We will get down to studying the fundamentals of fundamental analysis in this part, including its key components. As mentioned in the preceding section, fundamental analysis entails examining a company’s financial accounts in order to determine its future possibilities. We make an effort to forecast its potential earnings and base our valuation on them. Each of these ideas will be discussed in this section.
But first, let’s go over a notion known as the efficient market hypothesis, which aims to clarify why investors rush to acquire shares of businesses that are anticipated to perform well and drive their valuations up.
WHAT IS THE EFFICIENT MARKET HYPOTHESIS?
Like you, equity investors choose to put their money into businesses they think will have rapid profit growth in the future. This is due to the larger possibility for future dividend payments that fast-growth firms have. This then encourages other investors to purchase them. Ultimately, it causes the stock price to increase.
ASSURANCES OF AN EFFICIENT MARKET THEORY
Three tenets underlie this philosophy: other market participants have all the knowledge necessary to make a judgment about the company’s prospects for the future; they act on this information, and this information is represented in market pricing.
A market is referred to as efficient if it exhibits certain features. In such marketplaces, every investor has access to every piece of information about a firm. They all base their investment choices on the same set of data. As a consequence, no one may benefit more than the other, and market prices represent all essential facts. The efficient market hypothesis of Eugene Fama from the 1960s was based on this principle.
Three types of data are used by fundamental analysts: historical data, publicly available data, and
INTRODUCTION TO STOCK VALUATION
Given that the market conditions we face now are not ideal, it is obvious that equity analysis can provide you with better returns than the market. Next, let’s move on to the process of assessing businesses. The methods for determining a stock’s fair or intrinsic value are covered in this section.
The price a stock should really be trading at based on your research is its fair or intrinsic value. To determine if it is overvalued, undervalued, or reasonably valued, you may compare it to the price at which it now trades on the market. In order to make a profit, you would like to purchase an undervalued stock since its price should rise to your estimation of its fair worth. If
There are three techniques used for the valuation of equity shares:
- PRESENT VALUE MODELS: The foundation of present value models is the idea that as shareholders are co-owners of the business, they are also entitled to any future profits. Therefore, the value of these equity shares should equal the total value of these earnings, expressed in current dollars.
- Money’s worth fluctuates throughout time. In ten years, Rs. 100 won’t be valued the same as it is now. In a similar vein, expected future income values will change from what they are now.
- Future revenues are split by a particular discount rate to determine their worth today in order to take this into consideration. The term “time value of money” refers to this. There are several variations of the present value model. Each of them has a unique understanding of future earnings.
RELATIVE VALUE (MULTIPLIER) MODELS: A business can also be appraised in relation to the worth of other, comparable businesses. In this instance, one of its basics, such as sales, book equity value, and net income, is compared to the market price of its competitors. The ratio is then used to determine the worth of the firm in question. Price multiples are the ratios applied in this context.
VALUE BASED ON ASSETS: According to this concept, a company’s worth is determined by the market value of its assets and liabilities. To determine the value of equity, the market value of obligations (excluding equity) must be deducted from the market value of assets. The majority of the company’s assets must be movable, long-term assets in order for the model to function.
INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS
A company can also be valued in comparison to the value of other, similar companies. In this case, one of its fundamentals, such as sales, book equity value, and net income, is contrasted with its rivals’ market prices. The value of the company in question is then calculated using the ratio. The ratios used in this situation are price multiples.
ASSET-BASED VALUE: The market value of a company’s assets and liabilities, according to this theory, determines how valuable it is. The market value of obligations (excluding equity) must be subtracted from the market value of assets to get the value of equity. For the strategy to work, the bulk of the company’s assets must be moveable, long-term assets.
- THE INCOME STATEMENT: The income statement discusses a company’s earnings and outlays for a specific fiscal year. Their nature divides them into numerous categories. The profit for the year is calculated by deducting expenses from earnings.
- You should consider the stability and potential for future development of earnings and costs while examining the income statement. Income from a company’s “core businesses” is used to measure the performance of the company. Although businesses may derive income from other sources as well, they are not regarded as reliable indicators of how effectively the business is run.
- When it comes to costs, you’re once again interested in considering the many expense categories, their importance to the company, the likelihood that they’ll occur again, and their function in