Fundamental Analysis refers to performing a detailed analysis of a company and its business environment considering various macroeconomic and microeconomic factors.
It is Misunderstood the fundamental analysis of only listed company is done in case of investment decision. But Fundamental Analysis is done for multiple purposes like valuation of company , decision by VC's to invest in startups, decision by bank to lend a debt to company , auditor's evaluation for going conern and impairment of assets , etc..
Fundamental Analysis is used to determine the intrinsic value fair value of a security or a business and thereby taking the investment decisions. If the fair value is more than the current market price then the security or business is undervalued which simply means that the investor should buy the security as it is valued less than what it should be. Similarly, if the fair value is less than the current market price then the security or business is overvalued which simply means that the investor should sell (or should not buy) the security as it is valued less than what it should be.
Fundamental analysis is used by investors in order to take investment decisions, analysts to prepare research reports and providing recommendations and it is also used by the business itself at the time of corporate restructuring such as merger, acquisition, amalgamation, demerger and so on in order to assess the real worth of the business and to take further decisions accordingly.
Fundamental analysis comprises three components: Economy, Industry and the Company itself.
An investor can take Top to Down Approach or Bottom-Up Approach in order to evaluate these three components.
In Top to Down Approach, the analysis starts with analysis of Economy in which business operates then Industry to which the business belongs and finally it narrows to the Company.
Bottom-Up Approach, begins with the Company then Industry and inally the overall Economy.
For instance, in order to perform fundamental analysis of Tata Motors, the investor or analyst will review Indian economy, Automobile Industry in India and then finally Tata Motors.
It is vital to remember that while analysing these three components both Qualitative and Quantitative factors need to be considered.
Quantitative factors are those factors that can be measured in numbers, percentages or ratios such as growth rate, borrowings, interest rate etc whereas
Qualitative factors are those factors that cannot be measured such as government policies, demand, supply chain conditions, labour laws and so on.
Both factors create a significant impact on the business and its valuation.
Economy: While evaluating the worth of a business, it is important to understand the economic environment in which the business operates and how it can impact the business. In order to analyse the economy, there are multiple factors that need to be considered. Qualitative factors such as government policies, rules and regulations, political stability and stage of economic cycle (growth, peak and recession) Similarly, Quantitative factors such as Gross Domestic Product and its growth, Inflation, taxation rates, subsidies, exchange rate, fiscal policy, monetary policy, government borrowings, foreign exchange reserves and balance of payments. For instance, currently Indian government is encouraging Electric Vehicles and has launched various schemes for promoting EV business which implies that the economic environment for Electric Vehicle business is favourable in India and will create an overall positive impact on the business in the form of subsidies and incentives.
Industry: In order to obtain an overall and detailed analysis of the business environment understanding the business industry is equally important. While analysing the industry qualitative factors such as level of competition prevailing in the industry, customer and geographic exposure, technological changes, threat of new entrants, supply chain conditions, outlook of customer & government towards the industry, sensitivity to economic conditions and stage of industry lifecycle (preliminary, consolidation, maturity and decline) and quantitative factors such as Industry Growth Rate needs to be considered. For example, if the threat of new entrant in the industry is high then it is favourable for the existing business and creates a positive outlook in terms of growth prospects.
Company: Company analysis is a critical part of fundamental analysis where the individual business is evaluated in order to understand its real worth. Here, qualitative factors such as business model, competitive position in the industry, expertise of management, technological advancement, geographical expansion, labour relations and future prospects are taken into consideration. Quantitative factors such as revenue growth, earnings, profits and many more are evaluated by using different tools such as ratio analysis, common size and comparative financial statements to grab an understanding of financial performance of the company.
Ratio analysis
In Ratio Analysis , ratios of the company are compared with the competitors in the industry to evaluate relative performance OR the ratios of the current period are compared with the past period in order to understand that whether the performance has improved or worsened in the current period. There are numerous ratios that are considered divided in different categories.
Profitability Ratios: Profitability ratios measure the ability of the business to generate profits. If the profitability ratios are increasing, it simply means that the financial performance of the company is improving and vice versa. Profitability ratios such as Return on Capital Employed, Gross Profit Ratio, Operating Profit Ratio, Net Profit Ratio and Return on Equity are widely used.
Liquidity Ratios: Liquidity ratios determine the ability of the company to fulfil its short-term obligations. Inadequate liquidity ratios can create financial difficulties for the business. Liquidity ratios such as Current Ratio, Quick Ratio, Cash Ratio are quite popular.
