If you’re a value or equity investor, you’ve probably heard of fundamental analysis. Equity analysts, securities analysts, financial accountants, and corporate managers use fundamental analysis to determine the value of various securities, such as stocks, bonds, and derivatives.
Whether you want to measure business acumen, find a good company to invest in, or predict the stock market’s long-term trends, this analysis is your way to go.
The most common reason for using it is making a smart investment based on a particular stock’s fair market price.
With that in mind, let’s look at what fundamental analysis is, along with its types and importance in investing.
What is Fundamental Analysis?
Fundamental analysis is a method of analyzing a company’s financial statements and related economic factors to determine a particular security’s intrinsic value.
When a fundamental analyst determines the value, a value investor can assess whether the security is overvalued or undervalued by looking at its current market price.
This can help growth or long-term investors as well, as they can evaluate the stock market trends and focus on companies with high growth potential.
The intrinsic value of a stock
A stock’s intrinsic value refers to its fair market value, also known as real or true value. It’s a hypothetical value that shows what a particular would be worth on the open market.
Why is this value significant?
It is because a stock’s current market price isn’t always realistic. A company’s financial data that’s publicly available rarely equals its actual value. That’s where various fundamental factors come in, as they enable analysts to reach a number that’s much closer to the company’s actual value.
In stock valuation, those fundamentals include the company’s future growth, revenues, profit margins, ROE (Return on Equity), and other financial data from the company’s balance sheets, income statements, and other financial reports.
Hypothetically, a stock’s intrinsic value is different from that in options trading. Determining option pricing requires a specific formula, while stock valuation involves many different analytical methods.
That said, a single stock’s intrinsic value may differ from one analyst to the next. For instance, if the stock’s current market price is $18, one’s estimate for it may be $15, while another analyst’s estimate could be $17. Investors can then come at an average to determine if investing in that stock would be profitable.
Factors that affect a stock’s intrinsic value
When conducting fundamental analysis, analysts look at various macroeconomic (external) and microeconomic (internal) factors that affect a stock’s intrinsic value.
Some of the fundamental external factors determining a company’s macroeconomic environment and affecting its stocks’ real value include:
- The overall state of the economy or GDP (Gross Domestic Product)
- Currency exchange rate
- A country’s balance of payments
- External debt
- Domestic political factors
- The company’s market characteristics
- Industry conditions
Some of the fundamental internal factors affecting the true value of a company’s stocks include:
- The company’s profitability and revenue growth
- Its funding sources’ structure
- Ownership structure
- Turnover rate
- Current liquidity ratio
- Reputation and management quality
- Investor relations
If all the company’s fundamental factors are positive, including its historical data, its share prices will likely go up. Otherwise, they might suffer a negative impact.
Fundamental analysis and value investing
As you now know, fundamental analysts estimate a company’s share price by analyzing its publicly available data. They arrive at a particular intrinsic value that shows the share’s real worth (or rather what it should be worth) compared to its current market price.
If they determine that the stock should be worth more than its current market price, it means that the stock is undervalued. When the intrinsic value is higher, analysts recommend a buy, giving the stock the so-called overweight rating.
Value investors can then buy the undervalued stock at a discount and grab an opportunity to make more money in the future. That’s because stocks with high ratings tend to have a high probability of going up over time, which is why they have a “long” position.
Conversely, stocks with lower ratings tend to have a higher probability of moving down over time, which is why their position is “short.”
If a fundamental analyst estimates that the stock has a lower intrinsic value than its current market price, it is overvalued. To help value investors make a smart decision, the analyst recommends a sell, that is, issues the so-called underweight rating.
It’s important to note that this is all about the power of probability. An abundance of factors influence stock prices, so fundamental analysis is not always 100% accurate.
No one can guarantee that an undervalued stock won’t go up in a day and reach its intrinsic value. On the stock market or any other securities market, big swings can happen in either direction.
Types of fundamental analysis
Depending on the type of fundamental factors for determining a company’s intrinsic value, there are two types of fundamental analysis:
Quantitative fundamentals include a company’s financial data. Their qualitative counterparts include less tangible factors, such as the company’s brand value and management effectiveness.
