Understanding Fundamental Analysis
Fundamental Analysis vs. Technical Analysis
Quantitative and Qualitative Fundamental Analysis
Qualitative Fundamentals to Consider
Quantitative Fundamentals to Consider: Financial Statements
Fundamental Analysis Pros And Cons
Example of Fundamental Analysis
Fundamental analysis is an integral part of trading. Fundamental and technical analysis go hand in hand in the economics of equity firms, currencies, and cryptocurrencies. For some, fundamental analysis sounds a little threatening, but in reality everything is not as complicated as it might seem at first glance. And in this article we will cover all the subtleties and aspects of fundamental analysis.
Fundamental analysis is a method of analyzing and predicting the behavior of the foreign exchange market and other financial markets, taking into account fundamental factors. As a rule, it is used for planning long-term investments.
There are four categories of fundamental factors:
Key takeaways:
As we have already mentioned, fundamental analysis is an analysis of the value and future changes in the value of assets taking into account macroeconomic and microeconomic factors. Why do fundamental analysis?
There are several reasons:
There are several fundamental analysis resources, these include: reports for the 10th quarter (quarterly), annual reports, 10-K (annual) reports, as well as the 8-K report which is filed when major changes occur in the company, such as a change management, change of company ownership.
All these resources are usually published on company websites, in the section for investors. To conduct fundamental analysis, you can analyze the economics of the company's industry, key economic factors (such as interest rates), bond performance, and, of course, pay special attention to the reports of the company or companies you are interested in. We must also not lose sight of the main goals and directions of companies and their changes in credit ratings. Fundamental analysis uses a company's earnings, sales earnings, future growth, return on equity, profit margin, and other data to determine a company's underlying value and future growth potential.
Stock prices may not always reflect the intrinsic value of a company. And fundamental data is more likely to provide the correct assessment. For example, the market price of a stock is $20, but based on fundamental analysis and company reports, one analyst will conclude that the stock should be worth $24, and another will say that it should be worth $26. Investors often consider the average fair value of a stock to be $25. Determining the exact value of a company can be difficult, but approximations can be obtained from fundamental characteristics.
Another argument that proves the benefit of fundamental analysis is that in the long term, the stock market will reflect fundamental indicators. Based on the company's fundamental data, an investor can buy shares at a discount or sell at a premium. The investment will pay off when the market reaches fundamentals.
Fundamental analysis is most often used to evaluate stocks, but it is useful for evaluating any security, from bonds to derivatives. When you look at fundamentals, from the overall economy to the details of a company, you are performing fundamental analysis.
Both methods try to solve the same problem: to determine the direction of further price movement, but they approach it from different angles. Fundamentalists study the reasons driving the market, and technical analysts study the results. The fundamentalist constantly asks the question: "Why?" The technical analyst believes that the reason is not important because the price takes everything into account.
It is the understanding of the reasons, even “in hindsight,” that is the psychological advantage of fundamental analysis. With a lack of understanding of what is happening in the market, the trader is overcome by fear and thoughts that the market is unpredictable and uncontrollable.
At the same time, the disadvantage of fundamental analysis is its lag relative to the price. The most significant trends in history began in an environment where nothing, or almost nothing, in terms of fundamentals, indicated any change. When these changes became clear to fundamental analysts, the new trend was already developing in full force.
It would seem that fundamental analysis is more rational, but fundamental news is often ambiguous - the same indicator values in different economic situations lead to different results. The reason is similar, but the consequences are different.
Technical analysis is an excellent forecasting method, but it is also not a panacea. Therefore, to some extent, neither fundamental nor technical analysis are complete, but harmoniously complement each other. Accordingly, both technical and fundamental analysis are integral components of most trading strategies. Moreover, if technical analysis helps us choose a point to enter the market and an exit point, then fundamental analysis helps us understand the essence, causes and consequences of certain processes and changes occurring in the market. The time period also matters. Thus, in short-term trading, “technique” undoubtedly dominates, and in medium- and long-term strategies, the emphasis, as a rule, is on the macroeconomic situation. Fundamental analysis is, first of all, an understanding of everything that happens in the market, since any significant changes in exchange rates are based on the movement of capital, changes in monetary policy, and the reaction of market participants to economic and geopolitical events.
