How to do Fundamental Analysis? - Basics of Positional Trade in share market
In this article, we are going to learn about some of the basics, tips, and dos and don’ts of positional trading (i.e. investing) in stock market. Our special focus will be on learning the art and science of fundamental analysis of a company.
- What is Fundamental Analysis?
- Aspects of Fundamental Analysis
- Some Tips related to Investment
What is Fundamental Analysis?
In Fundamental Analysis, we seek to analyze the strength and weakness of a particular company. Here our focus is not on the price of their stock or their chart. Rather, we do old style balance sheet analysis of a company.
Positional traders invest in a company for long-term, say months or even years. So, they kind of become part-owners of the company they invest in and think like one. If you are an investor, what kind of business/company will you like to invest in?
Aim of fundamental analysis of a company is to foretell whether it will grow in future and make profits. Only if it does so, will it be able to provide dividends to its shareholders and enhance the demand of its shares (which will eventually push up its price). If you can gauge the future of a company based on its present, you will earn handsomely by buying its stocks.
For this purpose, you may use tickertape.in, which is a stock screening tool. Select the stock of your choice, open it in a new window and analayze the Financials (Income, Balance Sheet, Cash Flow) and Peers (Valuation) tabs.
Aspects of Fundamental Analysis
In fundamental analysis, we need to focus on the following aspects of a company:
- Health Indicators of a Company
- Share Price Indicators of a Company
- External Indicators
Let’s have a look at all these three.
Health Indicators of a Company
Revenue and Net Income of the Company: More the revenue and net income, the better the company. Also observe whether they are increasing per year or not. However, just someone earning a lot is not sufficient. We must also check if that entity is in debt. (You can see this under the Income tab in Financials section of tickertape.in)
Compounded Annual Growth Rate (CAGR): It will tell you how the company has been growing over the past few years.
Asset/Liability analysis: More the assets and lesser the liability, the better the company. Even if a company has a lot of liability (e.g. debts), if it has enough assets, the shareholders can be assured that they will get their money back by selling those assets even if the company goes bankrupt. Also observe whether assets are increasing per year or not (in general, liabilities should not increase at a faster rate than assets). A company should have much more assets than it has liabilities. If they are in the same range than it is not safe to invest in that company. (You can see this under the Balance Sheet tab in Financials section of tickertape.in) You may also have a look at their Debt-to-Equity ratio (in general, the lower the better). Debt to Equity ratio of 2.5 or lower is considered decent and you may think about buying such stocks (below 1 would be good, and around 0 would be excellent).
Cash Flow: Cash flow is the money that a company has at its disposal – the cash it is getting and the cash that is flowing out. More the cash flow of a company the better.
Revenue is the money a company earns from the sale of its products and services. It may also include money earned from other sources, such as interest, fees and royalties. It must be more than the expenses for a healthy company. Revenue is reported on an accrual basis, i.e. it includes the sales have been made but have not yet been paid for (apart from the cash that has already been paid).
Profit indicates the amount of money left over after all the expenses have been paid. So, it indicates success or failure of a company. Profit/Loss = Revenue – Expenses.
Cash flow indicates the net flow of cash into and out of a business/company. It is more of a liquidity indicator, and is required for day-to-day operations of a company. Cash flow (i.e. Cash Inflow – Cash Outflow) must always be in positive, or else the company will not be able to operate properly. Cash flow is reported on a cash basis, and not on accrual basis, i.e. we only account for the actual cash that moves in or out of a company. Revenue = Cash Inflow + Invoices yet to be paid by the customers. Say a customer has purchased $100 worth of company products, out of which he has paid $50. So, $50 here is the cash flow, while $100 is the total revenue of the company. A company needs some cash flow so as to pay for raw materials, pay salaries, etc.
- Annual Reports and Investor Presentation of the company: Annual report gives us an in-depth knowledge of the company we are investing in. Investor Presentation is generally released by bigger companies only.
You should not blindly rely on the annual reports and balance sheet of companies. Sometimes, they may be tampered and not showcase the complete or true picture.
