What Is Fundamental Analysis?
Fundamental analysis (FA) gauges a security’s intrinsic value by dissecting related economic and financial factors. Intrinsic value represents an investment’s worth based on the issuing company’s financial health amid current market and economic circumstances.
Fundamental analysts delve into elements influencing a security’s value, from macroeconomic factors like market conditions and the broader economy, to microeconomic aspects such as company management effectiveness.
The ultimate aim is to determine a figure an investor can use to compare with a security’s current price, helping determine if it is undervalued or overvalued by other investors.
Key Takeaways
- Fundamental analysis is a strategy used to ascertain a stock’s authentic or ‘fair market’ value.
- Analysts look for stocks trading at prices higher or lower than their true worth.
- If the fair market value surpasses the current market price, the stock is considered undervalued, prompting a buy recommendation.
- Conversely, if the fair market value is lower than the market price, the stock is seen as overvalued, likely leading to a sell recommendation.
- In contrast to FA, technical analysis predicts short-term future trends by examining the stock’s historical price patterns.
Understanding Fundamental Analysis
Fundamental analysis usually follows a “macro to micro” framework to spot securities mispriced by the market.
Analysts generally study the overall economy, the strength of the specific industry, and the financial performance of the issuing company in sequence.
This ensures a fair market value derived for the stock.
Sources for Fundamental Analysis
Publicly available financial data is pivotal for fundamental analysis, often found in financial statements like quarterly (10-Q) and annual (10-K) reports, alongside event-specific filings (8-K). Many public companies share yearly reports on their investor relations pages, documenting financial decisions and results.
For instance, analyzing a bond’s value demands considering interest rates and the broader economy, reviewing bond market data, and scrutinizing financial data from similar issuers. Detailed examination of financial statements such as 8-K, 10-Q, and 10-K reports can yield critical insights.
FA evaluates a company’s revenues, earnings, projected growth, return on equity, profit margins, and other metrics to unearth a company’s intrinsic value and future growth potential.
Intrinsic Value
A crucial FA premise is that a stock’s current price doesn’t always adequately reflect the company’s valuation based on available financial data. The value extracted from fundamental data is presumed nearer to the stock’s true valuation.
For example, if a stock trades at $20 and analysts, based on thorough research, assert its value to be between $24 and $26, they might average it out to an intrinsic value of $25. Stocks trading below this intrinsic value are typically flagged as attractive opportunities.
The idea is that, over the long term, market prices will align with fundamentals, though the ’long term’ could span days to years.
Fundamental Analysis vs. Technical Analysis
FA contrasts sharply with technical analysis, which predicts price trends based on historical market data like price movements and trading volume. Technical analysis relies on price trends and actions to generate indicators and patterns, guiding trading decisions.
In contrast, FA relies heavily on financial disclosures from the company in question, creating ratios and metrics to compare performance against similar companies.
Quantitative and Qualitative Fundamental Analysis
Fundamental factors are categorized into quantitative—numeric and measurable data, and qualitative—non-numeric, quality-based information.
Quantitative fundamentals include measurable financial metrics from statements, like revenue and profit.
Qualitative fundamentals cover factors such as management quality, brand recognition, patents, and proprietary technology.
Analysts often integrate both, without favoring one over the other.
Qualitative Fundamentals to Consider
There are four pivotal qualitative fundamentals directly impacting a company:
The Business Model
Define what the company does. Digging deeper reveals the core revenue mechanisms, like whether a fast-food chain makes money from direct sales or franchise fees.
Competitive Advantage
Sustained success is tied to a company’s competitive edge, such as brand strength or market domination. An enduring competitive advantage, like Coca-Cola’s brand, can secure decades of growth and profits.
Management
Effective management is critical. Scrutinizing executive performance histories, stock movement, and how management communicates insights about future directions is insightful.
Corporate Governance
Corporate governance marks the framework for management’s relationship with stakeholders, highlighted in the company charter, bylaws, and regulations. Look for ethical, transparent practices that respect shareholder rights and interests.
Industry
Evaluate the overall industry, identifying customer bases, market share, growth patterns, competition, regulation, and economic cycles. Understanding industry mechanics offers a deeper insight into a company’s financial health.
Quantitative Fundamentals to Consider: Financial Statements
Quantitative data from financial statements informs solid investment decisions. The three primary statements are the income statement, balance sheet, and cash flow statement.
The Balance Sheet
The balance sheet provides a snapshot of assets, liabilities, and equity at a certain time. With the equation Assets = Liabilities + Shareholders’ Equity, it mirrors a company’s financial standing in terms of owned resources and owed liabilities.
The Income Statement
The income statement evaluates performance over a time period, detailing revenues, expenses, and profit or loss, typically reported quarterly and annually.
Statement of Cash Flows
Cash flow statements capture cash movements over a timeframe, focusing on cash from investing activities, financing activities, and operating activities—essential for reflecting a company’s liquidity and operational health.
Example of Fundamental Analysis: Coca-Cola
Economic Metrics: Check overall economic markers like consumer price index, GDP growth, exports/imports, and interest rates.
Industry and Competitor Metrics: Examine sector statistics and metrics for a comprehensive industry and competitor landscape.
Company Analysis: Gather reports from Coca-Cola or databases like Edgar filings. Use comparative data for financial metrics like Y/Y Revenue Growth, P/E Ratio, Cash Flow, Debt to Equity, Quick Ratio, ROE, ROA, and ROI. This holistic view, combined with historical financial stability and brand strength, underscores Coca-Cola’s analysis insights.
Summing Up Fundamental Analysis
Fundamental analysis uses financial information to determine whether a stock is accurately valued by the market. It’s a pivotal tool for understanding a stock issuer’s value, factoring in elements from economic conditions to financial performance reports.
Stock valuation through FA involves tools like financial ratios, reports, and detailed analyses, delivering a grounded investment decision based on a stock’s intrinsic value.
Related Terms: technical analysis, stock market, financial ratios, intrinsic value, macroeconomic factors, microeconomic factors, financial metrics, market conditions
References
- Securities and Exchange Commission. “EDGAR | Company Filings”.
- CSIMarket. “Coca-Cola Co (KO)”. Use the dropdown menu titled Select the Comparisons: and choose different measurements.
- Coca-Cola. “History”.
- CSIMarket. “Coca Cola Co’s Net Cash Flow Margin by Quarter”.
