Alex GoodmanFundamental analysis (FA) looks at the economic and financial factors that affect a security to figure out what its true value is. Intrinsic value is the value of an investment based on the financial health of the issuing company and the current state of the economy and market.
Fundamental analysts study everything that can affect the value of the stock, from macroeconomic factors such as the state of the economy and industry conditions to microeconomic factors such as the effectiveness of the company’s management.
The ultimate goal is to determine a figure that an investor can compare to the current price of a security to see if it is undervalued or overvalued by other investors.
In a Nutshell
- In order to assess if a stock is overvalued or undervalued by the market, fundamental analysis is a valuation tool.
- It considers a company’s financial performance in addition to the economic, market, industry, and sector conditions in which it works.
- To value a company, financial ratios derived from financial reports as well as government economic and industry information are used.
- Financial reports, report ratios, spreadsheets, charts, graphs, infographics, reports from government agencies on industries and the economy, and market reports are just a few of the various tools used by analysts.
- For investors who wish to make well informed investing choices, fundamental research is a potent tool.
Understanding Fundamental Analysis
Fundamental analysis is often performed from a macro to micro perspective to identify stocks that the market is not valuing correctly.Analysts usually study, in order:
- The general state of the economy
- The strength of the specific sector
- The financial results of the company issuing the shares
This ensures that the market value of the shares is fair.
Sources for Fundamental Analysis
Fundamental analysis uses publicly available financial data to assess the value of an investment. The information is written down in financial statements like quarterly and annual reports and forms like the 10 Q (for quarterly) or 10 K (for annual) forms. The 8 K is also informative because public companies have to file it whenever something that needs to be reported happens, like an acquisition or a change in the top management.
The investor of today does not profit from yesterday’s growth.
Benjamin Graham
Most public companies and many private companies publish annual reports in the investor relations sections of their websites, highlighting financial decisions made and results achieved throughout the year.
For example, you might perform a fundamental analysis of a bond’s value by looking at economic factors such as interest rates and the general state of the economy. Next, I would evaluate the bond market and use financial data from similar bond issuers. Finally, it would analyze the issuing company’s financial data, including external factors such as potential changes in its credit rating.
I might also read the issuer’s 8 K, 10 Q, 10 K reports and annual reports to find out what they are doing, their goals or other issues.Fundamental analysis uses a company’s revenues, earnings, future growth, return on equity, profit margins and other data to determine its underlying value and future growth potential.
Intrinsic Value
Fundamental analysis is based on the idea that the current price of a stock doesn’t usually show the full value of the company when compared to publicly available financial data. A second assumption is that the value reflected in the company’s fundamental data is more likely to be closer to the actual value of the stock.
Intrinsic value has a different meaning in stock valuation than in options trading. Option valuation uses a standard calculation for intrinsic value, whereas intrinsic value can be calculated in many different ways for a stock.
For example, suppose a company’s stock is trading at $20 and, after extensive research on the company, one analyst determines that it should be worth $24. Another analyst does the same research, but decides they should be worth $26.
Many investors will consider the average of these estimates and assume that the intrinsic value of the stock may be close to $25. Often, investors consider these estimates very relevant because they want to buy stocks trading at prices significantly below these intrinsic values.
This brings us to a third important assumption of fundamental analysis: In the long run, the stock market will reflect fundamentals. The problem is that no one knows how long “the long term” really lasts. It could be days or years.
That is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a company and find opportunities to buy at a discount or sell at a premium. The investment will pay off when the market catches up with fundamentals.
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Fundamental analysis is most often used for stocks, but it is useful for evaluating any security, from a bond to a derivative. If you consider the fundamentals, from the overall economy to the details of the company, you are performing fundamental analysis.
Fundamental Versus Technical Analysis
This method of analysis is very different from technical analysis, which looks at price and volume data from the past to try to predict where prices will go. Technical analysis uses trends and price action to create indicators. Some of the patterns that the indicators make, like the head and shoulders pattern, have names that look like their shapes. Others use trend lines, support, and resistance to demonstrate how traders view investments and indicate what is going to happen. Examples include the symmetrical triangle or wedge.
Fundamental analysis is based on financial information provided by the company whose shares are being analyzed. From the data, ratios and metrics are created that indicate how a company performs compared to other similar companies.
Quantitative and Qualitative Fundamental Analysis
The problem with defining the word fundamentals is that they can encompass anything related to a company’s economic well being. They include figures such as revenues and profits, but they can also include anything from a company’s market share to the quality of its management.
