What’s fundamental analysis?
Fundamental analysis (FA) evaluates economic and financial elements to determine a security’s fundamental worth. An investment’s intrinsic worth depends on the issuing company’s finances and market and economic conditions.
Fundamental analysts examine all elements that might impact a security’s value, from macroeconomic factors like the economy and industry to microeconomic factors like management performance.
The idea is to find a figure that an investor may compare to a security’s current price to assess if other investors undervalue or overvalue it.
Knowing Fundamental Analysis
Fundamental analysis uses a macro-to-micro viewpoint to find mispriced assets.
Analysts study sequentially:
- Overall economic situation
- Specific industry strength
- The stock issuer’s financial performance
This provides a fair stock price.
Sources for Fundamental Analysis
Fundamental analysis values investments using public financial data. Financial statements like 10-Q and 10-K reports and filings provide the data. Public corporations must submit the 8-K after any reportable event, such as an acquisition or top management change, making it informative.
Most public and private firms post yearly reports on their investor relations websites, including financial choices and results.
A fundamental study of a bond’s value could consider interest rates and the economy. Assess the bond market and utilize financial data from similar bond issuers. Finally, assess financial data from the issuing firm, including external considerations such as credit rating fluctuations. You may also check the issuer’s 8-K, 10-Q, 10-K, and annual reports for updates on their aims and activities.
Fundamental analysis evaluates a company’s worth and growth potential based on its revenues, profits, future growth, return on equity, and profit margins.
Compared to publicly accessible financial data, fundamental analysis assumes that a stock’s present price frequently does not entirely reflect the company’s value. Another assumption is that the company’s primary data is more likely to reflect the stock’s worth.
Stock valuation and option trading use intrinsic value differently. Option pricing employs a standard intrinsic value methodology, although stock valuation might vary.
Say a company’s stock was $20, but an analyst thinks it should be $24 after considerable study. Another analyst undertakes comparable research but values it at $26.
Many people believe the stock’s intrinsic value is about $25 based on the average of these estimations. Investors appreciate these estimations because they seek to acquire companies at prices well below these fundamental values.
A third fundamental analysis assumption is that the stock market will eventually reflect the fundamentals. Nobody knows how long “the long run” is. Days or years.
Fundamental analysis involves this. Focusing on a single business allows an investor to determine its intrinsic worth and locate chances to purchase or sell at a discount or premium. The investment will pay off when the market matches the fundamentals.
Fundamental vs. Technical Analysis
This analytical approach differs from technical analysis, which uses previous market data like price and volume to predict price direction. Technical analysis indicators are based on price patterns and behavior. Indicators like the head and shoulders pattern have names that match their forms. Others employ trend, support, and resistance lines to show traders’ investing views and predictions. A wedge and a symmetrical triangle are examples.
Fundamental analysis uses firm financials to examine shares. Data-driven ratios and metrics show how an organization compares to others.
Fundamental Analysis: Quantitative and Qualitative
The term fundamentals can refer to any aspect of a company’s finances, making definition difficult. They might include revenue, profit, market share, and managerial quality.
Some fundamental aspects are quantitative, and some are qualitative. Their financial meanings are similar to well-known ones:
- Quantitative data: numbers, figures, ratios, or formulae
- Qualitative refers to the quality, standard, or type of something, not quantity.
In this perspective, quantitative fundamentals are numbers. Businesses have quantifiable traits. Financial statements are the primary source of quantitative data. We can measure revenue, earnings, assets, and more.
Less tangible are the qualitative principles. A company’s strengths may include its executives, brand awareness, patents, and exclusive technologies.
Neither qualitative nor quantitative analysis is superior. Many analysts group them.
Analysts always evaluate four factors while assessing a firm. All are qualitative, not quantitative. Among them:
The Business Model
What does the firm do? It is not as easy as it appears. Do companies make money selling fast-food chicken? Is it living off royalty and franchise fees?
A company’s long-term success depends on its capacity to sustain a competitive edge. Substantial competitive advantages, like Coca-Cola’s brand and Microsoft’s PC operating system dominance, generate a corporation’s moat, enabling growth and profit. When a firm gains a competitive edge, shareholders benefit for decades.
Management is the most crucial factor in investment, say others. It makes sense: even the strongest business model fails if executives don’t execute the strategy. Retail investors can review the business website and top brass and board member resumes, but meeting and evaluating managers is hard. How did they do in past jobs? Have they sold many stock shares recently?
Corporate governance policies outline the roles and duties of a corporation’s management, directors, and other stakeholders. Companies develop policies through their charter, bylaws, and corporate laws and regulations. You want to work with an ethical, fair, transparent, and efficient organization. Check whether management respects shareholder rights and interests. Make shareholder communications transparent, straightforward, and understood. You may not understand because they don’t want you to.
Consider a company’s industry, including customer base, market share, growth, competition, regulation, and business cycles. Investors can better assess a company’s finances by understanding the industry.
