Fundamental Analysis

What is Fundamental Analysis?

Fundamental analysis is a method of evaluating securities by analyzing the financial health and performance of companies. The core goal is determining the intrinsic value of a stock based on its underlying fundamentals.

How Does Fundamental Analysis Work?

Fundamental analysis consists of studying public information such as financial statements, industry data, economic reports, management profiles, and corporate announcements.

It aims to gauge the demand for a company’s products/services, its competitive strengths, operating efficiency, growth opportunities, and management capability to determine the fair value of its stock.

The key metric derived is the intrinsic value – a reasonable price for the business that is justified by its financials and prospects. The core assumption of fundamental analysis is that, in time, a stock’s market price will converge towards intrinsic value.

If the current trading price differs substantially from this appraised value, an opportunity exists.

Fundamental analysts aim to determine if a stock is currently undervalued (the market price is below the company’s intrinsic value) or overvalued (the market price exceeds intrinsic worth).

Undervalued stocks are bought as analysts expect that their prices will appreciate in the future.

Overvalued stocks are sold or avoided as prices will likely face a decline. Fundamental models consider growth assumptions and targeted risk-adjusted returns in their forecasts.

Approaches Used to Perform Fundamental Analysis

Approach	Description
Top-Down Analysis	Assesses the state of the economy and industry trends first before identifying which are the most attractive companies to invest in.
Bottom-Up Analysis	Focuses directly on evaluating company and stock-specific fundamentals rather than macroeconomic factors.

While technical analysis examines historical charts and trends, fundamental analysis dives directly into financial statements, management skills, competitive landscape, growth levers, and other qualitative and quantitative attributes inherent to the business.

Fundamental analysis pairs in-depth quantitative metrics and qualitative insights into investment decisions through financial modeling and valuation techniques.

The goal is to determine a company’s intrinsic value to make buy or sell decisions.

Key Elements Considered When Performing Fundamental Analysis

Below are some of the most relevant elements that analysts take a close look at when performing fundamental analysis on a business:

Financial Statement Analysis: Analyze income statements, balance sheets, and cash flows to examine the business’s historical performance and potential future trajectory. The most common financial ratios evaluated include profit margins, liquidity, leverage, profitability, growth rates, and risk indicators. Peers and industry averages provide comparison benchmarks.
Competitive Analysis: Evaluate the company’s products/services, target markets, industry position, barriers to entry, and other competitive strengths or weaknesses versus rivals. The goal is to determine the sustainability of the firm’s business model, its weaknesses, and external threats.
Management Evaluation: This involves researching the background, experience, vision, and track record of directors, executives, and managers who are leading the company’s strategy. Leadership skills are critical for a business to perform as or better than expected.
Macroeconomic Analysis: Assess the broader economic environment, including GDP growth rates, business cycles, interest rates, foreign currency fluctuations, and other macro factors that directly impact the purchasing power of consumers and businesses and the company’s cost structure and other operational aspects.
Qualitative Analysis: These are intangible attributes like brand equity, employee talent, patents, and goodwill that analysts evaluate to determine a company’s strengths in other areas outside of what the numbers tell.

By combining quantitative and qualitative insights, fundamental analysis forms a comprehensive perspective of a business to determine if it is a worthy investment opportunity.

Implementing Fundamental Analysis – A Step-by-Step Guide

The following is a brief step-by-step guide to perform fundamental analysis.

A 7-Step Guide to Fundamental Analysis

Screen Potential Investments

Short-list the stocks that offer the most promising upside potential by filtering them through some initial criteria like minimum market cap, profitability, past revenue growth, etc.

Gather Public Information

Extract financial statements, annual reports, regulatory filings, executive presentations, industry data, and other similar research materials to start gathering the data required to build financial models.

Produce Financial Models

Build detailed financial models that include forecasted income statements, balance sheets, and cash flows based on the company’s historical performance and growth assumptions.

Derive Intrinsic Value

Use different valuation methodologies like discounted cash flow analysis or trading multiples to quantify the firm’s intrinsic value.

