The decision to invest or trade in the stock market comes when you have available funds in your bank account. However, market conditions should also be favourable as per your investment goals or trading strategy. But at the time of investing, you need to follow certain rules and principles, to pick the best stock and improve the chances of success either for short-term trading or for long-term investments.

For trading, you can use the technical analysis, while for investing you have to go through the fundamental analysis to find the right stock that has the potential to give your returns on investment. Using the fundamental analysis for investing is not an easy task, you must have knowledge of analysing the financial data. Here we are going to discuss how you can use the fundamental analysis for stock picking.

What is Fundamental Analysis in the Stock Market?

It is the process of analysing the financial health and economic conditions of the company. This analysis process helps the investors to evaluate the revenue, net earnings and financial ratios to find out whether the share price of the company is overvalued or undervalued. Based on the financial ratios you can find out the financial condition of the company its operation efficiency and future growth prospects.

Also Read: What to Research & Analyse Before Buying a Stock of a Company

In a nutshell, you can say it helps to find out the intrinsic value or fair value of the share price of the company that usually does not change every day or is not affected by daily market fluctuation. While performing this analysis you have to analyse the company, its fundamentals, industry trends and economic conditions of the country that can affect the performance and growth of the company.

What is the Purpose of Fundamental Analysis?

The fundamental analysis is mainly used to identify the true value of the stock so that you can get to know if the stock is trading at higher or lower than its valuation. This analysis procedure is done through various factors that includes quantitative and qualitative analysis.

For trading you, need to perform the technical analysis but if you want to invest in any company from the long-term perspective, you need to perform the fundamental analysis? Overall, the main purpose of the fundamental analysis is to identify the stocks of the companies that are fundamentally strong in which you can invest your money to get returns in the long term.

Fundamental Analysis Tools

In the fundamental analysis,various tools and techniques are used to find out the financial efficiency of the company. Mainly there are ratios used as a tool to calculate and find out the values for the analysis. These values are used to compare with other companies and find if it is undervalued or overvalued. Below you can find the list of ratios and other tools used in fundamental analysis.

Profitability Ratios: This ratio will let you know about the profitability aspect of the company. These include gross profit margin, operating profit margin and return on equity to measure the financial performance and efficiency of the company.

Solvency Ratios: This is another important ratio that will help you to evaluate the financial stability and long-term debt management of the company. Debt-to-equity ratio and interest coverage ratio are the popular ratios, used to estimate the solvency level of the company.

Liquidity Ratios: This ratio helps to know how fast and how much the company is capable of paying its short-term borrowing and liabilities. Under this, you can use to calculate the current ratio and quick ratio of the company.

Efficiency Ratios: This ratio tells you how effectively a company utilises its assets while conducting its normal course of business. You can use asset turnover and inventory turnover to find out the efficiency of the company in terms of utilizing its assets in business operations.

Valuation Ratios: This is one of the most important and useful tools in fundamental analysis that will help you find out if the stock is undervalued or overvalued. The price-to-earnings is the most popular ratio used under this ratio while the price-to-sales and Price-to-book (P/B) ratio can be also used for the valuation of the company.

How to Use Fundamental Analysis in Stocks?

To use of implementing the fundamental analysis in stocks is time knowledge-driven process. This means you should have the technical knowledge and experience to understand the financial ratios and other parameters that are used as a fundamental analysis tool. And the most important thing is after calculating these ratios you must have the interpretational and analytical skills to compare the values of these ratios with other listed companies and find the best stocks in the market.

Also Read: Technical Analysis vs Fundamental Analysis: Which is Better

Performing the fundamental analysis in stocks is possible while for other underlying securities like indices or derivatives products trading in the market, it would be not possible to use this type of analysis. Here you have to follow the technical analysis, the fundamental analysis can be applicable in analysing the valuation of the equity shares of the company using various financial ratios.

Steps to Use Fundamental Analysis in Stocks:

Step 1: First, you have to perform the screening process using the financial ratios.

Step 2: Now you have to review the financial ratio reports of the company.

Step 3:While reviewing the ratios, carefully review the financial reports of the company.

Step 4:Here you have to research and analyse the competitors of the company.

Step 5: Analyse the revenue and net profit growth (CAGR) of the company in the last five years.

Step 6: Analyse the operating and net profit margin of the company in the last five years.

Step 7: Check the earnings per share (EPS) growth of the company in the last five years.

Step 8: Now analyse and compare the company's debt against its competitors.

Step 9: Here you have to examine the future potential growth of the company.

Step 10: Now pick the best stock having strong fundamentals in the industry.

How to Pick Stocks Using Fundamental Analysis?

