When you’re working with investments and trying to make sound decisions, it’s best to use hard data and publicly available information instead of relying on subjective feelings like your instincts. Your emotions may easily be swayed, but it’s hard to argue with numbers and facts.
Fundamental analysis, or FA, is one method that can help inform your choices regarding whether or not a company makes a good investment option. FA isn’t just for finance experts; it can help you make independent decisions about your own investment portfolio. Below, we’ll explore the fundamental analysis basics, how to practice this method, and explore other investment tips.
What is Fundamental Analysis?
Fundamental analysis is a way to determine a security’s fair market value by examining different financial and economic factors. The state of the economy, industry conditions, or the effectiveness of a company’s leaders can all influence fundamental analysis.
The main purpose of FA is to decide whether or not a security’s current pricing is overvalued or undervalued. Ideally, you’ll be able to find a company whose value is greater than or will be greater than its current market value.
Understanding Fundamental Analysis
Fundamental stock analysis helps potential investors figure out whether a security’s value makes sense within the market at large. FA can be conducted on a micro or macro scale in order to choose securities.
Analysts typically start from a wider perspective, such as current economic conditions, and then hone in on an individual company’s performance. Variables like interest rates, the state of the economy, and the bond issuer’s credit ratings may all come into play. Basically, any public data can be used to evaluate a security’s value – but we’ll dive specifically into what kinds of data and information fundamental analysis evaluate below.
Quantitative Fundamental Analysis
When you start to investigate a company to determine its potential for growth and overall health, it’s essential to get a good read on the underpinnings of the business. Of particular importance is understanding the financial statements of a company. This is what’s called quantitative fundamental analysis since you’re focused on the hard numbers a company provides.
A business’s income statement, balance sheet, and statement of cash flows are three large indicators that determine the overall health and success of a business.
- Income statement: The income statement shows a company’s profit after expenses are taken out. It also reveals a company’s performance within a specific time period.
- Balance sheet: A balance sheet reveals business assets compared to its liability and shareholders’ equity. A balance sheet follows this simple equation: Assets = Liabilities + Shareholders’ Equity. Assets can be cash, buildings, inventory, or equipment.
- Statement of cash flows: The statement of cash flows shows where money comes in, goes out, and for what purpose. In most cases, a statement of cash flows focuses on the activities below:
- Cash from investing (CFI): Cash used for investing and from the sale of other businesses or assets.
- Operating cash flow (OCF): Cash made from business operations.
- Cash from financing (CFF): Cash received from borrowed funds.
Qualitative Fundamental Analysis
Numbers don’t always give you the full picture. That’s where qualitative fundamental analysis comes in to help. For example, part of your qualitative investigation might come from a company’s annual report. In an annual report, a company’s leaders will explain the company’s performance and mention a strategy for the future.
Qualitative information might also come from the company’s brand name recognition, patents, the performance of key executives and leaders, and proprietary tech. Here are some basic fundamentals you’ll want to pay attention to conducting a qualitative analysis:
- Business model: Although this seems straightforward, it’s important to look at how the company makes its money (aka the business model). Does it sell a main product or mostly coast by on fees and franchising?
- Competitive advantage: A company can do well for a while based on its own products and services… until another company comes along and does it better. That’s why it’s incredibly important for companies to show a competitive advantage and be able to maintain it over the long term. Need an example? Think about the staying power of large corporations like Coca Cola or Johnson & Johnson.
- Leadership: There are a few experts that believe management is the most important part of the decision to invest in a company. And if you think about it, it makes sense. Even a company with a million-dollar idea can tank under the influence of incompetent leadership. With that said, it’s hard for small-time investors to go in and meet managers or vet them in an interview. Instead, you can look through the company’s main website to read about a company’s top executives. If you want to go a step further, you can even investigate board members and execs’ performance at their past companies.
- Corporate governance: Corporate governance refers to the policies that guide the relations between management, directors, and shareholders. You’ll find references to these policies in the company charter. The rules and bylaws governing how a company does business are important to know. Why? Because it’s important to put your money into a company that’s ethical and fair. Make sure to note any sections referring to management and shareholder interests. As a potential shareholder, you’ll want to see transparency and fairness as guiding principles.
Qualitative information is more abstract, but it’s not any better or worse than quantitative information. In fact, qualitative indicators provide analysts with a way to put the numbers in context and can provide insight into the business’s future. Most fundamental analysts use a combination of both qualitative and quantitative data to arrive at their conclusions.
