Fundamental analysis is very broad concept. In this investor have stocks as part business rather than pieces of paper that trade on exchanges. All the great investors put more emphasis on fundamental analysis than any other thing. There are may be thousand of aspects which may affect businesses to evaluate each of them is impossible we have to select some that have greater impact on business.
Investment analysis is the only method through which investor can select potential multibagger stocks without relying on luck. Take an example of Warren Buffett what he do? He just read thousands of annual report analyze large amount of information and select some fundamentally strong stocks and that made him one of the richest person in the world.
Fundamental analysis is simple thing but not easy. You do not need very advance knowledge of accounting nor you need mathematical skills to solve integration, derivatives or complex equations. The most important requirement is basic accounting knowledge and a rational mind to think unbiasedly .
Last important thing fundamental analysis is time consuming and patience checking process that is why 99 .9 percent never do this. But if you want to stand different than the crowd then this thing is must.
There are many steps in the process of equity analysis and there is no sequence for this. But over the period one should form his own method.
Industry is like a road and companies in that industry like a car If road is not that good then it is very difficult for car to run at fast speed no matter how good engine is and how many efforts driver take. But if road is good then only foot on accelerator is required.
Same is with the industry and stocks in it. Of industry has a tailwinds then companies will grow at tremendous pace.
Take an example of Pharma Industry in India. Cost of Production of Pharma products is staggering 40 % less than cost required to produce same product in North America or Europe because of availability of skilled workers at very less cost. This gave geographical advantage to Pharma companies in India.
And because of this see how good returns they gave
|Company Name||Stock Price Growth In Last 10 Years||Revenue Growth In Last 10 Years|
If company is in matured slow growing industry like Utilities where industry itself is growing at 5-6 % in this environment it is impossible for any company to grow at 15-20% CAGR.
Cyclical Or Non-Cyclical
Industries can be classified mainly in two types Cyclicals and Non – Cyclical (Growing). In cyclical earnings fluctuates with changing economic condition on the other hand earnings in growing industry are fluctuates less and grows steadily.
Profit can be made in both but method of investments are different .
Cyclicals are best to make 1-2 year bet when cycle is at lower point and earnings are at near historical lows . This may give investor 100%-200% return in matter of 1-2 years if timed perfectly.
If wrong approach is followed like investing in cyclical for 10 years then returns will be worst. For very long term investments only growing industry is required.
Things to understand from industry analysis:
- Growth in industry so to make right estimation of future growth of company for Intrinsic value calculation .(as said earlier company cannot grow at 25% if industry is growing at 5% CAGR)
- Make a list of headwinds and tailwinds industry have. And choose that company which is going to get benefit of tailwinds most.
- Right Decision of which types of bet to make whether short term or long term.
- Finding of perfect niche within the industry to excel up returns .(Say in Pharma Industry generics segment is growing faster that industry itself).
After getting idea of industry now it is time to understand business from the deep. The main source of getting business information is annual reports or a company website .
For basic understanding of business is necessary like products key persons what generally business do its production facilities etc. After that thorough analysis of is to be started.
Business models is product of thinking of founders and promoters . A good business models can make company a leader in industry.
Investors have to understand business models of company and its competitions and difference between them. They have to figure out which one is working best and reasons for the same.
Investors based on the knowledge of industry general economy and understanding of business can figure out which type of business models can work better in the future.
Information of business models and strategies can be obtained from management discussion and analysis section of annual report and from chairman’s letter also.
Here management discuss about their future business strategies their basic assumptions regarding to models and why it will work potential results that can be derived.
Things to give special attention :
- Check whether assumptions and estimations made by management are rational . Sometimes managements try to sell to reader than to give proper information. To avoid such pitfalls investor shall always be rational and must question everything written on business models by doing independent research to crosscheck with facts.
- Reading only one annual report is not sufficient fundamental analysis. Reading past annual reports of at least 5 years is necessary. By reading management discussion and analysis report over the past few years invest come to know whether company is changing business models every few years . If this is happening then there is huge red flag . Because it clearly means that management is not that competent to run business.
Raw Material Analysis
Cost of production is one of the important part of profit and loss statement. If there are many commodities where price is much volatile then business may not that consistent in profits or at least company have that price volatility risk.
Investor shall take out all the list of raw material required by company and calculate percentage of total raw material cost.
|Raw Material||Total Material Cost||Percentage Of Total Material|
|Asbestos Cement||152 Million $||53.3 %|
|Steel||45 Million$||15.8 %|
|Cement||76 Million $||26 %|
|Lime||10 Million $||3.5 %|
|Wood||2 Million $||0.7 %|
From this material most crucial to success can be found out.
