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What is Fundamental
Analysis ?
Fundamentals are
associated with the economic health of a company, measured in terms of revenues,
earnings, assets, liabilities, Return on Equity (ROE), Return on Assets (ROA),
Return on Investments (ROI), growth prospects and cash flows, etc. The
fundamentals tell you about a company. You can say a company is having robust
fundamentals if it is growing at a nice pace, generating a profit, has limited
debts and abundant cash.
The analysis of
a company's
fundamentals involves
getting deep into its financials, rather than day-to-day movement in its share
price. Equity researchers normally do fundamental
analysis in
order to calculate the intrinsic value of a company's stock. If a company's
stock is trading above the intrinsic value or fair value, then the stock is
overvalued. If a company's stock is trading below the intrinsic value, then the
stock is undervalued. However, if you watch the stock markets very closely, the
share price of most companies never matches the fair value. Often, day traders
and investors who would prefer short term investment options invest in those
stocks, regardless of the companies' long term growth prospects. However, long
term investors generally prefer to invest in companies with robust fundamentals
and ignore near-term share price movements.
The following are various components that constitute a
company's fundamentals:
Revenues:
Revenues (sales) are the total amount of money received by a company through the
sales of its goods and services during a specific period of time. Revenues are
one of the most important barometers of the growth of a company as it indicates
whether there is demand for their products and services.
Cash flows:
Cash flows are calculated by deducting a company's cash payments from cash
receipts over a particular period of time. Cash flows indicate the liquidity
position of a company. However, one must pay particular attention to the
operating cash flows, since the health of the business can be most clearly seen
there.
Net income:
Net income, which is also called the 'bottom line', is calculated by subtracting
from revenue, all of the company's costs, such as operating costs, interest
expenses, depreciation, taxes and other expenses associated with running the
business.
Balance Sheet:
Balance sheet is the company's financial statement, which reflects its assets
and liabilities. A company's fundamentals are said to be robust if its assets
are significantly higher than the liabilities. However, one must carefully
analyze companies who are reporting large intangible assets as they may have
questionable liquidation value to offset any real liabilities.
Return on Assets (ROA):
ROA is an Indicator of a company's profitability, which is calculated by
dividing the net income for the past 12 months by total average assets of the
company. This is one of the important indicators, which long-term investors
consider before investing into a particular stock.
Although long-term investors and institutional investors consider
a company's fundamentals before investing, the share price of a
company often does not correspond to the fundamentals - which can present
enormous investment opportunities. A company's long-term growth is driven
primarily by fundamentals, while a company's share price can be driven by
short-term news and investor sentiment, which can be extremely volatile. Every
investor must consider a company's fundamentals before investing into its stock
if you want to gain stable returns over the long term.
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