The Five Fundamentals of Fundamental Analysis

Fri, Jan 8, 2021 11:51 AM on Stock Market, Recommended, Exclusive,
Aashish Bhattarai
Disclaimer: This is an opinion piece. The author takes full credit and responsibility for the views presented in this article. 

Financial literacy is important in today's world led by money and finance. Every time you talk about finance, the capital market comes into the conversation. In Nepal, financial literacy is very low among people, perhaps only 20-30% are financially literate. People do not plan their retirement, safety fund, investments, and financial freedom.

You might have heard the popular Nepali song “चालिस कटेसि रमाउला |” (We'll rejoice after we turn 40.) But is an average Nepalese really in a comfortable financial state enough to do that?

Financial Literacy is hard to grasp given that our education system does not teach us anything about it. However, it is not rocket science! There are people from non-finance background investing wisely and earning a handful of profit. If you are educated enough to read, comprehend, and implement your learnings, you can master Finance and the capital market. Just to get things going, you can invest in IPOs with only Rs 1,000! With a few exceptions, IPOs are a great way to get almost-guaranteed profits!

Enough with the background, now I come to the point.

To invest in the capital market or stock market for the long term (more than 1 year), we should know the fundamentals of the particular stock that we buy. This means we should know whether the foundation of that company is strong or not. Behind every stock is a company that does a business of some sort. Our role is to find out what it does and how well it does it. Learning Fundamental analysis is a never-ending process. It needs dedication and observation. It might be hard, but it certainly is more rewarding.

There are five parameters to analyze a stock (company) to invest:

1. The Business Model of that Company:

We should be clear about the business model of the company: What it is selling, the quality of that product, how it is selling, etc. Let’s take NABIL Bank Limited as an example. This bank has a business model of selling loans at higher interest and getting a deposit in lower interest. The difference or the margin is what the bank gets as a profit. Now, I may be oversimplifying things, but isn't it a simple and effective business model?

The margin on interest is certainly not the only business of this bank - it earns a commission on other services provided. However, the interest margin is still the major income for Nabil banks and all other banks for that matter.

2. Industry Analysis:

We should analyze the industry of the stocks where we want to put our money. This may mean anything from studying its competitor, market share, industry growth, growth in business, possible merger and acquisition, entry barrier in the market, market share of the company, etc.

3. Financial Data Analysis:

We should analyze the financials of the company. We have to evaluate operating profit margins, sales (in the case of banks, this translates to the Loans and advances), working capital, cash/ liquidity status, Debt in company and Debt-equity ratio, reserve and surplus, retained earnings, etc.

4. Valuation:

We should know how to value a company. If we fail to properly value a company with a low margin of error, our profitability may get squeezed. An incorrect valuation can also lead to losses.

Charlie Munger says “A great business at a fair price is superior to a fair business at a great price”. This is why valuation is of utmost importance.

So how can we value a company? Here are different methods:

a. Analysis of the company's P/E, P/B ratios
b. Historical and Current EPS of the company
c. Analysis of the company's reserve and stability. Its ability to take losses while managing to stay in business.
d. Cash flow analysis.

These methods certainly help you to get a good valuation of the company.

5. Corporate Governance:

Last but not least, the success of any company is reliant on the integrity, competitiveness, and resourcefulness of BOD and Management. A keen investor takes notes of their media statements, their ambition towards the company, and their overall personality.

The percentage of promoters' holdings is also of utmost importance. It is beneficial to know who the promoters are, their background, what they were doing before starting this particular business, their vision for this business, etc.

Wrapping Up:

We should evaluate these five parameters to find the best company to invest in. In the capital market, like in any field, there are a lot of worthless charcoal and very few diamonds. It takes due diligence to discover such diamonds. But they are there, and fundamental analysis will help one find them. After finding them, a fundamental analyst should stick to it religiously. This is why investors doing fundamental analysis have a longer holding period than a technical analyst or a trader.

Lastly, the art of fundamental analysis does not have a checklist of things to put a tick mark on. The strategy is constantly evolving and so should an investor. As they say, change is the new constant. No guru or stock market expert can teach this art to its entirety. The best plan is to learn the skills, get direct exposure to the market, and perhaps learn from a lot of trials and errors.

Aashish Bhattarai is an Investor and a Stock Market Blogger learning the ropes as he goes.