Written by Brenda Nakalema

Fundamental analysis

Fundamental analysis refers to a method of analysis used to measure a security’s intrinsic value by taking into consideration related …

Fundamental analysis refers to a method of analysis used to measure a security’s intrinsic value by taking into consideration related economic and financial factors. A fundamental analyst studies everything and anything that can affect the core value of a security. The factors considered could be macro-economic in nature, such as the state of the economy and industry conditions. Still, it could also be micro-economic factors like the management team’s skill set, internal company policies, and other such factors.

The goal of fundamental analysis is to get to a number that an investor can compare with the current security price to determine whether the security is over or undervalued. Fundamental analysis stands in contrast to Technical analysis, which analyses past historical data such as price and volume using statistical tools and charts to predict the future performance of a security.

Understanding fundamental analysis

Stock analysis essentially seeks to determine whether a stock is correctly valued within the broader market. Typically, fundamental analysis is conducted from the macro to the micro-level in order to gain perspective and information on securities that might be incorrectly priced on the market.

Usually, an analyst will study the overall state of the economy and then the strength of a specific industry before narrowing the analysis down to an individual company’s performance to calculate the fair market value for the stock.

Fundamental analysis involves the use of public data to evaluate the value of a stock or any other type of security. For instance, an investor can conduct fundamental analysis on a bond’s value by analysing certain factors such as interest rates and the overall health of the economy, then studying information about the bond issuer, for example, changes in the credit rating.

In the case of stocks, fundamental analysis looks into revenues, earnings, future growth, return on equity, profit margins, and other types of data to calculate a company’s underlying value and potential for growth in the future. This information is gathered through an analysis of a company’s financial statements.

How to do fundamental analysis on a stock

Using publicly available data, an analyst works to create a model for determining the estimated value of a company’s share price. Usually, this value is simply an estimate, more like an educated guess of what the company’s share price should be worth in comparison to its current market price. Some analysts refer to their estimates as the company’s intrinsic value.

Following the analysis, if it is determined that a stock’s value should be much higher than the stock’s current market price, an analyst may publish a buy or overweight rating for the stock. This guides investment decisions made by investors regarding that particular stock. On the other hand, if an analyst’s calculations point to a stock that should be valued lower than its current market price, the stock is considered overvalued. A sell or underweight recommendation is then issued.

Investors that utilise these recommendations in their investment decisions would expect that they can buy stocks with favourable recommendations because such stocks should essentially have higher profitability of rising over time. In the same light, stocks with unfavourable ratings are expected to have a higher probability of falling in price. Stocks such as these become candidates for being removed from existing portfolios or simply added as “short” positions.

In this way, fundamental analysis is considered the opposite of technical analysis, which instead uses forecasts of price directions through the analysis of historical market data such as price and volume.

Types of fundamental analysis

What must always be remembered when dealing with fundamental analysis is that it involves the study of everything and anything that could affect the underlying value of a security. The data analysed could range from numbers like revenue and profit, then move to the analysis of the company’s market share and the quality of its management team.

The different fundamental factors can be put into two broad categories: quantitative and qualitative.

Quantitative: This is the analysis of information related to numerical data. I.e. numbers and amounts.

Qualitative: This is the analysis of information related to the nature or standard of something, as opposed to its quantity.

Using this context, quantitative fundamentals deal with hard numbers. They are measurable characteristics of a company. Revenue, profit, assets and much more can be measured precisely. For this reason, the biggest source of quantitative data is a company’s financial statements.

Qualitative fundamentals, on the other hand, are not as tangible; they include the quality of a company’s key executives, its brand, patents and proprietary technology.

Most analysts consider both types of fundamental analysis together.

Qualitative factors to consider in fundamental analysis

The business model: A company’s business model governs what it does and how it does It.

For instance, if a company’s business is making and selling pizzas, its business model would guide the company on how to carry on the business to make a profit.