Also, companies often boost the value of the assets they have. For example, a company may show the value of a machine it has as $4000, even though its value may have depreciated over time and it may not even be worth $400 in the open market now. So, make sure that the asset-liability ratio of a company is healthy. If it’s near about 1:1, then it’s a red flag.
Share Price Indicators of a Company
There are thousands of companies listed on the various equity indexes. But some of the shares may be undervalued, while others may be overvalued. Every share that we buy on a price also provides us some value. Our aim as an investor is to buy a stock that provides us much more value than the price we have to pay to buy it. So, here our aim is to find the undervalued shares and buy them. Once everyone else recognizes their value in the future, their prices will definitely increase. For this purpose, we use various indicators.
Kindly note that even a cheap share can be overvalued, and even an expensive looking share may be undervalued. For example, if a Rs. 20 share has only a value of Rs. 10, then it is overvalued. And if a Rs. 200 share has a value of Rs. 400, then it’s undervalued.
- P/E Ratio: This is Price to Earning Ratio. The P/E ratio is calculated by dividing the market value price per share by the company’s earnings per share. Lower it is, the better. For example, if P/E ratio is 8, then it means that to earn Rs. 1 per annum, you will have to invest Rs. 8. So, in 8 years you will get your money back. Ideally, you should not buy a share that has a P/E share higher than 25 (until and unless there are some other very strong bullish indicators that suggest that its price will rise substantially).
Some shares having very high P/E ratio are also very much in demand and that’s why their share value keeps on rising. That’s because price of a share is dependent on demand-supply ratio, and not P/E ratio. But as per Warren Buffet, we must only buy those shares that are priced at a rate that is lower than their intrinsic value. You may find the intrinsic value of a share, as well as P/E ratio, on tickertape.in
Also, do have a look at historic P/E ratio of that company, and the average P/E ratio of the companies in that sector too. It will provide you an even bigger picture.
If you can get some idea regarding the companies whose P/E ratio is about to expend (i.e. increase) in future, then you will become share market guru (if P/E ratio increases after you have bought the share, it will be beneficial for you. It will mean that the price of share has increased much more than the actual growth of the company – the share market has disproportionately rewarded the company – good for you as an investor!).
- P/B Ratio: It is the market’s valuation of a company relative to its book value. The market value of equity is typically higher than the book value of a company. P/B ratio is used by value investors to identify potential investments. P/B ratios under 1 are typically considered good and solid investments. You should avoid buying shares having P/B ratio more than 2.
In laymen’s terms, Book Value = Assets – Liability. While calculating book value of a company we only consider its tangible assets. We do not and cannot assess the value of its intangible assets, e.g. the technology that the company has, its good will among customers or general public, its brand awareness, etc. That’s why P/B ratio is more useful in case of companies that have tangible assets, e.g. manufacturing companies. It may not be that good an indicator for technology-related companies (for such companies P/B ratio may be too high as these companies do not have big tangible assets, and so their book value is very small as compared to their market value).
- Return on Equity (ROE): ROE is net income (i.e. profit) from the firm’s most recent income statement, divided by the total shareholder equity. It’s another indicator that many experts use. It showcases how much the company is making its money “work”. The more it is, the better. Ideally, it should be above 50.
You may apply the filters of your choice on tickertape.in, and export the data of as many companies as you like into an excel file. Therein you may further apply some filters and shortlist the companies that fulfil your criteria regarding asset-value/market cap ratio, P/E ratio, debt/equity ratio, CAGR, etc. Thereafter you may further analyse those companies in much more detail, e.g. by looking at their shareholding pattern, etc.
Economic moat: It refers to a company’s ability to maintain competitive advantages to protect its long-term profits and market share from competitors.
Apart from all this, Chart analysis (i.e. Technical Analysis) of a company’s monthly charts is also useful. Yes, technical analysis is useful even in positional trading (and not just in intra-day trading). But make sure you have done fundamental analysis of a company before you do this.
