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Published on: Jun 24, 2024
#Financial Markets
Fundamental analysis is all about making a buy or sell decision based on the public information available. But how to perform such an analysis?
For a long-term investment in a company, every aspect needs to be carefully researched. This is where fundamental analysis comes into play, offering a solid structure for assessing a company’s actual worth on the market.
Fundamental analysis involves going back to the basics to evaluate a company’s essential components. This analytical approach is beneficial in determining the fair value of a stock by evaluating the strength and profitability of a company using its financial statements and other economic variables, enabling investors to predict the future direction of the stock’s price and whether it is reasonable or overvalued.
Below, we will discuss the importance of fundamental analysis, different categories of analysis, what to look for when performing such an exercise, and more.
Fundamental analysis is all about making a buy or sell decision based on the information available. Traders apply this strategy to identify trade signals, appraise an asset’s fair value, and estimate macroeconomic factors that may shift an asset’s market price.
Specific indicators are applied depending on the type of asset under analysis. For example, interest rates could affect the values of bonds and currencies, while a stock's value could be affected by its competitive advantage and other ratios. These indicators are generally categorised into quantitative and qualitative fundamentals.
Image: Top Down and Bottom Up analysis, by Vecteezy
Quantitative fundamentals include measurable information. These metrics are especially useful when comparing the performance of the same kind of assets or industries. The most frequently used ratios in stock analysis include the price-to-earnings ratio, total sales, and current assets, usually included in balance sheets.
On the other hand, qualitative fundamentals are factors that cannot be measured through figures, such as the media of a given country or the board of directors of a company. These elements are mainly qualitative and, therefore, less measurable than the quantitative aspects.
‘Top-down’ is an approach which considers the industry's macroeconomic situation and conditions before analysing individual companies. In contrast, One of the most common approaches in fundamental analysis is' bottom-up'.
The bottom-up approach focuses on the details of a company, its cash flows, its growth rate, balance sheets, and other financial indicators. Advocates of this approach argue that even if the market is not very good, a company can still do well if it has sound fundamentals.
Through fundamental analysis, investors purchase stocks and invest in the company’s core, equipped with a vast knowledge of its functioning and niche. This model provides a significant competitive advantage in the growing and uncertain business environment. Analysts use four qualitative factors as essential indicators in addition to the figures when analysing a company's possibilities.
Understanding a company’s business model does not only mean knowing what it does and what it sells. For example, if a company claims to make revenue from selling fast-food chicken, one must ask: This may not be the primary source of revenue, as most of the income may be generated from franchise fees and royalties. This deeper examination can help understand what drives a company’s revenue.
The heart of long-term success for any company is competitive advantage. When it is a brand like Coca-Cola or a product like Microsoft’s PC operating system, it becomes a defensive wall against competitors. An excellent competitive position provides a long-term perspective of the company’s development and profitability.
Many experts claim that management is the key determinant of investments. Any good business strategy will suffer if competent leadership is not present to implement it. While direct communication with company heads may be difficult for a small investor, essential information can be gathered from the experience and achievements of the firm’s leaders and board of directors. Reflecting on how these leaders fared in their previous positions and whether they have been unloading their shares provides a sign of belief in the firm’s potential.
Corporate governance is the rules and principles that define the relationships and responsibilities between a firm’s management, board and shareholders. These principles should ensure the company’s ethical, fair, transparent, and efficient functioning. Shareholders should ensure that the company under-investment has a high level of respect for the shareholders’ rights and interests and has a good communication policy. If the disclosures are unclear or vague, it could be on purpose to make it difficult to comprehend, indicating deeper implications.
Determining the company's position to establish its strengths and weaknesses is also essential. This includes identifying the target customers, the company’s market share, rivals, legal factors, and its niche in the business cycle. Industry analysis plays an essential role in understanding the environment in which a company operates and its financial stability since industry factors are likely to affect its future performance.
Financial statements are written records that relate to a business's financial activities. They are the language of business and have been described as ‘the lifeblood of commerce’. Financial statements are the main way for a company to report its financial position and performance to users. However, fundamentalists base their investment decisions on the quantitative data obtained from these documents. The three main papers that form the centrepieces of this financial trove are the income statement, balance sheet, and cash flow statement.