Assess Qualitative Factors

Research and analyze the management’s leadership skills, the company’s competitive edge, brand equity, competitors’ barriers to entry, and other non-quantifiable aspects of the business that are still relevant to shape its valuation.

Gauge Sentiment & Technical Factors

Evaluate investor sentiment, analysts’ opinions, prevailing market trends, and technical factors to identify potential red flags or alignment with the initial fundamental thesis.

Make Buy/Sell Decision

Analysts often rate a company or stock as a buy, sell, or hold based on their material upside/downside potential versus their appraised intrinsic value and target return thresholds.

By following this workflow, both beginners and seasoned professionals can identify opportunities in the marketplace, such as undervalued companies trading below their fair market value.

Types of Fundamental Analysis

There are two ways to perform fundamental analysis. Here’s an overview of how each method works.

Top-Down Analysis

In top-down analysis, the initial focus is on broader economic trends. Analysts assess the overall state of the economy, including GDP growth, business cycles, monetary policy, currency moves, credit conditions, inflation, and other macroeconomic variables. This establishes the backdrop for analyzing businesses.

Next, their attention shifts to industry analysis by identifying sectors that best align with the economic landscape. Attractive industries are then analyzed to pinpoint the most well-positioned companies. These are considered worthy of investing capital based on economic tailwinds.

Bottom-Up Analysis

In bottom-up analysis, the macroeconomic perspective takes a backseat. The focus is on analyzing the fundamentals of each individual business.

This consists of an assessment of their financial statements, management capability, competitive position, growth opportunities, and other relevant metrics to gauge the stock’s potential and intrinsic value.

The bottom-up analysis assumes that strong companies can outperform the market even in challenging sectors or economic environments. Economic variables are considered secondary. The emphasis stays on the company’s financial fitness, leadership talent, and market strength as prime performance drivers.

While top-down and bottom-up approaches differ in sequence, both still rely on systematic assessment of the business, industry, and economic factors to determine a company’s fair value.

Pros and Cons of Fundamental Analysis

Benefits

Benefits	Description
Identify Under/Over Valuation	Determines a possible divergence between the market price and intrinsic value of a company that can be exploited to the benefit of the investor.
Assess Risks	Fundamental factors can be used to identify problems that a company is facing before they are reflected or spotted in price charts or market sentiment.
Overcome Emotions	Decisions are made based on hard data. This provides a higher degree of discipline against fear/greed biases that often undermine investors’ ability to perform and profit from their operations in the financial markets.
Estimate Intrinsic Value	Valuation models help estimate the fair value of a business based on sound financial projections.
Inform Investments	Fundamentals can be used to determine a company’s earnings power, growth prospects, and financial risks to guide the decision-making process.

Drawbacks

Drawbacks	Description
Time-Consuming	Producing high-quality fundamental analysis reports requires an important amount of time invested in gathering data, building financial models, and performing thorough risk assessments.
Past Results are Not Necessarily Indicative of Future Performance	Financial statements capture trailing results. Material changes underway may not be reflected in a company’s historical performance, but they will surely affect its development in the future.
Uncertainty	Despite rigorous projections, future conditions remain uncertain. This means that, no matter how thorough the analyst may have been, unexpected factors can still derail a company’s performance and valuation away from its perceived intrinsic value.
Subjective Assumptions May Affect Judgment	No uniform standard exists to perform fundamental analysis. Some degree of subjective human assumptions is still required to build models.
Human Error	Flawed assumptions or a poor mix of qualitative/quantitative factors may lead to inaccurate findings.

The Bottom Line

While fundamental analysis demands meticulous effort from the analyst to determine a business’s worth, perfect precision is not the objective.

The goal is to develop an informed perspective on a business’s prospects that helps investors estimate its intrinsic value to guide investment decisions rather than predict prices.

Used prudently, fundamental analysis allows investors to separate the signal from noise by relying on hard data that can be used to estimate and compare the appraised value of a company with the market’s perception of its true worth.