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What is Fundamental Analysis in Stock Market? Step by Step

  • Marisha Bhatt
  • Nov 04 2021
  • 7 minutes
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Investment in stocks has become a very important part of a person’s portfolio as the returns offered by equities have the ability to surpass returns by other traditional means of investment. However, simply taking a plunge in stocks is dangerous without having any knowledge or understanding of the markets. Analysis of stocks is the basis of investing or trading in stock markets. There are two aspects to such analysis, fundamental analysis and technical analysis. 

While both are crucial aspects in stocks, let us learn about the fundamental analysis of stocks in this article and the related information.

What is the meaning of fundamental analysis of stocks?

Fundamental analysis of stocks is the analysis of the basic company profile and studying the financials of the company. It involves careful study of various important ratios and its comparison of the company on a peer as well as industrial level. The performance of a company and its stock prices are affected by the macroeconomic and the micro-economic factors in play. Fundamental analysis involves the assessment and evaluation of all such factors affecting the growth and performance of a company which is believed to be reflected on its stock prices. 

Why is fundamental analysis important?

Fundamental analysis is the key to understanding the relative position of the company’s stock to its fair value. As mentioned above, it involves measuring and evaluating the key ratios of the company against its past performance as well as against its peers and industry average. It is the true assessment of the financials of the company to determine the future growth prospects and the relative stability of its stocks in the markets.

Fundamental analysis uses various tools like financial reports, the earnings of the company as well as the financial ratios like PE Ratio, PB ratio, debt equity ratio, return on capital (ROC) and return on equity (ROE), etc. to assess the intrinsic value of the company. If the market price of the company is higher than the intrinsic value then the stock is considered to be overvalued. On the other hand, if the market price of the stock is lower than the fair value of the shares, the stock is considered to be undervalued. It is a good opportunity for investors to buy this stock as the share price will increase in the future. 

What are the types of fundamental analysis?

There are two important aspects to fundamental analysis, qualitative and quantitative analysis. These aspects are discussed below.

a. Qualitative analysis

Qualitative analysis is the analysis of many unquantifiable or intangible factors important in the analysis of a company. Some examples of such factors are,

  • Economic analysis
  • Industry analysis
  • Management experience and expertise
  • Competition
  • Product reach and adaptability

b. Quantitative analysis 

Quantitative analysis is analysis of the company is the evaluation of the company’s financial statements based on various financial ratios. These ratios provide information about the financial health of the company and its relative market position. The calculation of these ratios is complex and requires thorough knowledge and understanding for its interpretation.

What are the steps in fundamental analysis?

There are various components in the process of fundamental analysis. Some of the basic steps are mentioned below.

  1. Understanding the company basics and its products
  2. Analyzing the financial reports and the ratios of the company
  3. Reviewing the debt and capital levels of the country and analyzing the financial viability of the company
  4. Keeping a check on the competition of the company 
  5. Analysis of the growth prospects and the capital requirements for the same
  6. Review of all the parameters from time to time to check the relative performance of the company in comparison to its past.
  7. Together with these factors, an investor will also have to take into account general economic factors in the country and around the world, depending on the products and services offered by the company.

What are the various ratios involved in fundamental analysis?

Fundamental analysis is the qualitative and quantitative analysis of the company. As mentioned above, quantitative analysis requires the analysis of the company based on various ratios. Some of the key ratios used in the fundamental analysis of any company are tabled below.

Ratio Formula
EPS (Earnings per share) Earnings (Net profit) of the company / Number of outstanding shares of the company
PE ratio (Price to Earnings Ratio) Current market price of the share / Earnings per share
PB Ratio (Price to Book Ratio) Current price of the stock / Book Value of the company
DE Ratio (Debt Equity Ratio) Total debt of the company / Total Equity capital of the company
ROE (Return on Equity capital) Net Income of the company / Number of outstanding shares of the company
Dividend Payout Ratio 1 – Retention Ratio, or,Dividend per share / Earnings per share

What are the pros and cons of fundamental analysis?

Some of the basic pros and cons of fundamental analysis are mentioned hereunder.

Pros

Some of the advantages of fundamental analysis are detailed below.

  1. Fundamental analysis is the basis for long-term investment decisions as it takes into account the core financial aspects of a company. 
  2. It helps in differentiating between quality stocks and stocks that may not stand the test of time. 
  3. Fundamental analysis helps in understanding the macro factors as well as the micro factors affecting the growth and performance of the company like the current economic condition, industry and competition analysis, etc. 
  4. It helps highlight any shortcomings or wrongdoings of the company that can affect its market position and the ultimate impact on the share prices.

Cons

The various shortcomings of fundamental analysis are detailed below.

  1. Fundamental analysis is a time-consuming and complex process and there are no shortcuts that can get the detailed analysis to the investors. 
  2. It requires a thorough market and knowledge and understanding of the company data which can be difficult for average investors.
  3. Fundamental analysis is based on hazard facts and it does not take into account the market sentiment or market trends that often drive the stock prices.

Conclusion 

Fundamental analysis is the first step in analyzing a stock for investment. It requires a detailed analysis of the company on an individual level as well as industry level to make a correct decision regarding the viability and profitability of the company. 

FAQs

Can fundamental analysis be used for short-term investment analysis?

Fundamental analysis is usually used for long-term analysis of the company and its stock movement.

 What are the two basic types of analysis of a stock?

The two basic modes of analyzing a stock are the fundamental and technical analysis of the stock.

What are the core considerations in the fundamental analysis of a stock?

The core considerations in the fundamental analysis of stock are,
-Comparison of the sales and the revenue of the company with its past performance,
-Considerations of the future growth prospects 
-Management approach towards the employees of the company

Is it sufficient to carry out only quantitative fundamental analysis of the company?

 No. Quantitative and qualitative aspects of fundamental analysis are both equally important and are mutually exclusive.

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