What is Fundamental Analysis, Beginner’s guide | Detailed Explanation | Part-1
Definition of fundamental analysis
Fundamental analysis is a method of evaluating the intrinsic value of a company’s stock by examining its financial health and performance. It involves analyzing key financial statements, such as the income statement, balance sheet, and cash flow statement, as well as ratios and other metrics that provide insight into a company’s profitability, liquidity, and solvency.
The goal of fundamental analysis is to determine the intrinsic value of a stock, which is the true value of the stock based on its underlying assets and future earnings potential. This value may be different from the current market price of the stock, and the difference between the two is known as the “market price discount” or “market price premium.”
If the intrinsic value of a stock is higher than the market price, the stock is considered undervalued and may be a good investment opportunity. If the intrinsic value is lower than the market price, the stock is considered overvalued and may be a riskier investment. If the intrinsic value is roughly equal to the market price, the stock is considered fairly valued.
Fundamental analysis can be used to assess a company’s long-term growth prospects and determine whether its stock is undervalued, overvalued, or fairly valued. It is a key tool for investors who want to make informed decisions about whether to buy, hold, or sell a stock.
Importance of fundamental analysis in stock market investing
Fundamental analysis is an important tool for stock market investors because it helps them understand the underlying value of a company’s stock.
There are several reasons why fundamental analysis is important in stock market investing:
It helps you identify long-term growth opportunities: By analyzing a company’s financial statements and other data, investors can get a sense of its growth potential and determine whether it is a good long-term investment.
It helps you avoid overvalued stocks: By using fundamental analysis to determine a stock’s intrinsic value, investors can avoid paying too much for a stock that is overestimate in the market.
It helps you avoid buying into a company with financial problems: By analyzing a company’s financial statements and other data, investors can identify potential red flags that may indicate financial problems or declining performance.
It helps you make informed decisions: By using fundamental analysis, we can thoroughly evaluate a company’s financial health and performance, you can make more informed decisions about which stocks to buy and when to sell them.
Overall, fundamental analysis is a crucial component of successful stock market investing, and it can help you make data-driven decisions that are based on a company’s long-term growth potential and financial health.
Some of the key term that are placed in the companies financial results. They are
- Income statement
- Balance sheet
- Cash flow statement
- Other financial statements (e.g. statement of shareholder equity)
- Ratio analysis (e.g. P/E ratio, EPS, ROE)
Income statement
The income statement is a financial statement that shows a company’s revenues, expenses, and net income (profit) over a specific period of time, typically a fiscal quarter or year. It is used to track a company’s financial performance and to determine its profitability.
The income statement is typically organized in a standard format, with revenues listed at the top and expenses listed below. The net income is calculated by subtracting the expenses from the revenues.
There are several key components of the income statement:
Revenues: This is the total amount of money a company generates from the sale of its products or services. It is the top line on the income statement.
Cost of goods sold (COGS): This is the direct cost of producing the products or services that a company sells. It includes the cost of raw materials, labor, and manufacturing overhead.
Gross profit: This is calculated by subtracting the COGS from the revenues. It represents the profit a company makes after accounting for the cost of producing its products or services.
Operating expenses: These are the expenses a company provokes in order to run its business, such as selling and marketing expenses, research and development expenses, and general and administrative expenses.
Operating income: This is calculated by subtracting the operating expenses from the gross profit. It represents the profit a company makes from its core business operations.
Net income: This is the bottom line on the income statement and represents the profit a company makes after accounting for all revenues and expenses. It is also known as the net profit or net earnings.
The income statement is an important financial statement for investors because it provides insight into a company’s profitability and how it is generating and using its revenue. It can be used in conjunction with other financial statements, such as the balance sheet and cash flow statement, to get a comprehensive view of a company’s financial health.
Balance sheet
The balance sheet is a financial statement that shows a company’s financial position at a specific point in time. It is used to track a company’s assets, liabilities, and shareholder equity.
