There are 2 ways to look at any stock; fundamental and technical. While fundamentals focus on the merits and the demerits of the company’s business and its valuation, the technicals focus more on charts and past price performance. In reality, if you are an investor you need to begin with fundamentals of a stock and then use technicals to time your entry and exit in the market. That is why fundamentals become so important for investors. How to analyze stocks for beginners without getting too technical? How to do fundamental analysis of a company and take a valuation view of the stock? Let us use a 15-point matrix to learn fundamental analysis of stocks.
A 15-point matrix for fundamental analysis of stocks..
1. What business is the company into? That is the first question you need to understand. Is the company into a cyclical commodity business or a non-cyclical business? Does the company have brands that can add value? Does the company cater to the consumer segment or the business segment? Understand and define the business of the company.
2. Is the company growing consistently? At the core of fundamental analysis lies growth. A stock becomes attractive if it is growing at a consistent pace and in a sustainable manner. When we talk of growth, we talk of growth in the revenues (volumes and pricing power) as well as growth in the profits of the company.
3. Is the company profitable? That is the next logical question that follows. Eyeballs and footfalls matter only up to a point. How many people visit your showroom or your website does not matter until it translates into transactions. It is only when you are able to acquire customers on auto mode that profits start to flow in.
4. Who are the company’s competitors? Are they large businesses or are they small companies? Does the real threat of competition come from existing products or emerging products. Google as competition for auto companies is a case in point. Then you need to look at how the company is positioned vis-à-vis competition.
5. What are the emerging threats to the industry the company operates in? Look at what happened to Nokia when smart phones flooded the market. For that matter what happened to Blockbuster Entertainment when Netflix broke their monopoly. Look at how ecommerce is breaking the back of retailers across India. These are the threats.
6. How is the perception of the company management? As Peter Lynch said, a good management can get you through a lot of rough corners. Most companies in India destroy value because managements are not committed or adopt low standards of corporate governance. Focus on management quality adequately.
7. Is the auditor’s report qualified? This may appear to be a minor point but that is where the problem areas in a company first start to emerge. Take an auditor qualification very seriously because if the auditor is not happy and willing to put it on record then it shows that something is seriously wrong with the business.
8. What is the company’s strategy to sustain growth and leadership in future? Becoming a leader is one thing, sustaining is another. Take the case of Jet Airways. It became the leader in the aviation market but lost out market share to Indigo when it could not perfect or sustain the low-cost efficient model. Sustainability matters a lot!
9. Is the company’s employee turnover high? Some industries like IT have a large employee turnover by default. But you have to be cautious if top management is undergoing a perpetual churn. Also if the employee turnover is higher than industry average it is a worry. At the height of its problems, Infy had above average employee churn.
10. Does the company have a second line of management? Most management of companies are defined by one larger than life personality. You can see that across Indian companies. But is there a second line of defence to fall back upon. You cannot let a company falter if the CEO retires. Bet on a strong second line of management.
11. What is the company’s moat and how long will it sustain? Has the company created some unique advantage that will sustain its leadership? It could be in the form of a unique brand positioning, an incomparable market network, a sharp product recall, brand loyalty with a certain class of customers etc. A moat is all about value!
12. Does the company have excess debt in its balance sheet? Look at the all the leveraged infrastructure companies in the last 10 years. It has been all about value destruction. Debt may be lower cost funding but it also adds financial risk. When the tide turns, as in case of infrastructure, it is debt that first comes back to haunt you.
13. How are the company’s ROE and ROCE? That is the bottom line. Is the company generating enough resources to reward its equity shareholders and its debt holders? ROCE is relevant from the business attractiveness point of view but ROE is more relevant from the equity attractiveness quotient of the company.
14. Does the company consistently payout dividends to shareholders? Why are dividends important? It is a sign that the company has real cash to pay out. Dividend payout ratios matter more than the dividend yield of the stock. Consistent dividend policy is also useful from the company’s commitment to share profits with shareholders.
15. How rich is the company’s valuations? At some price every stock is attractive and at some price every stock is overpriced. That is where margin of safety comes in handy. It is not just enough to get a market price that is below the valuation, but it is also essential to leave a margin of safety that is large enough to justify buying the stock.
The 15-point matrix is almost a sure-shot answer to all your fundamental analysis questions. Now it is time to make your fundamental move!