Solvency Ratios: Solvency ratios evaluate long term financial viability and credibility of the company. Inadequate solvency ratios can not only create financial problems in the long term but may lead to bankruptcy as well. Solvency Ratios such as debt to capital ratio, debt ratio and equity multiplier are often used by government, banks and institutional investors to evaluate credibility and repayment capacity of the borrower.
Efficiency Ratios: Efficiency ratios evaluate the level of efficiency by which the company is utilising its resources. Improving efficiency ratios indicates generation of more revenues and profits. Efficiency ratios such as include asset turnover ratios, inventory turnover ratio, payable turnover, fixed assets turnover ratio, working capital turnover and receivables turnover.
Coverage Ratios: Coverage Ratios measure the ability of the business to service its debts and other obligations. Higher the coverage ratios, better it is for the company. Coverage ratios such as interest coverage ratio, debt coverage ratios, EBITDA coverage and fixed charge coverage ratios are widely used.
Market Prospects Ratios: Market prospect ratios determine the earnings from investor’s perspective. The earnings include higher stock prices or future dividends. Market Prospects ratios include dividend yield, dividend payout ratio earning per share and price to earnings ratio.
Financial Statements
Prior to performing this quantitative analysis, it is important to have thorough understanding of financial statements and its elements. Broadly, Financial statements comprises three elements which are used for fundamental analysis: Balance Sheet, Statement of Profit and Loss and Cash Flow Statement.
Balance Sheet: It is a statement that represents assets, liability and shareholder’s equity of a company at a particular point of time. It is based on the equation that states Total assets are equal to the sum of total liabilities and shareholder’s equity.
Assets: These are the resources that the company utilizes for its business in order to generate revenue and profits. There are broadly two categories: Non-Current Assets (Assets that are held for more than one accounting period which is generally 12 months) and Current Assets (Assets that are held for less than one accounting period).
Fixed Assets: Non-Current Assets that are physical in nature such as land, plant and machinery, building and so on.
Intangible Assets: Non-current Assets that are not physical in nature and valuable for the business such as patent, trademark, intellectual property and goodwill.
Accounts Receivable: It represents the credit taken by the customers from the business.
Inventory: It refers to the goods held by the business in the form of raw material, work in progress and finished goods.
Marketable Securities: Investments made by the company which can be easily converted into cash.
Liabilities: Liability represents company’s debt obligations to outsiders such as banks, debenture holders and so on. There are broadly two categories: Non-Current Liabilities (Liabilities that are due after one accounting period which is generally 12 months) and Current Liabilities (Liabilities that are due within one accounting period).
Accounts Payable: It represents the credit taken by the business from its suppliers.
Long term debt: It refers to the loan taken by the business from external sources such as banks or financial institutions.
Debentures: Debentures represents borrowing from investors
Shareholders Equity: It represents the funds attributable to the shareholders of the company.
Share Capital: It refers to the money that has been invested by the shareholders in the form of capital.
Retained Earnings: It refers to the accumulated earnings of the business that can be used for reinvestment, debt repayment or dividend distribution.
Profit and Loss Statement: It is a statement that represents income earned and expenses incurred and finally the net profit or loss of the business during a specific period of time which is generally an accounting period (12 months).
Revenue from Operations: It is the income generated from its core operations such as selling a product or providing services.
Other Income: It is the income generated from sources other than its core operations such as rent, income from investments, commission earned and gain on sale of asset.
Cost of Goods Sold: This includes direct expenses incurred by the business for making the product or providing the service such as cost of raw material, changes in inventory and wages.
Employee Cost: This refers to the cost incurred for employees such as salaries, insurance, bonus and so on
Depreciation: Depreciation refers to capitalizing the cost of an asset over its useful life. In other words, depreciation is reduction in value of an asset due to wear and tear. It is a non-cash expense for the business. Depreciation is considered for tangible non-current assets.
Finance Costs: Finance cost is incurred to arrange funds for the business such as Interest on loan.
Other Expenses: It comprises expenses such as electricity, water, rent, power and fuel and more miscellaneous expenses.
Extraordinary Items: These are income or expense which does not happen on regular basis. These are once in a while items. These are not considered while performing fundamental analysis.
Fundamental Analysis requires deep and thorough understanding of financial statements along with detailed analysis of company, industry and economic environment. It is suitable for long term investment purpose.
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