The Basics of Fundamental Analysis in Stock Investing
Fundamental analysis is an approach to stock market investing that is concerned with a company’s financial strength, prospects for growth, executive team, and all other things that are specific to the company under analysis.
Unlike technical analysis, the fundamental approach does not concern itself with historical price behavior, believing instead that, over the long-term, the financial strength and performance of a company will be reflected in its stock price.
Value investors like Warren Buffett are proponents of the fundamental approach as they believe that it is not uncommon for promising stocks to fall temporarily out of favor with the market. It is this imperfection in pricing that can lead to fantastic stock investing opportunities.
What is Fundamental Analysis?
Fundamental analysis describes the methodology used to establish a stock‘s value. The financial analyst or investor uses financial statements and information about the company. Fundamental analysis employs only those fluctuating variables relating to the company, such as cash flow, sales, earnings, debt, and dividends.
Because fundamental analysis does not take the overall market into account, many financial analysts also use other qualitative and technical analysis methods and tools. Examples: A client requests a portfolio review. The financial planner uses fundamental valuation tools to examine investment holdings. She calculates the price-earnings ratio, the debt-equity ratio, the sales-equity ratio, and reviews the dividends collected from each stock.
She uses only the information supplied by each corporation to determine whether each company’s financial performance is on track to meet her client’s suitability and investment objectives. She makes buy- and sell recommendations based on fundamental analysis methods.
What are the Fundamentals of Stock Investing?
In the business of research and investing in individual equity securities, the discussion often breaks down into one of two camps; Fundamental and Technical Analysis. Whereas technical analysis focuses on the study of price movements and the volume of shares being traded over time, fundamental analysis has to do with the nuts and bolts of the business at hand.
A disciplined micro-economic, or company analysis, must include research on the products sold by the company, what their competition looks like, the prices charged to customers, industry trends, market share, balance sheet considerations, dividend payouts and growth rates, and critically important, the quality of the management team.
Competitive advantages in customer satisfaction, the cost of production, market location, logistics, proprietary values (patents) are also important.
Fundamental analysis and macro-economic
Fundamental analysis also requires a solid look at the macro-economic picture in terms of the general growth of the economy, employment and income trends, interest rates, inflation, overall debt levels, and government policies.
Any comprehensive research effort will include a process of gathering data and information on earnings and dividend histories, debt levels, along with any new product development. It will also include the manipulation of that data to calculate historical earnings growth rates, dividend payout ratios and growth rates, and price-earnings multiples.
With this information in hand, one can apply intelligent mathematics and calculate important metrics like comparative P/E ratios and debt levels versus similar companies in the same industry. In the final analysis one must apply rational judgments regarding forward-looking earnings growth rates, and whether the price being offered provides the investor with adequate return potential relative to the risks involved.
After we have gathered all the information we feel is necessary allowing us the ability to make quality investment grade decisions, we convert all the primary pertinent information down into seven critical assessments that are translated into metrics or numbers.
- How much current profit will the company likely make on a normalized basis?
- How much will it likely grow those earnings over a 3-5 year time horizon?
- What will the market pay for that future stream of earnings on a PE basis three to five years down the road? (With this information we can calculate a price target for each investment prospect).
- How much does it pay in dividends?
- How fast will the company likely grow its dividend over time?
- What does the balance sheet look like?
- what is the internal rate of return potential from a stock’s current price to its price target, inclusive of dividends? This might be viewed as the stock equivalent to a yield to maturity with respect to the purchase of a bond.
This helps us understand whether a stock is cheap enough to offer an investor an adequate return potential relative to the risks and relative to other investment alternatives. And whether any return potential remaining is high enough to justify holding a position if it is already owned? For taxable investments, the sell decision also includes a diligent assessment whether the tax liability generated from a sale, will more than be recouped by a relatively superior investment opportunity.
Every great company is a buy at some price, and a sell at some price. Knowing a reasonable return potential by doing your homework beforehand will make a big difference in an investor’s performance over time. It’s just fundamental.
