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Why is Fundamental Analysis Important for Investing in Stocks?

Why Fundamental Analysis Is Important

Investing in the stock market is not a blindfold game, either short-term or long-term there are certain criteria and parameters based on which stocks are picked. For intraday trading or day trading, you can completely rely on technical analysis.

Also Read: Is Technical Analysis Useful or Useless or Enough for Trading

But for medium to long-term investment, you have to analyze the fundamentals of the company. Even traders also consider the latest fundamental factors while choosing stocks for intraday trading. As fundamental analysis and technical analysis, both play an important role in the stock market. So today we are going to discuss about the importance of fundamental analysis while selecting the stocks for the investments with its various components.

Also Read: How to Do Intraday Trading: Best Stocks, Charts & Strategies

What is Fundamental Analysis in Stock Market?

Fundamental Analysis is the process of analyzing the fundamentals of a company to determine its intrinsic value. To analyse the fundamentals, economic, industry, financial, non-financial and various other qualitative and quantity factors are considered.

During the fundamental analysis, the economic condition of the country is analyzed with respect to the company's business operations in domestic and internal markets. The sector analysis is done to know the domestic political environment, the regulatory framework of the Government towards the industry's current financial conditions and competitors analysis.

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

After analyzing and considering all these related factors that can affect the business operations and performance of the company, the stock value of the company is evaluated using a certain valuation method to make the decision for the investments. And for medium to long-term investment, fundamental analysis is a very important factor to consider.

Why is Fundamental Analysis Important in Investing?

Fundamental analysis helps to know the latest fundamental and financial conditions of the company based on that you can find out the fair price value of the stock. From the investment point of view, it also helps to predict the long-term trend in the stock, and according to that you can buy sell or recommend investing in the stock from a long-term perspective.

Using the fundamental analysis when you evaluate the fair price of stocks, you can compare the same with the current market price, whether it is overvalued or undervalued, and based on that you can decide to invest or exit from your holdings in that stock. While analyzing the fundamentals of the company you get to know about the promoters and top management of the company their qualifications, experience and shareholdings and other corporate actions.

Also Read: Five Corporate Actions and Its Impact on Stock Prices

And while analyzing the finances you can find out the revenue and net earnings growth of the company. Based on these data you can evaluate the stock price and also compare the same with the nearest competitors. Similarly, there are various factors and components of fundamental analysis that are considered and used while performing this process.

What are the Components of Fundamental Analysis?

In fundamental analysis, there are various components that are analyzed and correlated with each other to find out the impact on the stock price of the company. The components of fundamental analysis mainly include financial ratios that are calculated and evaluated to compare with listed rivals and find out whether there is scope for investing or not. Though, there are various other components also included, let's find out what they are and their use.

Understanding the Business of the Company

You might know the industry or business overview of the company, but you have to minutely understand the business model and operational procedure of the company. What exactly company manufacture or offer the services for what kind of customers? Its manufacturing units or their locations and annual manufacturing capacity to produce.

You also need to understand the international market if a company exports or its product offerings are in overseas countries. You can find all this information on the official website of the company and annual reports published by the company yearly.

Management of the Company

The growth and profitability of the business of any company are also highly dependent on the management of the company. Yes, in fundamental analysis you also need to know about the promoters, board members and other top management of the company.

These are the key pillars of the company that make the right decisions in operations and strategic growth of the company and its revenue. Also check their background, and previous track record if appointed independent director in other companies and worked at a senior level in other divisions of the company. Also, check the corporate governance of the company.

Studying the Financial Statement

Now one of the most important parts of the fundamental analysis is analyzing the financial performance of the company. The stock price movement of the company is directly affected by the revenue growth and net earnings of the company.

In the financial statement, you have to check the compounded annual growth rate (CAGR) in the last three to five years. Calculate the CAGR or revenue, operating profit and net profit of the company, and if possible compare with the rivals, what is the growth rate?

If the revenue and earnings of the company are consistently growing means the company is doing well and has the potential to grow in the coming future. Also check the operating margins and net profit margins, whether it is increasing, decreasing or maintained by the company and also check the operating cost is increasing and key expenses like interest etc.

Check the Financial Health of the Company

After checking and analyzing the revenue and earnings growth also check the financial health of the company. Here you have to analyse the balance sheet of the company, how much the company has debts, assets and liabilities and check the cash flow statement.

Here various financial ratios like profitability ratio, liquidity ratio and solvency ratios are used to find out the health condition of the company. To analyze these ratios you must know about taking accurate data and calculating with the right formula. Fundamental analysts have a thorough knowledge of such things hence, they can easily evaluate the same.

Evaluating the Stock Price for Valuation

Finally, you have to check the valuation of the stock price of the company which is a time-consuming and critical process that also requires special knowledge and experience to perform. Discounted cash flow (DCF) analysis and Price-to-earnings (P/E) ratio are the popular valuation techniques that are used to find out the intrinsic value of the share price of the company.

After evaluating the intrinsic value of the share price of the company you can check with the current market price of the company. The valuation techniques are also useful to compare the stock price with sector PE and other competitors of the company.

Finding and Analysing the Competitors

And if you are looking to invest in a company of any particular sector, after evaluating the stock price of a company also analyse and compare the valuation of other competitors so that you can pick the best stocks in your portfolio for long-term investment.

Analyzing the competitors is one of the key points to know whether the company is performing better or underperforming in the industry. And in a highly competitive market, there is too much pressure to perform better and keep the growth momentum in the revenue and earnings. All these factors are reflected in the stock price of the company.

