Fundamental Analysis of Stocks
There are two primary methods used to research and analyze securities and make investment decisions: fundamental analysis and technical analysis. We already have discussed technical analysis earlier. In this post, we will delve into the details of fundamental analysis. We will try to understand what is Fundamental Analysis, and how you too can do it. With some study and practice, you should be all ready to go.
Key Points
There are two primary methods used to research and analyze securities and make investment decisions: fundamental analysis and technical analysis.
In fundamental analysis, you evaluate a security by using economic, financial, qualitative and quantitative factors to determine its intrinsic value.
How to do Fundamental Analysis of Stocks
Understand the company
It is very important that you understand the company in which you intend to invest. It will give you further insight as to how the company is performing, whether the company is taking right decisions towards its future goal, and whether you should hold or sell the stock. Visiting its website and learning about the company, its management, its promoters and its products is a good way to mine such information.
Study the financial reports of the company
Once you are done understanding the company, you should start analysing its financials such as balance sheet, profit-loss statements, cash flow statements, operating cost, revenue, expenses etc. You can evaluate its compounded annual growth rate (CAGR), sales and if the net profit has been increasing for the last 5 years, it can be considered a healthy sign for the company.
Check the debt
Debt is an important factor - one which can bring down a company’s performance. A security cannot perform well and reward you if it has a huge debt of its own. It is recommended that you avoid companies with huge debt. Always try to find a company to invest which has debt:equity ratio of less than 1.
Find the company’s competitors
The company you want to invest in must be one of the best among its peers. Try to find a company which is performing better than the other companies. It should have better future prospects, upcoming projects, new plant etc.
Analyse the future prospects
Fundamental analysis is most effective when you want to stay invest long term. Invest in those companies whose product will still be useful 15-25 years down the line.
Review all the aspects time to time
Do not invest in a company and forget about it. Stay updated about the company you have invested in. You should be updated about all its news and financial performance. Sell the security if there is a problem in the company.
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).
Investing and Fundamental Analysis
An analyst 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 current 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. Those interested in learning more about fundamental analysis and other financial topics may want to consider enrolling in one of the best investing courses currently available.
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: "related to information that can be shown in numbers and amounts."
Qualitative: "relating to the nature or standard of something, rather than to its 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.
The Concept of Intrinsic Value
One of the primary assumptions of fundamental analysis is that the current price from the stock market often does not fully reflect the 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 the 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 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 the 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.
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.
What Are the Steps in Fundamental Analysis?
Broadly speaking, fundamental analysis evaluates individual companies by looking at the firm's financial statements and examining various ratios and other metrics. This is used to estimate a company's intrinsic value based on its revenues, profit, costs, capital structure, cash flows, and so forth. Company metrics can then be compared with industry peers and competitors. Finally, these can be compared to the broader market or larger economic environment.
Who Uses Fundamental Analysis?
Fundamental analysis is used largely by long-term or value investors to identify well-priced stocks and those with favorable prospects. Equity analysts will also use fundamental analysis to generate price targets and recommendations to clients (e.g., buy, hold, or sell). Corporate managers and financial accountants will also use financial analysis to analyze and increase a firm's operating efficiency and profitability and to compare the firm against the competition. Warren Buffett, one of the world's most renowned value investors, is a promoter of fundamental analysis.
Does Fundamental Analysis Always Work?
No. Like any other investment strategy or technique, fundamental analysis is not always successful. The fact that fundamentals show a stock to be undervalued does not guarantee that its shares will rise to intrinsic value any time soon. Things are not so simple. In reality, real price behavior is influenced by a myriad of factors that may undermine fundamental analysis.
Investors and analysts will frequently use a combination of fundamental, technical, and quantitative analyses when evaluating a company’s potential for growth and profitability.