Since fundamental analysis covers many economic factors that together determine the level of well-being and prospects of a company, sometimes difficulties arise in determining fundamental factors. What does fundamental analysis refer to?
All factors of fundamental analysis can be divided into two categories: qualitative and quantitative.
Quantitative indicators are always more accurate as they are based on numbers and mathematics. Qualitative indicators can be more imprecise or subjective; qualitative indicators include the quality of work of the company's employees, brand awareness, patented technologies, and so on. In order to conduct a good analysis of a company, you need to take into account both qualitative and quantitative indicators.
There are four key fundamentals that analysts always consider when regarding a company. All are qualitative rather than quantitative. They include:
You need to understand what exactly the company does? What activities does she conduct? A company can make money on the specific products it produces, or it can make money on royalties and franchises.
It is important that the company has a competitive advantage, since it is this that will be able to provide shareholders with profits for many years. Competitors who do not have anything outstanding will not be able to stay afloat for long, unlike companies that are always several steps ahead.
Some believe management is the most important criterion for investing in a company. It makes sense: Even the best business model is doomed if the company's leaders fail to execute the plan properly. While it's hard for retail investors to meet and truly evaluate managers, you can look at the corporate website and check the resumes of the top brass and the board members. How well did they perform in previous jobs? Have they been unloading a lot of their stock shares lately?
The heart of a company is its management, not only those in leadership positions, but also company policies, corporate and regulatory standards. You must be confident that communications between shareholders and management are transparent and clear. A good investment requires a company that operates ethically, fairly, transparently and efficiently.
The following factors are no less important: customer base, market share among firms, industry-wide growth, competition, regulation, and business cycles. Learning how the industry works will give an investor a deeper understanding of a company's financial health.
Moving on to the mathematical component of fundamental analysis, below we will talk about quantitative factors:
The balance sheet represents a record of a company's assets, liabilities, and equity at a particular point in time. It is called a balance sheet because the three sections—assets, liabilities, and shareholders' equity must balance using the formula: Assets = Liabilities + Shareholders' Equity
Assets represent the resources the business owns or controls at a given time. This includes items such as cash, inventory, machinery, and buildings. The other side of the equation represents the total financing value the company has used to acquire those assets.
Financing comes as a result of liabilities or equity. Liabilities represent debts or obligations that must be paid. In contrast, equity represents the total value of money that the owners have contributed to the business—including retained earnings, which is the profit left after paying all current obligations, dividends, and taxes.
The profit and loss statement is one of the most important and basic indicators of fundamental analysis. It shows the profitability of a company over a certain period, while the balance sheet shows the financial condition of the company at a time.
The cash flow statement serves as a financial compass, charting the monetary currents flowing in and out of a company over a specified timeframe. This fiscal document typically zeroes in on three key areas of cash movement:
1. Investment Cash Streams (ICS): This tracks the capital deployed for asset acquisition and the influx from divesting businesses, equipment, or long-term holdings.
2. Financial Funding Flows (FFF): This captures the ebb and flow of funds related to capital raising and debt management activities.
3. Core Business Cash Generation (CBCG): This reflects the lifeblood of the enterprise - money produced by routine operational activities.
The cash flow statement holds particular significance due to its resistance to financial sleight of hand. While creative accounting can paint a rosy picture of earnings, it's far more challenging to fabricate actual cash reserves. Consequently, some savvy investors regard the cash flow statement as a more reliable barometer of a company's true financial health, using it as a pragmatic counterpoint to potentially embellished performance metrics.
Fundamental analysis has its advantages and disadvantages:
Advantages
Disadvantages:
There is a lot of news published, and it is quite difficult to correctly interpret and compare the data. In addition, fundamental analysis does not always indicate the direction of the trend and the best points to enter a trade and close a position.
Conducting fundamental analysis with all its stages will be difficult and time-consuming for a private investor, so you can rely on the reports of professional analysts. If an investor wants to create an investment strategy on his own, he can select one or more financial indicators of companies, compare them and select the desired assets.