Key Points of Fundamental Analysis

As we have already told you checking the financial performance and financial health of the company is one the most important factors while performing the fundamental analysis. However, there are a few key points important things you need to consider or check while analyzing the financial statement of the company. Let's find out what are they.

Key Things to Look for in Financial Statements for Fundamental Analysis:

Income from Core Business

The first thing you need to check is the main source of revenue of the company, whether it is coming from the core business operations of the company or it is earning from various undisclosed sources and showing the same under the other income heading.

Except, during some uncertain economic conditions a good company should earn the major revenue from its core business with the consistency in the revenue growth making such companies reliable and attractive from the investment point of view.

Check Unusual Other Expenses

All the companies incur various expenses like raw materials cost, employee salaries and other operational and promotional expenses. However, few companies show various undisclosed expenses under the heading of other expenses. Such companies do this kind of unsolicited practice to reduce their operating profit to minimize their tax liabilities.

Hence, check the other expenses are not too much or not rising abruptly, because any kind of illegal practice of showing unnecessary expenses can be identified by the relevant regulatory authorities resulting in legal against the company. Any kind of lawful action by such authorities against the company will also affect the stock price of the company.

Interest Payouts or Financing Cost

This is another important point you need to check while analyzing the financial statement of the company. The interest expense or financing cost is the cost of paying the interest on a loan borrowed by the company from the banks or financial institutions. If a company has borrowed excessive loans, then higher interest costs will directly reduce its net profits.

The high interest payments will directly impact the net earnings margins of the company, resulting the lower net income and eventually, the earnings per share or return on equity will be also low. This will make the stock price of the company costlier for investors.

Net Profit After Tax or PAT

The most important heading of the financial statement – the Net Profit also shown as Profit After Tax is the net income of the company after bearing all the expenses paying the interest on the loan and depreciating the value of assets.

You need to check the net profit growth of the company in the last three to five years, whether it growing decreasing or is its consistency in growth or not. Also check the net profit margins, whether it is improving or not, because it is not good for the company if revenue is growing and net profit is not growing at the same pace it means margins declining.

Calculate the Financial Ratios to Check the Financial Health of the Company

Apart from checking the revenue income and net earnings of the company you also need to check the financial health condition of the company. And it is possible with certain financial ratios that will tell you about the liquidity capability and return on the investments by the investors' money. Let's find out what are the key financial ratios.

Earnings Per Share (EPS):This is one of the most important sections for the investors or you can say for the equity shareholders. Yes, EPS means how much a company has earned in a financial year for each number of equity shares outstanding in the market.

Also Read: What is Equity Share: Types, Importance & How it is Calculated

EPS can be calculated by the net profit of the company divided by the number of outstanding equity shares. Higher EPS means the net profit of the company is increasing. EPS is also used to evaluate the stock price of the company using the PE ratio.

Price to Earnings (PE) Ratio: This is most simplest and most widely used financial ratio primarily known as the valuation ratio. The price-to-price-to-earnings ratio also called the P/E ratio shows the current market price of the stock is how many times of EPS. This means you can simply calculate the P/E by dividing the price of stock by EPS, and it is also used to compare with competitors.

Price to Book Ratio: This is another important valuation ratio that is mainly used for banking and financial companies. However, you can use this ratio to check the price against the book value of the company. It can be calculated by dividing the stock price by the book value of the company.

Debt to Equity Ratio: This important financial ratio shows the total debt of the company against the equity capital invested in the company. A higher ratio means that the company has invested a major portion of capital by borrowings resulting the high interest payments and less net earnings. This ratio can be calculated by dividing the total debt of the company by the total shareholders' equity.

Return on Equity Ratio: This is the amount of profit earned by the company by the total fund invested through the equity capital. A higher return on equity ratio means the company is capable of earning high returns on the capital invested through equity. This ratio can be easily calculated by dividing the net income of the company by the total shareholder’s equity.

Return on Net Worth: This is similar to the return on equity ratio and it can be calculated by dividing the net income of the company in question by shareholders’ equity. This ratio shows how much profit a company could generate from shareholders’ equity. However, the stock prices of the companies are not comparable in terms of the business cycle and industry, as the amount may not be relevant when comparing other companies based on their RONW.

Conclusion

Fundamental analysis is one of the very important factors while investing in stocks, however, it is mostly used when you are going to capitalize your money for the long-term investment. But intraday traders also check the fundamentals of the company to avoid any kind of uncertain movement in the stock price due to the company's related news.

Also Read: 7 Biggest Mistakes To Avoid While Doing Intraday Trading

Fundamental analysis not only helps to know about the company's management and its operational activities but also lets you know how much the company can pay off its debts or liabilities. Using the financial ratios you can find out the company’s liquidity capability condition, ability to earn on capital invested through equity shareholders etc.

And last but not least, using the fundamental analysis you can find out the intrinsic stock price value of the company. Comparing the current market price of stock and intrinsic value you can compare whether it is overvalued or undervalued. And according to that, you can decide to buy or sell the stock. However, for buying and selling stocks you can use the combination of fundamental analysis and technical analysis to get the best returns.

Also Read: What to Know Before Investing in Stocks: 10 Things to Consider

However, if you don’t know technical analysis or fundamental analysis which is better, you can get help from the market experts, who will apply the analysis techniques as per risk bearing capability and time horizon of the investment in the stock market.

Also Read: Top 5 Best Technical Indicators for Intraday or Day Trading

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