Fundamental analysis is a technique that can help you become a better stock-picker than before. It’s also very useful for those who want to understand the stock market better and in-depth. In addition, it’s not exclusive for stocks. You can also use fundamental analysis to valuate currencies, commodities, and other assets.
Oppose to technical analysis, fundamental analysis tends to have a longer-term horizon. This is why it’s here to stay no matter how many other techniques spring up.
In this article, we’re going to give you a comprehensive learning guide to understand what fundamental analysis is. Let’s start!
First, what exactly is fundamental analysis?
Fundamental analysis covers a lot of subject, so it’s not easy to decide where to begin. But for the purpose of this article, we’ll start with the very basics.
Fundamental analysis tries to find the real value of a stock by looking at the underlying factors that affect the actual business. Bear in mind that you can also apply fundamental analysis on a broader sector or even industry. You can even use it to assess a whole economy.
Fundamental analysis tries to answer several questions about a business. For instance, it tries to see if a business’s revenue is growing. Is the company really making profit? How fast does this happen?
Aside from those, it also tries to gauge the company’s strength by comparing it against other businesses. This means that you won’t limit your focus on the business itself. You have to look at its competitors and see how it can stand up against them.
Further, fundamental analysis also lets you take a peek on the trajectory of the company’s finances. By connecting the dots, you’ll gauge the company’s ability to fund its projects and even pay its debts.
While learning the basics of fundamental analysis won’t make you the sharpest stock valuator around, it will still add tremendously to your skills and understanding.
Qualitative and Quantitative Fundamentals
The term “fundamentals” may be difficult to grasp at first. This is because it involves a plethora of economic factors that affect a company.
While it’s obvious that these fundamentals include profit and losses, you also have to consider the management. You also have to study the implications of the company’s earnings report, outlook guidance, and other such things.
However, you can categorize the myriad fundamentals that you have to study into qualitative and quantitative fundamentals.
These names should be easy to understand. Qualitative fundamentals are those that depend on the quality or character of the company. This may include the overall reputation of the company in the market. Meanwhile, quantitative fundamentals are those that you measure based on numbers. This in turn includes the financial statements of the company, including revenue, profits, and more.
Where should we focus?
The answer to this question is this: we should take both of them into consideration. Neither the qualitative nor quantitative factors can mean anything by themselves.
It’s more advisable to take the whole shebang together and treat them as if they’re parts of a single organism—which is, in a way, what a company is.
This way, you can see the bigger picture much, much better.
Any discussion about fundamental analysis can never be complete without tackling the concept of intrinsic value.
The intrinsic value refers to the “real” value of a company. Before we go on, know that first assumption of fundamental analysis opposes the efficient market hypothesis. Fundamental analysis assumes that the market doesn’t completely reflect a stock’s true value.
This means that a stock may either be overvalued or undervalued. Overvalued stocks are those that have higher market prices than their intrinsic value. Meanwhile, undervalued stocks are those that have lower market prices than their intrinsic value.
Generally, you should sell overvalued stocks before the market prices them down. On the other side, you should hunt for undervalued stocks to gain profits when the market realizes their true value.
Read further: Some Ways to Improve your Investment Skills
When will the market reflect a stock’s real value?
Fundamental analysis also proposes that the market will, sooner or later, reflect a stock’s intrinsic value. The first assumption wouldn’t work if this isn’t also true.
Waiting for the market to reflect the stock’s intrinsic value can take days—or years.
Even so, many traders and investors stick to fundamental analysis because of the potential rewards. You focus on a specific stock and try to find its intrinsic value. Buy it if it’s undervalued and then sell it once the market reflects its value.
There are, however, two problems that you should face if you use fundamental analysis. First, you can’t be entirely sure if your estimate of the intrinsic value is correct. Second, you cannot possibly know when the market will exactly reflect the intrinsic value.
Against Technical Analysis and the Efficient Market Hypothesis
Just like other market approaches, fundamental analysis has its fair share of criticisms. Among these are technical analysis and the efficient market hypothesis.
Technical analysis holds that the price and volume movements of securities are the most important factors to consider. Technical analysts use charts, and indicators to find the best entry and exit points in a trade, completely ignoring fundamentals.
It’s possible to use both technical and fundamental analysis at the same time. However, technical analysis proposes that the market discounts everything. All news about the company is already priced into a stock. This means that it’s better to look at the stock’s price movement instead of the fundamentals.
Meanwhile, the efficient market hypothesis tells us that the market prices stocks fairly. It says that you cannot truly beat the market in the longer run. The gains you get through either fundamental or technical analysis will quickly get back to the market. In other words, the efficient market hypothesis dismisses both technical and fundamental analyses.
Now that you know the basic tenets and criticisms of fundamental analysis, it’s time to dive deeper into how to properly use this approach. Read on!
One of the most difficult parts of fundamental analysis is incorporating qualitative factors into your valuation. Qualitative factors, as we have said, are those that you can’t express in terms of numbers. However, we cannot just ignore them since these fundamentals can either make or break a company.