So, what does an analyst do with the information after they’ve conducted a fundamental analysis of a stock?
- If an analyst finds that a stock’s value is more than the stock’s current price, they might publish a “buy” or “undervalued rating” for the stock.
- If an analyst finds that a stock’s value is lower than the current price, they might publish a “sell” or “underweight rating” for the stock.
Investors who follow analyst recommendations use them to buy stocks with good ratings since they deem them to have a higher chance of growing in value over time.
Examples of Fundamental Analysis
There are different approaches analysts use for fundamental analysis but they can be placed into two main buckets: top-down analysis and bottom-up analysis. The first, top-down refers to an approach that takes in a larger perspective of the economy. That view gets narrower, from the economy, to the sector, to industry, and then whittled down to an individual company.
Bottom-up analysis starts with a particular stock and then zooms out to consider all the other variables that influence its market price.
The tools that a fundamental analyst uses depends on what asset is being traded. The tools that can be used in fundamental analysis can be found below.
Fundamental Analysis Tools
Fundamental analysts use a variety of tools to measure the value of a stock. Although an analyst might not use all of the ratios and calculations below, these represent common metrics you might find useful.
- Return on equity: To get this metric, divide the company’s net income by the shareholders’ equity, this will give you the return on equity. Return on equity is also referred to as a company’s return on net worth.
- Dividend yield: This is a stock’s yearly dividends in comparison to the share price, expressed as a percentage. To get the dividend yield, you need to divide dividend payments per share in one year by the value of a share.
- Dividend Payout Ratio: This ratio shows what was paid out to the shareholders in dividends compared to the company’s net income. It shows you a security’s retained earnings.
- Price to Book Ratio (P/B): Also referred to as price to equity ratio, this ratio compares a stock’s book value to its market value. To get this ratio, you can divide the stock’s most current closing price by last quarter’s book value per share. The definition of book value is the value of an asset, as it appears in a company’s books.
- Price to Sales Ratio (P/S): The price-to-sales ratio tells what a company’s stock price is as compared to its revenue. It’s also referred to as the PSR, sales multiple, or revenue multiple.
- Projected Earnings Growth (PEG): PEG is an estimate of what the one-year earnings growth rate of the stock will be.
- Price to Earnings (P/E): This ratio compares the current sales price of a company’s stock to its per-share earnings.
- Earnings Per Share (EPS): The number of shares or the earnings can’t tell you very much about a company isolated by itself, but if you put those numbers together, you get an EPS or Earnings Per Share. EPS gives you an idea of how much a company’s profit is assigned to each share of stock
How to Improve Your Understanding of Fundamental Analysis
Do you want to ensure that you have a concrete understanding of fundamental analysis? Consider giving yourself a homework project like the one below to practice your skills.
- Follow two stocks for three months
Opt for one stock that you like and one that you don’t. Make sure you examine the fundamentals of each and try to make a choice about each stock according to the information you gather on those metrics. Take note of the progress of each stock pick and evaluate performance from the selection day up to the three-month mark.
- Use a checklist
Now it’s time to get out the pencil and paper to compare hard numbers. Those ratios and other important numbers will comprise a checklist that you can use as your cheat sheet to evaluate a stock or security.
- Figure out your benchmarks
When you analyze stocks that you’re interested in tracking, use another stock in the same industry to act as a benchmark. What’s a benchmark? Benchmarks serve as a standard way for analysts to study the stock you’re evaluating.
But remember, not all stock comparisons make sense – you’ll need to compare similar companies. Comparing Google with a heavy industry stock like Steel Dynamics Inc. won’t yield any useful information for you. Make sure you use ratios and comparisons among similar companies, industries, or sectors. For example, comparing JPMorgan Chase and Bank of America would potentially reveal usable information for you regarding each company’s health and value.
Pros and Cons of Fundamental Analysis
FA helps you better evaluate a stock within a broader context. Although this stock analysis method has many benefits, it also has a few drawbacks to consider as well. Below, we’ve laid out a few key pros and cons:
Pros of Fundamental Analysis
- Easy to gather data: FA uses lots of publicly available data, which is fairly easy to acquire and analyze.
- Provides more relevant context: Knowing you’re putting your money into a company with a healthy financial background is typically a good idea.
- Gives you peace-of-mind: Although a company that performs well and has strong business underpinnings doesn’t guarantee success, it can still help you make a sound investment decision for the long-term.
Cons of Fundamental Analysis
- Time-consuming: Each company needs to be analyzed and studied independently. Depending on what data you’re gathering and what numbers you’re crunching, this can be a significant investment of your time and effort.
