What are the tools of fundamental analysis?

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As of 27th Mar 2021, with over 5,000 stocks in the market, India is 8th in the stock economy with a market cap of $2.52 tn. Sure, we might be a long way away from China with $10.90 tn in the 2nd position, but we’re definitely in the top 10. Well, top 10 or not, trying to pick from 5,000 stocks might make you apprehensive about picking the best stocks. But a useful approach is to simply understand their value.

While it is difficult to analyse and arrive at the value of anything, good investors are adept at forecasting trends. They use mathematical reasoning and factoring in other intangibles to define stock paths, owing largely to the unpredictable nature of things.

Enter fundamental analysis, a stock analysis method that uses the above principles. You might not have heard of fundamental analysis, but you must have heard of Warren Buffett. The ‘Oracle of Omaha’ was a vocal promoter of fundamental analysis, while his track record of investment speaks for itself.

This article covers:

A note on fundamental analysis

Fundamental analysis and particularly quantitative fundamental analysis is the searchlight you can use to shine a light on stocks before they catch fire. In simpler terms, it measures the intrinsic value of a stock by studying qualitative and quantitative factors affecting it.

What is the intrinsic value of a stock?

Intrinsic value is the value of a stock as determined by qualitative and quantitative methods of fundamental analysis. The intrinsic value might be higher or lower than its actual market value.

Quantitative analysis and its significance

In quantitative analysis, you justify buying stocks by studying the underlying numbers that make a successful company. Simply put, stock prices and shares are numbers. Investment is about maximising those numbers and both these factors depend on the company’s numbers.

“XYZ has good numbers” is common-speak for investors while assessing the performance of a company. Quantitative analysis studies these numbers, particularly the financial details of a company, to improve the investor’s chances of hitting on a successful stock.

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From earnings and financial reports to financial ratios, there are a number of tools used in the quantitative analysis as discussed below.

Financial reports

1. The balance sheet

The balance sheet of a company contains its assets and liabilities. You can also refer to it as a business’s net worth. Assets are company-owned and can include things like machinery, equipment, office space, copyrights, holdings and more. Liabilities are what it owes to others like debt and equity. High debt or equity usually leads to long-term complications, while a growing company maximises current assets and acquires new ones.

Check that the company has, or is growing towards a balance sheet where its assets keep growing more than its liabilities.

2. Profit and loss statement

These statements consist of the revenue and expenses of a company. For example, Google’s revenues would be money received through advertisements and income device sales, play store tax, and so on. Its expenses would include outgoing money through payments towards employees, taxes to the government and so on.

Profit/Loss = Revenue – Expenses

You need to look for companies whose revenues comfortably exceed their expenses. You should also note that revenues must come from ‘core’ sources as they have greater stability. Google obtained over 70% of its revenue from advertisements (core source) in 2018.

3. Cash flow statements

They are detailed reports of cash that moved in and out of a business account in a financial year. Cash flow statements measure the cash-based transactions a company makes in a year, including investments. Look for companies that finance a majority of their requirements through non-cash flow activities as lesser cash expenditure usually implies a low-risk business.

Apart from these, some companies also include a statement of change in equity and write notes to the shareholder on their positions. Keep an eye out for companies with complete transparency in all the above reports so you are not misled by false or lack of financial information.

Understanding a company’s financial reports can be the difference between a risky buy and a confident one. Tickertape’s Screener and Stock Pages give quantitative data regarding a company’s financials like income statement, balance sheet, and cash flow. You can filter these statements with over 150 filters listing companies based on total assets, total debt, free cash flow, raw materials, employee cost and make confident decisions.

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Earnings

Simply put, earnings are the money that a company makes. However, you may know them as net income, bottom line or profit; they all mean the same. Take the case of Bata. Subtract all the costs required to produce their footwear like manufacturing costs, cost of goods acquired and inventory from their income from sales, franchises and you will get their earnings (profit).

Thus, you must invest in companies that have high earnings sustained over a period of time. Higher profits are good business. It is also the same for investment and economics in general.

1. Quarterly earnings

Companies release quarterly reports detailing earnings, earnings per share and earnings from current operations for the most recent quarter. This indicates the current standing of a company.

2. Projected earnings

These are notoriously difficult to predict accurately. They are calculated by subtracting forecasted expenses from forecasted income. You can use a company’s financial statements from the current quarter to gauge how it might grow over the next ones.

Investors must pay close attention to profit as it is a key driver of stock value. Strong and sustained earnings are the most important denominators of a successful business. Low earnings force the company to borrow and incur further liabilities just to survive while increased profits get people to invest in their stocks. This influx raises their stock price, which again pushes up their earnings. 

You can find such companies using Tickertape’s Screener to create your custom buy/sell list. Use filters to list down companies based on growth metrics like Historical Earnings and Revenue Growth from 1 yr to over 5 yrs to land yourself solid stock options.

Financial ratios

Financial ratios are another important tool in quantitative analysis. They offer a clearer view of the company’s financials concerning profitability, expenses, equity and so on.

1. Earnings per share (EPS)

These are the earnings of a company divided by the number of shares of the company. Look for companies with high earnings per share so that when you decide to sell, the price of each share will be substantial, boosting your returns.

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2. Price to earnings ratio

This is the ratio of the share price and the EPS of a company. In essence, it indicates how much you need to pay to get Rs 1 of a company’s earnings. Ensuring a low P/E ratio will mean you spend less of your earnings for more of the company.

3. Return on equity

Use return on equity shares to assess the profitability of a company generated by using the shareholders’ money. Divide the net income/earnings/profit by equity shares of investors to assess this metric. Make sure you choose companies with a high return on equity to maximise your returns.

Other financial ratios you can analyse include the price to book ratio, dividend yield ratio, profitability ratios like operating profit margins, gross and net profit margins, and liquidity ratios like current, quick and cash ratios.

Debt to equity, current, and return on equity ratios are the ones Warren Buffett swore by as he amassed immeasurable wealth. Maybe you could apply the quantitative method just to analyse his earnings and see the results. 

Meanwhile, you can have a go at amassing immeasurable wealth yourself by picking stocks filtered using financial ratios like earning power, current ratio and debt to equity ratio in Tickertape’s Screener.

Conclusion

You need tools to build anything, and the same applies to building wealth. Regardless of whether you know Warren Buffett or not, you can still find out which stocks will catch fire. Yes, 5,000 stocks is a big number to choose from, but with a determined, filtered focus on your goals, quantitative analysis will help you make stock-picking fundamentally easier. 

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