The balance sheet is organized in a standard format, with assets listed on the left side and liabilities and shareholder equity listed on the right side.
Total assets = Total liabilities + Shareholder Equity
There are several key components of the balance sheet:
Assets: These are the resources that a company owns or controls, such as cash, investments, property, and inventory. Assets are divided into two categories: current assets, which are expected to be converted to cash or used up within one year, and non-current assets, which are expected to be held for more than one year.
Liabilities: These are the obligations that a company owes to creditors, such as loans, accounts payable, and taxes. Liabilities are also divided into two categories: current liabilities, which are expected to be paid within one year, and non-current liabilities, which are expected to be paid over a longer period of time.
Shareholder equity: This is the residual interest in the assets of a company after liabilities are paid. It represents the ownership interest of the company’s shareholders. Shareholder equity is divided into two categories: paid-in capital, which represents the amount of money shareholders have invested in the company, and retained earnings, which represent the net income that has been retained by the company and not distributed to shareholders as dividends.
The balance sheet is an important financial statement for investors because it provides a snapshot of a company’s financial position and how it is financed. It can be used in conjunction with other financial statements, such as the income statement and cash flow statement, to get a comprehensive view of a company’s financial health
Cash flow statement
The cash flow statement is a financial statement that shows how a company generates and uses cash over a specific period of time, typically a fiscal quarter or year. It is used to track a company’s liquidity and financial stability.
The cash flow statement is organized in a standard format, with three main sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.
There are several key components of the cash flow statement:
Cash flow from operating activities: This section the cash a company generates from its core business operations, such as the sale of products or services. It includes items such as net income, changes in working capital (e.g. accounts receivable and accounts payable), and non-cash expenses (e.g. depreciation and amortization).
Cash flow from investing activities: This section shows the cash a company generates from investing activities, such as the purchase or sale of investments, property, and equipment.
Cash flow from financing activities: This section shows the cash, a company generates from financing activities, such as the issuance or repayment of debt and the issuance or repurchase of stock.
The cash flow statement is an important financial statement for investors because it provides you a insight into a company’s liquidity and ability to generate cash. It can be used in conjunction with other financial statements, such as the income statement and balance sheet, to get a comprehensive view of a company’s financial health.
Ratio analysis
Ratio analysis is a method of evaluating a company’s financial performance and position by calculating and comparing various financial ratios. These ratios are calculated using financial data from a company’s financial statements, such as the income statement, balance sheet, and cash flow statement.
There are many different types of financial ratios that can be calculated, and they can be grouped into several categories:
Profitability ratios: These ratios measure a company’s profitability and efficiency, such as the gross margin ratio, net profit margin, and return on assets (ROA).
Liquidity ratios: These ratios measure a company’s ability to meet its short-term obligations, such as the current ratio, quick ratio, and cash ratio.
Solvency ratios: These ratios measure a company’s ability to meet its long-term obligations, such as the debt-to-equity ratio, interest coverage ratio, and times interest earned ratio.
Valuation ratios: These ratios measure a company’s stock price relative to its financial performance and position, such as the price-to-earnings ratio (P/E ratio), price-to-book ratio (P/B ratio), and dividend yield.
Ratio analysis can be a useful tool for investors because it helps them understand a company’s financial performance and position, and compare it to other companies or industry benchmarks. However, it is important to keep in mind that ratios should not be used in isolation, and it is always important to consider the context and other factors that may affect a company’s financial performance and position.
Profitability
Profitability is a measure of a company’s ability to generate profits, or earnings, from its operations. It is an important factor for investors to consider when evaluating a company’s financial health and risk profile.
There are several key measures of profitability that investors may consider, including:
Net income: Net income is the company’s total profits after subtracting expenses and taxes. It is a key measure of a company’s profitability and can be found on the company’s income statement.