Now next step is to figure our risk that each of material bring . For example.
- Commodity prices volatility.
- Foreign exchange risk.
- Material availability risk. (supplier bargaining power risk)
- Environmental hazard risk.
- Export and Import Duties Changes.
These risks have varying effect on company to company . From this exercise investor can find out list of significant risk to raw material.
For example : Aviation Companies face more risk of Jet Fuel price fluctuations than any other companies.
It has seen in the past that companies that have skill dependence rather than raw material dependence are more consistent value creators. Because once skilled labors and required know how is obtained then there will be no other major issue as employee turnover do not cause that much problem.
Products and Brand Analysis
Just like percentile contribution was calculated in raw material same things needs to be done with products of company.
Strong sell of any product can create wrong interpretation of huge future growth in company . If product is very famous and unique does not mean that success is inevitable. If it contributes very small portion to total revenue then stock will not show any major movement.
Products can be broadly classified into two types
This types are products are of exactly same type to that of competitor’s.
This type of product may have many things same as another same type of products but all have some unique feature.
Do not have a brand value as nothing is unique in them.
They have brand value because of unique features and customer experiences
If you take out list of multibagger stocks in last 10 years the one most common characteristics you will observe is the presence of band and differentiation in products.
Simple reason for this is when there is brand presence company has pricing power. So they can charge more for their unique features. So these type of companies have more profit margins than commodity products.
In the case of commodity products the only weapon for competition is price so they have very thin profit margins .
Other Things to check ..
- Product portfolio and competition
- Whether company has history of developing innovative products .
- How products are marketed.
Market size and Market share
Page Industries ltd. have grown at CAGR of 25% consistently for last 10 years. If investor consider this statement alone and calculate intrinsic value considering 25 % CAGR growth expectation in the future he will totally get valuation will lead to serious investment mistake.
This is because page is premium undergarments selling company and occupies nearly 70% of market share so there is no room for the company to grow within the same market .(It may happen that total market size grows at 25% but that’s just next to impossible thing.
In order to avoid such pitfalls market share analysis is necessary. Here is Quick checklist for market analysis.
- What is market size and what is revenue company . Calculate market share based on that .
- Is there sufficient room in market for company to grow either by overall growth of market or by eating share of other weak or unorganized player in market.
- What are estimations of future growth rate of market (such information can be obtained by various reports that are published on industry or that specific market).
- Does company really have capabilities brand strength to acquire share of others.
- How market share of company in the past.
- How market shares are distributed among the companies.
If there are one or two leaders who have 60-70% share then it is really hard for small companies to snatch market share from them.
What are possible threats that can destroy whole market structure? It may be any kind of innovation or any substitute product or it can be geopolitical factor.
What are possible threats that can destroy whole market structure? It may be any kind of innovation or any substitute product or it can be geopolitical factor.
Warren Buffett aka oracle of Omaha and world’s smartest investor loose almost 9 billion $ by investing in a company called Dextar Shoes just because he failed to sense the possibility strong competition that could arise from Europe to foot wares market in North America.
Hence estimating all the possible threats is one of the important part of fundamental analysis of company.
It is not necessary in India to disclose all the threats regarding to company in the view of management. But it is necessary element of 10 K which is equivalent to annual report and is annually filed in USA with securities and exchange commission.
So what investor can do is look in which take such 10K from internet of companies having same industry and take a look at all the threats disclosed. This will give rough ideal of possible threats to company.
Threats can also be estimated based on the experience and knowledge of investor.
Some types of threats are ..
- Threat of competition.
- Regulatory issues
- Price fluctuations
- Legal Compliance
- Availability of Credit related
One successful identification of future tailwind and companies benefiting from it can give investor his mutibagger stock without much analysis and efforts.
Tailwind has its purview some are for a specific geographical reasons some are for some industry and some are limited to specific company only.
Investor shall think about possible tailwinds to company and extent of its benefit to a particular company.
Some of the tailwinds for companies..
- Strong research and development
- Availability of rare raw material
- Less labor cost
- Subsidized taxes.
- Innovative culture in business
- Filed patents
- Unique marketing skills
- Less cost of production
- Unique niche products
- Cost saving production cycle.
- Large distribution network
- Highly integrated product cycle
- Good corporate relation with foreign businesses
- Strong demand forecasting team
- Strong network of dealers and suppliers.
