One of the most significant factors that will determine your success in the stock market is the accuracy of the information on which your investment decisions are based. Which securities to invest in and when to buy or sell are decisions best made after performing a thorough fundamental analysis of the market and the securities in question.
Investors can pick from various methodologies to recognize investment trends, analyze stock values, and identify exit and entry points. Two of the most commonly used analysis methods are fundamental analysis and technical analysis.
This article focuses on how fundamental analysis will give you insight into a company’s health and future growth. It will help you decide whether a company will be a good investment or a stock to avoid. It will ultimately assist you in improving your portfolio’s performance.
What Is Fundamental Analysis?
Fundamental Analysis measures a security’s true value or intrinsic value through a detailed evaluation of important financial and fundamental factors. Although investors and analysts often use it for stock analysis, you can also use it to evaluate other types of asset classes such as bonds and forex.
In fundamental analysis, analysts and investors study various microeconomic factors such as a company’s financial statements, management effectiveness, and competitive performance. Besides analyzing internal factors, fundamental analysis also looks at external macroeconomic factors like the economy, GDP, interest rates, financial markets, industry growth expectations, news, analyst projections, and more. When some of these fundamentals are positive (for example: higher than expected earnings result), the security’s price will most likely rise. Conversely, when the news is negative, the price will most likely fall.
Fundamental analysis aims to determine whether the security’s current market price is higher or lower than its real value. In other words, whether the security is over or undervalued. When the intrinsic value is higher than the market price, the security is considered undervalued. This means its future price is expected to rise, and therefore, it might be a good stock to buy. However, when the true value is lower than the current market price, the security is considered overvalued. In this case, many investors will sell the stock because its price will most likely go down.
Typically, long-term investors and value investors benefit most from fundamental analysis. However, short-term investors might also find value in fundamental analysis when used in combination with technical analysis to maximize their portfolio returns. There are many tools, metrics, and techniques that can be used to do fundamental analysis and value stocks. Analysts, investors, and traders love the versatility and use it in a way that suits their needs best.
Although there’s no “standard” way to conduct fundamental analysis, it usually consists of three primary components: economic analysis, industry/sector analysis, and company analysis. Economic analysis demands a good understanding of macroeconomics and economic indicators. For company analysis, basic finance and accounting knowledge will help you interpret a company’s financial statements and understand the methods used for valuing a company.
Two Approaches to Fundamental Analysis
There are two types of fundamental analysis, top-down and bottom-up analysis. Which approach to use depends on your goals, strategy, and the type of the underlying asset.
Top-down investing is an approach that starts with the analysis of the state of the economy and macroeconomic factors. Then it trickles down to sector and industry analysis and, finally, the fundamental analysis of a specific company.
Analysts and investors first consider macroeconomic factors such as GDP, interest rates, unemployment levels, and inflation to forecast the direction of the economy and market trends. After looking at the big picture, investors can then identify the industries and sectors that will most likely outperform the market and offer the most lucrative investment opportunities. Finally, the analysis of specific companies within the thriving industries can start. This will eventually result in picking the individual stocks that will offer the most potential.
Because the top-down approach focuses on analyzing readily available public information, most new and inexperienced investors prefer it. Other investors who prefer the top-down approach are those who lack the time or interest to do the in-depth financial calculations necessary to pick individual stocks themselves. Top-down investors often invest in industry-focused funds such as mutual funds, ETFs, and index funds. A top-down approach is a great way to diversify your portfolio and limit your investment risk.
Bottom-up fundamental analysis is the opposite of top-down analysis and starts with the analysis at a micro-level. You start by looking at individual companies and then select one or a few of those companies based on fundamentals and specific attributes.
For example, you might screen for companies with a low Price-To-Earnings ratio (PE ratio). A low P/E ratio often indicates that the stock is undervalued. Then you will do an in-depth evaluation based on each company’s financials, such as earnings growth and other fundamental factors. Factors such as a company’s management team, competitors, and its business plan should be part of the evaluation as well. You might even take external factors such a news reports and analysts’ reports into consideration.
Those who favor the bottom-up method look for strong companies that will perform well over time regardless of how well the industry or overall market will perform. Bottom-up investors usually follow the long-term buy-and-hold strategy.
There are pros and cons to both the top-down and the bottom-up approach to fundamental analysis. Which is best for you really is a personal matter and depends on your investment style. Another possibility is to combine both styles of fundamental analysis, as many investors do. This is not an easy thing to do. However, when you do it right, identify the correct criteria, and analyze them in a wider context, combining them can result in a highly diversified portfolio with high returns.
