Introduction to Fundamental Analysis

An overview

The constant desire to make money attracts many to the stock market. Random tips from friends, television channels, social media can be risky. Blind following without much thought process can be unsafe. We have a pre-disposition of consuming things without understanding them. This blind trust in others instead of doing their research is very common. The recent IPO fever is an example of how informed investors get influenced by the din created in the market and tend to lose. Warren Buffet aptly says “Risk comes from not knowing what you’re doing.” 

Fundamental analysis -common-sensical

People avoid fundamental analysis as it involves a lot of reading and information processing. It is seen as an academic exercise. However, fundamental analysis is more common-sensical than academic. Of course, some financial terminologies need to be understood but that is not outside common sense. Unaware we do a lot of analysis that is fundamental in our day-to-day life. We plan our monthly expenses, buying a car or house etc., and other familial needs. We plan how to mobilise resources, and also seek other modes of increasing our current earnings. Fundamental analysis of a business is just an extension of this. When we are investing, we are not buying a stock. As Peter Lynch puts it “Behind every stock is a company. Find out what it’s doing.”

 

Watch where you are going and you will avoid pitfalls

Do you remember Yes Bank? one of the largest private banks was trading in the range of Rs.380-Rs.400 during the period September 2018. As corporate governance issues surfaced since then, the stock price has not recovered and is hovering around Rs.13-15. Imagine an investor is not aware of the facts caught in this situation. More than 90 per cent value has been wiped off from the top of Rs.400. A simple analysis of the loans and deposits would have made things clear that the growth in deposits has been much lower than the growth in loans. A banking company accepts money from its clients in the form of a savings bank, current accounts and fixed deposits. It lends this amount to the borrowers in the form of short-term loans and long-term loans. A banking company that lends more than it accepts is heading towards bankruptcy. If the borrower is unable to repay the interest and principal it is termed a default. A default will create panic and the depositors will start withdrawing their money. Finally, all hell broke loose when RBI refused to extend the MD & CEO of Yes Bank Mr Rana Kapoor, the stock tanked almost 34 per cent on 21 September 2018. The bank was not following due diligence in lending and this resulted in high non-performing assets. A non-performing loan is a bank loan that is subject to late repayment or is unlikely to be repaid by the borrower in full. One needs to be aware of where one is investing and track the investment to avoid such situations.

What is fundamental analysis?

The purpose of fundamental analysis is to arrive at the intrinsic value of a business. Intrinsic value is nothing but the worth of a business. Intrinsic value is not the market price or book value of the asset. It is the worth of an asset-based on its capacity to generate future cash flows.

 

If you are buying an asset at the current market price you must be reasonably sure that the market price is much lower than its value. Simply put you buy an asset today assuming it is worth more than its current market price. The assumption that value is more than the current market price is to be arrived at. If not, you are playing blind and it can cause you financial losses. 

Financial analysis is the backbone of fundamental analysis

Financial Analysis- The backbone of fundamental analysis is the analysis of the financial statements. There are three statements that a company is mandated to share with its investors; the balance sheet, income statement and cash flow statement. Financial analysis involves the analysis of these three statements. 

 

• Balance sheet – A balance sheet is essentially a statement that shows the financial position of a company. A company with a strong balance sheet is more likely to survive economic shocks. How much the company owes and what are its receivables. What are the assets and investments of the company and its cash balances, and how are the assets of the company funded? It can be understood with a simple equation –

 

Asset = Capital + Liability

Liabilities	Assets
Capital- Owners Fund Equity capital, Reserves & Surplus	Fixed assets Property, Plant & equipment, goodwill
Liabilities-Outsider’s fund Borrowings, suppliers to be paid	Working assets or current assets Investments, Inventory, receivables, Advances, Cash and Bank

 

• Income statement – A profit and loss account convey the revenue and profits generated during a period. An analysis of this statement will highlight the revenue and profit and margin trends. The earnings per share of the company, the dividend paid and the retained earnings are recognized in this statement. Income-expenditure=Profit

 

Expenditure	Revenue
Direct expenses related to operating revenue or sale	Operating revenue or Sales
Indirect Expenses Administrative, Selling and distribution expenses, depreciation, Interest & taxes	Other incomes
Profit or Loss
Dividends, Retained earnings etc.

