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Fundamental Analysis

What is Fundamental Analysis?

While technical analysis evaluates the share price action of a stock, fundamental analysis evaluates the actual business operations to determine the financial health of the company, project future growth prospects and determine current and future valuation. Fundamental analysis can be performed quickly with various widely available financial tools or be extensive depending on how much time and effort the investor wants to commit.

How Does Fundamental Analysis Work?

Fundamental analysis uses publicly available information usually disclosed by the company through SEC filings to build an accurate assessment of the business. It is believed that a company’s fundamentals are the key long-term driver for share prices. While short-term market fluctuations impact immediate stock prices, the market will eventually price a stock correctly in the future. Fundamental analysis attempts to extract a fair valuation for the company to determine if the markets have overvalued or undervalued the shares. Based on this thesis, investors can decide if the shares are an attractive investment now or wait for a better valuation later.

Components of Fundamental Analysis

This various components of research include analysis of the earnings reports, company business model/strategy, catalysts, and financials including assets/liabilities, financing/debt obligations, credit facilities, rumors and press release documents. Additional research on the company’s sector/industry and peers can also be performed. It also involves staying current on any executive changes with the management and board of directors. Intensive fundamental analysis can be tedious and time consuming for an individual investor.

Research Departments

To attract and maintain clients, full service brokerage firms assign the heavy legwork to in-house financial analysts that specialize in specific sectors, industries and companies. Many online discount brokers have also beefed up their research departments to retain customers. The most widely followed analysts run intricate fundamental analysis through various qualitative and quantitative models to forecast future earnings results known as consensus analyst estimates. Meeting, beating or missing these estimates have an immediate and material impact on share prices.

Who is Fundamental Analysis For?

Long-term investors benefit the most with fundamental analysis, since valuations and stock prices ultimately reach parity in the longer run. Swing traders benefit depending on their holding period and premises for holding (IE: undervalued assets or buy the rumor, sell the news into a scheduled event). Intra-day traders are mostly affected when news, events or rumors trigger price volatility and spur momentum on heavy volume, often resulting in price gaps up or down in the pre and post-market. Earnings report releases generate the heaviest volume and price action, which is why traders look forward to each earnings season. For biotechnology companies, clinical trial data and FDA decisions tend to generate the most volatility.

Basics of Fundamental Analysis

Fundamental analysis requires information provided by the company to develop a thesis about the business. These are some of the factors that should be included in the thesis.

Understand a Company’s Real Value

Perception is reality in the financial markets. Different investors and analysts will have differing valuations for a company. Where one analyst sees a dying legacy pipeline, another may see an undervalued asset. For example, when retail big box stores suffered declining sales, private equity focused on the undervalued valuations of their real estate assets. This sparked a rally in the sector based on a new perception. However, the continued declining sales forecasts caused the sector to plummet, when the earnings reports revealed even larger revenue declines, as perception shifted negative again.

Sentiment Influences Perception

The markets are the ultimate judge and jury as to which valuation pricing prevails and when. Sentiment influences perception, which is why stocks tend to overshoot their valuations in strong bullish markets and undershoots during weak bearish markets, as the adage of a “rising tide lifts all boats” rings true. Astute fundamental analysts will work to develop their own valuation models using specialized metrics to calibrate them to any catalysts or events. Companies can be valued based on financial metrics as well as assets that may not be efficiently priced in. The “parts are worth more than the whole” is a common justification for under valuation, which assumes that the company may spin-off or sell certain assets to improve shareholder equity.

Reading Financial Statements

Publicly traded companies are required to file financial statements with the United Stated Securities and Exchange Commission (SEC). Investors can access this information directly from the SEC website through the EDGAR database. The three key documents every self-directed investor should be familiar with are the 10-K quarterly report; most recent annual report and recent 8-K filings of material events.

Quarterly earnings are initially disclosed in a press release and filed as a 10-K document afterwards. Companies will usually pair the earnings release with a conference call an hour afterwards or the next morning. The conference call can be very revealing, especially the question and answer session with analysts. Often times the company may disclose a bombshell item in the conference call including future earnings guidance estimates which may be increased or decrease from consensus analyst estimates, regulatory issues, impending lawsuits and major contract wins or losses, which can result in significant share price volatility

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Stocks are segmented by sector and industry. To ascertain the true performance of a stock, it should be evaluated amongst its competitors within the industry. When a particular sector or industry is very strong, it tends to lift most of the companies within. The leaders in the particular industry usually establish the industry trends. Therefore, it is prudent to stay abreast of the industry trends for your particular stocks. An effective way to pursue this is by identifying the top three leaders in the sector or industry. The performance of the industry leaders sets the sentiment with the group. For example, when a leading stock in the heavy machinery industry slashes its earnings guidance, it generates a top-down ripple effect for the peer stocks as well. It is guilt by association until proven otherwise as share prices sell-off.