Competitive advantage: The long term success of a company is driven by its ability to find and maintain its competitive advantage. Competitive advantages such as a powerful brand name, long history, and market dominance create an invisible shield around the business, thereby keeping profits up and competitors at bay.

Management: Popular belief is that management is the most important factor when determining whether to invest in a company. If left to an incompetent management team, the best business model can still fail. In the current world of social media, it has become so much easier to judge the likely suitability of an individual to run the team by looking through their social media pages.

Corporate governance: Corporate governance refers to the policies in place within an organisation specifying relationships and responsibilities between management, directors and stakeholders. The company charter defines these policies, by-laws and the corporate laws and regulations. An attractive investment would be a business that runs ethically, fairly, transparently and efficiently. It would also be important to take note of whether management respects shareholder rights and interests. Make certain that communications to shareholders are transparent, clear and understandable.

Finally, a company’s customer base, market share, industry-wide growth, competition, regulation and business cycles would be important to consider when conducting fundamental analysis.

Quantitative factors to consider in fundamental analysis

Financial statements

Companies disclose information about their financial performance through financial statements. Investors who base their investment decisions heavily on fundamental analysis use quantitative information from financial statements. There are three common financial statements consulted when gathering information for fundamental analysis;

  • The Balance sheet

The balance sheet is a snapshot of a company’s assets, liabilities and equity at any given point in time. It’s referred to as the balance sheet because it represents the balance in a company’s capital structure.

Assets= liabilities + shareholder’s equity

Assets are the resources that a business owns at a particular point in time, e.g. cash, inventory, machinery, buildings, patents and others. The other side of the equation is the total value of financing the company has utilised to acquire the assets. A company acquires financing through liabilities or equity. Liabilities are debts the company owes, which it must pay back in due time. Equity represents the total value of money the owners have contributed to the business- including retained earnings, which represents profit made in previous years.

  • Income statement

The income statement is used to measure a company’s performance over a specific period of time. The income statement contains information about revenues, expenses, and profit generated as a result of the business operations.

  • Cash Flow statement

The cash inflows and outflows are recorded and analysed using a cash flow statement. A cash flow statement shows the true position of a business at a particular point in time. It is the realest measure of where the company stands because only actual cash and cash transactions are recorded.

Key assumptions of fundamental analysis

One key assumption of fundamental analysis is that the current stock price from the stock market is not a comprehensive reflection of the true value of the asset-based on publicly available data. Another assumption of fundamental analysis is that a company’s value, as estimated by looking closely at a company’s fundamental data, is closer to the stock’s true value.

Fundamental analysts typically refer to this as the intrinsic value. It should, however, be recognised that usage of intrinsic value has different meanings in stock valuation and other contexts such as options trading. Standard calculations for intrinsic value are used with option pricing, whereas fundamental analysts use different complex models to arrive at their intrinsic value for a stock.

For example, if a company’s stock was trading at $30, after conducting an exhaustive search, the analyst determined that it ought to be worth $34. Another analyst also conducts research and discovers the stock ought to be worth $36. Most investors will take the average of these estimates and assume the stock’s intrinsic value to be closer to $35. Investors often depend heavily on these estimates because they want to buy stocks trading at prices lower than their intrinsic value.

The third assumption of fundamental analysis is that the stock market will reflect the fundamentals in the long run. The only challenge with this assumption is that no one can accurately say when the long run will come to an end.

Components of fundamental analysis

Fundamental analysis is made up of three major components;

  • Economic analysis
  • Industry analysis
  • Company analysis

Due to the depth of financial analysis as a discipline, it requires knowledge of a wide range of subjects such as accounting, finance and economics. Financial analysis, for instance, requires the ability to comprehend financial statements, an understanding of macroeconomic factors, plus the knowledge of different valuation techniques.