Picking the right stock on a fundamental analysis basis is one of the most critical processes. After screening, the few best stocks in the industry you need to analyse various financial ratios including the valuation ratio of the company. Once you compare the financial ratios you can compare them to find the best stock in the industry trading at a lower valuation with strong fundamentals.

However, the companies trading at lower valuations can have weak fundamentals or the financial health of the company is not running well. Here you need to consider the most important factors like checking the key financial ratios including the valuation of the company to pick the best one.

Important Financial Ratios for Fundamental Analysis:

Earnings Per Share (EPS):Net earnings of the company against the total number of outstanding equity shares will show you the EPS of the company. It shows how much the company is earning on each share and whether is there any growth in EPS in the last five years or not. EPS can be basic or diluted in which basic EPS includes current total outstanding shares, while diluted EPS includes new shares the company issued in the last financial year.

Debt to Equity Ratios: This is the total debt fund invested in the company against the total equity fund invested in the company. This ratio translates the total liabilities of the company against its shareholder equity. A higher ratio shows more risk while a lower the ratio means company is majorly using the equity funds to fund or meet the financial obligations of the company.

Return on Equity Ratio: The rate of return on the total funds invested in the form of equity showing the company’s proficiency to generate profits from its shareholders’ investments. You can use this ratio to compare the capability of the company to give returns to shareholders in terms of equity.

Price-to-sales Ratio: This is another valuation ratio that expresses the total value that investors are paying for every rupee of the company's revenue or sales. You can calculate this ratio by dividing the market capitalization of the company by the total revenue of the company for a specific period (Last 12 months).

Dividend Payout Ratio: Listed companies distribute some part of their profits among their shareholders and this is usually done through dividend payouts. These payouts are done after every quarter's financial results are declared, though few companies do them annually. When the net income of the company is divided by the total amount of dividends, you will get to know the ratio of how much the company paid from its earnings.

Dividend Yield Ratio: This is one of the most important ratios especially if you are looking for fundamentally strong stocks paying a high percentage of dividend every year. When you calculate the total dividend you received in a financial year against its latest market price share, you will get a dividend yield ratio. A high dividend yield means the company distributes a higher portion of its profit among the investors, while, a low dividend yield means some companies keep the portion of profits for future expansion of the company.

Projected Earnings Growth: While considering the fundamental factors, this could be another important factor helping you to know the expected growth in the earnings of the company. It shows how much you have to pay for each unit of future growth of earnings of the company. And to calculate this ratio you can divide the P/E ratio by projected growth in revenues. A stock having a lower PEG ratio is fundamentally stronger than the stock of a company having a higher PEG ratio.

Price-to-Book (P/B) Ratio: Book value is the value of each asset deducted by cumulative depreciation. And when you compare this book value with the share price of the company, you get the P/B ratio. If the P/B is more than one it means the stock is overvalued, while P/B less than one indicates the stock is undervalued. Using this ratio in fundamental analysis is suitable for companies having higher liquid assets like finance companies.

Price-to-earnings (P/E) Ratio: Last but not least, in fact, one of the most important and most widely used financial ratios that are used in fundamental analysis to find out whether the stock is trading at a higher valuation or lower valuation especially when you compare with peers or industry P/E ratio. To get the P/E divide the stock price by EPS and a high P/E means the stock is overvalued having a low potential to rise in future. While low P/E means the stock is undervalued and has a high potential to go up in the future.

When to Use Fundamental Analysis?

Technical analysis and fundamental analysis are the two types of analysis you can use while trading or investing in the financial markets. For intraday or short-term trading only technical analysis would be enough, while for long-term investment you need to perform the fundamental analysis. However, for the short term, you can also use the fundamental analysis to check if there is any economic event that can affect the share price.

Also Read: Types of Risks Associated with Investing in the Stock Market

However, long-term investors also use technical analysis to pick the stocks at the lower levels for better returns. However, it is highly recommended to use fundamental analysis to check the financial health of the company and find out if the current market price of the company is overvalued or undervalued. Before making the investment in such companies use the fundamental analysis and at the time of picking the stock use the technical analysis to know where you can pick the stock at the right levels.

Conclusion

Fundamental analysis helps to know the financial health and potential growth prospects of the company. Using this you will be able to know the performance of the company in terms of revenue growth and profitability efficiency. Based on the company's performance, its future growth prospects and evaluating the financial ratios you can find out the valuation of the stocks.

However, fundamental analysis is used when picking stocks for long-term investments. The company you find has strong fundamentals in terms of high revenue growth, high operating as well as net margins in the industry with a reasonable amount of debt and liabilities considered while selecting the stocks on a fundamental analysis basis. For valuation, you can use Price Book value and price-to-earnings ratios and stocks with low P/B and P/E would be a good option for investing with long-term outlook.