What is Fundamental Analysis and Its Objectives?
What is Fundamental Analysis?
Fundamental analysis is the critical evaluation of key quantitative and qualitative factors influencing a business in order to make better investment decisions.
In contrast to technical analysis, which screens securities by analyzing market activity statistics, previous prices, and volumes.
Fundamental analysis is one of four methods used for evaluating stocks or securities for investment.
What are the Four (4) Methods of Equity Analysis?
The four methods of equity analysis are:
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Fundamental Analysis
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Technical Analysis
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Value-Momentum Analysis
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Common Sense Analysis
Smart investors are consistently profitable because they commit to fundamental analysis and act quickly on it.
In contrast, most retail investors base their decisions solely on emotions (instincts, rumors, and sentiments), and they frequently lose more money than they make.
This article will teach you everything you need to know about fundamental analysis, its goals, and how it can be used in equity investing.
Let’s dive in.
Fundamental Analysis vs. Technical Analysis
The main difference between fundamental analysis and technical analysis is the attitude of their adherents toward financial securities and markets.
The fundamental analyst is concerned with value, valuation, and the ownership of the underlying business.
While the technical analyst is concerned with the speculation of the stock price direction (how to profit from market volatility).
Fundamental analysis is based on future performance projections, whereas technical analysis is based on past performance.
The difference in access to valuable information between professionals and everyday investors, along with the impact of panic resulting from news, rumors, and inexperienced traders, leads to increased market volatility and inefficiency.
When this maze of price data is captured over time, plotted on a chart, and analyzed by traders, it is known as technical analysis.
What are The Three (3) Domains of Fundamental Analysis
The three domains (key areas) of fundamental analysis are the economy, the industry or sector, and the company.
These domains or frameworks for fundamental analysis fall under external and internal factors:
(a.) The state of the economy as a whole—(External Factor)
P.E.S.T.L.E. is a useful tool for building expectations about the future of the economy and its impact on the company or companies under analysis.
(b.) The health of the specific industry or sector under review—(External Factor)
Porter’s Competitive Forces Model is a powerful tool for assessing industry dynamics and how it may impact the company under analysis.
(c.) The company’s business performance—(Internal Factor)
Ratio analysis is a technique for assessing current corporate strategies. This is an x-ray of a company’s performance based on its financial statements.
What are the Objectives of Fundamental Analysis?
The ultimate goal and objective of fundamental analysis are to reveal the intrinsic or fair value of a security or asset by examining various macro- and microeconomic factors as well as corporate financial statements.
After calculating a stock’s intrinsic value, also known as fair value, it is compared to its current market price to determine whether the stock is undervalued or overvalued.
If the current market price of a stock is less than its intrinsic or fair value, the stock is undervalued.
In contrast, if the current market price is greater than the stock’s fair or intrinsic value, the stock is overvalued.
You’ve probably heard people say, “The numbers don’t lie.”
Which numbers? Are they those derived from technical analysis or fundamental analysis?
It is the numbers generated from fundamental analysis via ratios analysis.
What are the Two (2) Types of Fundamental Analysis?
The two types of fundamental analysis are Quantitative Analysis and Qualitative Analysis.
Here’s a quick glance at quantitative and qualitative analysis and how they’re used:
What is Quantitative Analysis?
Quantitative Analysis entails looking at hard data or actual numbers.
What is the net income?
What is the profit margin?
What is the price-to-earnings ratio?
What is the total number of outstanding shares?
These are simple examples of quantitative characteristics in use. The answer to each of these queries is a hard code number.
In investing, quantitative analytics employs such characteristics to generate datasets that you can use to make investment decisions (buy, sell, hold).
Examples might include the following:
📌 Using profitability ratios to determine how well a company uses its assets to generate profit and value for shareholders.
📌 Using solvency ratios to evaluate a company’s financial health—how well a company’s cash flow can cover its long-term debt.
📌 Using efficiency ratios to assess a company’s ability to manage its assets and how efficiently it uses its assets to generate revenue.
What is Qualitative Analysis?
Qualitative Analysis involves subjective criteria and opinions that cannot be expressed in actual numbers.
Investors use qualitative analysis to evaluate situations where hard numbers are impractical.
Management effectiveness, economic policy pronouncements, legislation, consumer lifestyles, and so on are examples of qualitative analysis traits.
The Fundamental Analysis Funnel
The fundamental analysis funnel is a simplified representation of the process used to analyze a company’s financial health and the value of its stock.
Here’s a breakdown of the fundamental analysis funnel in simple terms:
There are two models for the fundamental analysis funnel:
The top-down fundamental analysis funnel and the bottom-up fundamental analysis funnel.
In the top-down fundamental analysis, investors begin their analysis with external factors such as the overall state of the economy and the industry.
But, because investors attempt to forecast economic effects, the market cycle precedes the economic cycle.
However, the logic behind the bottom-up approach is that the market discounts every piece of information from the economy or company.
