Introduction to Fundamental Analysis

Introduction

Consider legendary investors like Rakesh Jhunjhunwala, Radhakrishna Damani, Peter Lynch, and Warren Buffet. What did all of them have in common? A few things. Their ability to identify undervalued opportunities, to confidently invest, and to remain invested even when markets told them otherwise. If you would like to learn to invest like them, then an understanding of the principles of fundamental analysis is essential to make informed long-term investment decisions.

Fundamental Analysis is a method of evaluating the intrinsic or fair value of a company by examining its financial health, management quality, industry trends, and other factors to make informed investment decisions. In short, it is a way of deciding what any security is actually worth.

Some key principles of FA are:

• Intrinsic Value: FA operates on the belief that every asset has a fair value, which can be arrived by analysing its underlying fundamentals. At its core, the idea is that the true value of any asset is the discounted present value of the future cash flows an investor cash realise from that asset.
• Long-Term Perspective: Fundamental analysis is typically used by investors with a long-term investment horizon.
• Holistic Approach: It considers a wide range of factors, both quantitative (financial data) and qualitative (management quality, brand reputation), to form a comprehensive view.

Two key methods to arrive at the intrinsic value of any asset are: absolute and relative valuation.

Think of the last time you considered buying a new phone. What went through your mind as you considered the price? Perhaps it seemed fairly priced? Or was it a steal at this price!

How would you decide that?

In one approach, you analyse the product, its specifications, and features, and decide if this phone was worth buying at that particular price. In the world of Fundamental Analysis, you undertook absolute valuation.

In the second approach, you compare this phone to other equivalent products in the market and consider how it stacks up against its competitors. In the world of Fundamental Analysis, you undertook relative valuation!

Why is this important? If you can identify and buy undervalued stocks, you can expect to make good returns on your investment. On the other hand, identifying an overvalued stock should prompt you to stay away from it.

Understanding how to analyse a company’s financials is a key step at arriving or calculating the true value of a company. Numbers tell a story that investors can use to understand the company, validate management commentary, find areas of strength of weakness in a company’s overall structure. With that in mind, from the next chapter, we dive into financial reporting and understanding key financial statements.