Fundamental Analysis: Principles, Types, and How to Use It ?

 

What Is Fundamental Analysis?

Fundamental analysis (FA) measures a security's intrinsic value by examining related economic and financial factors. Intrinsic value is the value of an investment based on the issuing company's financial situation and current market and economic conditions.

Fundamental analysts study anything that can affect the security's value, from macroeconomic factors such as the state of the economy and industry conditions to microeconomic factors like the effectiveness of the company's management.

The end goal is to determine a number that an investor can compare with a security's current price to see whether the security is undervalued or overvalued by other investors.

KEY TAKEAWAYS

• Fundamental analysts search for stocks currently trading at prices higher or lower than their real value.

• If the fair market value is higher than the market price, the stock is deemed undervalued, and a buy recommendati

• Fundamental analysis is a method of determining a stock's real or "fair market" value.

• on is given.

• If the fair market value is lower than the market price, the stock is deemed overvalued, and the recommendation might be not to buy or to sell if the stock is held.

• In contrast, technical analysts favor studying the historical price trends of the stock to predict short-term future trends.

Understanding Fundamental Analysis

Fundamental analysis is usually done from a macro to micro perspective to identify securities that are not correctly priced by the market.

Analysts typically study, in order:

• The overall state of the economy

• The strength of the specific industry

• The financial performance of the company issuing the stock

This ensures they arrive at a fair market value for the stock.

Sources for Fundamental Analysis

Fundamental analysis uses publicly available financial data to evaluate the value of an investment. The data is recorded on financial statements such as quarterly and annual reports and filings like the 10-Q (quarterly) or 10-K (annual). The 8-K is also informative because public companies must file it any time a reportable event occurs, like an acquisition or upper-level management change.

For example, you might perform a fundamental analysis of a bond's value by looking at economic factors such as interest rates and the overall state of the economy. Then, you'd evaluate the bond market and use financial data from similar bond issuers. Finally, you'd analyze the financial data from the issuing company, including external factors such as potential changes in its credit rating. You could also read through the 8-K, 10-Q, 10-K, and the issuer's annual reports to find out what they are doing, their goals, or other issues.

Fundamental analysis uses a company's revenues, earnings, future growth, return on equity, profit margins, and other data to determine a company's underlying value and potential for future growth.

Intrinsic Value

One of the primary assumptions behind fundamental analysis is that a stock's current price often does not fully reflect the value of the company when compared to publicly available financial data. A second assumption is that the value reflected from the company's fundamental data is more likely to be closer to the true value of the stock.

For example, say that a company's stock was trading at $20, and after extensive research on the company, an analyst determines that it ought to be worth $24. Another analyst does equal research but decides it should be worth $26.

Many investors will consider the average of these estimates and assume that the stock's intrinsic value may be near $25. Often investors consider these estimates highly relevant because they want to buy stocks trading at prices significantly below these intrinsic values.

This leads to a third major assumption of fundamental analysis: In the long run, the stock market will reflect the fundamentals. The problem is, no one knows how long "the long run" really is. It could be days or years.

This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a firm and find opportunities to buy at a discount or sell at a premium. The investment will pay off when the market catches up to the fundamentals.

Qualitative Fundamentals to Consider

There are four key fundamentals that analysts always consider when regarding a company. All are qualitative rather than quantitative. They include:

1.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?

2.Competitive Advantage

A company's long-term success is primarily driven 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.

3.Management

Some believe management is the most important criterion for investing in a company. It makes sense: Even the best business model is doomed if the company's leaders fail to execute the plan properly. 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 previous jobs? Have they been unloading a lot of their stock shares lately?

4.Corporate Governance

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, its bylaws, and 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. Make sure their communications to shareholders are transparent, clear, and understandable. If you don't get it, it's probably because they don't want you to.

5.Industry

It's also important to consider a company's industry: its customer base, market share among firms, industry-wide growth, competition, regulation, and business cycles. Learning how the industry works will give an investor a deeper understanding of a company's financial health.

Quantitative Fundamentals to Consider: Financial Statements

Financial statements are the medium by which a company discloses information concerning its financial performance. Followers of fundamental analysis use quantitative information from financial statements to make investment decisions. 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. It is called a balance sheet because the three sections—assets, liabilities, and shareholders' equity—must balance using the formula:

Assets = Liabilities + Shareholders' Equity

Assets represent the resources the business owns or controls at a given time. This includes items such as cash, inventory, machinery, and buildings. The other side of the equation represents the total financing value the company has used to acquire those assets.

Financing comes as a result of liabilities or equity. Liabilities represent debts or obligations that must be paid. In contrast, equity represents the total value of money that the owners have contributed to the business—including retained earnings, which is the profit left after paying all current obligations, dividends, and taxes. 

The Income Statement

While the balance sheet takes a snapshot approach in examining a business, 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 revenues, expenses, and profit generated from 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 challenging 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.