Apart from all this we also need to have a look at some external indicators (i.e. factors outside the ambit of a company or its share price chart):
Management and Promoter: If management and promoters of a company have a substantial shareholding in that company, then it means that they are genuinely invested in the growth of that company and have confidence on its growth potential. However, if they are selling the stock, things might not be that rosy in the company. Promoters are the people who started the company, i.e. its founders. For example, Mukesh Ambani of Reliance, or Bill Gates of Microsoft, etc. While, management will be its board of directors, CEO, CFO, CTO, etc. To get the news that some big shareholder has bought/sold large chunks of shares, you may have to depend on some of your inside contacts, or you may track the big-bull/bear transactions on tickertape.in or some other similar website. There you will also get to see the overall shareholding pattern of the stock, i.e. the percentage of shares with promoters, mutual funds, retail investors, etc.
Peer Comparison: We can compare the company with similar companies in that sector (which are its natural competitors). It allows us to invest in the best company in a given field.
If you are a newbie, you should invest in companies that you have heard of, are aware of their business and products, etc. Apply common sense – sometimes it’s more useful than all the analysis in the world. See what the company is doing, how it works, the quality and popularity of its products. Put yourself in the shoes of the user of the product and services of that company, and ask yourself whether you will be satisfied with their product/service, their after-sale service, attitude of their customer care, etc. You will get your answer regarding whether that company will grow and make profits in future, and by extension whether you should invest in that.
Some Tips related to Investment
If you are interested in long-term investment in share market, there are a few tips regarding entry and exit that may come handy while decision making.
As per some stock market experts (e.g. Kunal Saraogi), Technical Analysis of charts is useful even in case you are investing in stocks for a long time. So, you can complement the fundamental analysis of the company/sector with the technical analysis of the chart of the stock.
The candlestick charts that investors study are of very long duration – say a candle representing one week, one month or more. All the concepts and philosophies remain the same, whether you are looking at a one-minute chart or a monthly chart. We have covered candlestick patterns in a separate article.
Some experts focus a lot on fundamental analysis, and dig a lot deeper than others. While others just do a basic fundamental analysis and then invest on the basis of technical analysis.
- When a stock has been moving sideways for a long time (months, even years), then it means that it has consolidated – only the people who really believe in that stock are invested in that stock, and all the weak hands have exited. Most of the times the people who remain invested for long in such a stock are learned people, who know that the stock will showcase a breakout soon.
- Also have a look at the trading volume of a stock. It there is a sudden rise in the traded volume, it signifies that some breakaway / trend change is about to come.
Some share market experts even combine the two – fundamental and technical analysis, and make their own models, which they follow to make investment decisions. However, as per some, it unnecessarily complicates the system. Rather than riding on two boats, they shortlist some shares based on fundamental analysis, and then finally invest in some of them based on technical analysis. In general, fundamental analysis will help you to invest early, but it will also force you to exit sooner than required. Technical analysis will delay your entry (because you will wait till the share shows a breakout), but will help you exit at the right time.
You must invest in a variety of stocks; if possible, from a plethora of sectors. Say, two stocks from Information Technology sector, 3 from Energy, 1 from Pharma, etc.
Also, even within the same sector you may diversify based on the strategy, cycles, target audience, etc. of the companies. For example, BMW may have a different target audience than Maruti, banks like HDFC, Kotak (conservative in lending, so low NPAs) have a different strategy than RBL, IDFC, (liberal in lending, so high NPAs) etc.
This will reduce your risk. Though it’s essential that you have some knowledge about the sectors and the companies you are investing in. So, diversification means that you will have to do a lot of research and invest some time and effort on this.
You need not consider thousands of stocks. Just focus on 10-15 stocks, and learn about them. The more you learn, the more you will get to know about the cycles of their business, and by extension the right time to invest in them or get out of them. You may aim to learn about 8-10 companies (preferably from 1 or 2 sectors) per year. Slowly your basket of shares will increase with your knowledge/information. Apart from studying the fundamentals of the company/stock, do also have a look at the monthly/weekly chart of the stock. Select the best-looking charts and invest with an adequate stop loss.
