitative Analysis: This involves assessing the quality of aspects like management, brand, products, and board. It's subjective.

The steps to do a qualitative analysis is to answer these questions

For this purpose, the answers to the following questions are determined.

How efficient is the company in terms of operations?
 
What is the quality of its key management personnel?
 
How does the brand value of a company appear?
 
Does the company use any exclusive (proprietary) technology?
 
What socially responsible initiatives is the company undertaking?
 
What is the company’s vision for the future?
 

Quantitative Analysis: This uses numerical data from financial statements, providing objective insights.

Check financial statements

A company's financial statements can be numerous. However, there are three primary financial statements that a company presents to display its performance.

Profit and Loss Statement

The profit and loss statement, also known as the income statement, P&L statement, operating statement, or earnings statement, typically includes several key elements:

The company's revenue for a specific period (quarterly or yearly)

  • Tax and depreciation figures
  • Earnings Per Share (EPS)
  • Expenses incurred to generate revenue

This statement provides valuable insights into a company's profitability, highlighting its bottom line. While various parameters can be included in a P&L statement depending on the industry, the primary metrics used to assess profitability across all companies are revenue, Profit Before Interest and Tax (PBIT), and net income.

Balance Sheet

A balance sheet displays a company’s assets, liabilities, and shareholder’s equity at a specific point in time. In a balance sheet, at any point in time, the total assets of a company should always be equal to the company’s liabilities, including shareholder’s equity. Hence, the name ‘balance sheet’.

If they are not balanced, there may be some issues, including incorrect or misplaced data, miscalculations, or exchange rate or inventory errors. Hence, in a balance sheet, Assets = Liabilities + Shareholders’ Equity

Cash-flow Statement

A cash flow statement shows the movement of money in and out of business. A cash-flow statement determines a company’s financial health. It helps you in analysing a company’s liquidity. The cash flow statement shows the net change in cash, usually divided into cash from operating activities, investing activities and financing activities.

For the purpose of analysis, we check the factor ‘Free Cash Flow’. A positive cash flow indicates that the company’s assets are growing from where they started. In contrast, a negative cash flow indicates otherwise.

Additionally, fundamental analysis can be approached in two ways:

  • Top-Down Analysis:Starts with macroeconomic factors, then narrows down to individual stocks.
  • Bottom-Up Analysis: Begins with individual companies, then builds a stock portfolio based on specific advantages.

Both qualitative and quantitative analyses are essential and complementary.

Acknowledging Investment Risks

While companies can achieve significant success, various risks could lead to financial losses or steep declines in business:

Operational Risks: Routine business operations can face numerous challenges, such as equipment failures, new competitors, price wars, increased input costs, economic downturns, or lost contracts and customers.
 
Political Risks: Changes in government could introduce policies that might negatively impact businesses, such as tax increases, new regulations, or asset nationalizations.
 
Currency Risks: Companies with international operations face risks from currency fluctuations, which can affect revenue and costs, altering the earnings in the home currency.
 
Legal Risks: Companies may face legal challenges, especially in sectors prone to intellectual property disputes, potentially resulting in significant financial penalties or business restrictions.
 
Insolvency Risks: Highly indebted companies may struggle to meet their financial obligations in challenging times. Investors analyze various ratios to assess a company's financial health, such as:
  • Debt to equity ratio = total debt/total equity
  • Times interest earned = operating income/interest payments
  • Current ratio = current assets/current liabilities

Understanding these elements helps investors make informed decisions and potentially mitigate risks associated with stock investments.

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