The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial meaning of these terms does not differ much from the known definitions:
- Quantitative: information that can be shown by numbers, figures, proportions or formulas
- Qualitative: rather than a quantity of something, it is its quality, standard or nature
In this context, quantitative fundamentals are hard numbers. They are the measurable characteristics of a company. That is why the major source of quantitative data is financial statements. Revenues, profits, assets, and other data can be accurately measured.
Qualitative fundamentals are less tangible. They may include the quality of a company’s key executives, brand recognition, patents and proprietary technology.Neither qualitative nor quantitative analysis is inherently better. Many analysts consider them together.
Qualitative Fundamentals to be Considered
There are four fundamental aspects that analysts always take into account when analyzing a company. All of them are more qualitative than quantitative. They are as follows
The Business Model
What exactly does the company do? This is not as simple as it seems. If a company’s business model is based on selling fast food chicken, is it making money that way? Or is it just feeding off royalties and franchises?
Competitive Advantage
A company’s long term success depends primarily on its ability to maintain and sustain a competitive advantage. Powerful competitive advantages, such as the Coca Cola brand and Microsoft’s dominance of the personal computer operating system, create a moat around a company that allows it to keep competitors at bay and enjoy growth and profits. When a company gains a competitive advantage, its shareholders can be well rewarded for decades.
Management
Some believe that management is the most important criterion for investing in a company. And it makes sense: Even the best business model is doomed to fail if the company’s leadership does not execute the plan properly. While it’s difficult for retail investors to really know and evaluate management, they can look at the company’s website and check the resumes of senior management and board members. How did they do in their previous jobs? Have they divested themselves of many of their shares lately?
Corporate Governance
Corporate governance describes the policies in place in an organization that denote the relationships and responsibilities between management, directors and stakeholders. These policies are defined and determined in the company’s articles of incorporation, bylaws, and corporate laws and regulations. You want to do business with a company that is run ethically, fairly, transparently and efficiently. Look especially at whether management respects the rights and interests of shareholders. Make sure your communications to shareholders are transparent, clear and understandable. If you don’t understand, it’s probably because they don’t want you to understand.
Industry
It is also important to consider a company’s industry: its customer base, market share among companies, industry growth, competition, regulation and economic cycles. Learning how the industry works will allow the investor to better understand the financial health of the company.
Quantitative Fundamentals to be Considered: Financial Statements
Financial statements are the means by which a company discloses information about its financial results. Proponents of fundamental analysis use the quantitative information in financial statements to make investment decisions. The three most important financial statements are income statements, balance sheets and cash flow statements.
The Balance
The balance sheet represents a record of a company’s assets, liabilities, and shareholder equity at a given point in time. A balance sheet is so named because the three sections β assets, liabilities, and shareholder equity β must balance using the formula: Assets represent the resources that the company owns or controls at any given time. This includes items such as cash, inventory, machinery, and buildings. The other side of the equation shows how much money the company has spent on loans to buy these assets.
Financing comes from liabilities or shareholders’ equity. Liabilities represent debts or obligations to be paid. Equity, on the other hand, represents the total value of the money that the owners have contributed to the company, including retained earnings, which are the profits remaining after all current liabilities, dividends and taxes have been paid.
The Income Statement
The balance sheet is a snapshot of a business, while the income statement shows how well a business did over a certain amount of time. Technically, you could have a balance sheet for a month or even a day, but you’ll only see public companies report quarterly and annually.
The income statement presents the revenues, expenses and profits generated by the company’s operations during the period.
Cash Flow Statement
The cash flow statement represents a record of a company’s cash inflows and outflows over a period of time. Typically, a cash flow statement focuses on the following cash related activities:
- Cash from investing (CFI): Cash used to invest in assets, as well as proceeds from the sale of other businesses, equipment or long term assets
- Cash from financing (CFF): Cash paid or received from the issuance and borrowing of funds
- Operating cash flow (OCF): Cash generated from the day to day operations of the business
The cash flow statement is important because it is difficult for a company to manipulate its cash position. Aggressive accountants can do many things to manipulate earnings, but it is difficult to fake cash in the bank. For this reason, some investors use the cash flow statement as a more conservative measure of a company’s performance.
Fundamental analysis is based on the use of financial ratios extracted from company financial statement data to make inferences about a company’s value and prospects.
Example of Fundamental Analysis
The Coca Cola company is a good example that can be used in fundamental analysis. To begin with, an analyst would examine the economics using some published metrics:
- Consumer price index (measure of inflation)
- Gross domestic product growth
- Exports/imports
- Purchasing managers’ index
- Interest rates
Emily RobertsNext, the sector and industry would be looked at using statistics and metrics from different reports and competitor companies. Last, analysts would put together reports based on information from Coca Cola or the SEC’s Edgar file database.
