Whether you have ambitions of writing supercomputer code using artificial intelligence to find the holy grail of life-long investment success, or whether you want to get into short term stock trading, sooner or later you are going to have to learn how to do fundamental analysis on stocks.
What is fundamental analysis
Here follows a rather dry definition.
Fundamental analysis is that branch of investing that looks principally into the ratios derived from the financial statements of a company. It compares a company against similar companies in its industry and sector and takes into account the broader market and wider economic trends in inflation and GDP.
Fundamental analysis seeks to assess a company’s intrinsic value and how that compares with its market value. The goal is to determine whether the current stock price is under or overvalued and to find other indicators that suggest where the stock price will go. Fundamental analysis is one of the main branches of analysis in the financial arena, the others are technical analysis and quantitative analysis.
To learn more about technical analysis, check here.
To learn more about quantitative analysis, check here.
Here is an earlier article that gives a straightforward and simple guide to financial ratios.
An important point to note, and it is easy to get confused over this is that fundamental analysis is both a method of analysis in its own right and, it has come to mean a particular investment strategy or philosophy if you like that word in this context. Though personally when I see the word philosophy I think of stuffy 17th-century guys wearing wigs.
From a pure analysis perspective the definition a few paragraphs up is sufficient. But as regards an investment strategy if you are an investor who adheres to the school of fundamental analysis then:
- you will invest in a stock that you find to have higher intrinsic value than their current market price, you might even up the ante trading options to increase your potential upside gain,
- and if you are feeling bold you might short-sell stock whose intrinsic value you find to be lower than the current market price.
There are several relevant theories here just to list and explain a few:
The efficient market hypothesis – states that the market is a big-thinking machine and prices adjust to reflect all the information everyone has about values and prices and what is going on in the economy, etc.
So if we do our fundamental analysis and find a stock whose price is currently undervalued by the market then if the efficient market hypothesis is correct, the market has blinders on and will eventually learn all it needs to know and the price will adjust over time to its true value.
The random walk hypothesis – says that stock prices move randomly from one day to the next. There may be long term trends that a stock price adjusts to driven by events such as dividends being raised or lowered or mergers or acquisitions. But from one day to the next, since all the information about companies is known to everyone in the market – or so the theory goes – any price changes follow a random path and in the short term cannot be predicted.
What to analyze
The simple answer to this question is pretty much anything that lends itself to analysis but obviously, that isn’t realistic. So starting from the company we could say let’s analyze: assets, liabilities, profit margins, returns on assets, returns on equity, earnings, dividends, competition, markets, the local economy, inflation and the global economy.
In reality, though most investors wouldn’t start with a company and decide to analyze it. You are much more likely to want to weed out the less promising prospects and focus only on likely targets for investment. So it makes more sense to start from the macro side. A logical approach would be.
Global economic situation – here we would be trying to answer a question whether it would make sense to invest in stock or would we be better of in fixed interest bonds or even cash. The questions here are:
- what has GDP growth been like,
- is inflation high, low, steady or volatile, and
- are interest rates high, low, steady or volatile
The global economic picture will tell us whether conditions are favorable for stocks altogether. Steady GDP growth, stable and low inflation, and interest rates, and other factors such as adequate supplies of and acceptably priced commodities and energy tend to favor up-trending stock prices.
If the general global economic situation points to favorable conditions for stocks, it will likely be more favorable for some economic sectors and some industries than for others. Politics may also play its part here. Political circumstances may for example favor public infrastructure projects, which could favor the construction industry or the telecom industry. Particular regions or states may also have policies that favor certain sectors or industries. Under those conditions, it is then a question of which companies would be best positioned to benefit.
Getting down to a small group of companies
There may be several avenues that our global economic analysis opens up, but for the moment let’s follow one imaginary lead. Let’s assume that we have identified conditions that are favorable for a distinct industry in a particular geographic area. At some point, our analysis will get down to a group of companies that could benefit.
We would then examine the financial statements of each company and look to benchmark each against the others for:
Operating parameters – return on assets, return on equity, gross profit margin, net profit margin
Solvency – leverage or debt to equity, debt to assets ratio
Liquidity – current ratio and quick ratio.
In this example, if it was a new opportunity, an industry in a specific area that was poised to get a boost in business and profitability we would be looking to see which companies would be in the best competitive position to win the business. This is a rather simplistic example but let’s say they would all be equally competitive and would all get an equal and fair shot at it.
We would look at the various indicators of valuation. These would include, price to sales, price to earnings, and price to book value, dividend yield, and dividend coverage.
One question leads to another
It is a process of asking question after question and whatever answers you get leads you to ask yet other questions. There is no real linear route of inquiry here but professional analysts would usually work off a checklist and any report the analysis generates would have to cover all those areas. A typical checklist would include:
- Company leadership and management
- Brands, intellectual properties
- The market for its goods and services
- Market position and competition
- Financials – all the above-described meat and potatoes ratios
- External factors – political, suppliers
- Environmental policies and practices
- Growth projections
The last part of our journey is to estimate the growth of the company and determine whether that growth is reflected in its current valuation. This is done by considering all the future cash flows, discounted to calculate a present value. There are several ways we can choose to do this.
At one end, you can take the dividends to be received by investors, plus the proceeds that would accrue from a future sale of the company and discount all those amounts to a present value.
Another approach is to consider the present, i.e. discounted values of earnings. And finally, we could consider the discounted value of future cash flows.
The forward-looking growth expectation of a stock is represented by its Price to Earning Growth, or PEG ratio. Because growth expectations are looking forward a certain length of time they are only projections and there is still an amount of subjectivity is baked in.
There is a range of different investment strategies that can use fundamental analysis. Here are just some of them:
Buy and hold – is an approach that is looking for long term gains and accepts holding on during market downturns. This is often combined with dollar-cost averaging which involves investing a regular fixed amount. It is an approach also discussed in other articles here.
Buy undervalued – this approach sticks with companies found to be undervalued as a result of fundamental analysis. The idea is that the market will eventually correct the errors of its ways and revalue these stocks giving investors the chance to cash in and buy into other under-valued stocks.
Contrarian – the contrarian investor can use fundamental analysis to seek stocks that are out of favor with other investors in the market.
Economic cycles – fundamental analysis can be used to determine certain kinds of companies with characteristics known to perform well in certain economic cycles.
Buy growth – fundamental analysis can reveal which stocks have high expected future growth rates.
If you are interested in finding out more about fundamental analysis, check here.
And here would be some reference materials I would recommend.
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