The Basics of Fundamental Analysis

Fundamental Analysis Definition

Fundamental analysis is a stock valuation method that uses financial and economic analysis to predict the movement of stock prices.

The fundamental information that is analyzed can include a company's financial reports, and non-financial information such as estimates of the growth of demand for products sold by the company, industry comparisons, and economy-wide changes, changes in government policies etc..

General Strategy

To a fundamentalist, the market price of a stock tends to move towards it's “real value” or “intrinsic value”. If the “intrinsic/real value” of a stock is above the current market price, the investor would purchase the stock because he knows that the stock price would rise and move towards its “intrinsic or real value”

If the intrinsic value of a stock was below the market price, the investor would sell the stock because he knows that the stock price is going to fall and come closer to its intrinsic value.

All this seems simple. Now the next obvious question is how do you find out what the intrinsic value of a company is? Once you know this, you will be able to compare this price to the market price of the company and decide whether you want to buy it (or sell it if you already own that stock).

To start finding out the intrinsic value, the fundamentalist analyzer makes an examination of the current and future overall health of the economy as a whole.

After you analyzed the overall economy, you have to analyze firm you are interested in. You should analyze factors that give the firm a competitive advantage in it’s sector such as management experience, history of performance, growth potential, low cost producer, brand name etc. Find out as much as possible about the company and their products.

Do they have any “core competency” or “fundamental strength” that puts them ahead of all the other competing firms?

What advantage do they have over their competing firms?

Do they have a strong market presence and market share?

Or do they constantly have to employ a large part of their profits and resources in marketing and finding new customers and fighting for market share?

After you understand the company & what they do, how they relate to the market and their customers, you will be in a much better position to decide whether the price of the companies stock is going to go up or down.

Having understood the basics of fundamental analysis, let us go into some more details.

When investing in the stocks, we want the price of our stock to rise. Not only do we want our stock price to rise, we want it to rise FAST! So the challenge is to figure out: which stock prices are going to rise fast?

Some stocks are cheap and some are costly. Some are worth Rs.500 and some are even worth 50paise. But the price of the stock is not important. The price of the stock does not make a stock good to buy. What is important is how much the price of the stock is likely to rise.

If you invest Rs.500 in one stock of Rs.500 and the price goes up to Rs.540 you will make Rs.40. However, if you invest Rs.500 in a 50paise stock, you will have 1000 stocks. If the price of the stock goes up from 50paise to Rs.1, then the Rs.500 you invested is now Rs.1000. You made a profit of Rs.500.

If you understand this, you can see that the price of the stock is not important. What is important is the rise in the stock’s price. More specifically the “percentage” rise in the stock price is important.

If the Rs.500 stock becomes worth Rs.540, then that is a 8% rise. This 8% rise only makes us Rs.40. On the other hand when we invest the same Rs.500 in the 50paise stock and the stock price goes up to Rs.1, it is a 100% rise as the stock price has doubled. This 100% rise makes us Rs.500.

The point is that when picking a company, we are interested in a company whose stock price will rise by a large percentage.

Please note: Looking at the above paragraphs, it may seem like a good idea to buy all the really cheap 50paise and Rs.1 stocks hoping that their price will rise by 100% or more. This sounds good, but it can also be really really bad some times! These really small stocks are very volatile and unless you know what you are doing, do NOT get into them.

However, the point to be noted is that we are interested in stocks that will have the highest % rise in the stock price. Now the question is, how do you compare stocks. How do you compare a stock worth Rs.500 to a stock worth 50paise and figure out which one will have a higher percentage rise.

How do you compare two companies that are in different fields and different industries? How do you know which one is fundamentally strong and which one is week?

If you try to compare two companies in different industries and different customers it is like comparing apples and elephants. There is no way to compare them!

So fundamental analysts use different tools and ratios to compare all sorts of companies no matter what business they are in or what they do!

Next let us get into the tools and ratios that tell us about the companies and their comparison....

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Why does a company issue stocks?

Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to "raise money". To do this, companies can either borrow it from somebody or raise it by selling part of the company, which is known as issuing stock.

A company can borrow by taking a loan from a bank or by issuing bonds. Both methods come under "debt financing". On the other hand, issuing stock is called “equity financing”. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way.

All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a stock, which is issued by the private company itself, is called the initial public offering (IPO).

It is important that you understand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments.

This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful - just as a small business owner isn't guaranteed a return, neither is a shareholder. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn't successful.

It’s a tricky game!

Note that: There are no guarantees when it comes to individual stocks. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends. Without dividends, an investor can make money on a stock only through its appreciation of the stock price in the open market.

On the downside, any stock may go bankrupt, in which case your investment is worth nothing.

Having understood this, we now want to know what makes stock prices rise and fall? If we know this, we will know which stocks to buy. In the next section we will try to understand what makes stock prices go up and down.

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How to make money in the stock market?

Inroduction

This article is a COMPLETE guide to the basics of making money in the stock market! If you are considering investing in the stock market, you MUST read this article! We have explained all the concepts and talked about all the "myths" that people have about the stock market!

What are stocks? Definition:

Plain and simple, a “stock” is a share in the ownership of a company.

A stock represents a claim on the company's assets and earnings. As you acquire more stocks, your ownership stake in the company becomes greater.

Note: Some times different words like shares, equity, stocks etc. are used. All these words mean the same thing.

So what does ownership of a company give you?

Holding a company's stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim to everything the company owns.

This means that technically you own a tiny little piece of all the furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company's earnings as well.