Quantitative Fundamentals: Financial Statements
Financial statements reveal a company’s financial performance. Fundamental analysts make investment recommendations using financial statement data. The three critical financial statements are income, balance sheets, and cash flow statements.
Balance sheets show a company’s assets, liabilities, and equity at a given moment. The method for balancing assets, liabilities, and shareholders’ equity makes it a balance sheet.
Total assets = liabilities + shareholders’ equity
Assets, on the other hand, are the current resources of the business. This includes cash as well as inventory, machinery, and buildings. On the other hand, the corporation’s total financial value to buy such assets is reflected on the other side of the equation.
Financing originates from obligations or equity. Liabilities are debts to pay. On the other hand, equity is the entire amount of money the owners have invested in the firm, including retained earnings.
The Income Statement
While the balance sheet gives a snapshot of a corporation, the income statement tracks its performance over time. Technically, you might have a balance sheet for a month or day, but public corporations only report quarterly and annually.
Income statements show business revenues, costs, and profits for that time.
Cash Flow Statement
Cash flow statements show a company’s cash inflows and outflows. A cash flow statement typically covers these cash-related activities:
- Investment cash and revenues from the sale of other firms, equipment, or long-term assets are CFI.
- Issuing and borrowing funds generate cash from financing (CFF).
- Operating Cash Flow (OCF): Daily company operations create cash.
Business cash manipulation is difficult; hence, the cash flow statement is crucial. Aggressive accountants may falsify results, but bank funds are more challenging to fabricate. The cash flow statement is a more cautious indicator of a company’s success for confident investors.
Fundamental analysis uses financial statistics from corporate financial statements to assess a company’s value and prospects.
Fundamental Analysis Example
Coca-Cola is an excellent basic analysis example. An analyst would start with reported economic metrics:
- The CPI measures inflation.
- GDP growth
- Purchasing manager index
- Interest rates
Use data and metrics from studies and competitive firms to assess the sector and industry. Finally, analysts would obtain reports from Coca-Cola or US Securities and Exchange Commission Edgar filings.
Analysts may also utilize CSIMarket data. Investors may use CSIMarket’s fundamental analytical data to value Coca-Cola’s assets, income streams, debts, and liabilities. The beverage sector may compare sales, earnings, and growth.
To determine Coca-Cola’s valuation, the analyst might use CSIMarket’s study to compare growth rates to the industry and sector it works in and other data. As of August 2022, Coca-Cola has (using only a few ratios and metrics):
|Y/Y Revenue Growth||13.48%||10.86%||16.18%|
|Price to Free Cash Flow||24||7.45||4.23|
|Debt to Equity (TTM)||1.57||0.14||0.11|
|Quick Ratio (TTM)||0.16||0.24||0.2|
|Return on Equity (TTM)||13.14%||30.21%||23.16%|
|Return on Assets (TTM)||11.5%||8.69%||7.91%|
|Return on Investment (TTM)||13.14%||19.76%||15.84%|
|Revenue per Employee (TTM)||$111,578||$55,015||$66,896|
Analysis of ratios and data does not reveal a company’s history or issues. Coca-Cola started in Atlanta in 1892. War, depression, recession, pandemics, stock market crashes, and a global financial crisis have not stopped it. Few businesses have such a history.
A company’s brand can encourage investment. Coca-Cola has served beverages for decades, and its logo is famous.
Thus, an analyst may combine brand, longevity, growth above the beverage manufacturing business, above-average P/E, and good ROI.
Coca-Cola makes more from its assets than the industry while having more debt than equity. This business has less liquidity than others despite low industry-fast ratios. Most corporations have little net cash flow, but Coca-Cola has almost $1 billion in wiggle room.
What’s Fundamental Analysis’s Goal?
Fundamental analysis evaluates a stock or company’s market value using publicly accessible financial data.
Types of Fundamental Analysis
Quantitative and qualitative fundamental analyses exist.
The Three Layers of Fundamental Analysis
First, study the economy, then the industry, then the firm.
Why does fundamental analysis matter?
Fundamental analysis shows corporate market worth. Many investors consider a stock’s current and past prices, not its fundamentals. Companies issue stocks. Therefore, their financial success affects their stock.
What Are Fundamental Analysis Tools?
Analysts employ several tools. Some examples include financial reports, ratios, spreadsheets, charts, graphs, infographics, government agency industry and economic reports, and market reports.
Analysts employ fundamental research to assess if a stock is overvalued or undervalued. It evaluates a company’s financial performance and economic, market, industry, and sector circumstances.
Company valuations employ financial ratios from financial reports, and government industry and economic analysts use various techniques and value equities differently. It’s crucial that the stock you research fits your value criteria and provides relevant information.
- Fundamental analysis calculates a stock’s “fair market” value.
- Fundamental analysts look for equities trading above or below their value.
- Buy the stock if its fair market value exceeds its market price.
- It may be best to hold a stock if its fair market value is lower than its market price.
- In contrast, technical analysts use stock price history to anticipate short-term patterns.