In reality there is tremendous pressure on management to fulfill wall street’s expectations or sometimes management got growth at any cost attitude.
This lead management to takeover companies at highly overvalued prices to gain artificial growth. So make sure that management is not doing something like that.
List down all the subsidiaries, associates and joint ventures of company and make assessment how it can be helpful for expansion of business. Subsidiaries can help company to enter into new geographical market . Like establish production facilities where it is most economical.
Joint Ventures also help both the parties to either gain required know how or to break entry barriers for new country.
Subsidiary JV portfolio gives idea of management’s competence to run business and ability to think strategically.
Enough for businesses now let’s discuss people who run them. A Great business run by the great management is the only option for find mutibagger stocks.
Management are hard to analyze but it is important part analysis and should not be ignored at any cost.
Firstly , management needs to have right incentives to run business properly and most importantly to creating value for shareholders. If management holds large part of their wealth in company they are managing then they are more likely to focus on increasing value of business than just reaping huge compensation.
Thus it is helpful for shareholders to management to have large stake in company.
Company have to report its shareholding pattern in every quarter. Investor must read these statements and figure out whether managements are unloading shares. If many promoters and key managerial person are doing this then surely something is wrong with business.
Mergers and Acquisitions
Mergers and acquisitions if done properly can enhance shareholders value significantly. By many ways like reducing competition by merging with him, forward and backward integration or gaining required technical knowhow.
Mergers and acquisition is a double edge sword it can weaken business also.
While investing in the company investor should look at the history of mergers and acquisitions happened in the past and how they are turned out .
Many times what happens is that management get attitude of growth at any cost. For that they do mergers or acquisitions at very overvalued price or they buy some business which is completely unrelated to present one.
In short mergers acquisitions and even JV shows ability of management to craft growth strategies or their inability to make right business decisions.
If many such events in the past have failed to give results then it means that company and its management have competitive disadvantage in such things.
Compensations by the way of stock options are do not put much pressure on profits of company but all that management get is charged form the pockets of shareholders.
When management get employee stock options and exercises it then number of shares outstanding increases. This reduce earnings per share of existing shareholders and that too for each year.
So investor should check,
- Whether managements deserves what they getting.
- Is ESOP compensations way higher than industry standards.
- How much dilutions has happened in the past because of this.(So as to get how shares outstanding will be in the future.)
Competition analysis becomes very simple when industry analysis is done.
Nature of competition is based on entry barriers, exit barriers, substitute products and differentiation in products.
Best method in competition analysis is to segregate an industry in subsections or niches and then analysis it, This gives more clear picture of who are the real competitors of the company are.
Here is the simple checklist for management analysis.
- Calculate who are the leaders in an industry.
- What are the success for the leaders in the industry.
- What are the traits unique features and tailwinds that competition have.
- Check whether any company in an industry is doing something unique which increases its chances of success in the future.(It does not matter what is the present condition that it have.)
- Compare business models of all the competitors.
- Compare products of all competitors.
While doing competitions analysis if you find any company which is better that the present one. Then never hesitate to switch.
Most of them ignore just because they have spent lot of time in analyzing present company . But the goal of investor is not to find stock by doing analysis but the best stock by doing analysis.
Thinking rationally really helps here .
Financial And Ratio Analysis
Accounting and finance is language of business any change whether good of bad that happens in company is reflected in numbers. Like if there is good management of production cycle it will be reflected in inventory days, profit margins of company in bad times will give insight into pricing power of the company.
Any long term investor shall get acquainted with this language.
Financial analysis start with some important ratios. Each of this rations shall be compared with past years, industry leaders and with industry averages .
Ratio analysis takes little time so investor shall go through all the ratios, but here is list of some very important ones that must not be missed .
- Return on equity
- Return on capital employed
- Interest coverage ratio
- Debt service coverage ratio.
- PAT margin
- Inventory days
- Debtor days
- Price to book value
Few important aspects of ratios
Ratios told only current position and the historical position about the company so some companies may have not that good record in past but may have potential to flare in future in such cases ratio analysis does not help much . Good ratio figure should not be taken as hard rules.
When there is sudden change in any ratio compared to last year then investor shall take deep look into this. As it can reveal some important changes (negative or positive in related to company)
We will not cover deep financial analysis here but will give insight what to look for in financial statements.
