Introduction To Fundamental Analysis of Stocks (Business)

What do we do when we say that we are doing a fundamental analysis of stocks We actually study the underlying business of that stock. To understand the need for fundamental analysis of business, let’s take a small example.

Suppose you want to eat 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 buys chocolates in this world.

But suppose you want to buy the company itself which manufactures 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 the 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.

This is what fundamental analysis does for its investors. It helps people to identify good business trading at fair price levels.

What is Fundamental Analysis?

Fundamental analysis is a 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 want to buy stocks of business and hold them for the long term. 

Why do such investors prefer fundamental analysis? Because fundamental analysis is a method that tells the investor whether the business he is considering for investment is strong or weak. When the holding period is long (3+ years), it is essential that the underlying business of the stock is fundamentally strong. Why? Because the price of stocks of such companies tends to appreciate with time when held for the 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 a strategy that long-term investors 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 its price valuation. Price valuation is a process that is a part of the 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. 

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What is intrinsic value?

Intrinsic value is the ‘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. The price of an overvalued stock has a tendency to go down instead of going up in the future. 

Hence as a part of fundamental analysis, the investor is obliged to do two things:

• First: Before investing, the investor should confirm whether the stock in consideration has an underlying business that is strong, or weak. Idea is to buy stocks of strong businesses and avoid weak companies.
• Second: Buy stocks of only those companies whose current price is trading at levels below their intrinsic value. As a part of fundamentals analysis, the analysis also estimates the intrinsic value of stocks.

Is The Fundamental analysis 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 learned by anybody. It is complicated for people who have not trained themself 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, learning may be slow for new bees. Why? Because they may be learning a few things which they are doing for the first time. But as they proceed with this article they will begin to realize 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 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 a few good stocks for the investment portfolio. 

Requirements to do a fundamental analysis of the company

There are a 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 is from annual reports of companies. Download the complete annual report of a company from its website. The best will be to download at least two years’ annual reports. 
• 10-year data: downloading 10-year annual reports from a company website may be easy but it is very difficult to read all of them. What I do personally is downloaded annual reports for two years and I also refer to the 10-year financial reports from websites like Moneycontrol, Economic Times, etc. I copy the 10-year data from websites like Moneycontrol and paste it into 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 a few calculations. Calculations can also be done using your calculator but an excel sheet makes the calculations more organized and easy to refer to after we are done with the job. 

Annual Reports

The 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 piece of 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 scrutinized by a certified auditor. Especially 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, 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, may be 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 publish 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

The 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 chapters in college textbooks. There are a few sections in the annual reports which are very important, and there may be a few sections that are less important than others. 

From the perspective of an investor, it is important for them to know which sections of the annual report are more relevant and important for them to read. This article will try to highlight those sections that investors 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 the annual report. 

The overall idea of writing this article was to give a feel to my readers about how to read the 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 to reading this document.

There is a reason why I am using Tata steel’s annual report as a 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 with 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 is 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 others. 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, its turnover profit net worth, etc. This is the section of the report where I find myself taking the most notes.
• The 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 the 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 a lot of insight into how the business is operated on a day-to-day basis. These two people not only speak 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, the profit and loss statement, balance sheet, and cash flow statement of the current year versus the last year are presented for the investors. In the study of fundamental analysis of companies, we will learn to study in detail how to read these three financial reports.