Fundamental analysis
Also written Fundamental research
Estimating what a share is worth from the profits and cash flows the business will generate, then buying only when the market price sits below that estimate.
In plain language
A share is part ownership of a company. Over the long run, the workbook argues, its value has to be driven by the profits and cash flows that company earns on its investments. Short-term prices wander away from that value, and when they wander far enough a profit-making opportunity appears.
So the fundamental analyst does two things in order. First, work out the fair price of the equity from the expected performance of the business. Second, compare it with the market price. Below intrinsic value, it is an attractive opportunity; above it, sell or avoid.
How it works
The workbook groups the whole exercise into three baskets, and every chapter of the syllabus after Chapter 4 fills one of them:
- Economic analysis — is the macro trend, cyclical and secular, going to help this industry grow or shrink?
- Industry analysis — how intense is the competition, and is the structure conducive to the existing players thriving?
- Company analysis — how is the company positioned against competitors, what is its cost structure, how strong is its financial position, how capable is the management, and is the governance structure sound?
It also separates two jobs that are usually run together. Research is obtaining the information; analysis is drawing the conclusion from it. The workbook is blunt that research is the harder half: an annual report is published once a year and starts going stale immediately, and it says nothing in depth about industry conditions or the economy. So the analyst reads market research, speaks to industry experts, and conducts primary research — visiting facilities, speaking to customers, suppliers and employees.
One boundary is absolute. Collating insider information is not research. Assembling individually insignificant pieces into an insight — mosaic analysis — is acceptable.
The formula
Fair value = f( expected profits, cash flows, risk )
Market price < fair value → attractive investment
Market price > fair value → sell or avoid
A worked example
Run the three baskets on a cement company.
Economy. Nominal GDP growing at 10%, infrastructure spending rising — cement demand tracks both.
Industry. National capacity 620 million tonnes against demand of 440 million tonnes: utilisation of 71%. Below roughly 80%, nobody has pricing power.
Company. Capacity 12 million tonnes, sales 9.1 million tonnes (76% utilisation), realisation Rs 4,650 a tonne, EBITDA Rs 950 a tonne.
Revenue = 9.1 mn t × Rs 4,650 = Rs 4,232 crore
EBITDA = 9.1 mn t × Rs 950 = Rs 864 crore
Less depreciation 260, interest 190 → PBT = Rs 414 crore
Tax 25% → PAT = Rs 311 crore
On 20 crore shares → EPS = Rs 15.55
At 14× earnings → Rs 218 per share
The share trades at Rs 176 — a 19% discount to the estimate. On the workbook's test, that is an attractive opportunity.
Now test the industry basket. Cut realisation by Rs 200 a tonne — a 4.3% price cut, which 71% utilisation makes entirely plausible. EBITDA per tonne falls to Rs 750:
EBITDA = Rs 682 crore → PBT 232 → PAT Rs 174 crore
EPS = Rs 8.72 → at 14× → Rs 122 per share
A 4.3% move in one industry variable took 44% off the valuation. That is why the economy and industry baskets exist, and why company analysis alone is not fundamental analysis.
Why NISM asks about it
Chapter 4 (Fundamentals of Research, section 4.4) defines fundamental analysis, lists the seven questions it asks and sorts them into the three baskets. Chapter 15.1 then tabulates it against technical analysis on focus, data source, time horizon, tools, assumptions, objectives and who uses it — that table is heavily examined.
Common exam traps
- Fundamental analysis is for long-term investing. Chapter 15.1's table is explicit: short and medium-term trading belongs to technical analysis. A correct valuation can be wrong for years.
- It contradicts the Efficient Market Hypothesis by construction (Chapter 4.4). If prices already reflected all relevant information there would be no divergence to exploit.
- A good company is not the same as a good investment. The test is price against intrinsic value, not the quality of the business on its own.
- The three baskets run economy, industry, company. An answer that reduces fundamental analysis to reading financial statements has dropped two-thirds of it.
- Research and analysis are different jobs (Chapter 4.2). Getting information the market does not have is the harder half, and the annual report goes stale from the day it is filed.
