Learn Fundamental Analysis: Final Section — Summing Fundamental Analysis
In the past sections, we’ve learned how to interpret financial statements and compute important financial ratios. These lessons set the stage for the ultimate goal, i.e. using fundamental analysis to pick the right stocks for investment. Before deciding to invest in a company, it’s important to go through a checklist based on its fundamentals. If a company meets most of the items on the checklist, it’s usually seen as a good investment choice.
There isn’t a one-size-fits-all checklist for investors. Each investor should create their own checklist based on their experience and preferences. However, it’s crucial to make sure that each item on the checklist is backed by sound logic and reasoning.
Here’s a simple process: first, we pick a stock that catches our attention. Then, we run it through our checklist to see if it meets our criteria. If it does, we consider investing; if not, we continue searching for other investment opportunities. This whole process helps to get perspective on making an investment decision whether to buy or not to buy a stock. We will go through each step in this section
Identifying the stock
So now when looking for interesting stocks, we can use a few methods like an observation of economic activities daily, i.e. getting a general view of the market and seeing which company an end user prefers, who is leading the national market, etc. Utilizing Stock screener features provided by all stock-related websites to pick a stock based on different parameters. Keeping an eye on both macro and microeconomics also helps to identify stocks. Investment opportunities can arise from various sources. Whenever you come across a stock that raises your interest, add it to your watch list. A stock may not meet your criteria initially, but as business conditions evolve, it might align with your checklist. Therefore, reassessing the stocks on your watch list is crucial.
Investment Due Diligence
Once you’ve chosen a stock, it’s important to conduct a thorough investigation using your checklist. This process is known as “Investment due diligence,” and it’s a critical step. Paying close attention to every aspect is essential to make informed investment decisions.
The investment due diligence process includes:
- Understanding the business which involves reading the company’s annual reports
- Evaluating the company based on your checklist criteria
- Estimating the intrinsic value of the business.
1. Understanding the business
It’s important to emphasize the significance of thoroughly understanding the business before making investment decisions. Many individuals skip this crucial step and jump straight into analyzing stock prices. While stock price analysis can be valuable for short-term goals, long-term investments must have a deep understanding of the business. Knowing the company well is vital because it boosts your confidence in holding onto your investment, even during tough times like bear markets. Understanding the business helps you see the value beyond market price fluctuations. In bear markets, consider adding to your position in a company you have strong conviction in instead of selling, as they often present value opportunities. To understand how a company is changing over time, it’s important to review its last five years of annual reports. This helps assess its performance across different business cycles.
When trying to understand a business, it’s essential to delve deep and get to know the company thoroughly. One effective approach is to create a list of questions that need answers. A fundamental starting point is to ask the basic question: “What is the core business of this company?” This helps establish a foundational understanding of the company’s operations. Rather than using Google search, it’s best to find this information in the company’s latest Annual Report or on their official website. This approach allows you to gain insights into how the company portrays itself and its business operations.
Some of the questions that can help to understand the business better may include:
These questions are just some examples. As you dig deeper into a company’s details, you’ll naturally come up with more questions that require answers. This iterative process helps uncover crucial information and leads to a more comprehensive assessment which will eventually help you get a greater understanding of the company.
Once you’ve completed this process, aim to create a concise one-page summary that captures the key findings and insights about the company. This summary sheet should effectively encapsulate all the essential information you’ve gathered during your research. The one-page summary should be concise and to the point. If you struggle to achieve this, it indicates that you might lack a comprehensive understanding of the company.
If you encounter any red flags or concerning issues while researching a company, it’s generally best to stop further analysis, regardless of how promising the business may seem initially. Addressing red flags or potential problems early on can save you from making risky investment decisions.
After completing step one proceed to step 2 which is applying the checklist.
2. Evaluating the company based on the checklist
Once we have a solid understanding of the business, we proceed to our next step, which involves applying our checklist. In this stage, we aim to gather performance-related insights. This helps to understand the financial figures and determine whether they are in harmony with the company’s core business. If there’s a mismatch between the two, it indicates that the company may not meet the criteria for investment.
Here’s a checklist that serves as a good starting point.
If you feel confident about the business after these two stages, based on facts, then it’s likely a good investment opportunity and worth considering.
Ultimately, even if a company meets all the criteria on the checklist, it’s crucial to consider whether the stock is trading at the right price in the market. The stock’s price is a key factor in determining whether it’s a good investment or not.
3. Estimating intrinsic value
A great investment happens when you get a great business for a great price. Buying a decent business can be acceptable as long as the price is fantastic. This emphasizes how crucial the price is in the world of investing.
The most popular valuation method is called the “Discounted Cash Flow (DCF) Analysis” which helps to determine the intrinsic value of the company. The intrinsic value, calculated using the Discounted Cash Flow (DCF) method, represents the estimated stock price of a company, considering all future cash flows.
The DCF (Discounted Cash Flow) model has several parts that work together. To understand it well, we’ll break down these parts step by step. We’ll begin with a core idea called “Net Present Value (NPV)”. After that, we’ll look at other concepts in DCF before putting it all together to understand DCF as a whole.
Next Chapter: Discounted Cash Flow (DCF) Analysis