With time, some stocks may underperform and hit stop loss, but some of them will give you huge profits that will almost nullify your losses. Even if 80% of your shares end up in losses, the remaining 20% may give you profits big enough to make you rich.
If you are investing in some mutual stock, then your portfolio will automatically get diversified to a certain extent. Even here you may diversify across multiple mutual funds. (However, do not over-diversify – holding 5-6 mutual funds is good enough diversification)
Even if you are an experienced stock market investor, you will still choose some wrong stocks and make losses. Experts just make sure that the profits they make are huge, while their losses are small. So, risk-reward management is essential even if you are investing, not just when you are trading. In share market, safeguarding your capital and risk management are more important than making profits. Remember that!
There are two approaches of selecting a share:
- Top-down: Shortlist a few sectors and then select some good shares in each sector.
- Bottom-up: Select the company shares just on the basis of your fundamental and technical analysis (without regard to which sector they belong too).
You may do both too. Shortlist a couple of sectors wherein you see immense growth prospects, or if you are very much familiar with it.
For the remaining, you may just adopt a bottom-up approach. Afterall, it is a particular stock that you invest in, not the sector as a whole. For this you can:
- Go to a stock exchange website or read a newspaper, and have a look at the top performing shares. Investors may shortlist 500 shares from these. (While, traders may have a look at the bottom performing shares too, i.e. any share showing price momentum – up or down.)
- As the 50 stocks listed in Nifty 50 are very big, the profit margin in these stocks is very less. So, you may remove them from the list. (you can invest in these if you are very risk averse, and want to earn dividends instead.)
- Of the remaining 450 shares shortlist 200 shares. Remove the company that is under some investigation, whose products/services are bad or if you are not well aware of them, or if the growth prospects of that company seem bleak. That is, use your common sense + current affairs knowledge + fundamental analysis to weed out the bad, rotten apples.
- Apply your technical chart analysis on the remaining 200 stocks. Invest in 30-50 of them whenever you see an opportunity. Spread your capital, diversify your assets. It will also make it easier for you to stay invested in a share for long-term (and not unnecessarily get pressurized to make early profits on seeing huge amounts), and make the quanta of your loss small (if the price hits your stop loss).
The shares you select for investment and trading need not be the same. You need to prepare separate lists/baskets for these two.
In trading we look for stocks with big enough trading volume, and sufficient volatility to justify intra-day trading.
While for investment you look for stocks with strong fundamentals and long-term growth prospects (even if the trade volume is low and there is minimal volatility in prices).
We should enter and exit at multiple levels, i.e. in a staggered way. When we do this while a stock is falling, it is called Averaging out.
Entering and exiting at one price point is a risky game, as maximum of us do not know what the high and low of a particular share will be (this is decided and influenced by big operators). That’s why we buy and sell any share in multiple phases (like Systematic Investment Plan - SIP) and adopt this strategy of averaging out.
However, keep in mind to buy a falling share only if you are convinced that it has solid fundamentals and will rise again.
Traders should not average out when the price is falling, e.g. do not do averaging by shorting Nifty. It’s a big trading blunder. However, this article is about investment, so we will not talk much about trading here.
Learn when to exit a share
We have experienced in general, that a good share (and by good we mean a share that has growth potential) will not trade below 15% of its high price in the last year (if it’s a blue-chip company; for midcap companies this may be 20%).
So, have a look at the price of the share in the last 52 weeks. If it has never gone down below 15% of its highest price point during that time, it can be bought. Otherwise, sell it (if you already have it). For example, if a share X has a high point of Rs. 100 in the last 52 weeks, and it goes down below Rs. 85, then it’s not a good share. So, you may sell it. Cut your losses, as such a share may go down a lot. (Advise from Stock Market Expert – Vivek Bajaj)
However, you should also be able to resist the temptation of booking small profits. Sometimes, we see some profit and exit, while we wait for a long time while the stock is falling and end up making big losses. Our aim should be to maximize our profits and minimize our losses (easier said than done!). Sometimes, it’s more important to learn when to exit a share, than selecting the right one.