None is more important than the other, as both are crucial for accurate estimates. Let’s delve a bit deeper into each to understand them better.
Quantitative fundamental analysis
Quantitative fundamental analysis is all about numbers. It considers quantitative fundamentals that analysts can measure (e.g., revenue and profit) to see how well a particular organization operates.
Every company shares its financial statements publicly to showcase its financial performance. Fundamental analysts then analyze them to help investors make informed decisions.
Some of the most critical financial statements for a fundamental quantitative analysis include:
- Income statements
- Balance sheets
- Cash flow statements
An income statement shows a company’s income and expenditures over a certain period. That could be a day, a week, or any other time frame, but most publicly traded companies publish them on a quarterly and/or annual basis.
When you look at a company’s income statement, you can see all the revenues, expenses, and profits generated over a particular period. That way, you can see whether it is making a profit or suffering a certain financial loss.
A balance sheet is a financial statement that shows all the assets, liabilities, and shareholders’ equity of a company at a specific point in time.
Business assets include cash, real estate properties, inventory, machinery, vehicles, computers, office furniture, and all the other physical goods that a company owns or controls.
Business liabilities are all the payables, that is, any debt that the company must pay.
Shareholders’ equity or business net worth is the total value of money that the owners have invested in the organization. It’s the difference between total business assets and total business liabilities, for which there’s a simple formula:
Shareholders’ Equity = Assets – Liabilities
The balance sheet shows this equity as common shares, preferred shares, and retained earnings.
Cash flow statements
A cash flow statement shows all the cash and cash equivalents going in and out of a company. It shows how they’re affected by various changes in income and balance sheet accounts.
This statement helps determine if the company is generating enough cash to pay off its debt, cover its operating expenses, and fund various investment and financing operations.
When you look at an organization’s cash flow statement, you can see three different statements based on operating, investing, and financing activities:
- OCF (Operating Cash Flow) or CFO (Cash Flow from Operations) shows the net cash flow the company generates from daily business activities.
- CFI (Cash Flow from Investing) shows the cash flow the company used to buy and sell capital assets, such as business equipment. It’s a reflection of the company’s profits or losses from such long-term investments.
- CFF (Cash Flow from Financing) shows the net cash flow used for financing the company, including both borrowed and issued funds. As such, it reflects the company’s financial health and capital structure.
The cash flow statement is perhaps the most vital financial statement for an accurate fundamental analysis. That’s because businesses can’t fake the cash that they have at the bank, as opposed to their earnings, for example. That’s why many investors rely on cash flow statements the most.
Qualitative fundamental analysis
Qualitative fundamental analysis considers subjective characteristics of a company. For instance, analysts can evaluate how well a company manages its employees and what it does to gain a competitive edge.
They analyze such intangible factors to see how well the business operates and evaluate its growth potential.
There are four main qualitative fundamental factors that analysts consider when assessing a company:
- Business model
- Corporate governance
- Competitive advantage
Apart from these factors, it’s vital to look into the various industry conditions of the company. Some of the most notable areas to analyze are business cycles, industry-wide growth, customer base, and market share.
A company’s business model is its plan for generating a profit. It showcases all its products or services, target market, and all the expenses it anticipates to have in the short or long term. Think of it as a core strategy for doing business successfully.
A business model can show whether a company is making a profit from direct sales, subscriptions, or franchise fees.
Management might be the most vital qualitative fundamental to analyze before making an investment decision. That’s because poor management may derail a company’s plans. Even if it has the best possible business plan, ineffective management strategies may cause it to stray away from its goals and objectives.
Assessing managers can be a bit challenging, but their resumes and information on the company’s website can speak volumes about their performance. Fundamental analysts often look into their previous job performance and stock shares to gain a better insight into their management capabilities.
Corporate governance represents all the rules, policies, and practices that a company’s board of directors, managers, and stakeholders must abide by to run an efficient, ethical, and transparent business.