Accounting for Company Growth

There are two types of accounting that is used with earnings reports. The official numbers are reported under Generally Accepted Accounting Principles (GAAP), which take into account all expense items including non-cash compensation like restricted stock and options. Companies like to also provide non-GAAP numbers, which excludes non-cash items. The purpose is to allow shareholders to better gauge the growth of the core business without being sidetracked by factors that don’t affect cash flow. However, critics argue that non-GAAP accounting is deceptive. Any and all compensation must be accounted for especially when existing shareholders face further dilution in shareholder equity.

Using Financial Ratios

There are a number of widely used financial ratios that can be used to help investors gauge valuation and assess how a company stacks up against its peers. These ratios are standard on broker platforms as well as most popular search engines. Just as with technical analysis, financial analysis should be performed using multiple financial ratios to help paint a clearer picture of the operations.

Price-Earnings (P/E) is perhaps the most commonly used financial ratio. It measures the profitability of the company relative to the share price. All sectors have an average P/E, which can be found quickly by looking up the heaviest traded exchange-traded-funds (ETF) which track the specific index. This ratio can be used to compare a specific company with the industry, peers and or benchmark indices. For example, if the consumer discretionary sector has a P/E of 20 and your stock has a P/E of 55, it may be overvalued. Some sectors traditionally have higher P/Es than others, like technology compared to utilities. The S&P 500 has a historical P/E ratio of 21. Keep in mind that a company needs to generate profits in order to have a P/E. There are more ratios that can be used in the absence of profits.

Price-Sales (P/S) and Price-Book (P/B) are comparative valuation ratios that indicate if a stock is trading at a premium or discount compared to its peers and sector/industry. If a stock is trading at a very deep discount like .3 P/S compared to industry average of 2.5 P/S, then there could be an inherent structural problem with the business or could be overlooked by Wall Street and presents an undervalued investment situation and warrants further investigation.

Cash-Per-Share (CPS) and Book Value (BV) are two valuation ratios that can help determine if the stock has been overly punished by investors. When a company trades under the CPS or BV, it has virtually valued the business operations at zero presenting either a very undervalued situation or potential bankruptcy. The cash burn rate and debt should also be investigated. Biotech stocks are notorious for these situations. These ratios don’t apply well to financials like banks and insurance companies that tend to trade at or below CPS and BV, due to federal banking regulations and off balance sheet entities.

Keep in mind that every sector and industry has an average financial ratio, which can be used as a measuring stick. However, just because a stock has an aggressively high financial ratio doesn’t necessarily mean it is overpriced. Momentum stocks are notorious for exorbitant ratios.

Fundamental Analysis

What Is Fundamental Analysis?

Fundamental analysis (FA) is a method of measuring a security’s intrinsic value by examining related economic and financial factors. 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 arrive at a number that an investor can compare with a security’s current price in order to see whether the security is undervalued or overvalued.

This method of stock analysis is considered to be in contrast to technical analysis, which forecasts the direction of prices through an analysis of historical market data such as price and volume.

Key Takeaways

  • Fundamental analysis is a method of determining a stock’s real or „fair market“ value.
  • Fundamental analysts search for stocks that are currently trading at prices that are higher or lower than their real value.
  • If the fair market value is higher than the market price, the stock is deemed to be undervalued and a buy recommendation is given.
  • In contrast, technical analysts ignore the fundamentals in favor of studying the historical price trends of the stock.

Understanding Fundamental Vs. Technical Analysis

Understanding Fundamental Analysis

All stock analysis tries to determine whether a security is correctly valued within the broader market. Fundamental analysis is usually done from a macro to micro perspective in order to identify securities that are not correctly priced by the market.

Analysts typically study, in order, the overall state of the economy and then the strength of the specific industry before concentrating on individual company performance to arrive at a fair market value for the stock.

Fundamental analysis uses public data to evaluate the value of a stock or any other type of security. For example, an investor can perform fundamental analysis on a bond’s value by looking at economic factors such as interest rates and the overall state of the economy, then
studying information about the bond issuer, such as potential changes in its credit rating.

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 (more on that below).

Fundamental analysis is used most often for stocks, but it is useful for evaluating any security, from a bond to a derivative. If you consider the fundamentals, from the broader economy to the company details, you are doing fundamental analysis.

