Fundamental Analysis: Understanding Stock Valuation

What is Fundamental Analysis?

Fundamental analysis is a method of evaluating a company's financial health and intrinsic value by analysing economic, financial, and industry-related factors. Investors use this approach to determine whether a stock is undervalued or overvalued before making investment decisions.

Key Principles of Fundamental Analysis

1. Qualitative Analysis

   This includes evaluating factors that are not directly measurable but influence a company’s long-term growth.

   • Business Model – Understanding how the company makes money.

   • Competitive Advantage – Identifying unique strengths like brand reputation or technology.

   • Industry Trends – Assessing the company’s position in its industry.

   • Management Quality – Reviewing leadership experience and past performance.

2. Quantitative Analysis

   This involves examining a company’s financial statements to evaluate its performance.

   • Balance Sheet – Shows the company’s assets, liabilities, and equity.

   • Income Statement – Displays revenue, expenses, and profitability.

   • Cash Flow Statement – Tracks cash inflows and outflows.

     
     

Important Financial Ratios

1. Earnings Per Share (EPS)

   EPS = Net Profit / Number of Outstanding Shares

   • Indicates a company’s profitability.

   • Higher EPS suggests a stronger financial position.

2. Price-to-Earnings (P/E) Ratio

   P/E Ratio = Stock Price / EPS

   • Helps investors determine if a stock is overvalued or undervalued.

   • A high P/E suggests high future growth expectations, while a low P/E may indicate an undervalued stock.

3. Price-to-Book (P/B) Ratio

   P/B Ratio = Market Price per Share / Book Value per Share

   • Measures whether a stock is trading above or below its book value.
     

4. Debt-to-Equity (D/E) Ratio

   D/E Ratio = Total Debt / Shareholders’ Equity

   • A high D/E indicates high debt levels, which can be risky.

   • A low D/E suggests financial stability.
     

5. Return on Equity (ROE)

   ROE = Net Income / Shareholders’ Equity

   • Measures how effectively a company generates profit from shareholders' investments.
     

6. Dividend Yield
   
   Dividend Yield = Annual Dividend per Share / Stock Price

   • Indicates the return on investment from dividends.

   • High dividend yield stocks are preferred by income-focused investors.

Steps to Perform Fundamental Analysis

1. Study the Company – Understand its business model, competitors, and industry trends.

2. Analyse Financial Statements – Review balance sheets, income statements, and cash flow reports.

3. Compare Ratios – Assess key financial metrics relative to industry benchmarks.

4. Evaluate Future Growth Potential – Look at expansion plans, innovation, and market trends.

5. Monitor Macroeconomic Factors – Consider interest rates, inflation, and government policies.

Fundamental Analysis vs. Technical Analysis

Summary

Fundamental analysis is a powerful tool for long-term investors who want to make informed decisions based on a company’s financial health and market potential. By understanding key metrics and analysing financial statements, investors can identify strong companies with growth potential and minimize risks.