It is said that fundamental analysists are very good at entering a stock at the right time, but they suck at exiting. Technical analysists on the other hand are better at exiting a stock.
New investors may also do Swing Trading – invest in a stock for a few days and exit on a favourable swing. You may learn more about swing trading in a separate article of ours.
Beware of Cheap Stocks
Do not buy cheap stocks unless you have a strong reason to believe that they will rise. Cheap stocks are cheap for a reason!
Investing in cheap stock is a high risk, high gain game. Sure, you may gain big, but chances of losing money are even greater. (This advice is for investors. Long term growth of shares does not matter to traders.)
Even some cheap stocks may be overvalued, while some expensive ones may be undervalued.
In the initial years, when you are still leaning, you should start small. Do not invest too much in stock market in one go.
- Invest in phases, not in one go.
- Invest in multiple stocks – do not keep all your eggs in one basket.
- Invest small – even in long run, do not invest all your capital in share market. Diversify your capital in other instruments too, e.g. FDs, PPFs, bonds, bullion, etc.
Some market experts also follow the following rules:
- They avoid investing in government companies, PSUs, and companies having excessive government interference in management. That’s because their policy and management may change out of a sudden. So, they are hard to predict over a long-term.
- They avoid companies where the promoter has some political link. That’s because if they are hounded by their political rivals, their company may go down the drain pretty soon. Also, sometimes the balance sheets of such companies may be tempered with, so as to transfer some funds to their political masters or the political party.
- Some experts play it safe and only invest in blue-chip and MNC companies, even though there shares are expensive. (of course, the ones where you see a breakout, there is momentum and trade-volume in the share, it’s making high-bottoms, and if it is trading above major levels).
- Investors should track/monitor at least 200-700 shares, to look out for investment opportunities. (While traders can aim to track 50-200 shares)
Whether you are a common person with no financial knowledge, or even a trader, it’s a good idea to learn about the basics of investment in share market. It provides us the best of both the worlds – it gives us better returns than FDs, PPFs, bonds, etc., and yet it is safer than trading (intra-day, futures, options).
People often overcomplicate stock market analysis, whether fundamental analysis of a company or technical analysis of the chart of a stock. Of course, you have to invest some time in learning its basics, but it’s something that can easily be done by yourself, especially in this information era.
You can do it yourself – just read articles, watch YouTube videos and practice. Need not even join a training class. But if you have to, even that can be done from the comfort of your home.
And remember – most of the rich people invest, not trade. Even traders slowly start investing in stocks for long-term, once they have earned enough money. Here, you also get bonuses and dividends. Trading makes you money, but Investing makes you wealth!
When we invest in share market, we can gain via two means:
If the share price increases, or/and
If the company pays dividends. Dividend is basically your share in the profits made by the company. Generally, a company only pays out a part of its profit as dividends.
Keep in mind that not all companies pay dividends. Companies that do not pay dividends to their stockholders are called Growth Companies (as they utilize their profits in the growth of the company, rather than in paying dividends to the shareholders). Dividends are generally paid by large cap companies, i.e. the companies that have already grown a lot.
If you are interested in dividend paying companies, you may search them on Google or on any stock screener software. Apart from this, you should also be aware of a few technical terms:
Dividend Yield or Dividend-Price Ratio: Dividend Yield = [Dividend per Share / Market price of the Share] × 100
Dividend Percentage: Dividend Percentage = Dividend per Share / Face value of the Share. Face value of a share is the price at which it was launched (this is generally Rs. 10).
Dividend Rate, or Dividend per share or DPS: Dividend rates are expressed as an actual rupee/dollar amount (and not a percentage), which is the amount per share an investor receives when the dividend is paid. Companies may distribute dividends annually, semi-annually, quarterly, or even monthly.