Return on assets (ROA): ROA is a measure of a company’s profitability relative to its total assets. It is calculated by dividing the company’s net income by its total assets. A higher ROA may indicate that the company is more profitable and efficient in using its assets to generate profits.
Return on equity (ROE): ROE is a measure of a company’s profitability relative to its shareholder equity. It is calculated by dividing the company’s net income by its shareholder equity. A higher ROE may indicate that the company is more profitable and efficient in using its shareholder equity to generate profits.
By analyzing a company’s profitability, investors can gain insight into the company’s ability to generate profits and make informed investment decisions. A company with strong profitability may be well positioned for future growth and success.
Liquidity
Liquidity refers to a company’s ability to meet its short-term obligations, such as paying its bills, debts, and other financial obligations as they come due. It is an important measure of a company’s financial health and stability.
There are several key factors that affect a company’s liquidity, including:
Cash and cash equivalents: These are highly liquid assets that a company can easily convert to cash, such as cash on hand, checking accounts, and money market investments.
Current assets: These are assets that a company expects to convert to cash or use up within one year, such as accounts receivable, inventory, and prepaid expenses.
Current liabilities: These are obligations that a company expects to pay within one year, such as accounts payable, taxes, and short-term debt.
To assess a company’s liquidity, investors and analysts typically use liquidity ratios, such as the current ratio, quick ratio, and cash ratio. These ratios compare a company’s current assets to its current liabilities and provide insight into its ability to meet its short-term obligations.
A company with strong liquidity is generally considered to be financially healthy and stable, while a company with weak liquidity may be at risk of financial difficulties. It is important for investors to consider a company’s liquidity when evaluating its financial health and risk profile.
Solvency
Solvency refers to a company’s ability to meet its long-term financial obligations, such as paying off its debts and other financial obligations as they come due. It is an important measure of a company’s financial stability and risk profile.
There are several key factors that affect a company’s solvency, including:
Long-term debt: This is debt that a company expects to pay off over a period of more than one year, such as loans and bonds.
Shareholder equity: This represents the residual interest in a company’s assets after liabilities are paid. It includes paid-in capital, retained earnings, and other equity instruments.
Credit rating: This is a measure of a company’s creditworthiness, based on its financial performance and risk profile. It is assigned by credit rating agencies, such as Standard & Poor’s and Moody’s.
To assess a company’s solvency, investors and analysts typically use solvency ratios, such as the debt-to-equity ratio, interest coverage ratio, and times interest earned ratio. These ratios compare a company’s debt to its shareholder equity and provide insight into its ability to meet its long-term obligations.
A company with strong solvency is generally considered to be financially stable and less risky, while a company with weak solvency may be at risk.
Growth
Growth refers to the increase in a company’s financial performance, such as revenue, profits, and shareholder equity, over a specific period of time. It is an important factor for investors and can be a key driver of a company’s stock price.
There are several key metrics that can be used to measure a company’s growth, including:
Revenue growth: This is the increase in a company’s total revenue over a specific period of time, such as a fiscal quarter or year. It is a key measure of a company’s top-line performance.
Earnings growth: This is the increase in a company’s net income or profits over a specific period of time. It is a key measure of a company’s bottom-line performance.
Net income margin: This is a measure of a company’s profitability, calculated as net income divided by total revenue. A higher net income margin indicates that a company is generating more profits relative to its revenue.
Return on assets (ROA): This is a measure of a company’s efficiency and profitability, calculated as net income divided by total assets. A higher ROA indicates that a company is generating more profits relative to its assets.
Return on equity (ROE): This is a measure of a company’s profitability and shareholder value, calculated as net income divided by shareholder equity. A higher ROE indicates that a company is generating more profits relative to the investments of its shareholders.
Growth is an important factor for investors because it can indicate a company’s potential for future success and profitability. However, it is important to keep in mind that past performance is not necessarily indicative of future results, and other factors, such as industry trends, economic conditions, and competition, can also impact a company’s growth prospects.
