Fundamental Analysis is the process to understand the intrinsic value of a share. In this process, external factors, company financials and other such factors are analyzed to understand the position of the company’s share. To understand what is that fair value, you should take the help of fundamentals, which are what drives prices up and down.
Fundamental analysis is a way to avoid short-term information about a company/stock. Every day there is some news on stocks. While these information may form the basis of trades, not everyone in the stock market is a trader. Many people believe in long-term investing. They want to buy and hold stocks.
Fundamental analysis helps you identify attributes of companies. The process of fundamental analysis will require you to understand a bit of mathematics, business and accounting basics. Along with this, you will need to have some common sense of how the company operates, the industry/sector and other things that can be imbibed from various documents.
For stocks, fundamental analysis uses revenues, earnings, future growth, return on equity, profit margins, and other data to determine a company’s underlying value and potential for future growth. All of this data is available in a company’s financial statements.
Fundamental analysis is used largely by long-term or value investors to identify well-priced stocks and those with favorable prospects. Equity analysts will also use fundamental analysis to generate price targets and recommendations to clients (e.g., buy, hold, or sell).
Components of Fundamental Analysis
Fundamental analysis consists of three main parts:
- Economic analysis
- Industry analysis
- Company analysis
The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial meaning of these terms isn’t much different from their standard definitions. Here is how a dictionary defines the terms:
- Quantitative– “related to information that can be shown in numbers and amounts.”
- Qualitative– “relating to the nature or standard of something, rather than to its quantity.”
There are four key fundamentals that analysts always consider when regarding a company. They include:
The business model
What exactly does the company do? This isn’t as straightforward as it seems. If a company’s business model is based on selling fast-food chicken, is it making its money that way? Or is it just coasting on royalty and franchise fees?
A company’s long-term success is driven largely by its ability to maintain a competitive advantage—and keep it. Powerful competitive advantages, such as Coca-Cola’s brand name and Microsoft’s domination of the personal computer operating system, create a moat around a business allowing it to keep competitors at bay and enjoy growth and profits. When a company can achieve a competitive advantage, its shareholders can be well rewarded for decades.
Some believe that management is the most important criterion for investing in a company. While it’s hard for retail investors to meet and truly evaluate managers, you can look at the corporate website and check the resumes of the top brass and the board members. How well did they perform in prior jobs? Have they been unloading a lot of their stock shares lately?
Corporate governance describes the policies in place within an organization denoting the relationships and responsibilities between management, directors, and stakeholders. These policies are defined and determined in the company charter and its bylaws, along with corporate laws and regulations. You want to do business with a company that is run ethically, fairly, transparently, and efficiently. Particularly note whether management respects shareholder rights and shareholder interests.
The three most important financial statements are income statements, balance sheets, and cash flow statements.
The Balance Sheet
The balance sheet represents a record of a company’s assets, liabilities, and equity at a particular point in time. The balance sheet is named by the fact that a business’s financial structure balances in the following manner:
Assets = Liabilities + Shareholders’ Equity
Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery, and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets.
Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business – including retained earnings, which is the profit made in previous years.
The Income Statement
The income statement measures a company’s performance over a specific time frame. Technically, you could have a balance sheet for a month or even a day, but you’ll only see public companies report quarterly and annually.
The income statement presents information about revenues, expenses, and profit that was generated as a result of the business’ operations for that period.
Statement of Cash Flows
The statement of cash flows represents a record of a business’ cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities:
- Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment, or long-term assets
- Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds
- Operating Cash Flow (OCF): Cash generated from day-to-day business operations
The cash flow statement is important because it’s very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it’s tough to fake cash in the bank. For this reason, some investors use the cash flow statement as a more conservative measure of a company’s performance.
Top-down vs. Bottom-up Fundamental Analysis
Fundamental analysis can be either top-down or bottom-up.
An investor who follows the top-down approach starts the analysis with the consideration of the health of the overall economy. By analyzing various macroeconomic factors such as interest rates, inflation, and GDP levels, an investor tries to determine the overall direction of the economy and identifies the industries and sectors of the economy offering the best investment opportunities.
Afterward, the investor assesses specific prospects and potential opportunities within the identified industries and sectors. Finally, they analyze and select individual stocks within the most promising industries and company valuation.
Alternatively, there is the bottom-up approach.
Instead of starting the analysis from the larger scale, the bottom-up approach immediately dives into the analysis of individual stocks. The rationale of investors who follow the bottom-up approach is that individual stocks may perform much better than the overall industry.
The bottom-up approach is primarily concentrated on various microeconomic factors such as a company’s earnings and financial metrics. Analysts who use such an approach develop a thorough assessment of each company to gain a better understanding of its operations.
Fundamental Analysis is used to make long term investments. Investment in a company with good fundamentals creates wealth. Using Fundamental Analysis, one can separate an investment-grade company from a junk company. All investment-grade companies exhibit a few common traits. Likewise, all junk companies exhibit common traits. Fundamental analysis helps the analysts identify these traits.