Investing and Fundamental Analysis

An analyst uses works to create a model for determining the estimated value of a company’s share price based on publicly available data. This value is only an estimate, the analyst’s educated opinion, of what the company’s share price should be worth compared to the currently trading market price. Some analysts may refer to their estimated price as the company’s intrinsic value.

If an analyst calculates that the stock’s value should be significantly higher than the stock’s current market price, they may publish a buy or overweight rating for the stock. This acts as a recommendation to investors who follow that analyst. If the analyst calculates a lower intrinsic value than the current market price, the stock is considered overvalued and a sell or underweight recommendation is issued.

Investors who follow these recommendations will expect that they can buy stocks with favorable recommendations because such stocks should have a higher probability of rising over time. Likewise stocks with unfavorable ratings are expected to have a higher probability of falling in price. Such stocks are candidates for being removed from existing portfolios or added as „short positions.

This method of stock analysis is considered to be the opposite of technical analysis, which forecasts the direction of prices through an analysis of historical market data such as price and volume.

Quantitative and Qualitative Fundamental Analysis

The problem with defining the word fundamentals is that it can cover anything related to the economic well-being of a company. They obviously include numbers like revenue and profit, but they can also include anything from a company’s market share to the quality of its management.

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 – capable of being measured or expressed in numerical terms.
  • Qualitative – related to or based on the quality or character of something, often as opposed to its size or quantity.

In this context, quantitative fundamentals are hard numbers. They are the measurable characteristics of a business. That’s why the biggest source of quantitative data is financial statements. Revenue, profit, assets, and more can be measured with great precision.

The qualitative fundamentals are less tangible. They might include the quality of a company’s key executives, its brand-name recognition, patents, and proprietary technology.

Neither qualitative nor quantitative analysis is inherently better. Many analysts consider them together.

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:

  • 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?
  • Competitive advantage: 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.
  • Management: Some believe that management is the most important criterion for investing in a company. It makes sense: Even the best business model is doomed if the leaders of the company fail to properly execute the plan. 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: 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. 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.

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

Quantitative Fundamentals to Consider

Financial statements are the medium by which a company discloses information concerning its financial performance. Followers of fundamental analysis use quantitative information gleaned 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. 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

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 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.

The Concept of Intrinsic Value

One of the primary assumptions of fundamental analysis is that the currently price from the stock market often does not fully reflect a value of the company supported by the publicly available data. A second assumption is that the value reflected from the company’s fundamental data is more likely to be closer to a true value of the stock.

Analysts often refer to this hypothetical true value as the intrinsic value. However, it should be noted that this usage of the phrase intrinsic value means something different in stock valuation than what it means in other contexts such as options trading. Option pricing uses a standard calculation for intrinsic value, however analysts use a various complex models to arrive at their intrinsic value for a stock. There is not a single, generally accepted formula for arriving at the intrinsic value of a 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 determines that it ought to be worth $26. Many investors will consider the average of such estimates and assume that intrinsic value of the stock may be near $25. Often investors consider these estimates highly relevant information because they want to buy stocks that are 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, nobody 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. The investment will pay off when the market catches up to the fundamentals.

One of the most famous and successful fundamental analysts is the so-called „Oracle of Omaha,“ Warren Buffett, who champions the technique in picking stocks.

Criticisms of Fundamental Analysis

The biggest criticisms of fundamental analysis come primarily from two groups: proponents of technical analysis and believers of the efficient market hypothesis.

Technical Analysis

Technical analysis is the other primary form of security analysis. Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of stocks. Using charts and other tools, they trade on momentum and ignore the fundamentals.

One of the basic tenets of technical analysis is that the market discounts everything. All news about a company is already priced into the stock. Therefore, the stock’s price movements give more insight than the underlying fundamentals of the business itself.

The Efficient Market Hypothesis

Followers of the efficient market hypothesis, however, are usually in disagreement with both fundamental and technical analysts.

The efficient market hypothesis contends that it is essentially impossible to beat the market through either fundamental or technical analysis. Since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns are almost immediately whittled away by the market’s many participants, making it impossible for anyone to meaningfully outperform the market over the long term.

Examples of Fundamental Analysis

Take the Coca-Cola Company, for example. When examining its stock, an analyst must look at the stock’s annual dividend payout, earnings per share, P/E ratio, and many other quantitative factors. However, no analysis of Coca-Cola is complete without taking into account its brand recognition. Anybody can start a company that sells sugar and water, but few companies are known to billions of people. It’s tough to put a finger on exactly what the Coke brand is worth, but you can be sure that it’s an essential ingredient contributing to the company’s ongoing success.

