Fundamental Analysis: Introduction

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 by the company itself which manufacturers KitKat and Munch. What you will do now?

For sure, Nestle the company will not be as simple as buying its end products.


But why you have to be careful in buying Nestle? The reason is simple you don’t want to end up buying a company which is not doing good business.

In all probability, when a stock investor buy stocks, he/she essentially wants to buy stocks of a company doing good, profitable business.

A profitable company is not necessarily that that company which makes money for its shareholders.

Here the profitable company is that company which makes more profits for itself in comparison to its expenses. In normal terms such companies are referred a companies with high Margins (like Apple, Microsoft etc).

But more than the profit margin what is essential to substantiate before buying a nice stock, is to check if the company is doing a good business or not.

Good Business

Company which is doing good business, and is also profitable, automatically makes more money for its shareholders.

Hence investors, must look into companies business first as a priority. Money making for self will automatically happen.

But how to know if a company is doing good business or not? How to know if the company is profitable enough or not? This can be understood by doing fundamental analysis.

Not everybody likes to do an in-depth fundamental analysis of business. Who are these people?

There are those people who practice stock trading? They rely more on technical analysis of stocks, than on fundamental analysis.

Then who needs fundamental analysis?

People who want to buy stocks of good business, and also wants to hold it for long term (5-7 years). For such people, fundamental analysis is the tool that they must master.

The concept is like this, a company whose business is very strong, and is also run by able & honest managers, will automatically make more money for its shareholders in a long term.

It is also important to highlight here that all stocks which trade in the stock market or not doing good business. In fact there are only a handful of stocks which can be classified as good.

There are about 5,000 stocks which is listed in Bombay Stock Exchange (BSE). Out of these 5,000 odd stocks, at a given moment of time, roughly only 2-3% can be said to be doing a good business.

What does it mean? It means, majority stocks that is listed in stock exchange or not good to be invested in.

If one does not take care while buying stocks, they may end up buying a bad stock instead of a good one. This will eventually lead to loss making.

To prevent such a mistake to happen, one must think like an investor. Learn to do fundamental analysis of stocks.

How to think like an investor?

It is important to realize that trading and investing in stocks is not the same thing.

People who buy stocks today and sell it in next days for small profits are trading in stocks. They are not investors, they are traders.

But investors do not buy stocks for making short term profits. Instead, they would like to purchase and hold stock forever, if its underlying business remain strong enough.

Investors are more inclined to build wealth by the process of compounding investment returns. A good business consistently makes profit. This in turn results in consistent growth of the shareholders wealth.

Generally investors (not traders), do not “assume” a lot before making their investment decision.

Investors tries to be as informed as possible about their preferred companies. This be accomplished by regularly studying the financial reports and annual reports of Companies. They also keep themselves updated about the trending news circulating about the company.

This is one quality of investors that separates them from traders.

In this world majority buy and sell stocks like traders.

Why I say so?

Because there are only a handful of people who first read companies balance sheets, profit loss accounts, and cash flow statements before buying its stocks.

If only one can start behaving like an investor, making large sums of money from stock market will not be a distant dream.

To realize this dream one must learn the skill of fundamental analysis.

Build Wealth

Wealth building by investing money can be slow process in the beginning.

People who are investing money must not be impatient.

Investing in stocks is not a quick money making process. It builds wealth gradually over a period of time.

Wealth building progress in a comparatively slower speed when one starts to invest money. But the long term results will beat even a sprinter.

Investing wisely, and then waiting for the long periods is the key.

In stocks, wealth building in fact happens automatically. Only care one must take is to buy a fundamentally strong stock at the right price.

If once investment portfolio is filled with such stocks, long term wealth building is going nowhere.

Not so obvious Attributes of fundamentally strong companies

Whenever I talk or write about the attributes of good companies, the first name that comes to mind is the Tata Group.

Comparatively, Tata Group runs its business in the most ethical way. And where does this ethics has taken Tata Group? It is the only hundred million dollar company in India.

Apart from the business ethics, other attributes that makes a company fundamentally strong is the quality of its top managers.

It is the top managers who build culture in the company. A company which is rich in culture will eventually capture more market and ensure high returns for all its stakeholders.

What other attributes that is required in a company?

How they protect interests of minority shareholders. For majority companies in India minority shareholders are treated more like insects. Time and again, below average dividends are thrown on their face to keep them interested.

But good companies never treat their minority shareholders interest like this. Instead, they think the opposite.

They consider that, if they can ensure the interest of a minority shareholder, interest of all other stakeholders will automatically be ensured.

The stake of promoters in the business, also talks a lot about whether a business can be considered fundamentally strong or not.

Promoters are necessarily those people who once started the business. But once the business matures, the same promoters lose interest and the exit by profit booking.

But consider this; a business is still going very strong. It has good probability to yield high future growth. Will the promoters still exit the business? Absolutely not.

A business in which the stake of promoters are high, are generally generally run in a more efficient and productive way.

I am not sure if this attribute can be correlated with business fundamentals or not, but I still like to make my point here. If the company’s Chairman/CEO/Top Managers displace there flamboyance by leading an extravagant lifestyle, its not a good sign.

There is a small hint hidden here. Probably, the companies accumulated wealth is not being used in a more productive way.

Obvious Attributes of fundamentally strong companies

What we discussed till now were the qualitative aspects to be considered while doing fundamental analysis of companies.

Now, what we will see are the quantitative aspects of a fundamentally strong company.

These are those attributes which are easily quantifiable.

These quantifiable attributes of company are generally available in companies financial reports.

What are these quantifiable attributes?

Sales growth, net profit growth, profitability, debt dependency of company, dividend history, shareholders equity growth etc.

All these quantifiable attributes can be analyzed by a potential stock Investor by use of suitable financial ratios.

Digging deep into the financial statements of companies, and establishing their financial ratios is one of the major component of fundamental analysis subject.

So let’s see how one can read and comprehend financial reports of Companies.

Next: Fundamental Analysis: Understanding Balance Sheets





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About the Author

Mani
I am a Blogger with a passion for investment education. I started blogging in 2007-08. Blogging didn’t happened to me as a coincidence, it was a conscious decision. The idea with which I started blogging still stands true. In my starting days my finances remained tight. I was reading heavily about how to manage finance. One day I got hold of a book which my father gifted me in 2003. It was stacked below my graduation books. It was a small-thin book with its cover named "Rich Dad Poor Dad".....more

2 Comments on "Fundamental Analysis: Introduction"

  1. Dear Mr.Mani

    You have put a lot of wisdom in such a coherent way in this article.

    Even though buying a share of Nestle is not like buying a Kit-Kat in the friendly neighbourhood grocery store, many innocent and unaware investors buy and sell stocks like that.

    I hope your sane advice will reach a wide audience.

    Thank you very much for the good efforts.

    I sure will return to your site.

    Thank you,

    With warm regards,

    Anand

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