Fundamental analysis of stock
Due to speculative nature of stock prices, it is nearly impossible to predict the future price of stocks. Stock prices are mainly run by investor perception about companies future performance and expected growth. But this assumption about growth of future stock prices is not scientific. Technical analysts do a detailed tracking of stock price In order to predict future stock prices but again this is not scientific and lot of information is left to assumptions. Fundamental analysts like Warren Buffett also estimates future prices of stocks and buy stocks, but the difference between Warren Buffett and technical analysts is the word “fundamental”.
Relationship between stock price and its fundamentals
Warren Buffett does the stock price estimation on basis of fundamental analysis of companies performance. In simple terms you can say Warren Buffett tries to establish a relationship between the market price of stock and business performance. But fundamental analysis of stocks holds true only for long term horizon. For short term investment goals technical analysis is more suitable. When I say long term it means time span of 10-15 years and short term means less than 3 years. Let me explain you how fundamental analysis is suitable for only long term investment goals. When we are linking market price of stocks with companies’ performance we also need to give time to companies to deliver results.
If we buy stocks today and in next one year we want our value to be doubled then its not scientific because stocks are not lotteries. Companies needs time to show results, suppose a companies stock is $10 today and its management decided to invest $1million dollar to expand and modernize its facilities to increase turnover and profit margin. The duration of the project is say 5 years, so till 5 years you cannot assume any substantial appreciation in the market price of stocks ($10). But as soon as the project is complete and company begins to increase its sales and profitability the same will start reflecting in the market price of stock. But why the market price of stocks appreciates after expansion and modernization of business? The answer is simple, expansion and modernization of business strengthens the fundamentals of business. When we say strengthening of fundamentals we mean increasing the following business performance parameters
- earnings &
- net worth of business.
Correlate price of stock with companies fundamentals
Here we will try to learn and correlate market price of stocks with company’s fundamentals performance parameters like sales, earnings and net worth. The objective is to study the fundamentals of past five years (say) of a company and try to predict the performance for next 5/10 years. Each listed company as a rule publishes its annual financial statements called Balance Sheet, Profit & Loss Statements & Cash Flow Statements. Details about sales, earnings and net worth are available in these financial statements. Fundamental analysis of stocks means studying balance sheet, profit and loss accounts, cash flow statements and correlating the results with market price of stocks. Financial statements shall be used to compute the following performance parameters:
- Sales / share (SPS)
- Earnings or net profit / share (EPS)
- Net worth – depreciation / share (NWPS)
By using the the above performance parameters one can study the behaviour of market price of stock with every change in sales, earnings & net worth of a company. Doing a study on financial results of at least last 5 years, one can understand the pattern of stock price movements. Select a company with the highest market capitalization; such companies follows a pattern (relating to financial performance) in a more certain way.