Fundamental Analysis

What Is Fundamental Analysis?

Fundamental analysis (FA) is the technique of analyzing and valuing security based on the value of the underlying business assets.

This entails considering everything from global events that can affect consumer behavior to firm management to trading multiples - anything that can affect the value of the business underlying the security.

The idea behind FA is that investors value a security based on the underlying business and then trade it based on whether it is overvalued or undervalued by comparing the calculated value with the security’s current price.

This follows the assumption that all assets will be priced at their true or “fair market” value over time, which may not always be correct in the markets.

If a security is being traded below its true value, fundamental analysts would see it as being undervalued, signaling a buying opportunity. In contrast, if a security is traded at a price above its fair market value, it is deemed overvalued. It indicates a selling opportunity before it returns to its intrinsic value.

Value investor Warren Buffet is one of the most successful proponents of this type of analysis. It is one of the very few investors who have outperformed the market over a long time. 

The other method used by investors is technical analysis (TA) which involves treating the security price independent of the underlying market and analyzing historical market data such as price and volume to predict the future price of securities.

Fundamental Analysis Importance

FA is used to determine the fair value of a security. The work of fundamental analysts revolves around ensuring that the investors who take their advice are able to make informed investment decisions.

As FA is a time-consuming process that involves looking at various factors affecting the target business, most investors delegate this work to fundamental analysts. This is due to a lack of both time and knowledge to conduct the same independently.

For instance, a casual investor may see that the price of a stock has been increasing for the past few months and decide to buy some shares due to the fear of missing out (FOMO) on profits due to rising prices.

In contrast, a fundamental analyst would take the time required to perform due diligence on the stock and its underlying business and only invest if their analysis reveals it to be underpriced, showing no regard to the actual market movements in its price.

Fundamental Analysis Types

Similar to how data scientists and analysts form insights from data, FA involves forming conclusions on the value of companies and potential opportunities based on those conclusions. FA is split into two based on the type of data being analyzed, namely:

• Qualitative analysis (using quantitative data)
• Quantitative analysis (using qualitative data)

When paired together, they provide an overall picture of a stock that encompasses both quantitative and qualitative aspects, providing analysis to an investor to base their investment decision.

Here is a video summarizing the two types of FA:

What is Qualitative Fundamental Analysis?

Qualitative fundamental analysis involves looking at factors affecting the performance of a business that cannot be quantified. Some essential qualitative factors that have a huge influence over the valuation of businesses are:

• Management
• Competitive advantage
• Business model

Analysis of a company’s management involves investigating how competent, experienced, and well-suited the managers are to their job.

Since the management is responsible for most of the business’s operating and capital allocation decisions, it can be regarded as the most critical aspect of qualitative analysis.

Uncovering and analyzing the key decision-makers' previous accomplishments and management style is paramount to gaining insight into a company’s future direction and performance, such as its potential to grow and increase profits.

An organization’s competitive advantage is another vital factor in qualitative analysis. It determines the organization’s uniqueness, which can influence the barrier of entry for potential competitors who want to disrupt the market.

The better a company’s competitive advantage is, the harder it is for new competitors to enter the market and replicate the strategies and products and vice versa.

Therefore, the more competitive advantage a company has, the higher the fair value of the company. This concept has been referred to as an “economic moat” by Warren Buffett, who is one of, if not the best, investors in the world to use FA.

Essentially, like a physical moat, an economic moat separates a company from its competition, making it unreachable to outsiders trying to invade its market space by making it hard to replicate its business strategy or products.

To explain this better, we would like to look at Coca-Cola as an example of a company with a strong economic moat derived from its brand value. This economic moat arises due to the fact that everyone knows about the beverage and associates it with the brand.

Even though Coca-Cola’s main product is simply a sweet beverage, its brand name makes it impossible for new businesses to enter the industry as potential competitors, despite the industry’s low barrier of entry.

Another example of a company with a strong economic moat would be Apple, as it has a high level of brand awareness (consumers know what Apple is and what it does, and the quality it provides) just like Coca-Cola, as well as a strong customer base due to having high customer satisfaction with their products.

