Written by Norman Isaac Mwambazi

Fundamental analysis in stock investment

Before serious stock investors buy any company’s stocks, they consider several things to make sure their investment will be worth …

Before serious stock investors buy any company’s stocks, they consider several things to make sure their investment will be worth it. Everything investors do is intended to answer the question, “How valuable, in terms of price, is this stock?”

As you might have already been aware, price is the underlying factor in all the businesses we do so knowing the right market price of something before buying or selling it is very fundamental.

With that brief introduction, let us dive into understanding what fundamental analysis is. Fundamental Analysis (FA) is simply defined as the process of determining the real value of a company’s stock through rigorously examining related economic and financial factors.

If the value arrived at by the analyst – called ‘real value’ – is lower than the current market value of that stock, then the stock is overvalued but if that real value is higher than the current market value, then such stock is deemed to be undervalued. In that case, the recommendation to buy such stock is usually made with the expectation of such stock to eventually appreciate its real value.  

Fundamental analysis looks at every aspect that is related to the stock of the target company from how the entire economy is performing, to how the industry within which the target company is a player is performing, to the financial behaviour of the company’s top management.

This kind of analysis is the opposite to the technical analysis which focuses solely on historical market data like the price of the stock and its volume in active trade to determine its real value.

Why investors go for fundamental analysis

The end goal for analysts taking this kind of fundamental analysis is to find stocks that are either undervalued or overvalued by the market but they need to look at several things to find them, which include as I mentioned earlier, studying the performance of the entire economy.

The performance of the entire economy affects the value of stocks in one way or another and thoroughly studying it to determine whether it is growing, stunted, or in a recess is essential to determine the final real value of a company’s stock.

This is followed by studying how the company’s industry is performing, for example, if an investor is interested in buying stock from Zoom, the analyst looks at how the entire tech industry is performing and then specifically examines other players in the video-conferencing software development and vending.

The final step is looking at the company individually. How is it performing financially? How are its revenues coming in? What are its profits and losses, and what is its potential to grow both in the near future and in the long run? Luckily, the factors used to answer these questions are publicly available because companies are required by law to release their financial details to the public.

Information like a company’s balance sheet and income statements among others is provided to the public through press releases or they are displayed at their premises.

Another thing analysts look at is the management of the company. Is the company being effectively, legally, and ethically run? How do they handle their shareholders? All this management and financial performances are factored in when the analyst makes their final estimate of the intrinsic value of the company’s stock to the investor.

Importance of fundamental analysis to an investor

Investors hire an analyst to do a fundamental analysis of the value of stocks so that they can make informed decisions about their investment in such stocks. Although these analysts have a wealth of experience and knowledge in the stock markets, they do not want to do guesswork and come up with recommendations that would cost them clients, so they study the entire micro and microeconomics of the company to help them back their recommendations.

The recommendations in question could either be advising the investor to buy the stock that is valued higher than its current market price. Because an investor trusts the analyst’s recommendation, they expect the price of this stock to rise, which would translate, into profits for the investor.

On the other hand, the analyst may recommend to the investor to sell the stock that is overvalued vis-à-vis its current market price. This stock is expected to depreciate over time and the investor would see it fit and wise to take it off their portfolio to prevent losses. Every investor’s goal is to make profits.

Categories of Fundamental Analysis

Fundamental analysis is divided into categories namely, qualitative and quantitative.

Qualitative Fundamentals

Qualitative fundamental analysis is where the analyst examines intangible economic factors when analysing a company. The four key fundamentals considered include the company’s management, its business model, competitive advantage, and corporate governance.

Management

This is arguably the most important factor when determining a company’s worth of investment. A Company’s management is tasked with the role of ensuring the company is run effectively and stays on course to achieve its set objectives and goals. How strong the company’s management is, and how innovative and willing to keep growing is essential to an interested investor. You do not want to invest in a company with people who don’t know how to run a company or are just too unfocused on achieving bigger things.

The company’s business model

The analyst has to find out the company’s line of business. Is it profitable? How does it make its money? 

The company’s competitive advantage

The fundamental analyst also looks at how the company is doing compared to its competitors. How big is their brand and how recognisable it is? How big is its market share compared to its competitors and how long has it dominated it? At what rate is it growing? Companies with a long-term competitive advantage over other players in the same line of business or industry are attractive to invest in because investors are confident of their long-term reward in profits. 

Corporate governance

This is to do with the company’s relationship with and between management, directors, and how it treats its shareholders. Investors prefer to do business with companies that value all stakeholders and treats them as one big family that is working for nothing but success.

Quantitative Fundamentals

The quantitative analysis deals with numbers. Here, the analyst examines the figures posted by the company over a period of time. These include the company’s profits, taxes, revenue, and assets among others. Most of these are reflected on the company’s financial statements that are prepared and released over a fixed period of time, say monthly, quarterly, or annually depending on the company’s policy. 

The financial statements that are given much focus are balance sheets, income statements, and cash-flow statements.

The Balance Sheet

A balance sheet is simply a record of a company’s assets, liabilities and shareholders’ equity at a specific point in time. This statement provides a basis for computing the company’s rates of return and evaluating its capital structure.

The company’s business structure should balance as: 

Assets = Liabilities + Shareholders’ Equity.

Assets are everything the company owns or controls at a given point in time and these may be cash, stocks, machinery, and buildings. Liabilities represent debts owed by the company and equity is the value of money that the owners have contributed to the business.

The Income Statement

The income statement of the company has information such as the company’s revenues, expenses, and profit that was generated from the company’s operations for that period.

Statement of Cash Flows

The statement of cash flows is a record of a company’s cash inflows and outflows over a period of time. This statement focuses on cash from investing, cash from financing, and operating cash flow.

Fundamental analysts do not favour one category over the other as both qualitative and quantitative analyses are equally considered when making decisions about the intrinsic value of that company’s stocks. 

Speaking of intrinsic value, it should be noted that there is no single generally accepted formula for calculating the intrinsic value of the stock. Different analysts may determine different prices of stocks even when they have employed the same methods discussed above.

Investors are left with finding the median figure of all the estimates presented to them to make their investment decisions. Investors take this information provided by fundamental analysts as the true reflection of the value of the stocks regardless of what they are currently valued at in the market. 

Criticism

Although Fundamental analysis looks like the better form of stock analysis, it is constantly criticised by those who prefer to do technical analysis, which I briefly talked up earlier, and those favouring the Efficient Market Hypothesis. 

Promoters of technical analysis believe that the price and volume of stocks being traded provide enough and better information for investors to make their investments because the market discounts everything. 

On the other hand, those who believe in the Efficient Market Hypothesis degree with both technical and fundamental analysts, arguing that it is impossible to outperform the stock market since all stocks are priced continuously.