For example, investors can invest in companies whose shares have risen steadily over a long period of time. Such companies will have a higher P/E multiple than other companies in the industry with lower growth rates. Investors can also use fundamental analysis to calculate undervalued companies - they have P/E (capitalization to earnings ratio), P/S (capitalization to revenue) and P/BV (capitalization to equity ratio) multipliers. will be below industry and market averages. Their securities may rise significantly in price in the future and bring profit to the holder, although at the current moment they will show relatively low returns.
We can also consider fundamental analysis with more detailed metrics using a separate example. Dive into the financial underpinnings of a fictional enterprise, ABC Inc., through the lens of fundamental analysis. We'll dissect its fiscal records and crunch the numbers on crucial ratios, painting a vivid picture of the company's economic vitality and operational prowess.
First, let's look at some data from ABC Inc.'s financial statements for the previous fiscal year:
| Income Statement ($ millions) | Amount | Balance Sheet ($ millions) | Amount |
|---|---|---|---|
| Revenue | $1,000 | Assets | |
| Cost of Goods Sold | $600 | Current Assets | $750 |
| Gross Profit | $400 | Cash | $200 |
| Operating Expenses | $200 | Marketable Securities | $250 |
| Operating Income | $200 | Accounts Receivable | $300 |
| Net Income | $150 | Non-Current Assets | $750 |
| Total Assets | $1,500 | ||
| Liabilities | |||
| Current Liabilities | $250 | ||
| Non-Current Liabilities | $250 | ||
| Total Liabilities | $500 | ||
| Shareholder Equity | $1,000 |
| Cash Flows from: ($ millions) | Amount | Stock Information | Amount |
|---|---|---|---|
| Operations | $250 | # Shares Outstanding | 100 million |
| Investments | $100 | Stock Price | $25.00 |
Now, let's calculate some key ratios:
Profitability Ratios:
ABC Inc.'s financial health shines through its profitability metrics. The company boasts a robust 40% gross margin, indicating strong pricing power or efficient production. Its operations yield a respectable 20% operating margin, while the bottom line remains hearty with a 15% net margin. The firm's asset utilization prowess is evident in its 10% return on assets (ROA), and shareholders have reason to cheer with a 15% return on equity (ROE). These figures paint a picture of a company adept at converting resources into profit across various stages of its business cycle.
Liquidity Ratios:
ABC Inc.'s financial snapshot reveals a liquid powerhouse. With $750 million in current assets facing off against $250 million in short-term debts, the company's coffers are brimming. Its current ratio of 3.0 and quick ratio of 2.2 paint a picture of a firm that could easily weather a financial squall. In short, ABC Inc. isn't just staying afloat – it's riding high on a wave of fiscal flexibility.
Solvency Ratios:
ABC Inc.'s financial tightrope act is a sight to behold. With a debt-to-equity ratio of 0.5 and debt-to-assets at 0.33, the company's borrowed burden is more feather than an anvil. This fiscal finesse means ABC Inc. isn't just treading water – it's swimming laps around its long-term obligations, with plenty of financial oxygen to spare.
Valuation Ratios (Assuming ABC Inc. has 100 million shares outstanding and its stock price is $25 per share):
ABC Inc.'s stock seems fairly priced. You pay $16.67 for every $1 of earnings, which is normal. The stock costs 2.5 times what the company owns and 2.5 times its yearly sales. This means ABC's stock isn't a steal, but it's not overpriced either. It's just about right. But remember, there's more to a company than just these numbers, there are also qualitative fundamentals:
Competitive Advantages:
Industry Trends:
Corporate Governance:
Fundamental analysis is one of the key parts of investment analysis. Fundamental analysis allows you to understand the overall picture of a company's prospects, its future profitability and intrinsic value.
The main three components of fundamental analysis are general economic analysis, industry analysis and company analysis.
Fundamental analysis in stocks is the determination of a company's intrinsic value; it can often differ from the value on the stock market.
Fundamental analysis is divided into two components: quantitative analysis and qualitative analysis.
The main tools of fundamental analysis are Balance sheet, Income statement, Cash flow statement, Profitability ratios (e.g., ROE, ROA, profit margins), Liquidity ratios (e.g., current ratio, quick ratio), Solvency ratios (e.g., debt-to-equity , interest coverage), Valuation ratios (e.g., P/E, P/B, P/S).
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