To summarize, competitive advantage is a measure of how unique and hard it is to replicate the success of a business, with a high level of competitive advantage being a strong indicator of higher long-term value.

A company’s business model is also crucial to qualitative analysis as it is a key criterion in judging and measuring the company’s success.

This is because the business model refers to what a company does to generate value and is closely linked to its revenue model, which is how a business makes money from the value it provides.

For instance, a company’s business model could improve the efficiency of the internal processes of its enterprise clients with a revenue model of set service packages for its clients to choose from.

A fundamental analyst could investigate how impactful the organization’s business model is in creating value for its shareholders and whether or not its revenue model is profitable. 

In addition to these three key aspects, there are also other qualitative factors to take into account before forming an opinion of the value of security.

These include supporting evidence for up-to-date qualitative information, such as headlines that a company would make, corporate actions/governance, institutional participation (like investments from hedge funds or mutual funds), employee satisfaction, and supplier relationships.

In addition to qualitative factors, FA involves looking at quantitative factors such as Securities and Exchange Commission (SEC) documents like the 10-K report and the 10-Q report and financial statements, which will be elaborated upon in the next section.

What is Quantitative Fundamental Analysis?

Quantitative fundamental analysis involves looking at how a business is performing and deciding if it is fairly valued.

This form of analysis is based on the numbers in the financial statements, as well as calculations made thereof; the three financial statements that are used the most for fundamental quantitative analysis are:

• Balance sheet
• Income statement
• Cash flow statement

The balance sheet provides analysts with information on the assets and liabilities of a company as of a particular day.

Analyzing the balance sheet as part of quantitative financial analysis, analysts can understand the sources from which the business raises money for its assets and can help them determine if it is over-leveraged or at what multiple net assets it is trading.

The income statement provides information on how a company generates its revenue and whether or not it is operating at a profit or loss over a specific period of time.

A closer analysis of the income statement generally reveals insights into how a business uses its profits. One such use would be to reinvest the profits into the business through research and development (R&D) ventures in the hopes of increasing profits in the future.

Another use case would be to buy capital assets, thereby increasing future productivity (this can be inferred by increasing depreciation expense in the income statement).

The cash flow statement provides information on how a company generates and uses its cash to operate the business and make investments. It also shows how much money is raised from borrowings and equity.

The net movement in the company’s overall cash position is divided into three:

• Cash from operating activities
• Cash from investing activities
• Cash from financing activities

It gives a cash-based account of how a business generates revenue and is, therefore, more difficult to manipulate than the income statement. The bank balances are used for reconciliation (which is harder to manipulate compared to intangible expenses such as depreciation).

However, these numbers are generally useless when used as individual data points, which is why analysts use ratios to help connect the dots to form information that can be compared across multiple entities. Common ratios used as part of quantitative FA include:

• Price/Earnings (P/E) ratio
• Price/Book Value (P/B) ratio
• Debt/Equity (D/E) ratio
• Return on Equity (ROE)
• Return on Assets (ROA)
• Current Ratio
• Net Profit Margin (NPM)

These ratios allow fundamental analysts to compare the valuation of different companies within the same industry. The most commonly used ratio is the P/E ratio which allows an investor to look beyond the price of a stock to see which company could be the best value.

Usually, the higher the P/E ratio, the more overvalued the company is.

Here is an excellent video giving an in-depth explanation of quantitative analysis:

How to conduct fundamental analysis?

Fundamental analysis helps understand the value of a business better so that an investor can make informed decisions about what securities to invest in. 

Since it considers all factors, micro and macro, that could affect a company’s value, there are two primary methods of performing FA:

• The top-down approach
• The bottom-up approach

The more common of the two is the top-down approach, when the analysis is done from a macro-to-micro perspective and involves taking into account the broad market conditions and various aspects of the company, such as quality of management, before inspecting the financial statements and making calculations.