Balance sheet statements shows financial position of the company .This statement has two sides one is asset side(what company owns) and other is liability(what company owes) side. Both sides of the balance sheet are always same that’s the reason it is called as balance sheet.
Main thing to understand from the balance sheet is whether company have strong financial position to survive if company face adverse economic conditions . Also does company have adequate liquid assets to fulfill short term needs of business .
Some quick checks for balance sheet.
Is debt level rising year by year and does company have sufficient profits to fulfill interest obligations (For this debt coverage ratio is extremely helpful.)
Check if inventory levels of company are rising faster than revenue growth of that is happening it will surely hurt business.
Does company have positive working capital.
How much company is earning for capital invested in it ?
Profit and Loss Statements
It shows how much company has earned during the year. Profit and loss gives important figures like earning per shares, interest expenses and of course revenue. Revenue segmentation give insight of most earning generating product or divisions of company .
Bad thing about Profit And Loss statement is that it can be easily manipulated either by capitalizing expenses or wrongdoing in revenue recognition processes.
Because of this many people give more emphasis on cash flow statement than Profit and Loss Statement
Cash Flow Statements
This statement is divided into three sections.
Cash Flow From Operating Activities
It tells how much cash is generated selling goods and services by the company.
This section highlight working capital problems of company . Many time company is very good at selling products but is not good at collection of cash. So although revenue is high but it mostly forms part of the debtors.
Net cash from operating activities is obtained from profit before tax plus non cash expenditure minus change in working capital.
Cash Flow From Investing Activities.
It records all the investments of company whether they are in capital assets or share investments in various securities.
Dividend obtained from such investments are also recorded as cash inflow in this section
Cash Flow From Finance Activities
Capital are or two types Debt and Equity. all cash transacction related to such activities like taking loan caused cash inflow or buyback of shares which reuire company to give money to selling shareholders is found here.
Capital has a cost whether in the form of interest or divided which has to be paid this dividend and interest is recorded in finance activities.
Why cash flow statement is better for analysis than profit and loss statement
Profit of company can be increased due to one time incomes such as sale of fixed assets like land at much more price than its historical cost. This gives wrong perception about companies growth but this effect is netted in cash flow from operating activities section.
Profits stuck in working capital of company can be identified in cash flow statements and not profit and loss statement.
In order to continue growing at faster pace company have to make investments in fixed assets much more than depreciation figure. So cash from operation does not consider depreciation because it is non cash expense instead another helpful number is used known as free cash flow which is cash from operating activities – capital expenditure . This figure consider investments made today as cost and not depreciation.
Intrinsic Value Calculation
Last step of Fundamental analysis is Intrinsic value calculation.
Markets are not rational while pricing stocks all the time because stock prices are decided by supply and demand of shares which is in turn based on what participants of market think . Human mind is driven by emotions and psychological tendencies because of which they may take wrong or biased decisions .
This may drive prices of company away from its real value. By calculating real value which is called as intrinsic value investor can buy under priced stocks and hold it for long run in anticipation that market will eventually realize its actual value and will prices will adjust according to that.
So intrinsic value is true of company or any other financial instruments calculated by investor based on the income it is going to earn in the future .
Most used method to calculate this intrinsic value is Discounted Cash Flow Valuation.
According to this model value of any financial instrument is present value of all the cash flow that companies going to earn over the its remaining life.
Learn about Discounted cash flow model here.
After calculating intrinsic value investor have to make decision based on current market price.
|Intrinsic value||>||Market Value||BUY|
|Intrinsic value||<||Market Value||SELL|
|Intrinsic value||=||Market Value||NO BUY NO SELL|
Concept of margin of safety was populated by Banjamin Graham.
It is different between intrinsic value and market price. While taking a bet investor should look for sufficient margin of safety because larger is the margin of safety greater the chances to earn returns from undervaluation of company and lesser the chances of loss from error in calculation of intrinsic value.
Say, Rick find two companies a Inc. and B Inc. whose intrinsic value per share is 100 $ but A Inc. is trading at 90$ and B Inc. is trading at 70 $ then B Inc has more margin of safety (100$-70$ =30 $)than A Inc. where margin of safety is only 10$.
You can put margin of safety in another way. If maximum load limit of bridge is 10000 kgs. then anyone will not drive 9999 kgs load carrying truck.
Fundamental analysis is time consuming and is complex process but it is only method to find multibagger stocks. It is only method that gives solid reasoning for doing particular action in market.
Almost all the investor who have made to the billionaire list believe in fundamental analysis to find great investments.