Fundamental Analytics: Why It Matters

Fundamental analytics is a tool that helps investors understand a company’s true value and financial health. It involves looking at things like earnings, revenue, and expenses to make informed investment decisions. It’s essential because it allows investors to see beyond short-term market changes and focus on a company’s potential for long-term success. By bothering with fundamental analytics, investors can make smarter choices, distinguishing between companies with solid foundations and those facing financial challenges. It’s a practical way to navigate the complexities of the financial markets and find opportunities for lasting growth.

Defining Fundamental Analytics

Fundamental analytics is a method of evaluating a security’s intrinsic value by examining various economic, financial, and qualitative factors related to the underlying asset.

• The current price of a stock may not always reflect the true value of the stock/performance of the company. The stock may be overvalued or undervalued in the market. Fundamental analysts study the underlying health of the company in order to find its intrinsic value.
• This is done by using various qualitative and quantitative factors such as the company’s revenues, profit margins, return on equity, future growth potential and other metrics. The main purpose of this method is to identify companies that are fundamentally strong in order to invest in them for the long term.

Fundamental Analytics Vs Technical Analysis

Distinguishing between fundamental analytics and technical analysis is crucial in stock selection. While the choice of when and how to use them often depends on personal preferences, each approach brings its unique strengths to the table.

• Fundamental analytics focuses on identifying stocks with strong growth potential at an attractive price. This involves examining the underlying company’s business, as well as assessing conditions within its industry or the broader economy.
• Technical analysis takes a different route by bypassing the company’s fundamentals. Instead, it relies on identifying statistical patterns on stock charts that may provide insights into future price and volume movements.

Both methods offer valuable perspectives for investors, allowing them to make informed decisions based on their preferred analytical approach.

Different Types of Fundamental Analytics

There are two main types of fundamental analytics:

• Qualitative: This is a study that involves brand value, management decisions, the financial performance of the company over a given period, and other similar factors.
• Quantitative: This is an analysis that is more number-based and considers the company’s financial statements and derives the share value from these observations.

Though the approaches are different, they are equally crucial for a comprehensive analysis of a company’s share price.

Fundamental analytics can also be done with a top-down or bottom-up approach:

• The top-down approach looks into the macroeconomic factors first and then digs into a specific company.
• The bottom-up approach analyses the company first and then checks the effect of macroeconomic factors on the company’s performance.

Basics of Fundamental Analytics

Before conducting fundamental analytics of a stock, you need to consider a few basic factors. These factors are:

• Company’s structure and revenue
• Company’s profits over the years
• Revenue growth over the years
• Company’s debt
• Corporate governance
• Rate of turnover

Analysts look at these factors while conducting fundamental analytics of any security and determine its intrinsic value.

Conducting Fundamental Analytics of a Stock

While there is no single standard method to perform fundamental analytics (stock trading is not as straightforward as solving a mathematics problem), you can certainly follow broad guidelines as you build your instincts and processes with experience. It is also important to understand that the same information may reflect different perspectives for different industries and stocks. Here are some key steps that you should learn to begin performing fundamental analytics of your target companies:

• Understand the company, its operations, business model, etc.
• Use the financial ratios for initial screening
• Closely study the financial reports of the company
• Find the company’s competitors/rivals and study them
• Check the company’s debt and compare it with its rivals
• Analyse the company’s prospects
• EPS, P/E ratio, P/B ratio, Debt/Equity ratio and RoE ratio are among the few fundamental indicators that help you understand deeper about the company/stock.

Understanding Important Ratios

1.   EPS

EPS or earning per share (EPS) is a measure of profitability.

