Intermediate Level

Learn more complex tools and techniques that will help you in trading.

Lesson 6: Fundamental Analysis

What is a Functional Analysis?

Fundamental
analysis is a method of measuring the inherent value of security by analyzing associated
economic and financial variables. Fundamental analysts research anything that
could affect the value of protection, from macroeconomic factors such as the
state of the economy and the conditions of industry to microeconomic factors
such as the efficiency of the company’s management.

The final
objective is to arrive at a number that an investor can equate to the current
security price in order to see whether the security is undervalued or
overvalued.

This
method of stock analysis is known to be the opposite of the technical analysis,
which predicts demand direction through an analysis of historical market data
such as price and volume.

Understanding Fundamental Analysis

Both stock
analysis attempts to assess whether protection is priced appropriately in the
wider market. Fundamental analysis is usually done from a macro to a micro
perspective in order to identify securities that are not valued correctly by
the market.

Analysts
usually research, in order to determine the general state of the economy, and
then the strength of the specific industry, before focusing on the output of
the individual company in order to obtain a fair market value for the
inventory.

Fundamental
analysis uses public information to determine the quality of an inventory or
any other form of security. For example, an investor may conduct a fundamental
analysis of the price of a bond by looking at economic factors such as interest
rates and the overall state of the economy, and then research data about a bond
issuer, such as potential changes in its credit rating.

Of shares,
the fundamental analysis uses sales, earnings, future growth, investment
returns, profit margins, and other information to assess the company’s
underlying value and potential of future growth. All of this data is included
in the company’s financial statements (more on that below).

Investing and
Fundamental Analysis

If the
intrinsic value is higher than the current market price, the stock is deemed to
be undervalued and a buying recommendation is made. If the intrinsic value is
less than its market price, the stock shall be considered overvalued and the
selling recommendation shall be given.

Investors
are going long (purchasing with the hope that the stock will increase in price)
companies that are big, and are going short (selling stocks that you believe
will fall in value with the expectation of buying them back at a lower price)
companies that are small.

This
method of stock analysis is known to be the opposite of the technical analysis,
which predicts demand direction through an analysis of historical market data
such as price and volume.

Quantitative and Qualitative
Fundamental Analysis

The
problem with qualifying the fundamentals is that it can include absolutely anything
related to the economic well-being of a company. Clearly these include figures
such as revenue and profit, but they can also include anything from the market
share of a business to the performance of its management.

Various
key factors can be divided into two categories: quantitative and qualitative.
The financial sense of these terms is not very different from their standard
definitions. Here’s how the dictionary defines these words:

  • Quantitative
    – capable of being calculated or represented in numerical terms.
  • Qualitative
    – linked to, and focused on, the value or character of something, often in
    comparison to its size or quantity.

Quantitative
metrics are complicated numbers in this sense. These are the observable
characteristics of a company. That’s why financial statements are the largest
source of quantitative data. Revenue, earnings, capital and more can be
calculated with great precision.

The
empirical principles are less concrete than that. These may include the value
of key executives of a corporation, the brand name recognition, patents and
proprietary technology.

Neither
qualitative nor quantitative evaluation is inherently better than that. Many
analysts consider them together.

Qualitative
Fundamentals to be considered

There are four main fundamentals which analysts often
consider when it comes to a product. We are all qualitative rather than
quantitative. These include:

  • The business model: what exactly is the company doing?
    This isn’t as simple as it seems to be. If the business model of a company is
    focused on selling fast-food chicken, is it making money that way? Or is it
    just paying royalty or license fees?
  • Competitive advantage: the long-term performance of a
    corporation is largely driven by its ability to maintain a competitive
    advantage. Powerful competitive advantages, such as Coca Cola’s brand name and
    Microsoft’s dominance of the personal computer operating system, they built a
    moat around their company’s which help to hold their rivals at bay, whilst they
    experience growth and income. If a company is able to gain a competitive
    advantage, its investors can be paid well for decades.
  • Management: Many people believe that
    management is the most important criterion for investing in a business. This
    makes sense: even the best business strategy is lost if the company’s
    representatives fail to implement the plan properly. While it is difficult for
    retail investors to meet and objectively assess executives, you can visit the
    corporate website and check the curriculum vitae of the top brass and board
    members. How well did they perform in previous jobs? Have they been unloading a
    lot of their shares lately?
  • Corporate governance: Corporate governance defines the
    policies in place within an entity that establish relationships and obligations
    between management, directors and shareholders. Such policies are specified and
    described in the constitution of companies and by-laws thereof, as well as in
    corporate laws and regulations. You want to do business with a company that
    works ethically, equally, transparently and efficiently. In general, it should
    be noted whether the management values investor rights and shareholder
    interests. Ensure that their correspondence with investors are open, consistent
    and understandable. If you don’t get it, it’s probably because you don’t want
    it.

