Fundamental analysis
Fundamental analysis is the process of looking at the fundamental or basic financial level of a company, especially sales, earnings, growth potential, assets, liabilities, management, products and competition. This type of analysis examines key metrics of a company to determine its financial health and gives you an idea of the value of its stock. Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes. Goals of fundamental analysis The goal is to determine the current value and, more importantly, how the market values the stock. Usually, fundamental analysis only takes into account the variables directly related to the company itself, rather than the overall state of the market or technical analysis data, but here I will describe a top-down approach to the typical fundamental evaluation.
How is the economy doing overall?
It starts with the overall economy and then goes down from industry groups to specific companies. As part of the analysis process, it is important to remember that all information is relative. Industry groups are compared against other industry groups and companies against other companies. It is important that companies are compared to others in the same group. First and foremost in a top-down approach would be an overall evaluation of the general economy. When the economy is expanding, most industry groups and companies benefit and grow. When the economy is contracting, most sectors and companies tend to suffer. Once a scenario for the overall economy has been developed, an investor can break down the economy into its various industry groups. If the forecast is for an expanding economy, some groups are likely to benefit more than others. An investor can narrow the field to those groups best placed to benefit from the current or future economic environment.
Economic expansion
If most companies are expected to benefit from an expansion, the risk in stocks would be relatively low and an aggressive growth-oriented strategy may be advisable. A growth strategy could involve buying technology, biotech, semiconductor and cyclical stocks.
Economic contraction
If the economy is expected to shrink, an investor may choose a more conservative approach and seek stable income-oriented companies. A defensive approach may involve buying consumer goods, utilities and energy-related stocks. To assess an industry group’s potential, an investor would want to consider the overall growth rate, market size and importance to the economy. While the individual company is still important, its industry group is likely to exert as much, or more, influence on the share price. When stocks move, they usually move as groups. Once the industry group is chosen, an investor would need to narrow down the list of companies before moving on to a more detailed analysis. Investors are usually interested in finding the leaders and innovators within a group.
Detailed analysis
The first task is to identify the current business and competitive environment within a group and future trends. – How do companies rank by market share, product position and competitive advantage? – Who is the current leader and how will changes in the sector affect the current balance of power? – What are the barriers to entry? Success depends on an advantage, be it marketing, technology, market share or innovation. A comparative analysis of the competition within a sector will help identify the companies that have an edge and those most likely to maintain it. At this point, you will have a shortlist of companies and the final step in this analysis process would be to take apart the financial statements and come up with a way of valuation. Some of the more popular ratios are found by dividing the share price by a key metric.
Fundamental analysis tools
The most popular tools for fundamental analysis focus on profit, growth and value in the market. While each of these factors may not be significant on its own, combining them and tailoring your approach to the sector and company you are analyzing can be very effective in identifying the true value of a stock. By doing so, you can determine the ‘ticket price’ of your potential investment and assess whether your current investments have reached their full potential. This method assumes that a company’s share price is tied to its earnings, revenue or growth. Investors can rank companies based on these valuation ratios. Those with high multiples may be considered overvalued, while those with low multiples may be considered good value. But it’s also possible that companies with low multiples are performing poorly, while companies with high multiples have room to grow.
Remember that the market is usually right in the long run
After all this work, you will be left with a handful of candidates and this is where I recommend using technical analysis to develop a trading plan for each of them. I know investors tend to shy away from technical analysis, but this is a serious mistake, in my opinion. Knowing how to read charts and understanding that technical analysis is actually understanding basic human psychology will help you maximize your profits and minimize your losses; how does that sound to you? So here, in a nutshell, are the pros and cons of fundamental analysis.
Advantages
Fundamental analysis is good for long-term investments based on long-term trends, very long-term. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who choose the right industry groups or companies. Sound fundamental analysis helps identify companies that represent good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the masters of value investing. Fundamental analysis can help reveal companies with valuable assets, a strong balance sheet, stable profits and staying power. One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such careful research and analysis, an investor will be familiar with the key drivers of revenue and profit behind a company. Profits and profit expectations can be potent drivers of stock prices. Even some technicians will agree. A good understanding can help investors avoid companies that are prone to losses and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock’s price is strongly influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are high-risk (technology), low-risk (utilities), growth-oriented (computer), value-driven (oil), non-cyclical (consumer products), cyclical (transportation), or income-oriented (high yield).
