Introduction to Fundamental Analysis
Investing in companies has been one of the most rewarding avenues to invest since the past century. The ability to identify great companies and hold them for long periods of time has created unprecedented wealth for investors. This creates a very important question for people looking to invest in the markets – What is the science behind identifying such quality companies? How does one separate good companies from bad? The answer to all that lies in fundamental investing
Fundamental investing is the art of adjudging the true value of a company. We all remember the tale where a man finds a piece of rock. He tries to sell it to various people and all of them quote him different prices with finally a diamond merchant quoting him the highest price. The tale has deep woven lessons for a fundamental investor and is basically the holy grit of the profession. An investor identifies a company and then adjudges a value for it. If the market quotes a value below his expected value, he will buy it. If it’s trading above his estimated value, he will wait for the market to quote below his estimate.
Now a question arises. What is Value? There have been lots of theories about value of a company. Some of the popular ways to estimate value are:
- Book Value- One of the simplest ways to adjudge a true value of the company is by estimating its book value. The book value is simply a subtraction of the company’s assets and its liabilities. The figure represents the net value that is available to company’s stockholders. If the firm trades below its book value, it is considered a buy and if not it is considered overvalued.
- Intrinsic Value- This is the most popular approach in trying to estimate the true value of a company. It states that the true value of a company can be judged by the cash it generates in future. The cash generated in future is brought to par with present. The sum of the cash flows thus generated is then multiplied by an appropriate multiple to come at a reasonable assumption about the value.
The above 2 popular approaches have been used consistently over the period of time by investors. Now what is common in both the approaches? They are all futuristic in nature. Book value approach believes that in future the company’s valuations will revert to its original mean in future while intrinsic value approach believes that the future cash flow value will be reflected in the stock prices. This brings us to a very important principle of fundamental investing- “In fundamental investing, you buy the future”. Buying the future means accounting for all the factors that can affect the company. Some of the factors that can affect the company are:
- Economic Conditions- Economic conditions play an important role in future of a company. The inflation level, interest rates and overall scenario plays a decisive role in determining the future of the company. It is necessary for the investor to identify the association of the company with the particular economic sector. Based on the sector an attempt is made to predict the future of the company.
- Business Model- Understanding the business model of the company will play an important role in analysis. When an investor understands the business model it becomes easy for him to extrapolate the future with rational assumptions. The ‘business model’ approach works in tandem with economic, sectoral and macro analysis. It looks to identify relationships between all the above factors and come at a conclusion to derive future growth of the company.
- Market size- Market size and scope for market expansion play an important role in analysing a company. A company in a small market which has scope for huge expansion due to various factors is a good bet to place in current time. An investor needs to understand the factors that could drive market growth and expansion. Just as an example, the AC industry in India has about 5-10% market penetration. As income levels improve there is a general expectation that this market can expand to nearly 40%. This is a typical example of an industry that can expand multiple times and possibly create wealth in future.
Hence fundamentals are a set of various factors that can influence the future value of the company. When you extrapolate these factors and estimate that the value of the company is greater than what it is now, you make an investing decision.
The benefits arising from such analysis are multifold in nature. It allows an investor to identify successful companies and avoid the mediocre and average ones. Through fundamentals, the person is able to monitor his investments and is able to take appropriate decisions. Good fundamentals compound wealth over longer periods of time, creating ‘multibagger’ in the process.
By now we hope you are able to grasp the basic idea of fundamental investing. In the next series, we will delve more into it and look at the key areas or metrics that create a successful business.
Until next time!
COMING UP NEXT- What drives a successful business? Key fundamentals of a successful enterprise