Top-down Vs. Bottom-up Fundamental analysis

Fundamental analysis can either be conducted top-down or bottom-up. An analyst that follows the top-down approach begins the analysis with the consideration of the macroeconomic factors in an environment. By analysing different macro-economic factors such as interest rates, inflation, and GDP levels, an analyst attempts to determine the economy’s overall direction and takes note of the industries/ sectors of the economy with the best investment opportunities.

After that, the analyst assesses specific potential prospects within the identified industries and sectors. Finally, the analyst looks into select individual stocks within the most promising industries.

When following the bottom-up approach, an analyst would begin with an investigation of microeconomic factors such as a company’s earnings and financial statements. Analysts that follow this approach develop an in-depth understanding of each company in order to gain a better understanding of its operations.

Criticisms of fundamental analysis

Technical Analysis

Technical analysis bases its findings on the price and volume movements of stocks. Using charts and other sophisticated tools of analysis, technical analysts determine the likely value of a stock or security while ignoring other fundamental factors. One of the underlying assumptions of technical analysis is that the market discounts everything, which means all news and information about the company is already priced into the stock.

The efficient market hypothesis

Investors who strongly consider the efficient market hypothesis disagree with technical and fundamental analysts. According to the efficient market hypothesis, it is essentially impossible to beat the market since the market itself efficiently prices all stocks on an ongoing basis. As a result of this, any opportunities for added gains are almost immediately taken away by the market’s large number of participants, thereby making it impossible for any investor to outperform the market meaningfully.

Examples of fundamental analysis

If an investor were to conduct an analysis on a company like Apple without considering its powerful brand name, that would be viewed as a mistake by fundamental analysts. There are many companies in the same technology space as Apple, yet none has a brand name as recognisable, admired and emulated as Apple. It would be difficult to place an exact figure on what the Apple brand name is worth, but its contribution to the company’s overall valuation is simply undeniable.

Therefore, fundamental analysis of the company would begin by assessing the value of Apple’s assets, income streams, debts, and liabilities.

Steps in fundamental analysis

Generally speaking, the fundamental analysis examines individual companies’ financial statements and analyses various ratios and other metrics. These are utilised to determine the intrinsic value of a company based on its revenues, profit, costs, capital structure, cash flows and other important data. The information gathered on a specific company can then be compared to industry peers and competitors. Finally, this data can also be analysed in a broader market or macro-economic environment.

Who uses fundamental analysis?

Fundamental analysis is mostly used by long-term or value investors to identify well-priced stocks and securities with good prospects quickly. Equity analysts also utilise fundamental analysis to generate price targets and make recommendations to clients. e.g. Hold, Buy or Sell. Corporate managers and financial accountants also use fundamental analysis to analyse and increase a firm’s operating efficiency and profitability. Warren Buffet is a known advocate of fundamental analysis.

How does fundamental analysis differ from technical analysis?

Technical analysts do not perform a deep dive into the darkest secrets of a company to determine the value of its stock. Instead, technical analysts prefer to look into short-term chart patterns to identify price signals, trends, and reversals. As a result, technical traders tend to take short-term positions and do not always look at the longer-term valuation.

Fundamental analysis and Forex trading

Fundamental analysis is used to analyse financial markets with the goal of forecasting currency prices. Forex fundamental analysis places its focus on the overall state of the economy and researches different factors such as interest rates, employment rate, GDP, international trade and manufacturing, plus their impact on the national currency. It involves understanding the various factors and how they work and influence each other to affect the price of a local currency.

Fundamental analysis and Cryptocurrency

Fundamental analysts use fundamental analysis to consider the internal and external factors to determine an asset’s intrinsic value and whether a cryptocurrency is under or overvalued. For a cryptocurrency, this might involve looking at the number of uses the currency is put to, the number of people using it, or even the team behind the currency.

With this brief background, it’s easy to understand how crucial fundamental analysis is when determining the value of stock/ security. Key to note is the fact that fundamental analysis isn’t only applied to stocks or forex but can be applied to any valuable asset, and in more recent circumstances, cryptocurrency as well.