In the evolving and dynamic world of stock market, investors are always looking for ways to make better decisions. While some investors take shorter-term price movements into account, other investors take a longer-term view by assessing a company's true value. This is where Fundamental Analysis comes in, considered as a primary tool for long-term investors trying to construct a quality portfolio.
This post will help you identify the purpose, types, parts, and successful use of fundamental analysis. For a broader understanding of market evaluation methods, and to see how this approach compares with others, explore the difference between technical and fundamental analysis.
What Is Fundamental Analysis?
Fundamental Analysis is a method of evaluating the intrinsic value of a security. Unlike technical analysis, which focuses on price patterns and trends, fundamental analysis concentrates on the economy, its underlying forces, financial factors that impact its business, and the stock price.
To put it into perspective, fundamental analysis is like determining why or if a house is worth its listing price, similar to analyzing whether its price reflects its true value. This is done by looking beyond the exterior condition of the home and analyzing its foundation, subfloor, plumbing, and electrical systems, as well as identifying the neighborhood in which it is located. A similar task fundamental analysis takes into account is determining whether the market price is equal to its intrinsic value. Should the market price be reflected at a lower price than the degree you establish the intrinsic value, it's possible that the market may be undervalued, which could signal a possible "buy."
On the other hand, if the market valuation is greater than the estimated intrinsic value, it could indicate that the stock is overvalued, suggesting the investor should "sell" or "ignore" the stock.
The fundamental analysis process combines several metrics, including evaluating company financial statements, the quality of management, understanding the competitive dynamics, current trends in the industry, and general economic conditions.
Why Is Fundamental Analysis Important?
Fundamental analysis is essential for a variety of reasons, particularly for long-term investors:
Sustainable Strategy: Important to build a sustainable investment strategy to help investors look past speculative noise.
Focus on Value: Refocuses on the sustainable financial health and growth potential of a company.
In-depth Learning: Dissecting financial statements, quality of management, and competitive landscape provides really in-depth learning about a company's economic engine.
Informed Decisions: Allows well-informed decisions that minimize the long-term risk of capital allocation through a disciplined investment process.
Wealth Compounding: Important for compounding wealth over long periods, and is the foundation of identifying truly valuable businesses.
Types of Fundamental Analysis
Fundamental analysis is primarily composed of two complementary processes:
Quantitative Analysis
It consists of measurable financial data to evaluate a company's financial health and value.
Involves studying measurable financial data.
Example: income statement, balance sheet, cash flow statements. To dive deeper into interpreting a company's financial position and understanding its assets, liabilities, and equity, explore our detailed guide on What is Balance Sheet Analysis and How to Analyze It?
Includes financial ratios to evaluate profitability, liquidity, and solvency.
Qualitative Analysis
It consists of non-quantifiable factors that can help determine a company's future performance. While non-quantifiable, they are equally as important:
Contributes to others' study.
Example: management skill, brand strength, competitive advantages such as economic moats, outlook of the sector, and government regulation.
Most non-quantifiable factors will contribute to a company's future performance and risk level.
Components of Fundamental Analysis
The structured fundamental analysis process is commonly referred to as the "EIC" framework:
Economic Analysis:
Macroeconomics: Interest rates, inflation, GDP growth, employment, consumer spending, and global trade policies.
Economic Cycles: Being aware of where we are in the economic cycle (expansion, peak, contraction, trough) can steer investment decisions.
Industry Analysis:
Industry Growth Prospects: Is the industry growing, flat, or declining?
Competitive Landscape: Who are the major competitors? What are the strengths and weaknesses of each? Are there high barriers to entry?
Regulatory Environment: Industry-specific regulations and their potential impact.
Supply and Demand: Factors affecting supply and demand for a particular industry product or service.
Company Analysis:
The deepest dive category, focusing on the individual company:
Financial Statements: Income Statement, Balance Sheet, Cash Flow Statement.
Financial Ratios: P/E, P/B, D/E, ROE, ROCE, Current Ratio, etc.
Management Quality: Leadership, experience, vision, governance.
Business Model and Strategy: How does the company make money, and future strategy?
Competitive Advantage (Moat): What does the company do better than its peers?
SWOT Analysis: Identifying Company Strengths, Weaknesses, Opportunities, and Threats (SWOT).
