How Does Fundamental Analysis Work?
Fundamental analysis is the process of assessing what a company is truly worth. This will typically be based on readily available financial information published by the company itself as well as non-financial data (such as current economic trends). The goal of the investor is to draw conclusions from this data to determine if it’s a good long-term prospect.
Fundamental analysis combines important aspects of the company that are both qualitative and quantitative.
The quantitative portion relies on key metrics that can be calculated based on regularly published available financial statements. In the U.S., publicly traded companies are required by the SEC (Securities and Exchange Commission) to publicly disclose their financial performance to investors. These publications typically include:
● A balance sheet - Compares assets against liabilities and shareholder equity
● An income statement - Lists revenue versus expenses to show how profitable the company is
● A cash flow statement - Reveals how the company manages its cash
An investor performing fundamental analysis can use these documents to learn how much profit the company earned or how much debt they are carrying. Financial media sites and trading platforms will also automatically calculate key performance metrics based on the latest financial statements.
From the qualitative side, fundamental analysis looks at various aspects that cannot be found in the numbers. These might include such qualities as:
● Brand recognition or following
● The strength of the management team or a new CEO
● A new product launch
● A rising consumer trend
Although these aspects are harder to quantify, they can influence the market price and therefore cannot be ignored.
There’s no one way to perform fundamental analysis. Most investors take either using a bottom-up or top-down approach.
● Bottom-up starts at the microeconomic level by investigating the financial statements, key performance indicators, and information about the company itself. It then combines this information with qualitative macro components about the company’s competitors, the industry it operates within, and the overall economy.
● Top-down begins from the opposite direction at the macroeconomic level by considering the overall market or industry. It then narrows down the top performers and focuses on their financial metrics.
While either approach works, there will be steps that are similar regardless of the direction. Therefore, the following process can be considered an otherwise general approach.
A good place for an investor to begin is to research companies that interest them. These may be:
● Well-known or recognizable companies whose products the investor has used for years
● Relatively new companies that the investor believes are on the cutting edge of a new technology
● Companies the investor feels will make good long-term investment prospects
This will be a highly subjective selection process based on the investor's specific preferences and goals.
Instead of reading the annual report of each target company, investors will often rely on certain key performance ratios to make quick but effective comparisons.
A few of the most commonly used metrics include:
● Price / Earnings Ratio - The preference is to find one that’s lower than the competition.
● Price / Book Ratio - Less than 1.0 is preferred.
● Debt / Equity - Less than 0.5 is preferred
● Return on Equity - Greater than 15% is preferred (average of the last 3 years)
● Current Ratio - Greater than 1.0 is preferred
● Net Profit Margin - Typically 10% or above is desirable
These metrics can easily be found on any financial media site or trading platform.
Generally, investors want companies that deliver profits to their shareholders. For this reason, it will be important to check the EPS (earnings per share) and confirm that it is positive. If it’s not, the analyst can take a closer look at the company's income statement for a more detailed understanding. Past financial statements can also reveal if this is a one-time occurrence or a persistent trend.
Investors can also have a look at the balance sheet to see how much debt the company is currently carrying. Usually, when a company has too much debt, there is a high likelihood that it may struggle to remain profitable - especially if economic conditions become challenging. The maximum debt-to-equity ratio to consider should be 1.0.
At the same time, the balance sheet and cash flow statement can help an investor see how much cash the company has available as a resource. Typically, companies with a greater amount of cash are better suited to reinvest for growth or handle a poor economic climate. This is why investors often say, "Cash is king.”
While an investor may have a preference for a company, it's important to be unbiased and consider the fact that the competition may be a better investment candidate. Investors should repeat the previous two steps using major players from the same industry. For example, if someone was considering investing in AT&T, then it would also be a good idea to analyze Verizon and T-Mobile.
Please keep in mind that when comparing the financial metrics of two or more stocks, this should only be done in the context of companies within the same industry. For instance, it would not make sense to judge an oil company against a tech stock based on the P/E ratio alone. Industrial companies tend to have lower P/E ratios while tech companies are generally higher. Therefore, it's best to stay within the boundaries of the type of market these companies operate within.
Given everything the investor knows so far about the company, the last piece of the puzzle is to make some estimations about what the economy will be like over the next few years. Although no one has a crystal ball to see into the future, this can be done by:
● Listening to economic news reports (such as actions taken by the Federal Reserve)
● Inspecting the stock market indices to see if it's in bull or bear territory
● Checking the latest employment figures
● Looking at the bond yield curve
● Taking into account political uncertainty (such as times of war or an upcoming presidential election)
From the perspective of events that may occur, the investor should then consider the likelihood of impact and make their selection.
Oftentimes investors will confuse the terms fundamental analysis and technical analysis. However, the two approaches differ significantly.
Unlike fundamental analysis, the technical analysis relies solely on the equity’s price chart and uses its movements to make predictions about where it may go next. It also ignores qualitative factors about the company that may be considered in fundamental analysis.
The logic behind these different methodologies has to do with a matter perspective. Fundamental analysis takes a long-term approach and assumes that all of the events going on at a company or in the market will eventually be reflected in its share price. By contrast, technical analysis takes a short-term approach and assumes all of this information has already been baked into the market price.
Generally speaking, preference for fundamental versus technical analysis will depend on the investor’s goals.
● Someone who is interested in making money in the short term will prefer to use technical analysis because the fundamental analysis will not reveal the same timely market exit and entry points.
● On the other hand, someone with a long-term mindset will prefer to use fundamental analysis because they want a stock that will produce consistent returns year over year.
Savvy investors will combine aspects from both methodologies to gain the most insight available.
Investors will use fundamental analysis to determine the overall health and profitability opportunity of a company. This will be done by carefully considering various qualitative and quantitative aspects of the business and its performance. Once a conclusion is reached about the company's "true value" based on its fundamentals, it can be compared to other similar companies or the market itself to reveal whether it's over or undervalued.
Fundamental analysis is different from technical analysis in that it does not rely on price history or short-term market trends to identify opportunities. Instead, it takes a more long-term focus by connecting the investor with a business that they believe will deliver consistent year-over-year results.