Fundamental analysis is the approach of viewing a publicly traded company as a business instead of just stock, in order to measure the financial health, growth and future prospects. Through fundamental analysis, value investors look for buying good, healthy businesses at cheap prices.
There are many ways fundamental analysis of a stock can be done, but I am going to share 5 step formula of fundamental analysis and how to pick stocks for long term portfolio:
Step 1: The financial performance
The first thing I look for in a company is its past financial performance. Analyzing past performance gives me a clear idea about company’s growth, earnings, profitability and how efficiently company is utilizing its capital. For this I look at 5 to 10 years of company’s data in the form of financial ratios. I use financial ratios because it makes it easier to compare a company’s performance with its peers. The financial ratios that I use are:
- Basic EPS: This is the basic earnings ratio which tells us about the company’s earnings on a per share basis. In other words, it is the ratio which tells us how much a company is earning against each share outstanding.
- Cash EPS: A conservative ratio compared to Basic EPS, which calculates how much cash a company is generating against each share of the company.
- Net profit margin: Gives you a idea about how much profit company is able to make on each sale made by the company. It is expressed in percentage terms. Higher percentage means company is able to charge high price from its customers, leaving fat profits in the pocket of the company.
- Debt/Equity: Gives an idea of how the company’s capital is financed. Companies with high debt usually are riskier investment because if a company suffers a loss, it still has to pay its debt, which can sometimes even lead to bankruptcy of a company. A company with low or zero debt is always preferable.
- ROCE: It is a financial ratio that measures how efficiently a company is utilizing its capital. For example i a company has employed Rs. 100 of capital and earns a return of Rs. 20, it means company’s ROCE is 20%. While Net profit margin shows the difference between the cost of making a product/service and revenue generated from the same, ROCE is calculated on total assets used by the company. Company with high ROCE are better investments as it shows company has good control over its financial resources and is able to run the business.
- Dividend per Share: It is the ratio that tells us how much dividend a company is paying against each share outstanding. Dividend is a part of company’s profit that company distributes to its shareholders. A company with consistent and growing dividend/share is a good investment as it keeps investors invested in the company.
Step 2: Reading Annual Reports
Reading annual report of the company for the past three years. This gives me an idea about what the company has been doing in its business, what goals and targets it had set for itself and if it has achieved them. A company that sets clear and time bound targets for this business shows how professional, and ambitious the management of the company is.
Step 3: Future plans
Every company has some future plans for its business. By looking at the company’s future plans, I get the direction in which the company is headed. Is the company going to start a new business, is it going to expand its current business? Is the company planning to go overseas? All such questions are answered by analyzing company’s future expansion and diversification plans.
After going through all the above mentioned steps I try to figure out how the company is going to look like in the future, what kind of revenues I can expect and what could be the profitability in the next 3 to 5 years. I don’t try to get the exact number but just a ballpark percentage growth I can expect in the future.
Step 4: Critical analysis
The fourth step I follow is to write down all the logical and rational reasons why I should invest in this stock. Doing so gives me ample positive and negative points about the company and areas where I should be cautious while investing. It is said that “If you cannot fill a page with logical reasons why you should invest in a stock, then you should not make that investment.“
Step 5: Waiting for the right price
Finally, I wait for the market correction to buy the stock at a low price. I do not put all the money at once, but buy on every dip in the price. Then there is a very long period of waiting, giving my investment time to grow. When I feel it is time to sell the stocks I start selling them in small quantities on every rally.
You may feel it’s a lot of work, but trust me it’s really worth all the effort.