These earnings will be given to you. These earnings are called “dividends” and are given to the shareholders from time to time.

A stock is represented by a "stock certificate". This is a piece of paper that is proof of your ownership. However, now-a-days you could also have a “demat” account. This means that there will be no “stock certificates”. Everything will be done though the computer electronically. Selling and buying stocks can be done just by a few clicks.

Being a shareholder of a public company does not mean you have a say in the day-to-day running of the business. Instead, “one vote per share” to elect the board of directors of the company at annual meetings is all you can do. For instance, being a Microsoft shareholder doesn't mean you can call up Bill Gates and tell him how you think the company should be run.

The management of the company is supposed to increase the value of the firm for shareholders. If this doesn't happen, the shareholders can vote to have the management removed. In reality, individual investors like you and I don't own enough shares to have a material influence on the company. It's really the big boys like large institutional investors and billionaire entrepreneurs who make the decisions.

For ordinary shareholders, not being able to manage the company isn't such a big deal. After all, the idea is that you don't want to have to work to make money, right? The importance of being a shareholder is that you are entitled to a portion of the company’s profits and have a claim on assets.

Profits are sometimes paid out in the form of dividends as mentioned earlier. The more shares you own, the larger the portion of the profits you get. Your claim on assets is only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left after all the creditors have been paid.

Another extremely important feature of stock is "limited liability", which means that, as an owner of a stock, you are "not personally liable" if the company is not able to pay its debts.

In other legal structures such as partnerships, if the partnership firm goes bankrupt the creditors can come after the partners “personally” and sell off their house, car, furniture, etc. To understand all this in more detail you could read our “How to incorporate?” article.

Owning stock means that, no matter what happens to the company, the maximum value you can lose is the value of your stocks. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets.

Why would the founders share the profits with thousands of people when they could keep profits to themselves? This is the obvious question that comes up next. This what the next section is all about!

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Stock Picking - Which stocks to buy?

Having understood all the basics of the stock market and the risk involved, now we will go into stock picking and how to pick the right stock. Before picking the right stock you need to do some analysis.

There are two major types of analysis:
1. Fundamental Analysis
2. Technical Analysis

Fundamental analysis is the analysis of a stock on the basis of core financial and economic analysis to predict the movement of stocks price.

On the other hand, technical analysis is the study of prices and volume, for forecasting of future stock price or financial price movements.

Simply put, fundamental analysis looks at the actual company and tries to figure out what the company price is going to be like in the future. On the other hand technical analysis look at the stocks chart, peoples buying behavior etc. to try and figure out what the stock price is going to be like in the future.

In this article we will go into the basics of “fundamental analysis”. Technical analysis is a little more complicated. It is much more of an "art" than a science. It depends more on experience and involves some statistics and mathematics, so explaining technical analysis is out of the scope of this article.

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What are the Sensex & the Nifty?

The Sensex is an "index". What is an index? An index is basically an indicator. It gives you a general idea about whether most of the stocks have gone up or most of the stocks have gone down.

The Sensex is an indicator of all the major companies of the BSE.

The Nifty is an indicator of all the major companies of the NSE.

If the Sensex goes up, it means that the prices of the stocks of most of the major companies on the BSE have gone up. If the Sensex goes down, this tells you that the stock price of most of the major stocks on the BSE have gone down.

Just like the Sensex represents the top stocks of the BSE, the Nifty represents the top stocks of the NSE.

Just in case you are confused, the BSE, is the Bombay Stock Exchange and the NSE is the National Stock Exchange. The BSE is situated at Bombay and the NSE is situated at Delhi. These are the major stock exchanges in the country. There are other stock exchanges like the Calcutta Stock Exchange etc. but they are not as popular as the BSE and the NSE.Most of the stock trading in the country is done though the BSE & the NSE.

Besides Sensex and the Nifty there are many other indexes. There is an index that gives you an idea about whether the mid-cap stocks go up and down. This is called the “BSE Mid-cap Index”. There are many other types of indexes.

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3 important things you must know and follow as an new investor!

You need to KNOW some “unforgettable basics” before you enter the world of investing in stocks. The stock market is a field dominated by savvy investors who know the ins-and-outs of the market. For people who are not “on the inside”, the stock market can be a VERY dangerous place. :

Don't even consider "tips" that tell you about "hot stocks". Consider the source: There are many people in the market who put in all their time and effort in promoting certain stocks. They do this because they have their money invested in those stocks. If they can get enough people to buy the stock and they can get the stock price to rise, they will sell the stock for a huge price, the stock price will crash and they will walk off to promote another stock.

Always use your own brain: It's extremely important. You must always use your own brain. Relying on the advice of others, no matter how well intentioned it may be, is almost always a complete disaster. Make sure you dig in and really examine the "facts about the companies" before you invest. Ignore press releases which have very little substance, and rely on "hype" to tell the company's story.

And finally the most important tip!!!
Only invest money you can afford to lose!! Sure this is a basic point, but many many people miss it. You should only invest money that you can honestly afford to lose!! Everyone enters into investments with the idea of earning big profits, but in many cases, this never works. (Especially if you are new to investing in the stock market!)

Please understand that the above tips are tips for beginners. Once you really get into the stock market you do not need to follow these rules anymore. But if you are a new investor, you MUST follow these rules. They are for your own safety.

But then again, nothing comes free. Everything has a price. You will have to loose some money, make some bad decisions and then only will you really understand the market. You cannot understand the market by just looking at it from far. By following these rules, you will basically not loose too much!

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