 

• Cash flow – This means the inflow and the outflow of cash from business activities. There are three broad ways a cash flow can be classified; cash flow from operations activities, cash flow from investing activities and cash flow from financing activities. The total sum of the three is the overall cash generated during the year.

• Cash flow from operations- Cash flow from operations is the cash generated from buying selling goods and managing payables and collecting money. The greater the cash flow from operations better it is for the company. 

 

• Cash flow from investing activities- this shows how the company has invested the cash inflows from operations and financing activities into assets. Cash outflows can be the sale of assets or investments. 

 

• Cash flow from financing activities- shows the inflow of money through borrowings or capital raised. Outflows like loan repayment, capital reduction through buy-backs, dividends paid on interest on borrowings are part of this.

 

Cash flow from operating activities	Cash flow from pure business activities. Involves revenue and expenditure and collections and payables
Cash flow from investing activities	Outflow: Investment of cash from operating activities and financing activities; Inflow; Sale of assets, sale of investments, interest and dividend income
Cash flow from financing activities	Inflow: Sourcing of funds like capital, borrowings, payment of interest, dividends etc. Outflow: repayment of borrowings, buybacks, interest on borrowings, the dividend paid to shareholders

 

• Ratio analysis- ratio analysis is a method where elements of the balance sheet, profit and loss accounts and cash flow statements are analysed by studying them as numeric ratios. Ratio analysis shows the company’s vital health parameters. It also helps in understanding the relative valuation of the company.

Solvency & leverage	Helps in analysing the assets and liabilities of the company and checking if the company is financially strong
Liquidity	Helps in understanding the immediate liquidity position of the company.
Profitability & returns	Helps in understanding how profitable a company is and what returns is it generating for the equity shareholders
Activity	Helps in knowing how efficiently the assets are put to use for generating revenue and cash. They are also known as efficiency ratios
Valuations	Helps in understanding the relationship of market price with the key elements of financial statements. It tells us about market perception. It tells us if a share is available cheap or expensive. It is relative to another company in the peer group
Cash flow	Helps in understanding the relationship of cash flows with the other elements of the financial statements. Comparing this with the previous year’s data helps in identifying the cash-generating capacity

Valuation

Price and value are two different ideas. While price is easily available value has to be evaluated or estimated. This difference between price and valuation needs to be understood. The price at discount or premium to value is at once a challenge and an opportunity. As aptly put by Benjamin Graham “Price is what you pay; value is what you get”.  There are three approaches to valuation: cost-based, market-based and discounted cash flow based. We shall look at these in detail as we progress.

Cost-based	Also known as the net assets value (NAV) this approach uses either book value or the fair value of the assets. This is based on the idea of the cost of creating an asset
Market-based	Also known as relative equity valuation as valuation is arrived at relative to another listed stock within the industry. P/E, P/BV, EV/EBIDTA are a few valuation ratios used to arrive at a valuation
Discounted cash flow based	This involves the projection of future cash flows and discounting them at an appropriate discount rate to arrive at a valuation

Conclusion

Fundamental analysis is an approach used for long term investment. It is a reasonably exhaustive study for an investor to make an informed decision. Analysing data brings objectivity to the decision-making process. Any shortcomings or over-optimistic statements of management can be corroborated with the historical and current data. While it has its advantages, it can be tedious and time-consuming. Also, many futuristic assumptions can go wrong and distort the valuation arrived at. Nevertheless, it is good to be informed than shoot in the dark

Frequently Asked Questions (FAQs)

What is fundamental analysis?

Fundamental analysis is a process of arriving at the value of a security

 

What is the difference between price and value of a security?

Price and value are two different ideas. While price is easily available value has to be evaluated or estimated. “Price is what you pay; value is what you get”. Value is the worth of a security. Simply put you buy an asset today assuming it is worth more than its current market price. 

 

What is financial analysis?

Financial analysis the core of fundamental analysis. Analysis of the financial statements like balance sheet, profit and loss account, cash flow statement and ratio analysis to arrive at the value of a security is the backbone of fundamental analysis.