Who Uses Fundamental Analysis?
Fundamental analysis is very popular with value and long-term investors. It helps them identify undervalued stocks with good growth prospects and relatively low prices. Equity analysts also use fundamental analysis. They use it to set price targets and make buy, sell and hold recommendations to their clients.
Corporate executives, such as financial accountants and strategic managers, are other users of fundamental analysis. They use it for various reasons. For example, to analyze their company’s operating efficiency and profitability and compare the company against competitors. This way, they can make plans on how to increase the company’s market share. Another reason executives use fundamental analysis is to evaluate its brand image, improve it, and increase sales.
One of the biggest proponents of fundamental analysis is the legendary investor Warren Buffett. He uses fundamental analysis to help him pick the most promising value stocks for his investment portfolio.
What Is Intrinsic Value?
What is the value of a stock? The easiest answer is that the value of the stock is the current stock market price. The current stock price is the price that investors are willing to pay for the stock. However, external factors such as greed, news reports, and other factors often influence the market price. This can create short-term price volatility. So, an alternative question to ask is; What is a stock’s true value? In other words, what is the stock really worth, or what is its intrinsic value?
As mentioned before, investors use fundamental analysis to calculate a stock’s intrinsic value by evaluating various financial and fundamental factors. Fundamental analysis is based on several assumptions. First, it is based on the assumption that the current stock price (market value) does not reflect its true value.
Another assumption is that the value reflected by the company’s fundamentals is likely to be closer to the true stock value than its current market price.
The third and final assumption is that the stock market will reflect the stock’s fundamentals in the long run. This means that the market price will adjust and match the stock’s intrinsic value at some point.
For example, if a stock is currently trading at $150, but several fundamental analysts believe that the stock has a higher true value, it is fair to assume that it has an intrinsic value exceeding $150. Usually, investors will take the average of the analysts’ intrinsic values to establish the intrinsic value they will use. For example, 3 analysts have calculated 3 different intrinsic values; $175, $185, and $195. Typically, an investor will then assume that the intrinsic value of the stock is $185. Analysts use different methods to evaluate and calculate a stock’s intrinsic value. Therefore, it is completely understandable that they come up with different intrinsic values.
The investor’s goal is to find stocks with good fundamentals and high growth potential at a discounted price. Investors will then hold on to the stock until they believe it has reached its intrinsic value, at which point they will sell it at a profit.
Types of Fundamental Analysis
Fundamental analysis covers anything related to the strength and well-being of a company. Typically, the first things that come to mind are hard numbers such as revenue, profits, and earnings per share. However, other, less tangible factors, such as market share and brand recognition, also come into play when analyzing the health of a company. Therefore, company fundamentals are broken down into two categories, qualitative and quantitative factors.
Qualitative fundamental analysis involves data relating to the character or quality of the company. This type of data is difficult to measure because it is intangible. Here are some of a company’s key qualitative fundamental factors:
Business model – A business model is a framework of how a company plans to make money with its product or service in a specific market. This framework defines what the company does and what its intent is. This business model also includes the company’s value proposition, cost structure, and key metrics.
Competitive advantage – A company’s distinct competitive advantage, and its ability to keep its competitive advantage, decides its long-term success. It protects its market share and profitability. Businesses with a compelling advantage over the competition are usually good investments. Examples of competitive advantages are unique product features that are difficult to copy and technologies that are patent protected. Keeping a competitive advantage usually ensures solid future returns for shareholders.
Corporate governance – Corporate governance outlines the system of policies, rules, and practices within an organization that dictates how to direct and manage a company. It shows the relationships between directors, management, and stakeholders. Investors typically look for companies that adhere to the following principles: accountability, transparency, fairness, and responsibility. Many investors focus on companies in which shareholder communication is transparent.
Management – Many investors believe that a company’s management team is one of the most critical considerations when investing in stocks. Even the best business model can fail if management is unable to execute the plan. However, evaluating management is usually not an easy task. One way to check up on management is by researching team member biographies and their performance in their previous positions.
There are many other qualitative factors investors should take into account when analyzing the fundamentals of a company. Some of these include industry growth and regulations, market dominance, patents, brand recognition, business cycles, etc.
Quantitative fundamental analysis generally relies on hard data and numbers that can typically be found in a company’s financial statements. An example of quantitative analysis is to compare a company’s 1st quarter current year earnings with its 1st quarter earnings of the previous year. Another example would be to analyze a company’s stock price over the last 10 years.
