Fundamental stock market analysis.

Fundamental analysis of the stock market is identification of a fair stock price.

You can identify the fair price using mathematical calculations, for example:

• rate of return method;
• cash flow discounting method;
• or comparing competitive companies.

Mathematical models are rather complex, that is why we recommend to use annual reports, developed by different reference websites. Investors compare the fair price with the current market price and make a decision about selling or buying stock for making profit. In other words, the main goal of the fundamental analysis is to make profit, mainly in the long-term (investment) perspective. Two Americans, Benjamin Graham and David Dodd, laid the foundation of the fundamental analysis as early as in 1934. The full-fledged fundamental analysis consists of three parts:

• Macro- and micro-economic analysis. GDP, inflation, interest rates, unemployment and economic cycles – we will not consider these indicators in this article, since we considered them in detail in the article about fundamental analysis of the currency markets.
• Industry analysis. This analysis is conducted for better understanding of the company’s activity and its financial health.
• Company analysis.

It takes time and effort to conduct a comprehensive fundamental analysis. We will explain how to do it correctly from the theoretical point of view and will show you a practical example. The theoretical part of this article is scholarly and full of terms. If you have difficulties in perceiving a flow of terms, move to the practical section about the Lukoil company.

When conducting the industry analysis, investors assess attractiveness of the whole industry and prospects of its development. Besides, they assess the following indicators:

• Market size of the industry volume – this indicator is interesting for an investor from the point of view of the company’s growth potential. If the market size is limited, the stock price would not grow or would grow slowly. Such stocks are interesting for investors if the issuer pays stable and high dividends on the stock.

• Rates of the industry growth and profitability.

• Stages of the industry development:

Startup – earnings grow but there is no profit yet. It is risky to invest at this stage, but in case of efficient company development, the stock price would grow dramatically; Expansion – profit emerges and is reinvested into the company development. It is less risky to invest at this stage, but the growth of the stock price is lower; Explosive growth – earnings grow slower but the profit grows. The company has competitors. Inexperienced private investors, at last, notice the company at this stage; Maturity – the company starts to pay dividends at this stage. Conservative investors prefer a stable income and the stock price changes insignificantly; Downturn – it makes sense to sell the company’s stock at this stage.

• Industry significance. Export/import, state support and input into GDP are taken into account. Russia, for example, is oriented at the export of natural resources. The state supports oil producing companies.
• Competitive environment – whether there are monopolists, a number of competitive enterprises and their sizes.

• Dangers for the industry – for example, sanctions imposed against Rusal influenced the whole metallurgy industry and aluminium price in the world.

• Driving forces of the industry – for example, innovations connected with development of 5G networks would exert more influence on technological companies than on metallurgical ones.

It is difficult and effort consuming to professionally analyze activity of a specific company. It is necessary to study financial reports for several previous years. Various reference and analytical resources provide these data in a convenient form. Sometimes this information is free of charge, for example, on investing.com, sometimes you have to pay for it, for example, on zacks.com.

• If you want to conduct the analysis independently, study balance sheets, profit and loss accounts, cash flow reports and other financial documents. Pay attention to:
• Income and expenditures;
• Pre-tax and after-tax income;
• Return on equity;
• Cash flow;
• Earnings per share;
• Company balance and leverage ratio;
• Capitalization;
• Book and disposal value of the company;
• Customer base;
• Technologies and innovations;
• Management;
• Market share.

Ideally, the indicators should improve every quarter and every year. If you do not want to read reports, use basic financial ratios.

Financial ratios reflect basic company characteristics briefly and clearly.

• EPS – Earnings Per Share – net profit on one ordinary share.
• ROE – Return On Equity – profitability of own capital or how much net profit was made on one dollar of own capital. It is the rate, under which the shareholders’ funds work. The higher the ROE is, the better the shareholders’ funds work.
• P/E – Price to Earning – relation of the company’s capitalization to the profit. Or, in simpler words, in how many years investment will return. The company is considered to be undervalued if this indicator is 0 to 5.
• P/B  – Price to Booking – relation of profitability of own capital to the required rate of return. If the company ratio is higher than the industry ratio and the competitors’ ratio, the company could be overvalued. However, on the other hand, shareholders’ funds work more efficiently in companies with a high P/B. It is important for investors to understand why the ratio high or low.
• P/S – Price to Sales – relation of the share price to return on one share. Usually, this ratio is about 2, but if it is lower than 1, the company is undervalued.
• EBITDA – Earnings Before Interest, Taxation, Depreciation and Amortisation.

There are other financial ratios, some of which are used in specific industries only. For example, the relation of the company’s capitalization to the production is used for analyzing oil producing companies.

In this part of the article, we will show you how to conduct a fundamental analysis of the Lukoil company step-by-step. We do not conduct a multi-sided assessment and do not identify investment attractiveness, we just describe an algorithm consisting of 3 steps:

1. assessment of the economy;
2. assessment of the industry;
3. assessment of the company.

We take data from the analytical and reference websites:

• Analytical Center for the Government of the Russian Federation;
• Federal State Statistics Service;
• https://ru-stat.com;
• https://www.conomy.ru/.

We will not consider all economic indicators but only significant ones and will explain their influence on attractiveness of investing into the Russian business. This is not sufficient for a full-fledged and professional assessment but is quite acceptable for the purpose of an informative example.

Picture shows GDP and production growth of the RF; the bulletin of the current tendencies of the Russian economy No. 48, April 2019.

Growth of GDP, Industrial Production Index and export increase investment attractiveness of the country. However, the GDP growth rates are insignificant and one shouldn’t expect a big inflow of investments. Slowdown in the growth of real wages reduces the consumer purchasing power, which is a negative factor. Reduction of inflation results in reduction of interest rates and economic growth, which is a positive factor for the economy and investments. When interest rates go down, investors would look for more profitable variants of investing money funds than bank deposits. However, slowdown of growth of real income might decrease investments and increase current expenditures. The sanction pressure exerts a big influence on the Russian economy. It is difficult to make firm conclusions about the attractiveness of investments. However, return on stocks and bonds of Russian issuers is higher than that of the American and European ones.