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10.2. What is Fundamental Analysis?
Fundamental analysis is the cornerstone of long-term investing. In fact, some would argue that you aren’t really investing if you aren’t assessing an underlying asset by using fundamental analysis tools. Since the subject is vast, it’s tough to know where to start. The goal of this tutorial is to provide new investors a foundation for understanding fundamental analysis.
Final Thoughts Fundamental Analysis Defined
The basis of the theory of fundamental analysis was first propounded by Americans, Benjamin Graham and David Dodd, in their 1934 classic publication, “Security Analysis.” The duo determined fundamental analysis as an instrument for prediction of future prices of stocks and bonds.
Fundamental analysis can be broadly defined as the method of evaluating a security’s intrinsic value by examining economic and financial factors. Fundamental analysts seek to analyze everything that can affect the value of a security, including macro factors (like the general economic and political conditions), as well as specific factors (such as the financial condition of a company and the performance of its management). Although most analysts utilize fundamental analysis to measure a stock’s value, this method can be used to derive the value of other leading assets like bonds, commodities and foreign exchange. An investor can fundamentally assess a sovereign bond by examining economic factors like interest rate trajectory, and GDP growth rate. For analyzing stocks, this method uses earnings growth, revenue, profit margin, debt, return on equity, and other company-specific data to determine its underlying value and future growth potential. Fundamental analysis in the context of the foreign exchange market can be broadly defined as the interpretation of economic data to forecast changes in an underlying currency’s price. Important macro-economic releases like changes in the interest rate, inflation data, GDP growth rates and employment figures have a direct impact on the value of a currency.
The end goal of fundamentally analyzing an asset is to estimate its intrinsic value so that an investor can compare it with the security’s current market price. If the current market price of a stock is lower than its intrinsic value, it is undervalued and is a good buy candidate. Contrarily, if current price of a stock is higher than its intrinsic value, it is overpriced and a good candidate to sell or short.
Concept of Intrinsic Value
A critical assumption of fundamental analysis is that the market price of an asset seldom fully reflects its “real” value. In financial market parlance, this “real” value is referred to as the intrinsic value.
Let us for example consider a company’s stock that is currently trading at $100. After performing extensive research on the company’s financials, you deduce that it really is worth $150. In other words, you calculate the intrinsic value of the company to be $150 per share. Since the stock is trading below its intrinsic value, you would want to buy the stock knowing that with time, other market participants would realize that it is under-valued and drive up its price.
This gets us to the second important assumptions of fundamental analysis – in the long run, the stock market will reflect the fundamentals. This is what lay at the crux of fundamental analysis. By focusing on a particular company, an investor can calculate the intrinsic value of its business and identify opportunities to buy its stock at a discount.
Top Down vs. Bottom Up
Investors employing fundamental analysis to find undervalued stocks should closely monitor the following 5 variables:
- Earnings – The most important element that all investors look for is earnings. Before investing in a stock you want to know how much the company is earning in profits, and how is its future earnings outlook.
- Profit Margins – The profit margin is the amount a company keeps in earnings out of every dollar of sales.
- Return on Equity (ROE) – It is a measure of how efficient a company is in generating profits.
- Price-to-Earnings – P/E ratio is defined as a stock’s current market price divided by it’s per share earnings. It is an easy way to measure a stock’s relative value.
- Price-to-Book (P/B) – A price-to-book (P/B) ratio gives investors an idea of whether they are paying too high a price for a stock. It denotes what would be the residual value if the underlying company went bankrupt today.
Fundamental Analysis Tools
The tools required for fundamentally analyzing a stock are mostly available for free.
- Annual and Quarterly Report – All the company-specific financial information that you need for fundamental analysis is available in its annual report and the quarterly releases. You can download them for free from the company’s website.
- Industry Data – Industry data is necessary to see how the company under analysis is performing relative to the broader industry to which it belongs. Basic sector-wise data is available for free, and can be accessed from publications available in the websites of the various industry associations.
- News Access – Staying abreast of news can help you remain updated about latest developments happening both in the company and the industry under examination.
- Microsoft Excel – Even though MS Excel is not free, it can be extremely helpful in fundamental calculations and comparisons.
Criticisms of Fundamental Analysis
The two biggest critics of fundamental analysis are proponents of technical analysis and believers of the “efficient market hypothesis”.
Technical analysis is the other major form of security analysis. Simply put, technicians base their investments and trades solely on the price and volume movements of a security. One of the basic tenets of technical analysis is that the market discounts everything. Accordingly, technical analysts believe that all news related to a security has already been factored in to its market price, rendering the analysis of underlying fundamental factors of the business to be futile.
The other major group to denounce fundamental analysis are the followers of the efficient market hypothesis. The efficient market hypothesis states that it is practically impossible to generate market-beating returns in the long run, through either fundamental analysis or technical analysis. Followers of this hypothesis content that since the market efficiently prices all assets on an ongoing basis, any opportunities to produce excess returns would be almost immediately whittled away, making it virtually impossible for anyone to consistently outperform the market over the long term.
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