How to Do Fundamental Analysis in Stock Market?
Fundamental Analysis in stock market is a logical process. Below is a step-by-step process with sample questions to guide your fundamental analysis.
Define Investment Objectives
Establish your investment's objectives (e.g., growth, value, income) for each investment to focus your analysis.
Company Screening
Search for potential investments with financial screeners, establishing preliminary quantitative criteria on aspects such as market cap, debt, or profitability.
Economy & Industry Research
Begin with the larger economy, where you start with the economy as a whole, examining macroeconomic trends.
Once you identify macroeconomic data, research industry reports, and ask questions regarding cyclical industries, whether they are growing or shrinking, etc.
In-depth Company Scrutiny
Examine Financials: Examine 10-K (annual reporting) and 10-Q (quarterly reporting) from company filings such as SEC EDGAR to focus on trends for required revenue, profit, and cash flow trends over 5-10 years using some type of data sheet to identify data.
Ratios Analysis: Utilize financial ratios associated with efficiency, liquidity, and profits to compare against historical and industry averages.
Qualitative Assessment: Examine management, their backgrounds, competitive advantages, product name recognition, and strategies/plans via presentations, news, and industry publications.
Valuation
Employ applicable models, net present value (Discounted Cash Flow (DCF)), net present value of expected dividends (Dividend Discount Model (DDM)), or relative valuation (market price compared to P/E ratios of peer companies) to calculate intrinsic value.
Comparison & Decision
Compare your intrinsic value to the current market price.
If it is significant, for example 50% or more, the intrinsic value exceeds the market price "buy" because it may indicate it is undervalued.
If the intrinsic value is significantly lower than the market price, for example 50% "avoid" or "sell".
Ongoing Monitoring
Fundamentals are not static; make sure you check back on your holdings about changes in business conditions and market settings. For those seeking to master these techniques, consider enrolling in an Advanced Level Fundamental Analysis Certificate Course.
Pros and Cons of Fundamental Analysis
Like any investment strategy, there are benefits and drawbacks to fundamental analysis as well.
Pros
Informed Decisions: It allows you to make informed, long-term investment decisions.
Identifying Value: It gets to the heart of a company's value, allowing you to see through most market noise.
Business Knowledge: It helps you develop a deep understanding of what these businesses do on a day-to-day basis.
Risk Aversion: Fundamentally, it helps you think about risk.
Cons
Time Consuming: It can be extremely time-consuming.
Complex: It does require a reasonable amount of financial literacy.
No Perfect Timing: Fundamental analysis helps you see and understand intrinsic value; it does nothing to help alert you when or predict a short-term situation that may cause price appreciation or decline. To complement this, understanding collective investor sentiment through tools like the Market Mood Index (MMI) can provide crucial insights into optimal entry and exit points, especially in the emotional Indian share market.
Subjectivity: With much of fundamental analysis being qualitative and the qualitative assessments and assumptions made in the valuation process, subjective thought can enter into whether a conclusion is justified; therefore, depending upon individual analysis, conclusions can be different.
Fundamental Analysis Examples
Let's illustrate using fictitious examples:
Undervalued Opportunity (Hypothetical)
An investor conducts an analysis on "GreenBaker Solutions."
Findings: Strong revenue growth, improving profit margins, strong balance sheet.
Qualitative Factors: Unique patents, visionary management in a growing industry.
Conclusion: Intrinsic value is well above the current price being offered in the market; clearly undervalued.
Overvalued Risk (Hypothetical)
An investor scans "Legacy Retail Co."
Findings: No real sales, declining profitability, and very high debt.
Qualitative Factors: No competitive differentiation in the declining category.
Conclusion: Although a low PE imposes little risk, its intrinsic value is even lower than the market price; hence, the potential overvaluation risk to not worth taking.
Conclusion
In general, fundamental analysis is not just a method, but it is a belief system in sound investing. A good investor can evaluate a company's value by analyzing its financial health, operating performance, management talent, and the company's position with regard to the economy and the industry in which the company competes. Through this disciplined approach, investors will find quality assets and will find value, possibly the true value. This approach will allow you to make rational decisions, reduce speculative risk, and maintain discipline to manage investments over time in order to build wealth. By learning to use fundamental analysis from Online NIFM, you will become more of a business investor and less of a stock speculator.
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