- Primary research is legitimate; insider information is not. Mosaic analysis — individually insignificant pieces assembled into an insight — is acceptable, and the analyst must be able to tell which side of the line an insight came from.
Check yourself
1.The fundamental analyst's thought process — that price can diverge significantly from fair value, creating a profit-making opportunity — is described in the workbook as:
- a)A direct application of the Efficient Market Hypothesis
- b)In contradiction of the Efficient Market Hypothesis
- c)Unrelated to the Efficient Market Hypothesis
- d)A special case of the Efficient Market Hypothesis that applies only to small-cap stocks
Show the answer
Answer: (b) In contradiction of the Efficient Market Hypothesis
The workbook says this thought process is in contradiction of Efficient Market Hypothesis (EMH), which propagates that share prices incorporate and reflect all relevant information.
The logic is worth holding on to. If EMH were fully true, price would always equal fair value, there would be no divergence to exploit, and estimating intrinsic value would be pointless. Fundamental analysis only earns its keep because prices can be wrong.
Option A inverts the relationship. Option C is wrong because the workbook explicitly links them. Option D invents a size-based carve-out found nowhere in the text.
2.Which of the following is NOT one of the core assumptions of technical analysis listed in the workbook?
- a)Price discounts everything
- b)Price moves in trends
- c)Intrinsic value determines the market price over time
- d)Volume confirms price
Show the answer
Answer: (c) Intrinsic value determines the market price over time
The workbook lists five assumptions: price discounts everything, price moves in trends, history repeats itself, market action is predictable to a degree, and volume confirms price.
Intrinsic value determining price is the fundamental analyst’s position, and the comparison table draws the line explicitly: the technical assumption is that the current market price captures all the information, while fundamental analysis holds that prices may at times deviate from intrinsic value.
The other three options are quoted assumptions and are therefore wrong answers to a "NOT" question.
3.The ________ of commodities is largely dependent on the supply and demand dynamics of the particular commodity.
- a)Technical analysis
- b)Fundamental analysis
- c)SWOT analysis
- d)Ratio analysis
Show the answer
Answer: (b) Fundamental analysis
The fundamental analysis of commodities is largely dependent on the supply and demand dynamics of a particular commodity whereas in equity market, it is largely the study of balance sheet, profit and loss account as well as cash flow statement and performance of the company, industry and economy.
This contrast is the organising idea of the whole chapter. A commodity has no financial statements to analyse — two barrels of the same grade of crude are identical regardless of who produced them. So the analyst's attention shifts entirely to physical availability and consumption.
On the supply side, the drivers are production levels — crop yields, mining output, oil drilling capacity, weather and natural disasters, geopolitical events, technology and infrastructure, government policies and cost of production.
On the demand side: global economic growth, industrial and infrastructure development, consumer preferences and lifestyle, population growth and urbanization, substitutes and alternatives, and seasonality.
And geography matters in a way it does not for equities: copper is largely produced in Chile, a South American Country, which is largely affected by weather aberrations, labour strike and many more, that affects supply of copper to the world market.
Where this is taught
- Series XV · Chapter 4: Fundamentals of Researchintroduced here
- Series X-A · Chapter 8: Investing in Stocksintroduced here
Related terms
- Discounted Cash FlowA valuation method that estimates the cash a business will generate in future years and converts each year back to what it is worth today.
- Efficient Market HypothesisThe proposition that share prices already incorporate and reflect all relevant information — which, if true, leaves nothing for an analyst to find by studying that information.
- Intrinsic valueWhat an asset is actually worth — the present value of the cash it will generate over its remaining life, as against whatever price the market is quoting today.
- Margin of safetyThe gap between a security's estimated intrinsic value and the lower price paid for it — the cushion that protects the buyer when the estimate turns out to be wrong.
- MoatThe durable competitive advantage that lets a company keep earning high returns while competitors try and fail to take its business.
- Technical analysisForecasting price direction from past price and volume alone, on the assumption that everything worth knowing about a company is already in its price.
- Top-down approachSizing a market by starting from macro-economic or population-level data and narrowing down to the industry — the opposite of aggregating individual companies.
- Bottom-up approachSizing a market by taking the revenue of individual companies and aggregating it upward — accurate where companies disclose, blind where they do not.