Introduction to Fundamental Analysis of Stocks
We have discussed the basics of long-term investing in one of our previous articles, which is buying and holding shares for a long period (>1 year). In this article, we will learn how to identify good quality stocks to invest in, when to invest, and how much to invest. Discover how to evaluate a company's financial health, assess its growth potential, and make wise investment choices!
Long-Term Investing in Stocks vs Fixed Deposits
Investing in high-quality stocks will allow your hard-earned money to grow at a fast pace and become a sizable corpus over time. With this money, you can meet your financial goals can be met later in life. In contrast, if you simply deposit your money in a fixed deposit, it will only grow at a rate of 5-6% annually. However, investing in a good portfolio of stocks will grow at a rate of 15-18% or even higher each year. The returns between an FD and a stock portfolio differ wildly:
The lump sum invested in a stock portfolio giving a 15% CAGR grew to ₹6.62 crores, while the amount invested in a fixed deposit giving a return of 6% every year grew to just ₹57 lakhs. The difference in the corpus is wildly different. This is why you should invest in a stock portfolio instead of traditional methods like fixed deposits or bank savings accounts.
How to Find Good Quality Stocks to Invest in?
The direct answer to the question is: carefully analyze companies thoroughly. To find high-quality stocks, we should deeply study the overall business and financials of various companies across sectors. We must understand and analyze a company’s business model, its financial performance and position, its market, its competitors, its management, and even the economic factors that could affect the future growth and prospects of the business. This type of study is known as fundamental analysis. Fundamental analysis is a method of determining a stock's real or "fair market" value. We will learn how to do fundamental analysis in the upcoming modules.
You can do fundamental analysis to understand if a company can be invested in. However, when it comes to picking companies for long-term investments, there are two schools of thought in the market. They are:
1. Value Investing
By doing a fundamental analysis, we will arrive at the intrinsic or true value of a company. In value investing, if the intrinsic value of the company is lower than the current market value, then that company is a buy candidate. We will buy the stock and eventually make a profit when the current value increases to the intrinsic value. Veteran investors like Warren Buffet and the late Rakesh Jhunjhunwala are renowned value investors.
2. Growth Investing
In growth investing, investors do not give much importance to the true valuation of a company. Suppose the fundamentals of a company are good and its business is growing. In that case, the investor buys the stock even though the current market value is higher than the true value, assuming that the company will keep growing in the future and hence profit from it.
What to Study in Fundamental Analysis?
While doing fundamental analysis, there are three things we should study:
We should study the management of a company. Efficient and effective management is the key to the success of a business. If the management is poor, then the business is on a path to failure. While analyzing the management, we must study the executives who run the business, what their strengths and weaknesses are, their background, their potential, their past, and current performance, etc. We must also see if the management is drawing a high salary even though the business is doing poorly.
We must study the business model of a company and its current & future relevance. Find out if the business excites you as well.
While studying a business, we must look into its financials such as revenue, expenses, profits, etc. We can also look into the dividends the company distributes to its shareholders. We can judge a company from a purely financial perspective based on its future prospects and potential.
The three main areas of study can be called MBV, which stands for Management, Business, and Valuation.
Factors to Consider in Fundamental Analysis
The two factors to be considered when doing fundamental analysis are:
1. Business Model - A business model is an outline of how a company plans to make money. Understanding the business model is an important factor to consider while doing fundamental analysis. You should only consider a company for investments if its business model excites you.
2. Management Background - A strong idea of who runs the business is an important element of fundamental analysis. We need to analyze if the management is capable of running the business and taking it to new heights.
3. Ethics - All businesses need to be ethical in all their activities. It also has to be ethical toward all its stakeholders.
4. Corporate Governance - It refers to the corporate structure of a company. The efficiency and productivity of a business depend on its corporate governance.
5. MOAT - A MOAT is a company’s competitive edge over its competitors. It’s a feature that makes the company highly resistant to competition from other firms. For example, Fevicol (produced by Pidilite Industries) has a moat advantage because it is extremely difficult for another company to reach its level of brand value and sales.
6. Industry - It is also important to analyze the industry in which a company operates. Even if a company is performing well now, it may not be in the future due to a lack of opportunities for the company to grow.
1. Earnings & Growth - We should analyze the earnings or revenue of a company to understand how much money it's making. An analysis of the trend of revenue over different years should also be considered to understand if a company is growing or not.
2. Expenses - We should be aware of how much money a company is spending and where those expenses are going. Excessive spending is not favourable. However, if the money is allocated toward activities for business expansion and development, it will lay the foundation for future growth.
3. Profit & Margin - The profit that a company makes helps us to understand if its business is growing.
4. Assets & Liabilities - A thorough analysis of the assets and liabilities of a company is a must.
5. Debt - If a company has too much debt burden, it's unfavourable as there is a high chance of falling into a debt trap.
Where to Find Qualitative & Quantitative Data of Listed Companies?
The annual report of a company contains all the necessary information from which we can collect quantitative and qualitative data. An annual report is a company's yearly report to shareholders, documenting its activities and finances of the previous financial year. It is a 300-400 page document containing all vital information about a company.
- The qualitative factors of a company can be found in its annual report across various sections.
- The quantitative factors of a company can be found in the financial statements section of its annual report.
- In addition to the annual report, other sources such as videos related to the company, interviews with the founders and management, business magazines, articles, etc., can be used to collect data.
When to Buy Stocks?
The two ways in which people invest in stocks are:
1. Lump Sum Investment
When we invest a large amount into stocks all at once, it is called a lump sum investment. People usually do this when they receive bonuses or any other large sum of money. However, the drawback of this method is that we cannot maintain a better average price. If we do a lumpsum investment and the stock keeps on falling, we cannot take advantage of this price discount as all the money was invested in a single go previously.
2. Systematic Investment Plan (SIP)
SIP is a method of investing a fixed sum regularly into a portfolio. Most salaried people have a regular income every month. Out of this, they invest a certain percentage as SIP. A better average price can be maintained in this method as the purchase price will be lower and higher sometimes.
When to do SIP?
The two approaches to SIP investments are:
1. Fixed Date/Time
The most common method is to invest on a particular date or time. Some people invest every month, while others invest every week. People buy stocks blindly on a specified date or maybe the first working day of every month.
2. At low prices using technical analysis
Some people also do technical analysis to find if the stock prices are low or high and invest if the prices are low. If technical analysis implies that the stock is overpriced now, the investor waits until the stock price is low. We will discuss Technical analysis in detail in the upcoming module.
The first method, i.e., investing regularly on a fixed date/time is the most convenient. As our aim is to meet the benchmark, it is not necessary to take the extra effort of technical analysis for doing SIPs in the long term.
How Much to Invest For the Long Term?
The most commonly used method of investing is the 50-30-20 rule, which suggests that 50% of your income should cover your basic needs, 30% should go towards your wants, and the remaining 20% should be invested. However, this method cannot be used by people with low incomes as most of the amount will be used for basic needs. Also, if our income increases, our expenses will more or less be similar so that we will be able to invest. So our aim should be to invest as much as possible. However, it is a very subjective question as needs and financial goals vary from person to person.
The best way to determine how much you should invest is to calculate how much money you will need during retirement. To reach that number, you should consider your current lifestyle and what your lifestyle will be after retirement, among other things.
In one of our next articles, we will learn how to calculate the corpus you’ll need when you retire, how much to invest to reach that corpus and plan long-term & short-term financial goals using an Excel calculator.