Analysts could also use data collected by another company, such as CSIMarket. CSIMarket gives investors data for fundamental analysis, so you could start by figuring out how much Coca Cola’s assets, income streams, debts, and liabilities are worth. You might find comparisons of objective metrics such as revenue, earnings and growth, especially in the context of the broader beverage industry.
Using CSIMarket’s analysis, the analyst could compare growth rates to the industry and sector in which Coca Cola operates, along with the other information provided, to see if the company is valued correctly. For example, in August 2022, for the last twelve months (LTM), Coca Cola had (using only some of the possible ratios and metrics):
One factor that does not show up in an analysis of ratios and figures is the length of time a company has existed and the conditions it has endured. Coca Cola was founded in 1892 in Atlanta, Georgia. It has survived several wars, depressions, recessions, epidemics, pandemics, stock market crashes and a global financial crisis. Not many companies can boast such a history.
In addition, a company’s brand can add value to an investment. Coca Cola has been supplying beverages for a long time, and its logo is recognized around the world.Thus, an analyst can combine brand, longevity, above industry growth in the beverage manufacturing industry, an above average price/earnings ratio and a good return on investment.
Coca Cola has more debt than equity, but it also generates more profit using its assets than the rest of the sector. The company is not as liquid as others, but it appears that the sector moves at fairly low quick ratios. Over 1.0 means a company can quickly pay off its short term obligations, so in general most of the sector is low, but Coca Cola has over $1 billion in net cash flows, which gives it plenty of room to maneuver.
One interesting measure is the amount of revenue an employee generates. Coca Cola employees generate approximately twice as much revenue as employees of comparable companies. This might warrant further investigation into what Coca Cola is doing differently. They may have invested in new technologies or have much more efficient systems. Examining press releases and reading company reports may provide insight into what the company is doing. It may also be the case that Coca Cola simply sells more products than its competitors, so it is important to review all reports and releases and perform a thorough fundamental analysis.
Wrap Up
Investors can choose whether to purchase, sell, or hold a stock more wisely by having a solid understanding of a company’s fundamentals. Investors can make better judgments regarding whether to purchase, sell, or hold a stock by having a better grasp of the economic, market, industry, and sector conditions in which a company works, as well as its financial performance. Fundamental analysis may be useful for investors who want to make informed investment decisions.
To figure out how much a company is worth, financial ratios from financial reports and government economic and industry reports are used. Not all analysts use the same tools or have a similar view of stocks. What is important is that the stock you analyze meets your value criteria and that your analysis provides you with practical information.
FAQs
A method of appraising a security known as fundamental analysis examines financial and economic information relating to the security, including business financial statements, market movements, and macroeconomic factors. Identifying possible investment opportunities and a security’s intrinsic value are the two goals of fundamental analysis.
Company’s financial statements, including its income statement, balance sheet, and cash flow statement, as well as its competitive position in its industry and macroeconomic variables like interest rates, inflation, and economic growth, are some of the important elements of fundamental analysis.
The benefits of fundamental analysis include the capacity to spot possible investing opportunities, determine an asset’s inherent value, and decide when to buy and sell a security with knowledge.
Using obsolete or faulty data, assuming the wrong things about a company’s finances or industry, and choosing the wrong times to buy and sell securities are just a few of the hazards involved with fundamental analysis.
Financial statement analysis, sector analysis, and macroeconomic analysis are some of the instruments employed in fundamental analysis. Analyzing financial statements entails looking at the income statement, balance sheet, and cash flow statement of a business.
Analyzing a company’s competitive position within its industry entails doing an industry analysis. Analyzing macroeconomic elements including interest rates, inflation, and economic growth is part of macroeconomic analysis.
There are two types of fundamental analysis: qualitative and quantitative.
When conducting an analysis, we start with the economic analysis, then we analyze the sector and, finally, the company.
Fundamental analysis allows us to see what the market value of a company should be. Many investors only look at the price at which a stock is currently trading and at which it has traded in the past, instead of analyzing what is behind the stock. A stock is issued by a company, so its overall performance is related to the company’s financial results.
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- Securities and Exchange Commission – EDGAR | Company Filings
- CSIMarket – Coca-Cola Co (KO) Use the dropdown menu titled “Select the Comparisons:” and choose different measurements.
- Coca-Cola – History
- CSIMarket – Fundamental Analysis – Coca Cola Co’s Net Cash Flow Margin by Quarter