EPS = Net Profit of The Company/Number of Outstanding Shares

• Higher earnings per share (EPS) generally indicate better financial performance, correlating with potentially improved stock performance.
• The assessment of what qualifies as a ‘good’ EPS varies, considering factors like recent company performance, competitor benchmarks, and market expectations.
• Despite a growing EPS, a company’s stock may decline if market expectations are even higher, highlighting the influence of market sentiment.
• Conversely, a decreasing EPS might lead to a stock price increase if analysts anticipated a more negative outcome.
• It’s crucial to evaluate EPS in relation to the company’s share price, often done through metrics like the Price/Earnings ratio (P/E) or earnings yield.

2.   P/E Ratio

• The P/E ratio or price to earnings ratio (P/E ratio) is a measure of valuation.
• The P/E ratio shows whether a share of stock pays well compared to its price.

P/E = Price of Stock/Earnings Per Share

Example

• Hypothetically, for XYZ company, the stock price is ₹100, and it pays ₹10 earnings per share, resulting in a P/E ratio of ₹10.
• A lower P/E ratio indicates higher earnings, making the stock a potentially profitable deal.
• If the P/E ratio is notably lower than that of competing firms, it may suggest that the stock is undervalued, presenting an opportunity for a future price rise.

3.   P/B Ratio

P/B ratio or price to book ratio (P/B), is a measure of valuation for banking and financial companies.

P/B = Price of Stock/ Book Value of Stock

Example

• If a company is valued at ₹100 crores with 5,000,000 shares outstanding, its book value per share would be ₹200.
• With the stock trading at ₹800 per share, the resulting P/B ratio is 4.
• A P/B ratio greater than 1 signifies that the stock is growing at a faster pace than its book value suggests.
• P/B ratios exceeding 100 are often observed in high-growth stocks.

4.   RoE Ratio

The RoE ratio or return on equity ratio (RoE), is a profit measure that can be generated with the money that has been invested by its shareholders. ROE is generally displayed in percentage. The higher the earnings per share, the healthier the company, and so the better the stock is likely to perform.

RoE = Net Income of company/Shareholder’s equity

Pros and Cons of Fundamental Analytics

Advantages

Develops Thorough Understanding

Stock fundamental analytics helps in the development of a rich understanding of the business where you are about to invest your hard-earned money. It helps you gather the right information and make rational decisions about the position to take.

Limited Room for Biases

Investment decisions can go wrong due to cognitive biases. However, crude numbers at your disposal limit room for personal biases, essential for wealth creation in the long run. Rather than establishing entry and exit points, this analysis helps you take a long-term view of the markets.

Helps Detect Red Flags

Through fundamental research and analysis, you can easily detect red flags in the financial statements of a firm that serve as a warning about possible potential problems with the company and its stocks in the future. In the long run, this prevents your wealth from being destroyed.

Disadvantages

The cons of analysing stock market fundamentals are:

Time-Consuming

This is perhaps the biggest disadvantage of fundamental analytics. You need to analyse several areas, which makes the entire process tedious and time-consuming. At the same time, you need to periodically monitor all the financial data related to a firm and other economic indicators that may impact its performance negatively.

Too Many Assumptions

Often while analysing stock market fundamentals, one tends to make too many assumptions and interpretations. These require skills, learning, knowledge and experience. Without them in your arsenal, you can go wrong with your analysis.

Herd Mentality Not Considered

Sometimes herd mentality and emotions result in bull and bear phases of the stock market and affect stock prices that may be missed during analysis. You may end up purchasing a fundamentally sound stock at the wrong time and watch it go down or remain stagnant for a long period.

Conclusion

Fundamental analytics is a critical approach to evaluating the intrinsic value and overall health of a financial asset, such as stocks. It involves a thorough examination of a company’s financial statements, performance metrics, and economic indicators to make informed investment decisions. Bothering with fundamental analytics is essential for investors as it provides insights beyond short-term market trends, allowing for a deeper understanding of a company’s potential for long-term success. This approach empowers investors to make strategic decisions based on a comprehensive analysis of a company’s fundamentals rather than relying solely on market fluctuations.

Frequently Asked Questions (FAQs)