What is fundamental analysis

Previously, we discussed technical analysis to evaluate investment opportunities and spot trends that can help us predict the possible price movements of financial instruments. Fundamental analysis is another tool that investors use to arrive at a number (fair market value) that we can compare to the security’s current price, thus determining whether it is undervalued. This type of analysis focuses on both the macro and microeconomic factors that can affect the price of a given financial instrument. In contrast with technical analysis, which only considers the historical price movements, the fundamental analysis uses company financials. It considers related economic factors to arrive at an intrinsic value and decide whether it is profitable to invest in that company.

Traders prefer fundamental analysis when evaluating stocks, but it is also helpful with other financial instruments, like bonds and derivatives. The “fundamental” idea is to use publicly available data and information about the macro and microeconomic environment to develop an educated estimate for the company’s real (intrinsic) value. In the end, based on the analysis, investors choose to buy, sell, or short a stock.

Types of fundamental analysis

We distinguish two types of fundamental analysis: quantitative and qualitative. The first focuses on a company’s publicly available financial data, such as revenue, EBITDA, price-earnings ratio, return on equity, and others. On the other hand, the qualitative fundamental analysis considers the less tangible information about a company, like how management performs, strong brand recognition, the company’s intellectual property, and others. Because the two types are entirely different in essence, we cannot say which is more valuable, and investors instead use a combination of both to help them derive the fair market value of the target investment.

Quantitative analysis

As mentioned above, quantitative fundamental analysis is based on the company’s financials or, in other words, the measurable characteristics of the business. We use financial statements to draw information about the financial performance and current economic state of the company.

• Income statements (or profit & loss statements) show the company’s performance over a specific time frame (usually quarterly or annually).
• Balance sheets provide snapshots of the company’s assets, liabilities, and equity at a specific point in time (usually the end of the quarter or year).
• The statement of cash flows is also helpful as it represents all cash movements (inflows and outflows) over a particular time frame (usually quarterly or annually).

The cash flow is probably most important as it is hard to manipulate, unlike the other statements, where CPAs (Certified Public Accountants) can use various approaches to present the company’s performance in a better light.

Qualitative analysis

Qualitative analysis is more subjective because it relies on non-quantifiable (soft) data, such as management proficiency, competition within the industry, the state of the economy as a whole, and many other macro/microeconomic factors affecting the performance of a business. Some of the fundamental pieces of information we need to acknowledge when performing this type of analysis include:

• Brand recognition and association – whether the brand itself affects the price of the stock. For example, Apple’s share price reflects that it has one of the strongest positive brand associations.
• Competitive advantage – the availability of factors that allow a company to perform better than its competitors have a positive effect on the business’s intrinsic value.
• Management performance – analysts believe this is an essential characteristic of a company when deciding whether it is profitable to invest in it.
• Customer satisfaction – a solid and satisfied customer base adds much value to the price of the company.
• Corporate governance – Investors need accurate information on whether the company does business ethically, fairly, and transparently.

Advantages and disadvantages

As with any concept in finance and economics, we need to fully understand the pros and cons of fundamental analysis:

• Advantages:
  • Objective: the quantitative part of fundamental analysis helps eliminate biases in making decisions on investments.
  • Whole: the inclusion of qualitative analysis in quantitative research helps provide a complete view of the company’s performance.
  • Long-term: a thorough analysis can give helpful information on where and when to invest in generating high earnings over a long-term period.
• Disadvantages:
  • Time-consuming: because fundamental analysis tries to capture both macro and micro factors, it can take a long to prepare.
  • Overcomplicated: investors may overcomplicate their analysis when a more concise approach would yield better insights.
  • Subjective: the qualitative part of the analysis always involves being subjective because the data is not quantifiable, and we cannot evaluate it objectively.

Example

A basic example will help us further develop our skills in performing fundamental analysis. Usually, we start by deciding on characteristics that our target company should have because there are too many different stock options on the market. One way to filter out what we are looking for is using stock screeners, which allow you to input filters, such as region, market cap, different ratios, and then choose a stock from a significantly limited list. We will be using Yahoo Finance’s stock screener, and we are looking for a US stock with a large cap and ratios as followed:

• P/E ratio – between 20 and 50;
• Total Enterprise Value (TEV) / EBITDA – greater than 20
• Quick Ratio – between 0.5 and 1

And here is the resulting list of companies that have those characteristics

We are all familiar with Apple Inc. (AAPL) and may be interested in investing in it. The next would be to perform quantitative fundamental analysis. We can decide to work with company filings, like 10-K’s or 10-Q’s, to calculate the ratios needed later for comparison. Or we can use Morningstar, as they have most of the important ratios readily calculated. We can find these by searching for the AAPL ticker and then clicking on the Financials tab.

From the information in the Details View section, we can see that Apple has been growing in revenue for the past three years and their Trailing Twelve Months (TTM) revenue is even higher. Moreover, the Earning per Share (EPS) is also growing at a good pace.

Now, let’s compare some of Apple’s valuation and profitability ratios to the industry averages. We can easily find industry averages at places like CSIMarket. We filter by industry and choose which type of ratios we want to see. If we look at the Price/Earnings ratio, we can see that Apple is performing significantly better than the industry average: 32.12 vs. 28.79 (as of Q2 2021):

Next, looking at the profitability ratios, we see that Apple is performing above average again. Return on Assets (ROA), Return on Equity (ROE), and Return on Investment (ROI) are all higher than the industry averages:

In reality, we would look at more metrics. Still, for the exercise, we can assume we now have a good enough understanding that Apple should be a good investment opportunity based on these growth percentages and ratios. This is the quantitative part of our analysis.

Now, we want to support further the idea of investing in Apple by performing qualitative research. One way to do that is to go online and read news about the company. For our example, we will be looking for helpful information in Yahoo! Finance, more precisely, the Summary tab. Scrolling down, we find an article stating that Apple is close to launching a new high-end minicomputer (Mac Mini) using Apple’s M1 processor, rather than Intel’s (https://finance.yahoo.com/news/apple-close-launching-higher-end-125550425.html). Another article states that there is a new Apple headset soon to be launched (https://finance.yahoo.com/m/c6cf381c-37ff-3ee2-94a3-7c4dd71ddd85/apple-iphone-sales-remain.html). Moreover, Apple’s annual event is in September, where they announce the new iPhones and other devices.

All this information suggests that Apple will be growing in the next few months. Combining this information with the quantitative research from earlier, we can conclude that Apple is currently a good investment opportunity.

Conclusion

Fundamental analysis is a powerful tool for investors to decide whether it is the right time to invest in stocks. By adding Technical analysis to the equation, we can make an informative and reasonably confident decision on whether our investment will be profitable or not. However, Fundamental analysis should always be approached with caution, as there is lots of misleading information. Investors should be skilled in filtering out the relevant information and disregarding false claims.