Trading in stocks can be a rewarding experience, but like anything good in life, it comes with its own set of risks. This is why investors are regularly advised to evaluate the risks involved and perform a fundamental stock analysis before trading them. The term ‘fundamental analysis’ is a broad one that comprises several techniques and principles within it, all with the same objective of identifying the reasonable market value of the stock.

What is the Fundamental Analysis of Stocks?

The fundamental analysis of stocks is the process of identifying a stock's ‘real value'. The process involves thoroughly analysing the company's financial statements, such as its profit & loss statements, income earned, balance sheet, and cash flow reports, to assess its financial health, profitability, and growth prospects. Additionally, the fundamental analysis considers broader economic factors, such as industry trends, interest rates, macroeconomic indicators like inflation, etc.

Why is Fundamental Analysis Needed?

There was a recent IPO boom when the market was flooded with startups going public. The market conditions also supported this rush. However, many of those IPOs failed to live up to their expectations. There are many reasons for this, but one of the foremost was overvaluation. Many of those companies were valued way more than the actual worth of this stock. So, many investors purchased at the IPO price, and when the recent market correction happened, the prices dropped significantly, wiping out thousands of crores of investors’ wealth.

You can avoid falling into such a situation by first conducting the fundamental analysis of the stocks that you wish to invest in and determining beforehand if they are worth their current market price. 

Benefits of Fundamental Analysis

Here are some other benefits you can enjoy through this process:

• Identify the actual value of stocks – Using fundamental analysis, identify economically sound stocks presently undervalued in the market. Such stocks can be bought low, and you can earn a profit when the stock price rises. The principle also helps you identify overvalued stocks you can avoid.
• Evaluate a company's growth prospects – By diving into a company's financial statements as part of the fundamental analysis of stocks, you can receive valuable insights into a company's growth potential,  a vital criterion for long-term wealth creation.
• Assess its financial health – Fundamental analysis helps investors evaluate a company's financial health, including its profitability, liquidity, and solvency. Financially healthy companies are more likely to survive economic downturns and generate long-term returns for investors.

By providing a comprehensive understanding of a company's financial health and growth potential, fundamental analysis of stocks will help you make informed investment decisions that align with your investment objectives and risk tolerance.

Frequently Asked Questions

What are the types of fundamental analysis of stocks?

There are two main types: Quantitative Analysis and Qualitative Analysis. 

Quantitative Analysis uses financial statements (like income statements, balance sheets, and cash flow) and accounting metrics to evaluate a company's financial health, performance, solvency, and growth prospects. Financial ratios used to compare a company's financial performance to its peers and industry benchmarks, such as the price-to-earnings ratio (P/E ratio) and price-to-book ratio (P/B ratio), are all part of Quantitative Analysis.

Qualitative Analysis is more subjective and involves evaluating a company's non-financial factors, such as industry trends, competitive landscape, management quality, brand value, and overall business strategy.

How do you analyse the fundamentals of a stock?

To achieve a wholesome stock analysis, you must use quantitative and qualitative analysis principles. The subsequent recommended steps include; 

• Identifying the company you wish to invest in and gathering its financial statements and other metrics such as revenue, earnings, cash flow, debt, etc.
• Reviewing the company's financial statements to assess its financial health, profitability, liquidity, solvency, and growth prospects.
• Evaluating the company’s management stability, industry trends and other macroeconomic factors that may impede or accelerate the company's growth prospects.
• Using quantitative analysis tools, such as discounted cash flow analysis or price-to-earnings ratio, to estimate the stock's inherent value.
• Benchmark this value with the industry average to determine if the stock is overvalued or undervalued.

How do you use fundamental analysis?

The output of the fundamental analysis is used to make informed investment decisions. You can identify undervalued stocks that offer a higher earning potential or find overvalued stocks to stay away from. You can also identify a company's growth prospects and assess its financial health.