It is also
important to consider the sector of a company: customer base, market share
between companies, industry-wide growth, competition, regulation and business
cycles. Understanding how the business operates will give an investor a deeper understanding
of the financial health of a product.

Quantitative
Fundamentals to be considered

Financial
statements are the process by which a company discloses data on its financial
performance. Simple research followers use statistical information gleaned from
financial statements to make investment decisions. The three most significant
financial statements were income statements, balance sheets and cash flow statements.

The balance sheets

The balance sheet contains a record of the assets,
liabilities and equity of the business at a particular point in time. The
balance sheet is defined by the assumption that the financial structure of the
company balances in the following way:

Assets = liabilities
+ shareholders

 
equity

Assets represent
the wealth that the business owns and manages at a given point in time. These
include things such as money, stocks, machinery and buildings. The other side
of the equation is the total value of the borrowing used by the corporation to
purchase those properties. Financing is the product of debt and assets.
Liabilities represent liabilities (which, of course, must be repaid), while
equity represents the overall value of money that the owners have lent to the
business-including retained earnings, which is the gain made in previous years.

The Income Statement

While the
balance sheet takes a snapshot approach when analyzing a firm, the income
statement examines the performance of a company over a specific timeframe.
Technically, you could have a balance sheet for a month or even a day, but you’ll
only see public companies report on a quarterly or annual basis.

The income
statement provides information on the sales, expenditures and profits generated
as a result of the business operations for that year.

Statement of Cash Flows

The cash
flow statement contains a summary of the cash inflows and outflows of the
company over a period of time. Usually, the cash flow statement focuses on the
following money-related activities:

  • Cash
    from investment (CFI): Money used to invest in assets, as well as proceeds from
    the sale of other companies, equipment and long-term assets
  • Cash
    from financing (CFF): Cash paid or earned from the issuing and lending of funds
  • Operating
    Cash Flow (OCF): Cash generated from day-to-day business operations

There’s a
lot that malicious accountants can do to maximize their earnings, or make them
appear to be something more than they are, but it’s hard to get fake cash in
the bank. For this reason, many shareholders are using the cash flow statement as
a more conservative indicator of the company’s performance.

The Concept of Intrinsic Value

One of the
key principles of the fundamental analysis is that the price on the stock
market does not completely reflect the real value of the stock. How else do you
have a cost analysis?

In
financial jargon, this true value is known as an inherent value.

For
example, assume that the company’s stock was worth $20. After you’ve done a lot
of homework on the product, you decide it’s really worth $25. That is, you
calculate the value of the stock to be $25.

This is
clearly relevant because you want to purchase shares that are exchanged at
rates that are far below their intrinsic value.

This leads
to a second major premise of the fundamental analysis: the stock market should
represent the fundamentals in the long run. The thing is, nobody knows how long
the “long run” really is. It could have been days or years.

That’s
what the fundamental analysis is all about. By concentrating on a particular
business, an investor may calculate the firm’s inherent value and find
opportunities to buy at a discount. Investment will pay off when the market
follows the fundamentals.

 One of the most famous and successful
fundamental analysts is the so-called “Oracle of Omaha,” Warren
Buffett, who advocates the stock-picking technique.

Criticisms of Fundamental Analysis

The main
criticisms of fundamental analysis come mainly from two groups: the advocates
of technical analysis and the adherents of an efficient market hypothesis.

Technical analysis

The
technical analysis is the other primary form of security analysis. Simply put,
technical analysts base their investments (or, more specifically, their
transactions) solely on price and volume movements of stocks. Using maps and
other devices, we rely on energy and forget the fundamentals.

One of the
basic principles of technical analysis is that everything is discounted by the
market. All the news about a business is already priced on the inventory. As a
result, the price movements of the stock offer more insight than the
fundamentals of the market itself.

The Efficient Market
Theory

The
proponents of the efficient market hypothesis, however, are generally at odds
with both theoretical and technical analysts.

The
efficient market hypothesis holds that it is practically impossible to beat the
competition through either a fundamental or a technical analysis. Since the
market essentially values all stocks on a continuous basis, any incentives for
excess returns are almost inevitably dominated by the many market participants,
making it impossible for anyone to substantially outperform the market in the
long term.

An Example of Fundamental Analysis

Take the
Coca-Cola Company, for example. The analyst will look at the annual dividend payment
of the stock, the earnings per share, the P/E ratio and many other statistical
considerations when analyzing the stock.

Nevertheless,
no study of Coca-Cola is complete without considering the popularity of its
name. Anyone can set up a company that sells sugar and water, but few companies
know billions of people.

It’s hard
to put a finger on just what the brand Coke is worth, but you can be sure it’s
a key ingredient that contributes to the company’s continued success.