Fundamental analysis of stocks

Fundamental analysis is a technique used by investors to determine the true value and growth potential of a company. It involves studying a company’s financial statements, such as its profit and loss account, balance sheet, and cash flow. By making this assessment, investors can easily understand whether a stock is overvalued or undervalued.

Several successful investors like Warren Buffett and Peter Lynch have used fundamental analysis to pick stocks that grow steadily over time. This technique even helped them earn significant returns for their portfolios.

The reason fundamental analysis is so important is that it gives a clear picture of what a stock truly represents. In this article, let’s look at the five major things you must consider while performing a fundamental analysis of stocks.

For a comprehensive analysis and to see whether the stock holds any economic moat, you can analyse these factors:

1. Understand the business and management quality

Fundamental analysis of stocks starts by understanding a company's business model. While doing so, you must focus on areas within your "circle of competence." This concept was introduced by Warren Buffett, who encouraged investors to stick to businesses they understand well. For example,

• Companies with simple models like Britannia are easier to evaluate.
• On the other hand, complex businesses like Infosys are harder to predict.

The next step is to evaluate the company’s management. Good management is transparent and shares clear business plans with investors. A reliable management team will always provide specific growth strategies, while dishonest management may use vague statements. Furthermore, quality management can strategically handle industry challenges and competition better.

2. Check financial ratios

To identify strong companies in the stock market, you must use several financial ratios. They offer a simplified way to evaluate a company's health without analysing complex reports. By reviewing these ratios, you can easily identify well-performing companies. Let’s have a look at some important ratios and their ideal values:

• EPS (Earnings Per Share)
  EPS shows a company’s profitability. A consistently increasing EPS over 3-5 years signals strong growth.
• Price to Earnings (PE) Ratio
  A lower PE ratio compared to industry peers suggests the stock may be undervalued and a better buy.
• Return on Equity (ROE)
  An ROE above 15% over three years indicates the company is efficiently using its equity to generate profits.
• Debt to equity ratio
• A ratio under 0.5 means the company has low debt compared to its equity. This reduces financial risk.
• Current ratio
  A ratio above 1 shows the company has enough assets to cover its liabilities. This ratio indicates “financial stability”.

3. Analyse past performance

To assess a company's past financial performance, you should review its three key financial statements

• Balance Sheet
• Profit & Loss Statement
• Cash Flow Statement

The general rule is that if a company shows consistent growth in revenues, net profits, and profit margins over the past five years, it is a strong candidate for long-term investment. Additionally, to gain a deeper understanding of its financial health, you must analyse the company’s:

• Operating costs
• Expenses
• Assets
• Liabilities
• Net cash flow

These factors will help you determine whether the company is profitable and capable of strong future growth.

4. Perform competition analysis

Competitor analysis is an important part of the fundamental analysis of stocks. In this, you compare a company to its industry peers and see how it stands out. While making an analysis, you should focus on the company's:

• Unique Selling Proposition (USP)
• Competitive advantages
• Product Quality
• Control over pricing
• Brand value

This analysis helps to identify whether the company has an edge in its industry. Additionally, you should compare future strategies (such as expansion or innovation) to check if the company is positioned for growth.

5. Do a debt analysis

In debt analysis, you check how much money a company owes to its creditors. Be aware that a company with high debt must prioritise paying off its creditors and interest before distributing profits as dividends to shareholders. As per a thumb rule, the higher the debt, the less likely shareholders are to receive dividends. This happens because more funds are needed to meet financial obligations.

Therefore, prefer companies with a debt-to-equity ratio lower than 1. It shows they have manageable debt levels and are financially healthier. Lower debt generally reduces financial risks and increases the company's ability to do business in the long term.