Introduction to advanced fundamental anaylsis - what to do with the financials?

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So far, you’ve seen how to read the financials of a company and the reports available to the public. But what happens after that? What do you do with the financials once you’ve read them? What is the purpose of gathering all that information? Well, that’s what advanced fundamental analysis is all about. And that’s what we’ll be looking into in this chapter. 

Remember how, in the beginning of this module, we saw that picking a player for a cricket team had many parallels with fundamental analysis? Let’s revisit that once more to understand what happens after you’ve performed the techniques of fundamental analysis. The first step to figuring out if a certain player will be the right choice of captain of your team is to look at the performance and the track record of that player. Once you’ve used this technique to identify that he’s a good player, you look at his individual statistics to see if he meets your requirements. 

Let’s say you’ve done all of this analysis and you find that Varun, a player with 5 years of experience backing him up, appears to be the right choice. So, you now know that Varun is the player you want. But when it comes to the auction, what price are you willing to pay to make him a part of your team? 

  • He may be the best choice of captain for your team, but how much is he worth? 
  • Should you pay 10 crores for him? 
  • Or perhaps, 100 crores?
  • What if your total budget is only around 20 crores? And if you buy one Varun for your team, does that mean you cannot afford any other good players for your team?
  • In that case, it will leave your team with a great captain, some good batsmen, but below-average bowlers, won’t it?
  • In other words, is the player you wish to purchase worth the price you’re paying to have him in your team?

These questions, when applied to investing in a company’s shares, take you into the world of advanced fundamental analysis. Before you invest in a company, you’ll need to perform some due diligence to identify how that company’s stocks fit into your overall investment portfolio.

Advanced fundamental analysis: An overview 

Fundamental analysis is quite a large concept. It doesn’t just stop with interpreting and analysing the financial statements of a company. Assessing the quality of a stock is only the first step. You need to see what a stock is worth, and how it fits into your portfolio.

In fact, the goal of advanced fundamental analysis is to find out the intrinsic value of a company’s shares. By finding out the intrinsic value, you can determine the actual worth of a company and make an objective assessment of whether the stock of the said company is overvalued or undervalued. 

There are 3 main phases in performing company or equity research.

  1. Understanding the business, its financials, and its functioning 
  2. Application of your investor’s checklist 
  3. Valuation 

Let’s see how Pravin, a 30-year-old investor who is interested in investing in the shares of a company, goes through these phases. 

1. Understanding the business, its financials, and its functioning 

First, Pravin spends some time researching the financials and the annual report of the company. He then backs up this research with a lot of other information and insights from other reports prepared by analysts and experts. Following this, Pravin decides that the company he’s eyeing is a fundamentally strong entity that has the potential to be a good choice for an investment. 

Next, he needs to verify if the shares of the company fit into his portfolio and match his investor profile. Here’s where his individual investor’s checklist comes in. 

2. Application of the investor’s checklist 

Pravin lists out all his expectations in the form of a checklist and sets off on a mission to check whether the company that he chose satisfies them. Here’s a brief look at his expectations and the reasoning behind them.

 

Pravin’s expectations

His reasoning

1

PAT margin: greater than 15% 

The greater the profit, the more there is available for the shareholders.

2

Operating revenue: must increase YOY (year-over-year)  

An increase in the operating revenue signifies that the company is growing.

3

Earnings per share: must increase YOY 

A growth in the EPS directly benefits the shareholders.  

4

Return on capital employed: greater than 40% 

A high ROCE indicates that a company is efficient at utilising its overall capital. 

5

Debt to equity ratio: less than 1 

A low debt to equity ratio means that the company is not too heavily dependent on debt.

6

Average collection period: not greater than 15 days 

A low average collection period signifies that the company collects pending payments frequently from its debtors. 

7

Operating cash flow ratio: greater than 1

A high operating cash flow ratio indicates that the company generates enough cash to pay off all its current debt obligations. 

3. Valuation 

Upon verifying that the company successfully satisfies his checklist of expectations, Pravin takes a look at the current market price of the company. It is presently trading at Rs. 325 in the stock market. 

However, just like in the case of picking the right capital for your cricket, how does Pravin know that Rs. 325 is the right price for the share? And, how does he determine whether the company is worth the price it is being quoted at? 

Here’s where valuation of shares comes in handy. 

Wrapping up

Valuation helps you identify the real intrinsic value of the company. You can then use this information to determine whether the shares of the company are undervalued or overvalued. In the next module of Smart Money, we’ll be focusing singularly on the concept of valuation and the various methods used for valuing the shares of a company. So, stay tuned!  

A quick recap

  • Fundamental analysis is quite a large concept. It doesn’t just stop with interpreting and analysing the financial statements of a company. 
  • Assessing the quality of a stock is only the first step. You need to see what a stock is worth, and how it fits into your portfolio.
  • The goal of advanced fundamental analysis is to find out the intrinsic value of a company. 
  • By finding out the intrinsic value, you can determine the actual worth of a company and make an objective assessment of whether the stock of the said company is overvalued or undervalued. 
  • There are 3 main phases in performing company or equity research: understanding the business, its financials, and its functioning, application of your investor’s checklist, and valuation
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