What we do when we say that we are doing fundamental analysis of stocks We actually study the underlying business of that stock. To understand the need of fundamental analysis of business, let’s take a small example.
Suppose you want to eat a chocolate, what you will do? You will go to the market and take a bite of KitKat or have a Munch. This is easy, and this is the way everybody buy chocolates in this world.
But suppose you want to buy the company itself which manufacturers KitKat and Munch. What you will do now? For sure, buying Nestle (the company) will not be as simple as buying its end products (kitKat). Why? Because capital required to buy a company is very large.
But apart from the capital limitation, as an investor we must also be careful buying in buying Companies. Why? The reason is simple, we should limit ourselves to buying stocks of fundamentally strong companies.
What is Fundamental Analysis?
Fundamental analysis is broad study of business. Here not only the impact of underlying business on its stock price is studied, but the outside influence (like of economy) is also considered.
Who does fundamental analysis? Fundamental analysis is for those investors who wants to buy stocks of business and hold them for long-term.
Why such investors prefer fundamental analysis? Because fundamental analysis is a method which tells the investor that the business he is considering for investment is strong or weak. When holding period is long (3+ years), it is essential that the underlying business of the stock is fundamentally strong. Why? Because price of stocks of such companies tend to appreciate with time when held for long-term.
It is also important to note that our stock market is also full of low quality stocks. So on one hand we have fundamentally strong stocks, and on other hand we have a plethora of weak stocks. As an investor it is our responsibility to differentiate between weak stocks and fundamentally strong stocks. Fundamental analysis is that strategy that long-term investor use to differentiate between weak stocks and strong stocks.
Once this clarity is achieved that a particular stock is fundamentally strong, the next step is to do is its price valuation. Price valuation is a process which is a part of fundamental analysis of companies. In price valuation the analysis is done about the current market price of the stock. Here the current price is compared with the intrinsic value of the stock.
What is intrinsic value?
Intrinsic value is that ‘fair price’ that an investor should pay for a stock to buy it. An investor who pays more than the intrinsic value has a chance of making losses in times to come. Why? Because buying stocks above intrinsic value means buying an overvalued stock. Price of an overvalued stock has a tendency to go down instead of going up in future.
Hence as a part of fundamental analysis, investor is obliged to do two things:
- First: Before investing, the investor should confirm that whether the stock in consideration has an underlying business which is strong, or weak. Idea is to buy stocks of strong business and avoid weak companies.
- Second: Buy stocks of only those companies whose current price is trading at levels below its intrinsic value. As a part of fundamentals analysis, analysis also estimate intrinsic value of stocks.
Fundamental analysis is complicated?
It is true that fundamental analysis of stocks is not as easy as reading and comprehending financial ratios. Having said that, I will also like to confirm that fundamental analysis can be learnt by anybody. It is complicated for people who have not trained them self for the process. Training oneself is easy and it can be done with a little bit of practice.
In this series of articles our objective will be to provide a platform for the readers to train themselves in the process of fundamental analysis. Initially the learning maybe slow for new bees. Why? Because they may be learning few things which they are doing it for the first time. But as they proceed with this article they will begin to realise that the process is not as difficult as they thought.
I am sure by the end of the series, they will become so conversant with fundamental analysis that they can read financial reports of companies and make a first impression about them.
Fundamental analysis is a skill that that not many people in this world can boast about. So it will be a lot of fun to learn the process of fundamental analysis and also to make use of it in buying few good stocks for the investment portfolio.
Requirements to do fundamental analysis of company
There are few things that will be required when you start learning the process of fundamental analysis. Here is a list of three things that you must have in front of you so that you can start learning in a more holistic way:
- Financial reports: The best document where you will get financial reports if from annual reports of companies. Download the complete annual report of a company from their website. Best will be to download at least two years annual report.
- 10 year data: downloading 10 year annual reports from a company website maybe easy but it is very difficult to read all of them. What I do personally is to download annual report for two years and I also refer the 10 year financial reports from websites like moneycontrol, economic Times etc. I copy the 10 year data from website like moneycontrol and paste it in my excel sheet.
- Excel sheet: Reading annual reports, and reading 10 year financial data is not enough. It is also important to comprehend the numbers which we read in these reports. How to do it? It can be done in Excel – by performing few calculations. Calculations can also be done using your calculator but an excel sheet makes the calculations more organised and easy to refer after we are done with the job.
Annual report is an official document published by the company for the existing and potential shareholders. If an investor wants to know about a company they should look into the annual report. It will not be an overstatement to say that an annual report virtually contains almost every information about the company.
How reliable is the information published in the annual reports? The reliability of the annual report is very high. Why? Because almost everything that is published in the annual report is scrutinised by a certified auditor. Specially the financial data published in the annual reports are audited numbers. It is legally binding for the auditors to certify and approve the sanctity of information published in the annual reports.
Hence we can say that, though annual reports are published by the company, but they will dare not publish any wrong information inside it. Why it is so? Because any wrong information will be first caught by the auditor. If not auditors, then this being a public document, maybe caught by other higher authorities.
Generally speaking the reliability of annual reports is paramount. There are other companies like money control et cetera which also publishes financial reports of the company. But a long-term investor should prefer to pick data from the company’s published annual reports.
Important Information Inside Annual Reports
Annual report is a very detailed document. People who are not used to reading financial reports may find it overwhelming to read annual reports.
It is advisable to read it not like a free-flowing novel but rather as as chapters in a college text books. There are few sections in the annual reports which are very important, and there maybe few sections which are less important than others.
From the perspective of investor, it is important for them to know that which sections of the annual report is more relevant and important for them to read. This article will try to highlight those sections which investor should never skip and give more time in reading those sections.
Just for example we will use the annual report of Tata steel in this blog for referencing various sections of annual report.
The overall idea of writing this article was to give a feel to my readers about how to read annual reports of a company. What I am going to explain here is how I personally read this report. I am sure, more knowledgeable people will have a different approach of reading this document.
There is a reason why I am using Tata steel’s annual report as reference. The way Tata steel prepares this report is unparalleled. It is one of the best structured, and one of the most honest and transparent reports that is published in India.
After reading the annual report of Tata steel, you will feel that you know the business of Tata steel to a reasonable clarity. This should be the objective of the report. It should give confidence to the investor that the company that they are seeking to invest in his worthy of their confidence.
Even before I start reading the annual report of a company I make sure that I have a notebook and a pen on my table. As I go about reading the report of a company I make it a point that I keep taking notes about important things that I read in the report.
I may not read the annual report strictly from page one to page last because I have my own structure based on which I may open certain sections before the other. So let me give you an idea about which sections I read first and which I leave for the last.
- Introduction about the company: in the initial 10-15 pages of the annual report the company talks about itself. In these sections of the annual report enough information is given about the company to the shareholders so that a decent first impression can be made. By going through the first 10-15 pages of the annual report you will start to understand the nature of the business, who are the people who run the business, where are its facilities located, is it’s turnover profit net worth etc. This is that section of the report where I find myself taking most number of notes.
- Message of the Management: Generally a short story about the company is presented here by the chairman and also by the managing director. These are two most important people in any company. As an investor we should read into every word they speak. To me how the chairman and managing director speaks gives lot of insight about how the business is operated on date to day basis. These two people not only speaks about the past but also about the future prospects of the business. Yes it is often interesting to read into their mind.
- Financial Statements: generally the annual report ends with financial statements. For an analyst, perhaps financial statements are the most important portion of the report. In this section, profit and loss statement, balance sheet, and cash flow statement of the current year versus the last year is presented for the investors. In the study of fundamental analysis of companies we will learn to study in detail about how to read these three financial reports.