Fundamental analysis aims to determine the intrinsic value of securities based on fundamental data. In order to do so, investors using fundamental analysis try to value companies based on business fundamentals. Once they are able to estimate the value of a certain business, they can then compare it with the current market capitalization. This allows them to determine whether a certain stock is over or undervalued.
Fundamental analysis takes into account both past, current and forecasted financials of the company. In order to value the business, fundamental analysis of the qualitative and quantitative aspects of the business is carried out. It offers an overall view from a broader perspective, that it is much more analytical than technical analysis. Certainly, the best way for investors to get acquainted with this type of research is to read fundamental analysis books.
What does fundamental analysis mean?
Fundamental analysis is a form of business analysis. In contrast to technical analysis based on price developments, and fluctuations in price. In order to conduct a fundamental analysis of a company, investors will research its financials. They will also use different tools, and data to estimate the qualitative value of the business.
Once they are able to estimate the current value, they will try to estimate the company’s ability to generate future cash flow. This way they will be able to calculate the future value of the business. Based on its ability to generate earnings and cash flow. Fundamental analysis approach takes into consideration how the future could impact a particular company. This analysis approach is used by a wide variety of investors with value or growth approaches. Their goal is to pick stocks whose returns will be above average and therefore beat the market.
Conducting fundamental analysis
Depending on the investor, fund, or portfolio manager fundamental analysis can be conducted in different ways. There are often two main approaches to fundamental analysis that differ in their initial focus.
- Top-down approach
- Bottom-up approach
The top-down approach is based on the analysis of macroeconomic data like fiscal and monetary policy. Investors will look at the macroeconomic environment and choose the best investments based on that. Therefore they will identify industries and sectors that are more attractive. Once they have done that, they will look at individual stocks within those industries.
The bottom-up approach is entirely different. Investors will look for individual stocks that seem attractive. This type of approach focuses on researching the company, and its market position. Value investors adopt this type of approach to conducting fundamental analysis.
Business fundamental analysis
Business analysis has two main categories: a quantitative and qualitative analysis.
Fundamental analysis is based on existing data and information produced by the company. Most investors will start by analyzing the company’s financials. This allows them to research the quantitative part of the business. They will determine how much the company is growing, its margins, debt, and a few more key aspects.
Once this data is compiled, investors will project how the company’s financials will be in the future. Thus, allowing them to predict revenues, growth, earnings, and margins.
The qualitative analysis is far more complicated to conduct. This is because although it is dependent on data, it is much more subjective. Investors will try to analyze the company’s market share, customer retention, and brand loyalty among other aspects. This component of fundamental analysis allows investors to determine the competitive advantages of the business. If the business has a moat, this will directly impact its valuation and future financial estimates.
Industry fundamental analysis
Another important step in a fundamental analysis approach is to research the industry. What does the individual industry structure look like? How do competitors position themselves? Which factors determine supply and demand? How cyclical is the industry? What influence do industry-relevant, political decisions have? The answers to these questions can help investors get a deeper understanding of a particular industry. This will ultimately impact the company’s value.
Considerations of key figures in relation to the stock price are of great importance in fundamental analysis. Important key figures include:
P/E ratio (price-to-earnings)
It is perhaps the most important fundamental ratio. It is defined by dividing the current share price by the earnings per share (P/E ratio = current share price/earnings per share). Therefore, it shows how much profit a company generates per share. Thus, a low P/E ratio is, therefore, an indicator of a favorable valuation of the company.
It is one of the most reliable ratios to determine a company’s value. As it tells investors how much cash flow the company is generating after paying all of its expenses. Investors often use P/FCF as a replacement for the P/E ratio.
P/S (price-to-sales ratio)
It is also interpreted in a similar way to the P/E ratio. However, its importance is not comparable. Because it does not convey the company’s profitability. There are certain companies with different prices to sales, and they might have the same earnings. P/S should always be compared against the company’s margins.
P/B (price-to-book ratio)
It sets the market value of a company in relation to its balance sheet value. P/B considers the difference between the share price and the equity value per share. It allows investors to know how high or low the market values the company’s equity. Making it easy to compare it with competitors.
Image source: techwire