- Unique datasets necessary: Because fundamental analysis involves public information, it’s fairly difficult to find unique datasets that have limited publication to gain an edge.
- Short term “blindness”: Short-term volatility can’t be predicted by past financial statements.
Fundamental Analysis vs. Technical Analysis
When you start researching fundamental analysis, you’ll likely see another analysis method come up in your search results: technical analysis. Technical analysis is based on only a stock’s price or on its volume data. Instead of predicting the future, technical analysis, or TA, attempts to figure out price patterns.
Technical analysts use chart patterns, trends, price, and volume behavior to identify stocks with the greatest chance for growth in value. It doesn’t take into consideration the business’ health or the broader economy.
The main difference between fundamental and technical analysis is that fundamental analysts want to figure out the difference between a stock’s intrinsic value versus its current market price. Technical analysis is focused on price action, which points to a stock’s supply and demand pattern. While this isn’t always the case, FA is often used for long-term investments, and TA is typically used for short-term investments.
The debate over fundamental and technical analysis is ongoing. Fundamental analysis can be more helpful for figuring out long-term investments while technical analysis is better served for short-term trading and timing the market. You can use both to plan investments over the short term and long term.
Top Research Tools for Fundamental Analysis
- Finviz: Finviz allows you to screen stocks based on fundamental parameters you set. You can use the free version to access basic information or upgrade to the subscription model for more comprehensive access.
- TD Ameritrade: TD Ameritrade is a very popular online brokerage with a huge section dedicated to stock research. You can use the site’s stock screener to filter stocks based on the fundamental benchmarks you choose. You’ll also be able to peruse other types of research like investing newsletters from major news sites.
- Yahoo Finance: Yahoo is one of the oldest sites that shows investors stock data. You can use the search bar to explore different data sets. Explore a company’s historical data, financial reports, and statistics.
Fundamental Investing Tips
Every investor has their own strategy for investing in stocks. Fundamental analysis can be a great method to use, but it comes down to personal preference and your overall financial objectives.
For example, if you’re interested in steady growth, then you’d probably look for a company that would make a sound long-term investment. So, you’d focus on the fundamentals to evaluate what company to invest in, based on how the business is expected to grow over a longer timeline.
For value investors, the focus is on identifying a stock that makes a good buy. In turn, you’d use tools like dividend yields and low P/E ratios which show strong fundamentals within a market that undervalues it.
When you’re first getting started with fundamental analysis, focus on the basics in the beginning. It’s very easy to get overwhelmed when faced with a veritable tidal wave of ratios, figures, and numbers. Instead, focus on simpler numbers like profits and earnings or revenue to determine whether or not a stock makes a good investment. These fundamentals don’t guarantee future earnings, but it’s a way to “hedge your bets”. Once you feel like you’ve built up experience with looking at basic numbers, you can jump into more complex figures to evaluate your stock options.
It’s also a smart idea to think about what you’d gain from working with a professional advisor as opposed to working on your own. If you’re a brand new investor, you can use an online brokerage to make stock trading lower cost and user-friendly.
Wrapping Up: Learning Fundamental Analysis, One Stock at a Time
Investors use a variety of methods to evaluate whether a stock makes a good investment choice – fundamental analysis is just one of them. Although you can practice this approach on your own, you might find more success working with a financial advisor that can help you tailor your investment strategy to better align with your money objectives.
- Know your objectives: Make sure that you understand your objectives before you get started. Do you want long-term growth? Are you looking for short-term gains? Are you focused on value? How long will you hold the stock?
- Decide on DIY or use an advisor: Do you feel confident in your knowledge and ability or will you rely on an expert (or robo-advisor) to help you plan your investment strategy?
- Take care of other financial priorities: Do you have enough money to portion out for an investment, or are there financial priorities that demand your attention first? For example, you might want to pay off any high-interest credit card debt before funneling money into an investment since any returns might be negated by high interest rate fees from your debt.
- Don’t forget all investments are a risk: All investments represent a risk, although it’s true that some investments are riskier than others. Even if you conduct an incredibly thorough fundamental analysis, it doesn’t provide you with any foolproof guarantees.
If you want to better comprehend how your investments will impact your overall finances, you may want to consider using Mint’s investment calculator. This online financial calculator can help you understand what gains you can expect over time. By entering in a few key numbers, you can generate your own investment goals, forecast growth, and look for potential opportunities to increase your portfolio’s success.