A company’s financial statements are the most critical components of quantitative fundamental analysis. These statements disclose information about the company’s financial performance and overall health. The information used in quantitative analysis can generally be found in one of the following three financial statements: the Balance sheet, the Income statement, and the Statement of Cash Flows.
A balance sheet is a comprehensive record of a company’s liabilities, assets, and shareholders’ equity at a specific point in time. It offers a snapshot of what a company owns, owes, and the amount invested by its shareholders at a specific point in time. A balance sheet can help you understand a company’s financial position and thus help you determine a company’s real worth.
A balance sheet has two sections. One side represents a company’s assets, and the other side shows its liabilities and shareholders’ equity.
ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
A company’s assets are the resources a company owns or controls, including machinery, cash, buildings, and inventory. Liabilities represent debt, while equity represents the shareholders’ contribution to the business and includes retained earnings. Retained earnings are the previous year’s earnings that have not been distributed but have been put back into the business.
An income statement measures the performance of a company over a given time period. Income statements are typically published quarterly and annually and contain information about profit, profit margins, expenses, and revenue generated from a company’s business operations. You can analyze income statements on a year-to-year and quarter-to-quarter basis to get a good understanding of a company’s operations and its performance in comparison to its peers.
Investors should pay attention to high expenses, depreciation, financing costs, and any other line items that erode a company’s profitability. Income statements help investors understand whether the company will be able to sustain its earnings growth.
Statement of Cash Flows
The Statement of Cash Flows presents a record of cash inflow and outflow over a specific time frame. The three main activities that are included in the statement of cash flows are Cash From Investing (CFI), Cash From Financing (CFF), and Operating Cash Flow (OCF). Many investors pay close attention to cash flow statements because they are hard to manipulate. This is why investors use them as a more reliable measure of a company’s performance than income statements because income statements are sometimes “enhanced” by creative accountants.
Quantitative fundamental analysis also relies heavily on the use of financial ratios. Ratio analysis typically involves data from financial statements used in calculations to measure a company’s overall health and prospects.
Financial Ratios Used for Fundamental Stock Analysis
Fundamental analysis involves analyzing a company’s fundamentals to find its true value and its future growth prospects. There are many different tools you can use to analyze a company’s profitability and future performance. A key part of fundamental analysis is ratio analysis.
Here are some of the most common financial ratios that analysts and investors use to gauge a company’s fundamentals:
You can calculate the Price-to-Earnings ratio by dividing the company’s share price by its Earnings Per Share (EPS). It shows you how many dollars you have to pay for $1 in earnings. Typically, a lower P/E ratio means a good investment opportunity, while a high P/E ratio indicates an overvalued stock. However, sometimes, a high P/E ratio is good because it might mean that investors expect high future growth rates and that the high price is justified. An example of this would be the high P/E ratios of technology stocks.
Besides indicating whether a stock price is overvalued or undervalued, the P/E ratio also allows investors to compare stocks across the same sector or industry group and even across a benchmark like the S&P 500 index. The P/E ratio is a great starting point for identifying potential investments.
This ratio gives an idea of the businesses’ profitability. Earnings Per Share indicate how much profit is allocated to each outstanding share. A higher ratio denotes better performance and profitability and hence a better investment opportunity. You can easily calculate EPS by dividing the company’s earnings by the number of shares outstanding. Luckily many financial websites publish this number, so you do not have to calculate it.
The Price Earnings Growth ratio is an indicator that shows you how much you pay per unit of the expected earnings growth. The PEG ratio can be calculated by dividing a company’s P/E ratio by its earnings growth rate over a specific period of time. Investors often prefer it over the P/E ratio because the PEG doesn’t just look at historical earnings but estimates how likely it will gain value over time. It is best to only use it for companies with high growth rates and high P/E ratios. It can uncover companies with relatively limited earnings today that might, in fact, be strong investment candidates when future growth potential is taken into account.
Typically, stocks with a PEG ratio between 0 and 1.0 are considered undervalued, and stocks with a PEG ratio higher than 1.0 are considered overvalued. The degree to which a PEG ratio result indicates an over or underpriced stock varies by industry and company type.
The Debt-to-Equity ratio tells you how much debt a company uses to finance its operations. For example, if a company has a D/E ratio of 2.0, it has $2 of debt for every $1 in equity. Most investors prefer to invest in companies with low D/E ratios because the less debt a company has, the lower the risk.