Let’s look at some of them.
The company’s business model
A company’s business model refers to the way the company profits. You have to first look at what the company does to get a feel of how it performs.
Understanding business models is easy most of the time, especially for those well-known brands and companies. Many companies have very simple business models. However, it can also get tough at times.
To illustrate, imagine a fastfood restaurant that sells their fries, burgers, and the like. You can say that their business model is a no-brainer. They sell food to make money.
On the other hand, imagine another restaurant that also apparently sells food to make money. You’d be surprised to know that the company actually makes money by franchising. They actually make money by getting royalty fees and high-interest loans.
This can be detrimental since you wouldn’t be sure if all franchisees perform as well as the other. You might even wake up one day hearing that the restaurant has already gone bankrupt.
In other words, you shouldn’t invest in a business that you don’t fully understand. This is a dictum that Warren Buffett, the legendary investor, follows. In addition, understanding the business model will work better if you know the company‘s main drivers for growth.
When a company is successful, it’s not enough that it is. The bigger concern is whether the company can hold on to that success for the longer-term.
Powerful competitive advantage tells you if the stock will reward you for how long. If the company sports such an advantage, it means it can beat its rivals to the ground. Thus, you and the company will enjoy profit.
According to Michael Porter, who is a Harvard Business School professor, the company can gain sustainable competitive advantage by various ways.
For one, the company should have a unique and competitive position. It should also have activities appropriate for the company’s strategy, as well as a high degree of operation effectiveness.
The company is like a battalion of soldiers. And these soldiers follow a leader, a captain, or a general. No matter how good the parts of the company are, it would definitely fail if the leaders mismanage the operations.
It’s quite difficult to get an accurate feel of the company’s management. You cannot set a meeting vis-à-vis the executives of the company.
However, the following will help you get more information about the company’s management.
1. Conference calls by executive
For the case of many successful businesses, top executives like the CEO and CFO host conference calls every quarter. You may even get the chance to listen to other top officials. In such calls, the management usually spends the first part for the reading of the financial results.
Afterwards, the management’s line will be open for direct questions from analysts. This is your chance to judge the company’s officials based on the way they answer. If they sound like they’re trying to hide something shady, it tells you something negative about the company’s future. If they answer questions forthright, you can be a little more comfortable.
2. Ownership and Insider Sales
Almost all large companies will reward their executives with a combination of cash, options, and restricted stocks. If you see that the top officials are also shareholders, this is generally a good sign. This is doubly ideal when the founder of the company is also still a shareholder.
This is because you can almost be sure that the management will try everything to make the company grow.
You might also want to check if the management has been unloading its stock. Check that information on the Securities and Exchange Commission. There’s only a small caveat in this: start wondering if they’re selling stocks while saying something else in public.
3. Previous Performance
Looking at a management’s past performance is also a good way to gauge their managing abilities. In fact, it’s another no-brainer.
You can typically see the management history and executive biographies on a company’s website. What you then have to do is study how the management worked in the past. See if they are pursuing a different strategy and gauge how it would affect the overall performance of the business.
4. Management Discussion and Analysis
You can find this one at the beginning of a company’s annual report. Theoretically, this part should be a straightforward and frank commentary on the management’s outlook. However, that’s not always the case.
What you can do is compare what the company is saying now versus what they had said in previous reports. Check if what they said before has been successfully done. If they had laid out some plans, did they execute it properly?
The answers to those questions will shine some more light on the question of the management’s ability.
When we say corporate governance, we refer to the policies in an organization that keeps everything in check. It also pertains to the relationships and responsibilities between directors, stakeholders, and the management.
Such policies are in place to make that no one or entity will commit something unethical or illegal. These policies protect the interest of the company’s stakeholders and investors.
Corporate governance has some concepts that we can study. If we understand these concepts, we can perform fundamental analysis on the company more properly.
This part of corporate governance talks about the extent to which the policies benefit stakeholder and shareholders’ interests. In general, shareholders should be able to communicate with the management if they want to address an issue or concern.
Shareholders are effectively owners of the company. Therefore, good corporate governance must give them the rights to vote or discuss pressing matters.
You might also want to check if the owners of the company have some good takeover defenses. These are those policies that enable them to prevent quick or sudden changes in management or ownership.
Finance and Information Accessibility
This aspect talks about the quality and the timeliness of the company’s disclosure of information and financial details.
Transparent information dissemination means the company’s financial releases are clear-cut and easy to understand. Stakeholders should not have a hard time following what the management is doing and planning to do.
Ultimately, the stakeholders should easily get the bigger picture of the company’s financial situation.
Board of Directors
The Board of Directors is the representative both from the inside and outside of the company. Their purpose is to ensure that shareholders’ rights are protected. In the process, they provide an independent assessment on how the management performs.
The Board of Directors should have great independence to serve as critics of the management. This is why outside representatives should be present.
