An Overview of Fundamental Analysis

Gains and losses are intrinsic part of the stock market, especially for those looking to make a quick buck through trading. While studies have shown that equities tend to outperform all other asset classes over the long run, a key component that most market participants tend to overlook is the time frame - one needs to be invested in equities for the long term. This typically varies from three to ten years, depending on the company, the levels at which the shares were bought, and the overall performance of the equity markets during that period.

Why Long Term?

The reason why an investment in equities typically demands a longer time frame compared to other asset classes is that the movement in share prices tends to be non-linear. When investing in equities, an investor is essentially betting on the growth prospects of the company, which is expected to drive the value of its shares.

What Causes Share Prices to Move?

At the very core, earnings growth drives the share price of a company. However, a host of other factors can also influence share prices. These include several macroeconomic, industry-level, and company-specific factors. The analysis of these factors can be done in two ways:
 

a) Top-Down Approach
 

• This method starts with an analysis at a macro level, then moves to the industry, and finally delves into the details of the company. For instance, if an investor wants to evaluate shares of XYZ company in the steel space in India, here’s what the analysis would look like:
  • The investor would first assess India’s economy, including its growth, sovereign rating, political stability, and foreign investment inflows.
  • Next, the investor would examine the country's stance and reforms for the steel industry. For example, as a developing country, India's demand for steel grows at a higher pace compared to overall economic growth. Thus, a high-growth nation like India would ideally experience robust growth in steel demand.
  • A strong emphasis on infrastructure development and thriving capital expenditure from the private and public sectors would also support the industry.
  • Conversely, debt-heavy balance sheets of industry players, weak alloy prices, or high raw material costs could pose challenges for the industry.
  • Finally, the investor would study individual companies within the steel sector.

b. Bottom-Up Approach

• This approach works in the reverse manner of the top-down approach, starting at the company level, followed by the industry, and then the assessment of various macroeconomic factors.
  
  • Analysis at the company level is typically the most extensive and involves looking at several aspects. This includes the company’s growth history, corporate governance trends, balance sheet (including debt obligations), free cash flow generation, and fund utilization.
  • Additionally, the company’s standing relative to peers and how its stock is valued compared to the industry average and its peers are considered.
    o Other factors include the quality of management, brand value, technological usage and approach, and market reach.
  • This is not an exhaustive list, and analysts and investors may consider several other factors to determine the fair value of a company’s shares.

What is Fundamental Analysis?

• In essence, an investor or analyst tries to derive the value, referred to as the fair value or intrinsic value of the shares, through a combination of analyzing all these factors, with an emphasis on financial statements.
• Fundamental analysis can be either qualitative or quantitative. Quantitative analysis involves studying numerical data such as ratios, profit and loss statements, balance sheets, and cash flows.
• Qualitative analysis looks at non-tangible data such as the brand value of a company, its perception within the investor community, and the quality of its management.

What are the Advantages of Fundamental Analysis?

• For those looking to remain invested in the equity market for a relatively longer time frame, fundamental analysis can be extremely helpful as it enables well-informed decision-making.
• Investments backed by fundamental analysis can also help investors remain calm, especially during market corrections.
   

What are the Disadvantages of Fundamental Analysis?

• A comprehensive study of a company is a time-consuming process, and not all retail investors may be able to devote the necessary time.
• Even with fundamental analysis, investors need to stay updated with key events within the company and external factors that could impact it.
• Not everyone may have the knowledge needed to comprehend financial statements and determine whether and when they should invest in or exit a stock.

Conclusion

Investing in the stock market requires a comprehensive understanding of both the broader economic environment and specific company fundamentals. While short-term trading can often seem driven by luck, long-term investments in equities tend to outperform other asset classes, provided one conducts thorough fundamental analysis. This method, though time-consuming and requiring ongoing attention, equips investors with the knowledge to make informed decisions and withstand market volatility. By focusing on a company's intrinsic value and growth prospects, investors can achieve more consistent and substantial returns, emphasizing the importance of patience and diligent research in successful equity investment strategies.