Stocks move as a group
By understanding a company’s business, investors can better position themselves to categorize stocks within their relevant industry group. The business can change rapidly and with it the revenue mix of a company. This happened to many of the pure-play internet retailers, which were not really internet companies, but regular retailers. Knowing a company’s business and being able to place it in a group can make a huge difference in relative valuations.
Disadvantages
The main drawback for me is that if used on its own, fundamental analysis does not take into account the phenomenon of herd mentality. – In the long run, the price per share (PPS) of companies is governed by their earnings, that is, the profits they bring. – In the short run, momentum can be quite influential on PPS. I’m sure you’ve noticed that some stocks are considered darlings of the market and to a certain extent it doesn’t matter what their quarterly results are; people keep buying. The same goes for companies that all of a sudden fall out of favor for whatever reason, genuine or not. They continue to get hammered no matter what results the company pumps out, until one day it turns around. Fundamental analysis does not take this irrational behavior into account. Fundamental analysis can provide excellent insights, but it can be extraordinarily time consuming. Time-consuming models often produce valuations that are at odds with the current price prevailing on Wall Street. When this happens, the analyst basically claims that the entire street is wrong. This is not to say that there aren’t misunderstood companies out there, but it’s pretty brazen to suggest that the market price, and thus Wall Street, is wrong. Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can become quite time-consuming, which can limit the amount of analysis that can be performed.
Fair value is based on assumptions
Any changes in growth or multiplier assumptions can significantly change the final valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base case valuation, a best-case valuation and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the question is just how much. The majority of the information that goes into the analysis comes from the company itself. Companies hire investor relations managers specifically to manage the analyst community and release information. As Mark Twain said, “there are lies, damn lies, and statistics.” When it comes to massaging data or spinning the announcement, CFOs and investor relations managers are professionals. Only buy-side analysts tend to venture past the corporate stats. Buy-side analysts work for mutual funds and money managers. They read the reports written by sell-side analysts working for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine Weber, DLJ to name a few). These brokers are also involved in underwriting and investment banking for the companies. Although there are restrictions to prevent a conflict of interest, brokers have an ongoing relationship with the company being analyzed. When reading these reports, it is important to take into account any biases that a sell-side analyst may have. The buy-side analyst, on the other hand, is analyzing the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases, this may be a major shareholder. When market valuations extend beyond historical norms, there is pressure to adjust growth and multiplier assumptions to compensate. If Wall Street values a stock at 50 times earnings and the current assumption is 30 times, the analyst would be pressured to revise that assumption higher. There is an old saying on Wall Street: The value of an asset (stock) is only what someone is willing to pay for it (current price).
Wall Street Adage
Just as stock prices fluctuate, so do growth and multiplier assumptions. Should we believe Wall Street and the stock price or analysts and market assumptions? It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. But because so many companies were and are losing money, it has become popular to value a company as a multiple of its earnings. This seems to be OK, except that the multiple was higher than the PE of many stocks! Some companies were considered bargains at 30 times earnings. In conclusion, fundamental analysis can be valuable, but it should be treated with caution. If you are reading research written by a sell-side analyst, it is important to be familiar with the analyst behind the report. We all have personal biases, and every analyst has some form of bias. There is nothing wrong with this and the research can still be of great value. Learn what the ratings mean and an analyst’s track record before jumping off the deep end. Company statements and press releases provide good information, but they should be read with a healthy degree of skepticism to separate the facts from the spin. Press releases don’t happen by chance; they are an important PR tool for companies. Investors should become skilled readers to sift out the important information and ignore the hype.
Quantitative and qualitative
You can define fundamental analysis as “fundamental research”. This is not much help to an investor who does not know what “fundamentals” are and how to use them. Fundamentals include things like revenue and profit. Fundamentals also include everything from the company’s market share to the quality of its management. Fundamental factors are grouped into two categories: quantitative and qualitative. Quantitative factors can be measured in numerical terms. Quantitative fundamentals are numerical characteristics of a company. The easiest way to identify quantitative data is the financial statements. Revenue, profit and assets can be measured with great precision. Qualitative factors relate to the quality or character of something, as opposed to size or quantity. Qualitative fundamentals are less tangible factors – things like the quality of a company’s directors and key managers, its brand recognition, patents or proprietary technology.
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