Using the top-down approach, one can perform FA by going through these steps:

1. Research the market and then the company

Taking on a broad view of security, the first step is to understand how the market is performing as a whole and then look at how the company is performing relative to the market as well as other qualitative elements of FA, like identifying the company’s business model.

For example, one would consider whether the industry’s market size is going up or down, whether a company is following the trend or against it, and how the business model affects its performance.

2. Analyze current and potential competitors

A company that performs is a company that provides good value for investment, and one of the ways to measure its performance is by comparing it with that of its competitors.

This is where concepts like a competitive advantage from qualitative FA are used to identify companies that can outperform their competition.

3. Analyze the company’s financial statements

This is where investors start concentrating on the micro aspect of the top-down approach by studying the company’s financial statements to understand various factors such as its cash flows, how it operates and spends its capital.

Calculating ratios from the data gathered in these statements can help compare the information against comparable companies in the same industry. 

4. Understand the company’s future plans

Similar to how researching the company’s current and past performance is essential, it is also necessary to understand what projects and initiatives the business has planned for the future and what this means for future profitability and growth of the business.

This is due to the fact that FA generally focuses on long-term investments, and as such, the future direction of a company is a crucial aspect of it.

5. Stay Informed

Last but not least, staying up-to-date with the news and information about companies that one has invested in is vital to ensure that those long-term investments continue to be beneficial and are not extremely overvalued.

If a lot overvalues the company, the investor can close out positions to realize the profit on the same before the prices fall to represent the fair value.

If we want to use the bottom-up approach, we would do the exact reverse and start with analyzing the company first before analyzing the broader market.

Fundamental Analysis (FA) Vs. Technical Analysis (TA)

The two main ways of measuring the value of securities are fundamental analysis and technical analysis.

FA provides investors with information on what securities to buy, whereas technical analysis allows traders to form predictions on when to buy these securities.

This is achieved by analyzing price trends by scrutinizing market data like indicators of the price and volume of a security.

These trends and patterns are the cornerstones of technical analysis. Technical analysis relies on past trading data and basic principles of economics, such as supply and demand. Hence, it is simpler to understand as there are fewer components to worry about, but still very difficult to learn and master.

Technical analysis is simpler to understand because it narrows down most of the information gathered by fundamental analysts - like management and competitive advantage - into one main point of concentration, the stock’s market price.

This allows technical analysts to research the history of price movements and common trends and patterns that form, as opposed to performing qualitative FA in addition to quantitative, which requires heavy and messy calculations.

Despite these differences, both forms of analysis still have some common features. Neither can be considered a better form of analysis as they both have their purpose and style that could suit one individual but not another.

It is best to experiment with both styles before deciding which one to concentrate on or use both when determining what companies to invest in to gain the best of both worlds of security analysis.

Fundamental Analysis Advantages and Disadvantages

Some of the advantages are: 

• Fundamental analysis is generally focused on long-term investment decisions. If done right can lead to higher-than-average returns because of low incidental costs such as slippage due to the low trading frequency.
• Legendary investor Warren Buffett is a prime example of a successful fundamental investor. Since it is used for long-term investing, it requires less monitoring than technical analysis.
• Using it for long-term investing can be likened to planting a seed and letting it grow into a tree to reap the rewards many years into the future.
• Due to the low frequency of trading, this method leads to lower execution risk as trading does not occur very fast.

On the contrary the disadvantages are:

• FA requires a thorough analysis of all factors affecting the business, both current and future. This leads to many projections that may or may not be accurate and therefore is, only as good as the analyst who is analyzing the company. 
• It considers the investment long-term rather than short-term, so investors may suffer a loss rather than a profit in the near future. In addition to this, there may be some big moves in share prices that occur in a short timeframe which is not suited to the style of FA.
• It is more time-consuming than technical analysis due to the depth of analysis required.
• It requires an understanding of how to read financial statements, the various caveats used by companies in their financial statements, and the calculations derived from them, which may be difficult for regular individuals who have just started investing.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Annual Return
• Capital Markets
• High-Frequency Trading (HFT)
• Market Indicator
• Pegging