In other words, the balance sheet shows a particular period involving the company’s assets, liabilities and shareholders’ equity. It adheres to a fundamental accounting equation:
Image: A simple equation of a balance sheet
The basic accounting equation is:
[\text{Assets} = \text{Liabilities} + \text{Shareholders’Equity}\]
Here, assets refer to those items that the business uses or owns rights to; these include cash, stocks, machines, buildings, and others. The right side of the equation outlines the company’s sources of financing for these assets, both liabilities and equity, or what the company owes and what the shareholders have invested in the company, including retained earnings, dividends, and taxes.
While the balance sheet provides a snapshot of a company's financial position, the income statement actively records the company’s financial performance within a given period. Public companies usually present it at three—or twelve-month intervals and show revenues, expenditures, and profits from operations within the given period.
Image: Cash flow analysis with paper
This financial statement summarises a business’s revenues and expenditures for a period. It usually categorises cash movements into three activities:
• Cash from Investing (CFI): This involves the amounts paid in cash for asset acquisitions and cash received from the disposal of business segments, equipment, or other types of long-term assets.
• Cash from Financing (CFF): This will show the cash transactions related to credit giving and borrowing.
• Operating Cash Flow (OCF): measures cash derived from the business’s normal trading activities.
The cash flow statement is thus essential in presenting a clear picture of a firm’s liquidity position with minimal possibility of manipulation. Although earnings are always more or less a matter of accounting discretion, cash is much more challenging to fiddle with and, thus, a more unvarnished measure of a company’s well-being. This is why some investors use it instead of other statements to get a more conservative view of organisational performance.
While it is applicable, the extent of its usage differs from one market to another. Fundamental analysis is common in stock and foreign exchange markets. It relies on extensive data sets that listed companies must provide in their annual reports. This data is beneficial for analysts in determining the actual value of stocks. Likewise, the commodity and foreign exchange markets are slightly less detailed, though they also go through a similar process where countries reveal specific financial figures that affect these markets.
Ultimately, fundamental analysis provides a strong arsenal when exploring the market further. However, all of these tools cannot be used independently of each other. The fundamental indicators do not give buy or sell signals but should be blended into the trading plan incorporating other variables that enable the analysts to rank countries, stocks, and other assets. Investors can thus determine the relative value of one market to another and create strategies based on sound analytical foundations.
Certainly not. Fundamental analysis is a critical and effective tool for every investor, no matter how experienced or knowledgeable they are. Therefore, it is essential and valuable for any investor planning to invest in stocks in the long term to adopt this method.
The two can be used side by side since each has advantages that can be applied to a project. Fundamental analysis assesses financial statements and economic data to develop a long-term plan for investment, while technical analysis studies charts and prices to create a short-term plan for trading. One should base the choice of these methodologies on one's time horizon for investing.
Fundamental analysis is a broader form of analysis that can give more information about the state of the firm and its likely performance. To perform fundamental analysis effectively:
Start with the company’s business model, management, and market niche. It is recommended that the P/E ratio be used as one of the financial ratios for assessing the company’s value. Evaluating the financial statements is the most appropriate method for determining the firm's fiscal performance.
￫ Identify competitive advantage by analysing the competition and the general environment.
￫ Consider the ratio of debt that the company has incurred to that of its rivals.
￫ Assess the company’s potential and the measures that should be taken towards formulating a strategic plan.
￫ It is also good to revisit such an analysis regarding new information and market trends from time to time.
Fundamental analysis can be categorised into two main types: Qualitative research and quantitative research. Quantitative analysis looks at aspects that can be measured in terms of numerical value, such as market share, customer base, and financial resources, while qualitative analysis deals with factors that cannot easily be measured, such as business model, brand value, patents, and managerial expertise.
Practical fundamental analysis is layered. Fundamental analysis is a procedure that is also sequential and complex.
￫Economic Analysis: Perform a macroeconomic analysis of the business.
￫Industry Analysis: Evaluate the sector in terms of its nature and its condition within the economy.
￫Company Analysis: Evaluate the general and specific economic conditions and rivalry in the company's case.
Many tools can be used for analysis, including financial statements, economic statistics, industry reports by government bodies, and market research papers. Other tools, such as ratio analysis from financial statements, model-building spreadsheets, charts, graphs, and other infographics, can also be beneficial in showcasing a company’s performance and prospects.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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