The Primary Components of Fundamental Analysis
Some main things a fundamental analyst will review as part of the research process include:
- Price/Earnings Ratio (P/E) – The price/earnings ratio helps the investor determine how much they are paying for a stock in relation to its earnings-per-share (EPS). In this way, the P/E ratio provides a valuation measure and the relative appeal of a stock price.
Generally speaking, the lower the P/E ratio, the less you are paying for company earnings.
Price/Earnings to Growth Ratio (PEG)- Like the P/E ratio, the PEG ratio is a valuation measure that looks at a stock price relative to company earnings, but the PEG ratio factors in earnings growth as a more accurate way of arriving at the real value of a stock.
- Price/ Book Ratio (P/B) – The price/book ratio enables investors to compare the book value of a company against the current market value.
P/B is another way of gauging the relative value of a stock as a low P/B compared to industry competitors can represent a good investment opportunity.
- Dividend Yield (DY) – When looking at companies that pay dividends to their shareholders, the dividend yield provides a measure of how much the company pays in dividends compared to its stock price.
It is an easy way to measure the cash flow you are getting from a dividend stock. As the stock market in general calls and questions almost every portion of a stock portfolio, virtually every investor can start doubting themselves in times of uncertainty and market volatility.
An investor at times wonders if the decision made is the right one when a stock was bought. The answer should be rational and should be based on sound judgement. In times of uncertainty, strong fundamental analysis is the key to realize a sound investment and drive gains from the investor’s decision.
With this in mind fundamental analysis is based on:
- The balance sheets.
- The income statement.
- Management success.
- Resource quantification.
- Company ability to drive shareholder confidence and value.
Company ability to drive shareholder confidence and value.
Understanding fundamental analysis and deciphering accounting reports is the key for long term investments. The fundamental analyst will have a keen eye for details, dismissing any emotion short term or long term because it is the fundamentals driving a company forward as the basis of an investment.
Serious investing requires serious analysis. Tracking your portfolio progress should be as important as the investment made. Historical data is important to gauge and understand economic, political and global events that ultimately effect public companies, their financial value and potential future growth.
The fundamental analyst will assess value in a company, be it book value, liquidation value or even a resource strike estimate. Looking at the quality of management and the historical value realized since the company began trading. The success of management to return value to their shareholders is also part of the fundamentals sought. Fundamental analysis involves a lot of calculations being independent of market psychology and emotions.
Whether valuing the intrinsic value or market value of a stock as these may differ immensely based on current market sentiment of the company or even management, fundamentally the market price is the true reflected value as it is based on current worth and is undeniable.
Assuming the intrinsic value is acceptable, the stock value that the market placed on an asset will play a big part towards true value in due time. The key to fundamentals is to find a stock which is near or below its intrinsic value for a long term hold.
Understanding Company Reports
Learning how to unlock and understand company reports is crucial for any fundamental analysis taken. This will ultimately result in the better understanding of balance sheets, financial reports, resource estimate upgrades and much other information provided by the company during the course of its operations, in order for the investor to make a sound decision based on calculations rather than emotion and gut feeling.
By being able to calculate and understand these reports and announcements, having the ability to print the results and date them, you are in control of your investment by referring to historical data collected, hence giving you an overall view of your investment’s progress.
There is continuous demand for strong focus on fundamental analysis of a share market investment, in both small cap, medium cap and blue chips. How does a small cap company make its mark in the corporate world and become a heavyweight blue-chip company. Fundamental analysis forms the backbone of any DIY investor and is the key to unlock potential targets, medium to long term.
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Investing Basics: Fundamental Analysis
Initiating Analysis – the key to give investors an idea of the financial health of a company
Choosing a stock must be a decision based on a strong overview of a company, after all it is all about identifying the pros and cons of any business proposition. Performing fundamental analysis entails a deep study of the company in order to deduce, is this proposition really as good as it sounds?
