How to pick the right stock? (Analysis)

Stephen Covey, the author of The 7 Habits of Highly Effective People says, “You are a product of your decisions, not your circumstances” emphasizing the importance of decision making in our success or failure.

Our decisions become all the more important when it comes to investing in stocks.

Everybody aims for a 2-bagger, 3-bagger, or a multi-bagger but fundamentally it is our decision to pick a stock that is earning us money. So let’s come to the real question, how do we arrive at a decision to pick a particular stock?

There are different ways but primarily categorized as – Fundamental Analysis and Technical Analysis.

Fundamental Analysis is important to identify the intrinsic value of a stock by understanding the business both from a macro and microeconomic perspective.

Technical Analysis is to identify the future trends that stock might follow based on the patterns observed using the data from its previous trajectory.

Now we are talking on how Fundamental Analysis can aid us in picking the right stock. Though the parameters that influence a business are large in number but the fundamental factors that have a significant impact can be studied in detail.

When we understand the fundamentals there is a high probability that we are better positioned to predict the future of a business.

What exactly is Fundamental Analysis?

“Fundamental Analysis is the analysis of a business’s financial statements (earnings, assets, and liabilities), its health, its competitors and markets”, says Wikipedia.

Further, it also considers the macro-economic factors like economic outputs, interest rates, inflation, GDP, employment, etc as part of the analysis of a business.

Investing without any scientific basis, just with a profit motive is called speculative investing. It is similar to gambling. And such investment is of high risk.

Investing by adopting a rational approach is different from investing by speculation. Fundamental Analysis is that rational approach, for arriving at decisions, bringing the risk to lower proportions compared to speculation.

So on the whole, Fundamental Analysis means, considering the overall economic scenario while analyzing business and in that context understanding the business financial statements. This holistic picture of the fundamentals of a business will provide a solid background to arrive at a decision to pick up stock for investment. 

How Fundamental Analysis is done?

As mentioned above, it is a combination of the macroeconomic factors and the business fundamentals that we have to analyze as part of the fundamental analysis. It can be divided into 4 steps.

• The good bad and the ugly – Use the Financial Ratios for filtering a few good ones among hundreds of bad and ugly stocks. The stocks to be avoided are of high P/E, low sales growth, low ROE and ROCE, etc
• Follow the KYC procedure – i.e., Know Your Company. What’s the business? Its future prospects are given the current economic scenario? Who are its Competitors? Economic Moat? etc
• The Reports Troika of the Company – The Income Statement, The Balance Sheet, and The Cash Flow Statement. Analyze these statements to better understand the assets, liabilities, shareholder’s equity, cash flows, Revenues, Expenditure, Losses, etc
• The Equation – Verify the positives. And more importantly, check for the negatives like high debt, low cash flow, if any shares pledged, low promoter investment proportion, etc.

Finally make the informed decision based on above factors by selecting those stocks which are relatively better and have good future prospects.

The Final Verdict

Thus Fundamental Analysis forms an important role in rational decision making while investing in stocks. Although it cannot eliminate risk completely but can reduce the risk proportion of investment in the stock market drastically to a minimal level.

The key difference lies in here that we are making an informed decision while picking a stock using fundamental analysis and that is surely bound to give us decent returns when compared to the typical low return investment options.

Fundamental Analysis is a game of calculated risk, in our journey to financial freedom, that helps us in picking the right stocks and in turn giving meaningful returns.