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Why is it important to look at the fundamentals of a stock before investing

17 Jul 2023

Research and analysis lies at the base of investing. The smart trader will tell you that you don’t need to spend time on fundamentals. The market is normally smart and the best you can do is to identify trends using technical. There are also traders who purely trade on news flows. Then why are fundamentals so important. That is because the best to way to find an under-priced investment is by understanding the financial and non-financial contours of the company. Only then can you have a reasonable value imputation done and take an investment decision accordingly. Let us now look at how to analyst a stock before investing and the importance of fundamental analysis in the investment decision. Let us also learn fundamental analysis of stocks with some key decision points. There are 5 things that really matter to a stock value and all these are actually fundamental.

Growth is sales, profits and margins

For a company to create value, it has to be constantly growing. Agreed that the best of companies will see downturns but the average CAGR of growth must be positive over a period of time.  The average CAGR of growth is a good measure of a company's long-term performance. You can use a CAGR calculator to estimate the average CAGR of growth for a company over a specific period of time. This information can be helpful in making investment decisions.When we talk of growth will refer to the most basic growth in top line. This growth in top line comes either from higher volumes or from higher price, depending on the size of the market and the pricing power of the company. Higher sales also must translate into higher profit growth because that is what your shareholders are earning after meeting all expenses. The best way is to capture the profit margins under different conditions like margins from sales, operating margins, gross margins etc.

How efficiently is the company being run?

When two companies operative in the same industry with almost similar operating conditions, what distinguishes them is efficiency. How is one oil company able to maintain higher levels of gross refining margins? How is just one company able to keep a sales to assets ratio of above 2, while the rest are struggling even to cross, In case of banks and financials, the efficiency is measured by how efficiently the bank manages the net interest margins (NIMs) and the NPA. One of the most popular measures of this is the asset turnover ratio, which is the ratio of sales to assets and shows the efficiency of utilization.

How is the company rewarding capital?

It is one thing to raise fresh capital but another thing to service the capital. Here are a number of factors come into play. Is the debt component of capital too huge to afford the interest cost on debt? What are the risks entailed. Also look at if the company has the capacity to service equity and be wary dilution is hitting you. Also compare the ROE of the company with the ROE and the healthier they are and the more the ROE and the ROCE align it means that the interests of the stakeholders are better aligned.

How is the company creating a moat?

Moat refers to a unique advantage that the company has created through sheer investment and diligence. For example brands like Britannia; distribution networks like ITC are at great advantage due to these moats that they have created. Also, these moats are critical to valuation of the company since a cop nay with a better moat normally gets a better valuation. The moat can be in the form of brands, distribution networks, access to cheap funds etc. Warren Buffett has always talked about a moat for sustainable growth and valuation in the future.

Valuations and the margin of safety

This is the ultimate purpose of all the above exercise. You need to arrive at an intrinsic value for the company and then decide whether the stock is under-priced or overpriced. For this exercise, the first step is to project the future cash flows of the company for the next few years. Then these cash flows are discounted backward to the current value based on a cost of capital discounting. Once this valuation is arrived, this is further ratified with benchmarks of P/E Ratios, P/BV ratios and dividend yields. That is where fundamental analysis ends and it is the key to valuing a stock in the market.

It needs to be remembered that fundamental analysis is not just about quantitative valuations but also factors intangibles like management quality, corporate governance standards and the disclosure levels. It is only when you mange to combine all these factors that you get a reasonable benchmark to value the companies. Technical or news flows can only give you short term trends in the market. For long term value, you still need to some serious fundamental analysis.

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