Return on Equity (ROE) is a popular financial indicator. You can calculate it by dividing a company’s shareholders’ equity by its net income. It is usually expressed as a percentage and measures how efficient a company is when using its shareholders’ equity. The higher the ratio, the more efficient the company is.
The Price to Book ratio (P/B) shows the market value of a stock compared to its book value. You can calculate the P/B value by dividing a company’s stock price by its book value per share. The book value can be found on a company’s financial statements and is typically reported quarterly. A P/B ratio higher than 1 indicates that the market believes that the stock will grow faster than its book value suggests. High P/B ratios are common in high-growth stocks.
The Beta of a stock is a measurement of its volatility of returns relative to the market. The higher the Beta, the higher the volatility, but also, the higher the return potential. When Beta is between 0 and 1, the stock is less volatile than the market, and when Beta is greater than 1, the stock is more volatile than the market. When Beta is lower than 0, it indicates a negative correlation between the stock and the market.
This indicator shows the percentage a company pays out to its shareholders annually in dividends per dollar invested. You can find the dividend yield by dividing the yearly dividends per share by the total share value.
Differences between Fundamental Analysis and Technical Analysis
Fundamental analysis and technical analysis are used to analyze securities to make informed investment decisions. However, the two methods are quite different, and each has its own strengths and applications.
Fundamental analysis looks at a company’s financial statements and ratios, its growth prospects, management team, performance, press releases, and other fundamental factors specific to the company. Its objective is to find undervalued assets and to hold on to them for the long term. In other words, you can use fundamental analysis to identify assets with intrinsic values that are below their current market values. Then you hold on to these assets for the long term until their market value rises to the same level as its intrinsic value, at which point you should sell the asset at a profit.
Fundamental analysis is a favorite investment strategy for value investors and long-term investors saving for retirement. Although fundamental analysis is suitable for stocks, bonds, and derivatives, it does not work well for other types of securities.
On the other hand, technical analysis focuses on recent price and volume trends. It is useful for forecasting future price movements to find the best moment to enter and exit the market. Traders interested in short-term price movements generally carry out this analysis on charts. Technical analysts do not rely on a company’s fundamentals but instead, they rely on various technical indicators and chart patterns to predict a company’s future stock price behavior. Technical analysis is suitable for all asset classes.
Limitations of Fundamental Analysis
Although fundamental analysis is a great tool to find undervalued stocks, it does have some limitations. Investors should be aware of these limitations and adjust their strategy accordingly before making investment decisions. Here are some of the key limitations of fundamental analysis.
Time-consuming – Fundamental analysis is often time-consuming because it involves in-depth research into a company’s well-being. This is why fundamental analysis only works for longer-term investors. Investors with limited time might prefer the top-down analysis over the bottom-up approach.
Complex – To determine if a company will be a good investment, you must evaluate each company independently. The valuation of specific companies across industries can become very complex as different industries require different valuation techniques. This can make the process difficult and increase the chances of ambiguous results.
Over-dependence on past data – Fundamental analysis uses historical data to predict a company’s future growth. The fact that fundamental analysis finds undervalued stock does not guarantee that its intrinsic value will go up in the future.
False or biased data – Fundamental analysis is based on publicly available data and information coming directly from the company. There is a chance that analysts “misinterpret” this data during their analysis or that management manipulates data in their favor. This can result in incorrect information, leading to investment decisions that will not produce the returns you might expect.
Incorrect assumptions – When you project a company’s prospects based on assumed growth rates or interest rates, those assumptions must be correct. If your expectations are too high or unachievable, the entire investment can be a bust.
Fundamental analysis is a vital component of any investor’s toolkit. Its main purpose is to evaluate the quality of an investment and to determine the fair value of a company. Stock analysts use it to make recommendations to their clients, and investors use it to maximize their portfolio performance.
Fundamental analysis includes evaluating a company’s qualitative and quantitative factors, industry/sector analysis industry, and economic analysis. Analysis of a company’s financial statements and ratios, competitiveness, management efficiency, and growth prospects are all part of fundamental analysis. Its main focus is finding out-of-favor stocks and companies that trade significantly below their “true” or intrinsic value.
Fundamental analysis mostly benefits long-term investors. However, short-term investors can benefit from this strategy as well when used in combination with technical analysis.
You can fit both types of analysis to suit your investment style, time horizon, and type of security. By analyzing securities from as many different angles as possible, you most certainly will improve your chances of identifying investments with the largest return potential.