Even the market as a whole can be evaluated using fundamental analysis. For example, analysts looked at fundamental indicators of the S&P 500 from July 4 to July 8, 2020. During this time, the S&P rose to 2129.90 after the release of a positive jobs‘ report in the United States. In fact, the market just missed a new record high, coming in just under the May 2020 high of 2132.80. The economic surprise of an additional 287,000 jobs for the month of June specifically increased the value of the stock market on July 8, 2020.

However, there are differing views on the market’s true value. Some analysts believe the economy is heading for a bear market, while other analysts believe it will continue as a bull market.

The Top Tools of Fundamental Analysis

Andrew Unangst / Getty Images

Fundamental analysis is the process of looking at a business at the most basic or fundamental financial level.   This type of analysis examines the key ratios of a business to determine its financial health. Fundamental analysis can also give you an idea of the value of what a company’s stock could be expected to trade for based on a comparative appraisal of similar companies. The analysis should take several factors into account, including revenue, asset management, and the production of a business, as well as the interest rate. 

Many investors use strictly fundamental factors in their analysis of a company and its share price, but others have found that they can develop a more robust model of valuation and price expectation using a combination both fundamental and technical factors, such as relative price strength or market sentiment. The goal is to determine whether the current price of the stock reflects a value that is different from what the fundamental factors and prevailing market sentiment might suggest. If such a difference is found, then perhaps an investment opportunity exists.

Even if you don’t plan to do an in-depth fundamental analysis yourself, understanding the key ratios and terms can help you follow stocks more closely and accurately.

First Thing’s First: Check the Earnings

Investors should consider a wide range of data, but the first data point they’re likely to look for is the company’s earnings. That figure is the quickest way to cut to the heart of a key investing question: How much money is the company making, and how much is it likely to make in the future?

In other words, earnings are profits. They can be complicated to calculate, but that’s what buying a company is all about. Conveniently for investors, companies report earnings every quarter.   Analysts follow these reports closely, especially for major companies.

When a company reports that earnings are on the rise, that generally leads to a higher stock price and, in some cases, a larger dividend (or the introduction of a dividend, if one doesn’t already exist). When earnings fall short of expectations, the market can hammer the stock. 

Fundamental Analysis Tools

Although earnings are important, they don’t tell you much by themselves. On their own, earnings don’t identify how the market values the stock. You’ll need to incorporate more fundamental analysis tools to begin building a picture of how the stock is valued.

You can find most of these ratios completed for you on finance-related websites, but they aren’t difficult to calculate on your own. If you want to wade in for yourself, keep in mind that some of the most popular tools of fundamental analysis focus on earnings, growth, and value in the market. These are some of the factors you’ll want to identify and include:

  • Earnings per share (EPS): Neither earnings nor the number of shares can tell you much about a company on its own, but when you combine them, you get one of the most commonly used ratios for company analysis. EPS tells us how much of a company’s profit is assigned to each share of stock. EPS is calculated as net income (after dividends on preferred stock) divided by the number of outstanding shares. 
  • Price-to-earnings ratio (P/E): This ratio compares the current sales price of a company’s stock to its per-share earnings. 
  • Projected earnings growth (PEG): PEG anticipates the one-year earnings growth rate of the stock. 
  • Price-to-sales ratio (P/S): The price-to-sales ratio values a company’s stock price as compared to its revenues. It’s also sometimes called the PSR, revenue multiple, or sales multiple. 
  • Price-to-book ratio (P/B): This ratio, also known as the price-to-equity ratio, compares a stock’s book value to its market value. You can arrive at it by dividing the stock’s most recent closing price by last quarter’s book value per share. Book value is the value of an asset, as it appears in the company’s books. It’s equal to the cost of each asset less cumulative depreciation. 
  • Dividend payout ratio: This compares dividends paid out to the stockholders to the company’s total net income. It accounts for retained earnings—income that is not paid out, but rather, retained for potential growth. 
  • Dividend yield: This, too, is a ratio—yearly dividends compared to share price. It’s expressed as a percentage. Divide dividend payments per share in one year by the value of a share. 
  • Return on equity: Divide the company’s net income by shareholders‘ equity to find its return on equity. You might also hear this expressed as the company’s return on net worth. 

There Are No Magic Bullets

Remember, these numbers are just tools, and no single ratio or number is a magic bullet. They can’t give you buy or sell recommendations by themselves. They must be weighed in tandem with other considerations and ratios.

What these numbers can do, as you begin to develop a picture of what you want in an investment, is serve as benchmarks to measure and compare the worths of companies.

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