Fundamental analysis requires you to consider not only the company but also the industry in which it belongs.
There are many factors to consider in this area, such as market share, customers, competition, and others. If you manage to understand the company’s standing in its industry, you’ll gauge the business’s financial health better.
There are businesses that serve only a specific bunch of customers. Others serve millions around the world.
In general, a company that takes a huge portion of its sales from a small group of customer is not so good. It just means that a single change in the customer base can translate to huge adjustments in the company’s earnings.
Growth in the Industry
After checking the company’s customer base, check the industry growth. To do this, try to know whether the amount of customers will grow in the industry. When such event happens, the company will have to ramp up efforts to gather more market share.
One of the fastest-growing industries belongs to the tech sector. Some of the most successful products in the previous decades might not have fighting chance these days. That’s because of the massive growth that happens in the tech sector.
A company that cannot cope up with the pace of industry growth is generally not an ideal investment.
A lot of companies are vying for larger market shares, hoping to be the market leader. Fundamental analysis requires you to check the company’s market share.
If the company is the biggest player in its market, it means it has the competitive advantage against other firms. It’s practically insured of its current and future earnings. Larger market share also puts the company in an advantageous position to absorb the high fixed-costs of the industry.
Looking at the number of competitors that a company has can be beneficial in many ways. Basically, the more competitors a company has, the more difficulties it has in operating.
In a cut-throat competition, the biggest risk that a company faces is the pricing power. The pricing power refers to the capability of a supplier to increase prices and let customers shoulder it.
There are industries that have to follow lots of tight regulation. This is typically because of the importance of the industry’s services and products. These regulations ensure that the competitions within the industry remain healthy to protect consumers’ interests.
However, such regulations tend to affect even the most attractive companies in the industry in terms of investing.
In some cases, the government limits the amount of profit a company can take. If this is the case, you can still obtain sizable profits, though they will be limited.
The Balance Sheet
Among the quantitative factors that fundamental analysis considers, the balance sheet shouldn’t be overlooked. This financial statement practically tells a huge part of the company’s financial situation.
In terms of fundamental analysis, the balance sheet gives you a quick overview of the company’s health. Simply put, it tells you how much the company owns and owes. And by finding the difference between those two figures, you get the company’s equity.
In other words, this is your quickest fundamental to knowing if the company is a good or bad investment.
Let’s talk about the three most important things that a balance sheet tells you.
What the company owns, or Assets
There are two main types of assets. First, the current assets, and then the non-current assets.
Current assets are those that the company will likely use up or convert into cash within a business cycle. And a business cycle is typically 12 months. On the balance sheet, you can find three very important current assets. These are the:
- Account receivables
You might want to chase after companies with huge cash arsenal on their balance sheets. Cash is some sort of insurance during difficult times. In addition, it provides the company some option for future expansion.
Fundamental analysis tells us that growing cash reserves means strong performance. Conversely, a minimal cash reserve could spell trouble. On the flip side, you need to ask why the company doesn’t put the money to use. It could, after all, be a sign that the company has already run out of investment opportunities.
Meanwhile, inventories are finished products that the company hasn’t sold. Fundamental analysis tells you to know if a company’s cash reserve ties up with its inventories. The company needs to sell the merchandise they purchase from suppliers. If the inventory grows faster than sales, you might want to have a double-take on the company.
Lastly, receivables are the uncollected bills. You can use this information to know how quickly a company collects what others owe. It’s typically a red flag if the company takes longer time to collect such receivables. Remember that it’s better for the company to collect cash quickly than wait longer.
Non-current assets are those that do not belong to the above categories. Fixed assets like plant and equipment and properties fall under this category.
What the company owes, or liabilities
Similar to assets, you can categorize liabilities into current and non-current liabilities.
Current liabilities are those that the company needs to pay within a year. These include payments to suppliers. On the other hand, non-current liabilities are those that the company can pay for more than a year. These include bank and shareholder debt.
Fundamental analysis tells us that the company should manage debt efficiently. Look for signs that the debt level is falling. In general, you want the company to have more assets than liabilities. It goes without saying that a company with larger liabilities than assets is on the red line.
The difference between assets and liabilities, or equity
This is also the shareholder’s equity since it represents what shareholders own.
You’ll find the two most important equity items on a balance sheet. These are the paid-in capital and retained earnings.
The paid-in capital refers to how much the shareholders paid for the shares during the company’s IPO. Meanwhile, retained earnings refer to the money that the company chose to reinvest in the business. As an investor, you should scrutinize how the company uses its retained capital and how it earns profits from it.
Fundamental Analysis: The Conclusion
What fundamental analysis ultimately tells us is that we should never ignore the company’s health. It also teaches us the inner workings of a company and an industry. What we get from this is a long-term education that we can use through and through.
We learn to be prudent, disciplined, and critical of an investment, making us sharp and confident of our decisions. Fundamental analysis is here to stay. Try it out today. It might just be the perfect trading approach for you!
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