How to do Fundamental Analysis on Stocks?

Fundamental analysis of a stock is used to determine the financial and business health of a company. It is always recommended to perform a proper fundamental analysis of the stock before investing if you are planning for long term investment.

If you’re involved in the market, you might also have about the term ‘Technical Analysis’. Well, technical analysis is a good approach to find the entry and exit time stock for intraday trading or short term. You can make good profits using different technical indicators efficiently. However, if you want to find a multi-bagger stock to invest, which can give you good returns year after year, then the fundamental analysis is the actual tool that you have to utilize.

Fundamental This is because to get multiple times returns (say 5x or 10x), you need to remain invested in a stock for the long term. While the technical indicators will show you exit signs in the short term whenever there’s a downtrend or small setbacks, however, you have to remain invested in that stock if the company is fundamentally strong. In such cases, you have to be confident that the stock will grow and give good returns in the future and avoid short-term underperformance. Short-term market fluctuations, unavoidable factors, or mishappenings won’t affect the fundamentals of the strong company in the long term.

In this post, we are going to discuss how to do fundamental analysis on stocks. Here, we will elaborate on a few guidelines that if you follow with discipline, you can easily be able to select fundamentally strong companies.

How to do fundamental analysis on stocks?

Here are the six essential steps that you need to perform to analyze the fundamentals of a company in Indian stock market. They are really simple, yet effective to find fundamentally healthy companies. Here it goes:

Step 1: Use the financial ratios for initial screening

There are over 5,500 stocks listed in the Indian stock exchange. If you start reading the financials of all these companies (i.e. balance sheet, profit-loss statement, etc.), then it might take years. The annual reports of most companies are around 200-300 pages long. And it’s not worth your time to read each and every company’s report.

A better approach is first to shortlist a few good companies based on a few criteria. And then to study these screened companies one-by-one to pick the one that suits you the best.

For the initial screening of the stocks, you can use various financial ratios like Price to Earnings (PE) ratio, Price to Book Value (PBV) ratio, ROE, CAGR, Current ratio, Dividend yield, etc. If you want to know more about best financial ratios for screening, here’s an article on 8 Financial Ratio Analysis that Every Stock Investor Should Know. In short, you need to use different financial ratios for initial screening.

Next, for performing the stock screening using financial ratios, you can use different financial websites like Screener, Investing.comTickertape, etc. Let me give you an example of how to screen stocks using Investing.com.

How to do a screening of stocks using Investing.com?

Step 1: Go to Investing.com

Step 2: From the top menu, select Tools -> Stock Screener

Step 3: Add Criteria (financial ratios) to screen stocks

For example, if you want to filter companies with PE ratio between (5, 18) and dividend yield % between (1, 3), you can select the following criteria. Investing.com Screener will shortlist the stocks according to the criteria mentioned and give you the list of companies.

Further, you can also add a number of financial ratios in your criteria like CAGR, ROE, etc.

Besides, you can also use other financial websites to screen stocks as mentioned earlier. Here’s a demo on how to shortlist companies using Screener.in website:

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Step 2: Understand the company

Once you’ve screened the companies based on the above criteria, the next step is to investigate them. It is important that you understand the company in which you are investing. Because if you don’t, you won’t be able to decide whether the company is performing good or bad, whether the company is making the right decisions towards its future goal or not; whether their competitors are doing good or bad compared to them and most importantly whether you should hold or sell the stock.

Therefore, it is essential that you understand the company. Questions like what are its products/services, who are leading the company (founders/promoters), management efficiency, competitors, etc should be known to you.

A simple way to understand the company is to visit its website. Go to the company’s website and check it’s ‘ABOUT’, ‘PRODUCTS’, ‘PROMOTERS/BOARD OF DIRECTORS’ page, etc. Read the mission and vision statement of that company. Further, if you can find the annual report of the company, download and read it. This report will give the in-depth knowledge of the company.

Further, if you are able to understand the products, services & vision of the company and find it attractive, then move further to next step. Else, ignore that company.

Step 3: Study the financial reports of the company

Once you have understood the company and found it appealing, next you need to check the financials of the company like Balance sheet, Profit loss statements, and cash flow statements.

As a thumb rule, Revenue/Sales, net profit, and margin increasing for the last five years can be considered a healthy sign for the company. After that, you also need to check the other financials like Operating cost, expenses, assets, liabilities, etc.

Now, where can you find the financials of a company that you’re interested to invest? One of the best websites to check the financial statements of a company that I most frequently use is SCREENER. Here are the steps to check the financial reports of a company on Screener website:

Step 1: Go to screener.in

Step 2: Enter the company’s name in the search box. The company’s details will open like charts, analysis, peers, quarters, profit and loss, balance sheet, etc.

Step 3: Study the company’s financial reports for the last 10 years.

It is required that you study the financials of the company carefully in order to select a good stock for long term investment. If you do not know how to read the financials of a company, you can check out this financial statement and ratio analysis course for beginners.

Step 4: Check the debt and Red Flags

The total debt in a company is one of the biggest factors to check before investing in a stock. A company cannot perform well and reward its shareholders if it has a huge debt. They have to repay the debt and also pay interest on the borrowed money before anything else.  In short, avoid companies with huge debts.

As a thumb rule, always invest in companies with a debt/equity ratio of less than one. You can use this ratio in the initial screening of stocks or else check it while reading the financials of a company.

In addition, also other red flags in the company can be continuously declining profit/ margin, low liquidity, and pledging of shares.

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Step 5. Find the company’s competitors

It’s always good to study the peers of a company before investing. Determine what this company is doing that its competitors aren’t.

Further, you should be able to answer the question that why you are investing in this company and not any of its competitors. The answer should be convincing one like Unique selling point (USP), Competitive advantage, Low-cost products, Brand Value,  future prospects (upcoming projects, new plant), etc.

You can find the list of the competitors of the company on the Screener website itself. Just enter the stock name in the search box and navigate down. You will find a peer comparison there. Else, you can do a google search to find the competitors of the company. Study the competitors in detail before investing.

Step 6: Analyze future prospects

Most good investments are based on the future aspects/potential of the company and hardly on their current situation. Investors are interested in how much returns they can get from their investments in futures. Therefore, always invest in a company with strong long future prospects. Select only those companies to invest whose product or services will still be used twenty years from now.

Moreover, there is no point in investing in a CD or pen-drive making company with no long term (say 10 years from now) prospects. With cloud drives evolving so fast, these products will become obsolete with time.

If you are planning to invest for the long term, then the long life of the company’s product is a must criterion to check. Further, check future prospects, expansion possibility, potential sources of revenue in the future, etc.

Summary

Fundamental analysis is an old and proven method to find strong companies for long term investment. In this post, we discussed how to do the fundamental analysis of stocks.

The six steps to perform fundamental analysis on stocks explained in this article are: 1) Use the financial ratios for initial screening, 2)Understand the company, 3) Study the financial reports of the company, 4) Check the debt and red signs, 5) Find the company’s competitors 6) Analyse the future prospects.