A corporate charter and company bylaws contain all the rules for running a company, and the board of directors determines them.
When there’s poor corporate governance within an organization, it often leads to a bad reputation and lower profitability. For instance, some managers may not respect certain shareholders’ rights, thus treating them unfairly and unethically. No one wants to do business with such an organization.
Every reliable company will gladly disclose critical information regarding its corporate governance so that fundamental analysts and related experts can assign it a corporate governance score.
Competitive advantage is another crucial factor influencing a company’s success in the long run. When it gains a competitive advantage and manages to keep it, it can keep generating profits continuously and support its shareholders for many years to come.
Take Apple, Microsoft, and The Coca-Cola Company, for example. They dominate their respective markets, not allowing their rivals to get closer and sit on their throne.
Investing in a powerful company with a tremendous competitive advantage is nearly always a smart idea.
Fundamental analysis processes
There are two main processes of fundamental analysis:
- A top-down approach
- A bottom-up approach
The top-down approach to fundamental analysis involves considering various macroeconomic factors first before analyzing a specific company. An analyst using this approach forecasts the trends in the economy as a whole, then assesses the industry, and finally evaluates the company itself.
This approach looks at the big picture, including how different industries and niches perform. When you see how numerous economic factors drive the overall market and various industries, including their individual stocks, you can gain a better insight into stock prices across sectors.
Investors who are new to the stock market or don’t have the time to sift through all the financial statements of an organization often choose the top-down approach.
The bottom-up approach is entirely the opposite. The fundamental analyst assesses the company first and then drills down to the macroeconomic factors that affect the company’s performance and potential for growth and profitability.
Using this approach, the analyst can compare a specific company’s performance to its competitors and drive valuable insights for smart investments. They can identify outperforming stocks quickly, as they spend the most time evaluating a company.
Experienced investors looking to find promising stocks with a high probability of outperforming the stock market, even during periods of downward trending prices, typically go for the bottom-up approach.
Technical analysis and the efficient market hypothesis
Not every stock analyst relies on fundamental analysis. Many criticize those who use it as they deem it ineffective or inaccurate.
Some of them prefer technical analysis, while others swear by the efficient market hypothesis (EMH). Here’s how they are different from fundamental analysis.
Technical analysis is a method of forecasting stock prices by analyzing historical trading data, such as stock prices and volume.
Technical analysts don’t consider any fundamentals but instead focus on stock movements over time to predict the direction of prices based on past trends and trading activity.
They look at short-term statistical charts to identify patterns and forecast trends, reversals, and price signals.
Introduced by Charles H. Dow back in the 1800s, technical analysis is an essential part of the Dow Theory, which posits that the stock market represents the overall economic and business conditions reliably. Analyzing the market could help identify the trends and forecast stocks’ direction.
The Dow Theory has six components, the most crucial being “The market discounts everything.” It means that the stock market incorporates all the information about a company into its stock prices and even discounts future events as a risk management strategy.
Hence, any stock’s price movements are better indicators of a company’s performance than its fundamental factors.
The efficient market hypothesis
The efficient market hypothesis is another crucial part of the Dow Theory. It’s closely related to technical analysis but has one significant difference.
This investment hypothesis also suggests that the market discounts everything, but it argues that beating the stock market through technical or fundamental analysis is impossible.
Stock prices change continuously, and no one can beat the market or make high returns in the long run, even with expert analyses. Only through risky investments could investors make high returns.
Fundamental analysis is an exciting method of measuring securities’ intrinsic value and assessing an organization’s growth and profitability potential. It may not provide accurate reports every time, but it can give a very close estimate.
It’s particularly beneficial for long-term investments, while technical analysis might be better for short-term investments, such as active trading.
Securities analysts, equity analysts, financial accountants, corporate managers, and investors often combine fundamental analysis with technical analysis to arrive at more accurate numbers and make smarter decisions. After all, both can be very insightful.
The former provides a more in-depth analysis of a company, while the latter can help identify trading patterns and trends on which investors can capitalize.