What is fundamental analysis?
Before we jump on to the Fundamental Analysis importance of fundamental analysis, let us understand what Fundamental Analysis really is! It is a method of examining a company’s quantitative (financial statements) and qualitative factors (management’s abilities) so as to determine the actual value of the securities issued by it. It also includes analysis of the macroeconomic factors such as the industry conditions and the overall economy of the country.
The sources of information for fundamental analysis are :-
- Balance sheet
- Profit and Loss Statement
- Annual Reports
- Announcements by the company
- Industry specific news
- Any major economic reforms like change in relevant laws
Before we understand Fundamental Analysis Importance, let us understand how the fundamental analysis is carried out using these sources of information :-
Fundamental Analysis – what is the right way?
Some of the parameters to carry out a fundamental analysis of a company are listed below :-
(Note – these are just a few examples, there are a lot of other parameters as well.)
1. Earnings per Share (EPS) :
Analysing the Earning per Share of a stock for the past financial years is an important method in assessing a stock’s profitability. It gives a gist of company’s earnings, and tells us about how much out of these earnings is distributed to the shareholders. If we compare a company’s current Earnings per Share with that of the previous years, we can see the Growth Potential of that company and make our judgements based on it.
2. Return on Equity/ Return on Assets :
Return on Equity (ROE) and Return on Assets are some ratios which are considered as some of the most important ratios. These ratios measures the efficacy of a company in making earning revenues and profits. This helps us in judging the company’s effectiveness in earning returns on the money invested in it.
The Return on Equity and Return on Assets is calculated as :-
Return on Equity = Net Income/Shareholders Equity
Return on Assets = Net Income/Total Assets (or Average Total Assets)
3. Price to Book Ratio (P/B Ratio):
P/B ratio is another important ratio. It is used to compare a company’s market value to its book value. You can calculate the P/B ratio by dividing the current market share price by book value per share as stated in the financial statements.
These were just a few ways of carrying out the fundamental analysis, there are many other parameters as well. Do a complete research before investing into a stock.
Fundamental Analysis importance for investors?
Most of the investors rely on the Financial Information available to make their judgements while investing in stocks. This is because the financial information illustrated in monetary terms is the easiest way to judge success and forecast the future of a company. It helps in determining who is outperforming in the market by giving a means for comparison. We can only make judgements by comparing one thing with another. It is difficult to make preferences without looking at two or more alternatives.
Fundamental Analysis is essential because it provides consistent and reliable information. With the help of fundamental analysis, we can evaluate a security’s intrinsic value. The discounted cash flow model is a common valuation method used to determine a company’s intrinsic value. The discounted cash flow model takes into account a company’s free cash flow and weighted average cost of capital, which accounts for the time value of money.
Such intrinsic value can then be compared to the security’s market value. If the stocks are being traded are less than its intrinsic value, then it is wise to buy the stock. Such form of investing is know as Value Investing. Benjamin Graham was considered the guru of value investing, and billionaire investor Warren Buffet followed the footsteps of Benjamin Graham to become the most successful investor of all time.
The conclusion :-
Thus, basic Fundamental Analysis is very important for long term investments, market trends and charts should be the secondary source of information. Fundamental analysis importance has been rooted for by almost every expert. Most of the financial news we get emphasise on short term opinion and trends. Long term information may be hard to get, but it is more valuable for the investor. Also, both quantitative and qualitative aspects should be analysed while investing.
The market is considered to be a huge gossip mill, where even the most senior investors tend to listen and spread the gossip. However, this does not mean that these senior investors does not have a well structured strategy for the long term which is based on the fundamental analysis. You must believe in fundamental analysis and its value, in order to make rational and logical decisions while investing. Fundamental Analysis is relevant for investing.
Liked Fundamental Analysis Importance? Checkout some really interesting stock evaluation techniques as well :-