Keeping in mind that any advertising or investor relation aimed generally to promote the company’s business is geared towards a positive outlook of the company in order to make it sound extraordinary at times and wonderful to be part of. However, at times there is often more than meets the eye, and only a keen eye for detail is able to filter what is relevant and what is not.
Typically, there are some considerations and factors to take note of, when choosing a company. These are key elements which must be collected prior to any proposed investment in general.
The Opportunity and The Strength.
- Is the company based on a profitable model and a key sector.
- Is the company potentially an international business.
- Is the company able to meet supply at fixed costs.
- Is the company able to grow supply without further cost to infrastructure.
- Is the company’s management proactive in building the business.
The Downside, The Weakness.
- Is the company able to compete with the current market.
- Is the company dependent upon foreign sales which brings risk through volatile currency exchange.
- Is the company in considerable debt and locked in high interest charges.
- Is the company likely to dilute shares in order to continue operations.
- Is the company consistently issuing shares diluting shareholder equity.
The Management, The Board and The Financials.
- Does the management have a history of prior achievements.
- Does the management have experience in the public sector.
- Does the management have experience in this specific business sector.
- Quarterly reports, do these show engagement and productivity leading to growth.
- Final year results, do these show a pattern for growth or decline each quarter.
- Corporate updates and general operations, are directors investing in their own company.
The directors and management are often critical to a company’s success. It is imperative to research the board of directors background and keep very close tabs on their activities and announcements.
The CEO (Chief Executive Officer) and Executive Chairman drive success and head up the company. There is also the Financial Director who normally handles the accounting and some corporate affairs duties. There may also be Operations Managers dealing with day to day running of the business, depending on its size and nature.
The board normally consists of highly skilled and experienced Non-Executive Directors who may at times sit on the board of numerous companies and are not simply limited to one. These Non-Executive Directors advise Executive Directors on certain aspects of the business.
The above are merely basic details initiating our understanding of what to look for, and what to avoid. We also need to have a close look at the sector in question and not simply the company in question. The company could be a great performer, however the sector may lack future growth, hence rendering our analysis fruitless as we seek current fundamentals rather than a future outlook.
In summary, we look for the sector, the management and lastly the company. Many believe that fundamental analysis is all about the company itself. Although they are partly correct, the company analysis is simply the icing on the cake in comparison to achieving true fundamental analysis.
Qualitative Factors in Fundamental Analysis
Qualitative analysis is that part of the fundamental analysis where the investor looks at the intangible factors of the company as part of a company as part of the process of assessing its health and future prospects.
While this part of the fundamental analysis process is more subjective than the quantitative aspect (which looks at hard numbers), many investors believe it is equally important. Qualitative factors might include such things and the company’s business model, its management team, competitive advantages, and corporate culture.
4 Qualitative Factors in Fundamental Analysis
- Business Model: Generally speaking, a company’s business model describes the company’s day-to-day operations and how it makes money. The business model serves as a working description of the company’s operations and looks, from a high-level, at how it goes about generating revenues, the expenses it incurs, the company structure, and sales and marketing efforts. After reviewing the company’s business model, the investor should come away with the belief that the company has positioned itself for success.
- Management Team: One of the primary keys to success for any company is its management team and that teams’ ability to develop and cultivate a powerful vision for the company while successfully navigating changing competitive and economic conditions. In assessing the strength of the management team, many investors will look at their backgrounds to see if there is a track record of success at previous companies. If it’s a public company, there will be a section of the company website that provides biographical information for each of the top executives.
- Competitive Advantages: The long-term success of the company also has a great deal to do with any competitive advantage the company might enjoy. If through your investigation you determine that the company has developed a wide moat, it will be hard for current and future competitors to take away market share. In general, companies seek to develop a competitive advantage through price leadership, product superiority or brand loyalty.
