The goal of fundamental analysis is to determine the intrinsic value of a stock. But why is intrinsic value important? what does that tell you?

Let's understand this with an example. You want to buy a shirt. The merchant will tell you that its price is Rs.1000. You look at the material of the shirt, stitch, color, pattern, etc. You decide that it cannot be worth more than Rs.700.

This Rs 700 is its 'intrinsic value'. A company's intrinsic value is simply its total assets minus its total liabilities.

Let's apply the same concept to stocks. Tata Consultancy Services Ltd (TCS) stock price is Rs 3,100. You believe the stock will do well in the future. But he also believes that the current prices are a bit "overvalued". So you wait till fall to buy TCS at a discount.

TCS stock price drops to Rs 2,800 after 1 month. Go ahead and buy the stock. Think you got a discount of Rs.300.

But what if I told you that the ‘intrinsic value’ of TCS is Rs 2,500?

Now, you have paid Rs 300 more for the stock! It is important to know a stock’s intrinsic value to avoid such situations. It will help you decide whether you are buying shares at a discount or paying extra.

  • If the Intrinsic Value is higher than the stock price, the stock is undervalued.
  • If the Intrinsic Value is lower than the stock price, the stock is overvalued.

Remember, stock prices generally revert to their intrinsic value in the long run. In the above example, suppose TCS is trading at Rs 2,000. Its intrinsic value is Rs 2,500.

  • In this case, TCS is undervalued. So, you will buy TCS Ltd at Rs 2,000 as you expect it to revert to its intrinsic value (Rs 2,500).
  • If TCS was trading at Rs 3,100 then you will sell it as it will revert to its intrinsic value (Rs 2,500).

Types of Fundamental Analysis

Fundamental analysis is not limited to only studying a company’s balance sheet. There are two types of fundamental analysis –

 

Let us first understand qualitative fundamental analysis. What do you see in the below picture? A skull or a little girl playing in a garden?

Both are true! There are people who see a skull and others who see a girl. There is no change in the picture, but opinions do. This is an example of qualitative analysis. It is subjective.

Qualitative Fundamental Analysis includes studying a company’s:

  • Quality of management
  • Corporate governance

For example: Should a business be managed by promoters or experienced professionals?

  • Business owners and promoters who built the business from the ground up and know everything about it may be considered better managers by some investors.
  • Some investors may favor having experts manage their businesses. By doing so, the company can make tough decisions and remain at the top of its game.

Same situations, different conclusions.

This is why qualitative financial analysis is not solid science. It changes with every investor. But investment decisions cannot be made based on emotions. This is where ‘Quantitative Analysis’ comes into the picture.

Quantitative Fundamental Analysis is a study of a company’s finances. It involves studying:

  • Balance Sheet
  • Cash flow statements
  • Profit and Loss (P&L) statements.

Quantitative analysis is based on formulas and ratios. It helps you find how the company has performed year after year. Whether the revenues are stable or not. Financial ratios play an important role in fundamental analysis. There are five types of financial ratios. We will discuss these ratios in detail later.