In other words, all of the information you received from economic and political news in the past, present, and future has already been reflected in equity prices.
Thus, the market is a leading indicator of all fundamental data, including economic and political events.
These corroborate with the principles of technical analysis.
The macroeconomic factors, on the other hand, are lagging indicators. The stock market moves months ahead of the economy.
Therefore, considering first and relying on the overall economic bias may make you come to the markets too late.
This is clearly depicted in the figure below from a model by Sam Stowell, Chief Investment Strategist of CFRA Research.
Based on Sam Stovall’s S&P’s Guide to Sector Rotation, this theoretical model asserts that different sectors are stronger at different points in the economic cycle.
The graph above depicts these relationships as well as the order in which the economy should benefit the various sectors.
The fundamentals lead to other factors. Investors who spend a few minutes performing fundamental analysis will find undervalued stocks that others have overlooked.
They will recognise when a stock’s price is incorrect or excessive.
Read also:
Anatomy of the Income Statement: How to Read a Company’s Income Statement
5 Steps to Performing Top-Down Fundamental Analysis
Components of Fundamental Analysis
The components of fundamental analysis straddle the general economic, industry, and individual company factors:
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Lucrative Business Model
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Industry and Risk Level
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Liquidity
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Dividend Policy
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Interest Rates
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Inflation
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GDP levels
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Wide Economic Moat
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Financial Analysis and Forecasting
1. Lucrative Business Model
What is the company’s line of business? How do they make money? What exactly is the foundation?
These are some of the questions that fundamental analysts are looking for answers to.
Don’t just ‘pick’ stocks for the sake of ‘picking’ stocks.
Rather, invest in companies that would be appealing to you as a business owner; have a solid business plan, and have evident long-term potential for good profits.
2. Industry and Risk Level
Is there an industry-related risk? Are people interested in the company‘s product(s)?
What are the industry’s history and dynamics? What’s the competitive structure in the industry? Who are the major competitors? What is the competitive position of the company?
With the numbers generated through ratio analyses, investors compare and contrast industries and companies among peers to determine the strength of one over the other and how it will affect the bottom line of a company.
3. Liquidity
Liquidity is a function of the number of shares of a company that are traded on a daily basis.
The daily dollar volume is calculated by multiplying this figure by the day’s closing price (price at the close of trade).
Beware of stocks that are too illiquid.
4. Dividend Policy
Income and retiree investors are particularly interested in this.
They conduct research on the attitudes of corporations toward dividend declaration and payment.
Some businesses follow a dividend equalization policy. They pay a set amount in dividends regardless of their earnings or profits.
In the US market, there are two types of elite dividend stocks: Dividend Aristocrats and Dividend Kings.
5. A Wide Economic Moat
An economic moat is a company’s ability to keep competitors out for an extended period of time, which ultimately translates into prolonged market control and profitability.
Also read, 6 Factors That Give a Company a Wide Economic Moat
6. Financial Analysis and Forecasting
The main goal of financial analysis is to reveal the narratives hidden in financial statements by using financial ratio analysis.
Financial forecasting is concerned with the future.
Therefore, investors expect quarterly reports at the end of January, April, and July.
Thereafter, annual reports and audited accounts for the fiscal year in October, all things being equal.
Informed investors track each stock in their portfolio quarterly, as they commit a few minutes to dig deep into their company‘s financial reports using certain ratios and parameters.
A financial statement is made up of five (5) parts:
1️⃣ Income Statement (or Profit & Loss account or statement of operations) —shows the profitability of a business
2️⃣ Balance Sheet (or statement of financial position) – shows the financial strength of a business
3️⃣ Cash Flow Statement – shows where cash is generated and where it is utilized in the business
4️⃣ Statement of Owners’ Equity
5️⃣ Notes to the account: The actual financial statements themselves only tell part of the story.
For full disclosure, notes are provided to allow the reader of the financial statements to understand and make a judgment of the financial activities of the company.
Conclusion
The analysis of financial ratios has three dimensions:
(a.) Vertical Analysis—Conducting ratio analysis of items on the financial statements
(b.) Horizontal Analysis—Analysing the percentage changes in the ratios relative to the previous years.
(c.) Benchmark Analysis—Analysing a company relative to its industry peers or major competitors.
Financial forecasting is concerned with the future. Ratio analysis can also help you build a more accurate forecast of where a business might go from where it is now.
Where to Get Information About a Company’s Performance
Get additional investing tools and resources here.
- Investor Relations Website of the Company: You can download quarterly or annual financial reports and calculate the ratios yourself.
- A Public Information Book (PIB): A document that compiles all publicly available information on a specific company
- Bloomberg: Here you can find pre-calculated ratios as well as raw data sources if you want to do the calculation yourself.
- Google Finance: You can have historical ratios for companies calculated automatically here. However, you will not have a complete understanding of how the ratios are calculated.
- Stockswatch: Here, you can get pre-calculated historical ratios for companies as well as expert analysis of the Nigerian stock market.