- Corporate Culture: A company’s corporate culture its way of instilling a general ideology or philosophy into its brand. You can think of the company’s corporate culture as its personality and how it expects its employees to think and behave. Wrapped into the corporate culture are the company’s mission, its ethics, and its values. Given this, it’s not hard to see how the cultivation of a winning culture is critical to a company’s long-term viability.
Profitability Ratios for Fundamental Analysis
Profitability ratios are used by fundamental analysts to evaluate a company’s financial performance by measuring the costs the company incurs against its ability to generate earnings. Profitability ratios can help potential investors gain an understanding of the debt and asset management of a company and how well it is performing over time and relative to its industry competitors.
The company’s income statement and its balance sheet provide many of the metrics required to calculate these ratios.
Some primary profitability ratios used by fundamental investors include;
- profit margin – which gives an indication of how well the company controls its costs
- return on assets – which looks at income earned by the company through its assets
- return on equity – which measures earned income against shareholder’s equity. In calculating these ratios, it is important to exclude any extraordinary items or events that might distort the measure.
The Income Statement and Fundamental Analysis
A company’s income statement is a record of its earnings or losses for a given period. It shows the revenues and expenses for the company for this period. The income statement is one of the three primary financial statements, the others being the balance sheet and the statement of cash flows. In analyzing company fundamentals, the income statement indicates to investors of how well the company is performing.
A Gauge of Fundamental Strength
The Income Statement may apply to a three-month fiscal quarter or a fiscal year, providing a measuring stick of profitability for that period. Generally speaking, companies ought to be able to bring in more money than they spend to be successful. Companies that demonstrate low expenses relative to revenue and/or high profits relative to revenue display fundamental strength to investors.
What Investors Can Learn
To savvy investors, though, the income statement may reveal more than the company’s earnings as it provides insights into the company’s management of expenses, interest income and expenses and tax information.
Through income statement analysis, investors can compare a company’s profits to its competitors by examining the various profit margins and determine the rate of return the business is earning on retained earnings and company assets.
Parts of the Income Statement
The income statement is divided into two sections: the operating and non-operating sections.
- Operating items: Reports information regarding revenues and expenses that result directly from regular business operations.
- Non-operating items: Reports revenue and expense information regarding activities not directly tied to regular operations.
The income statement can reveal a lot about the operations of an organization. In analyzing the information, investors often measure the rate of change for key items and calculate ratios to comparative ratios from the data.
Find Growth Stocks Through Fundamental Analysis
Growth investing is one of the primary investing approaches investors may choose in finding worth stocks for their portfolio. Finding growth stocks is about seeking out those companies that show promise for high growth when compared to other stocks within their industry or the market as a whole.
Growth investors are typically making qualitative judgments in finding the stocks with the best growth potential and are committed to a longer-term approach to stock investing than other types of strategies (e.g. technical investing). Most investors see a growth strategy as more of an art than a science as there is no guaranteed method for finding the best growth stocks.
Fundamental Analysis and Growth Investing
While a growth investor employs fundamental analysis to assess the strength and viability of a company, a growth strategy places a greater emphasis on qualitative factors, including the company’s business model, the strength of its management team, business model and the overall prospects for the industry in which the company operates.
Steps to Find Growth Stocks
Look for financial strength: The first step to thinking about in choosing a good growth stock is in making sure that the company is and will likely remain financially viable. Looking at the company’s current ratio, for example, will give you an idea of whether the company will be able to pay its short-term debts.
- Assess the company’s industry: The strategy for many growth investors starts with finding those industries that show the most promise for future growth, and then finding the company within that industry that is best positioned to emerge as the leader. A top-down investment strategy can help to identify the most promising industries for the near future.
- Emphasize profitability: Make sure to look at the company’s profitability by examining its return on equity. ROE measures profitability and will tell you the level of profit the company is generating for its shareholders with the money they invest. Because earnings cannot exceed a company’s ROE, growth investors will look at the measure as a means of determining growth potential.