Fundamental Analysis

Meaning of Fundamental Analysis

Fundamental Analysis is an approach for market prospects analysis of a security or stock. It covers the financial as well as the complete business ecosystem. It is a useful analysis in the long run for long-term investment decisions in stocks and securities. Analyst conducts this analysis to find the influence of various factors that affect the intrinsic value of financial security or stocks. The analyst considers multiple factors and sources to understand and appreciate the impact. These factors and sources are like financial statements, industry trends, external events, the general economic situation of the country, and their influences.

Factors Considered for Fundamental Analysis

This analysis considers both macro and microeconomic factors. Macro-economic factors include economy-related aspects that affect the company’s performance. While the microeconomic factors are company-specific factors like management effectiveness, earning capacity, etc.

The analyst uses these factors to analyze the fair market value of a stock or security. After that, the analyst attempts a comparison of the fair market value so arrive at the current market price of the security. It is to find out whether the stock is undervalued or over-valued. And then take the investment decision accordingly. The key questions are – Whether the timing is the right time to invest?  Is the security has enough potential with regard to return and appreciation? And what could be the reasonable timeline for such appreciation and so on?

If the fair market value calculated using this analysis is higher than the current market price, then the stock is recommended to buy. Because it is assumed to be undervalued and vice versa. Lastly, this analysis is not only limited to stocks. However, we must note that such an analysis happens and remains useful for other classes of securities like bonds, debenture, and other related financial instruments.

Approaches for Fundamental Analysis

Majorly there are two approaches for fundamental analysis.

• Top-down Analysis
• Bottom-Up Analysis

Top-down analysis is more like a funnel wherein the analysis begins with a broader perspective of the economy. Then it moves to sector and industry-specifics. While in the bottom-up approach, the analysis begins with the specific stock/security of the company, followed by sector specifics and then general economic status respectively.

Tools used for Fundamental Analysis

The analyst uses multiple tools for this analysis depending on the type of security or instrument being analyzed. For instance, some might use the company’s annual report for analyzing the earning capacity, total revenues generated, and the growth of EPS on a quarter on a quarter or year on year basis.

Fundamental Analysis includes

1. Economic Analysis
2. Industry Analysis
3. Company Analysis

Economic Analysis

It becomes very crucial to analyze the economy in detail to identify different macro factors and their influence on the company’s performance that will ultimately reflect and impact the potential of the stock/ security under analysis. For this analysis, the analyst considers various aspects like the overall growth of the economy, inflation or deflation, ruling political dispensation, geo-political situation, etc.

Industry Analysis

The overall performance and prospects of the industry have a direct impact on the company’s performance. Therefore, industry analysis is an integral part of fundamental analysis. Hence, the analysts also consider this part in their analysis. For this analysis, the analysts consider various aspects like how the industry works, market share of the company and competitors, the overall growth of the sector, its future prospects, bargaining power of customers, the new threat of entrants, rivalry among competitors, etc.

Company Analysis

The organization’s internal performance is the most crucial part of fundamental analysis. When the analyst conducts the company analysis, they consider two aspects of the company, i.e., quantitative and qualitative performance of the company.

Qualitative and Quantitative aspect of Fundamental Analysis

The quantitative aspect of fundamental analysis is related to the performance measurable in figures or numbers. For this, the analyst looks in-depth at the various financial statements, schedules, and supporting documents. They analyze data relating to revenues, profits, returns, and various profitability and efficiency measures.

They also evaluate the qualitative parameters like the composition of key executive members, their tenure of association and experience, the goodwill of the company, brand name, and popularity, etc. Analysts prefer using a combination of both qualitative and quantitative aspects of this analysis before reaching a conclusion.

Quantitative Aspect

In this aspect of analysis, the analyst considers different quantitative information for decision making. The analyst evaluates quantitative information from publicly available annual accounts and financial statements. These key statements are the income statement, balance sheet, and cash flow statement.

Income Statement

It is a mirror of the operating activity and performance of the company during the given accounting period. It describes the various sources and types of income and expenses of the company during the period under consideration. Moreover, this statement shows the net income or profits earned after meeting all the expenses. It can be that the company has more expenses and less income resulting in a net loss for the period.

Balance Sheet

It discloses the company’s assets and liabilities and shareholders’ kity at a given point in time.

Assets = Liabilities + Shareholders’ Funds

Assets are what the company owns and controls, while the liabilities are the total debts and other payables of the company.

And shareholders’ kity is what has been contributed by shareholders for acquiring the company stocks and the total of funds generated by the company in the form of profits through its business operations over the years.

Cash Flow Statement

The cash flow statement shows all transactions affecting the movement of cash, i.e., all cash inflows and outflows of the firm in a given tenure. It records multiple cash-related activities to determine the actual cash balance at the end. The following three activities are part of this statement.

1. Operating Activities related to Cash Flow: Cash spent or generated from various business operations or operating activities.
2. Investment Activities related to Cash Flow: Cash utilized for asset/security investments or cash received from selling off them.
3. Financing Activities related to Cash Flow: Cash received from borrowings or cash receipts for the issue of stocks and securities.

Types of Analysis from these Statements

All these financial statements and their numbers gives way to basic analysis of the company related with monetary aspects. These are:

Ratio Analysis

Through ratio analysis technique and based on the numbers reflecting in these statements, various types of analysis is happens. This assessment is with regard to business and operational growth on various time frames, business stability, business solvency and debt capacity, operational efficiency and profitability indications, asset utilization, status of short term and long term liquidity, etc.

Trend Analysis

By comparing and ascertaining the company’s operations on various parameters, over several years, the analysts try to draw a trend of growth, profits, cash earnings, etc. with the help of trend analysis. 

Inter-firm Comparison

The analysts also try to compare the company’s performance with other company’s in a similar industry segment, or vis-a-vis average industry performance. This is to see and confirm whether the company’s performance is good, bad or at par with the industry average. How good is the company’s performance as compared to the industry leaders, etc. 

Future Projections

By combining the results of all the above indicators and parameters future projection of company’s performance and in turn the company stock’s or securities’ performance happens over the next 2-5 years. 

Qualitative Aspect

In this area the analysts consider the following things to evaluate the quality of the company:

Goodwill/Brand Recognition

Brand recognition among customers is very crucial in acceptance of the product or service by the company which in turn affects the goodwill of the company in the market

Competitive Advantage

The ability to maintain a competitive advantage leads to the success story of a company

Business Model

It tells about the business and various operations about how the business functions.

Management

Management is a team of key executives which determines the policies and functioning of the company. Their experience, track record, length of their association with the company and their stability is of vital importance. This provides the stability to the vision, process and operations of the company.

Corporate Governance

It shows the policy implementation within the organization and the interrelation and responsibilities of key executives and various stakeholders. Moreover, the compliance of various regulations and statutory requirements, coupled with the transparency in various transactions.

Pros and Cons of Fundamental Analysis

Pros

Detailed Analysis

The analysis involves evaluating the financial statements of the company. Along with that, evaluation of the industry and economy-specific impact on the instruments also happens simultaneously. So it is a broader approach leading to the avoidance of personal biases and preferences. Hence, a correct and reasonably fair evaluation can happen.

Beneficial in the Long Term

This analysis is useful in the long run as it considers multiple areas affecting the stocks and securities. Hence, it proves to be more fruitful in the long run to the investors. We need to keep in mind that ultimately it is the fundamental analysis and good business performance expectation that helps the long-term investment.

Cons

Time-consuming

Since the analysis involves various approaches like company and economy analysis together, it is a bit time-consuming.  Because it tries to cover all the macro and micro factors affecting a stock’s/securities’ performance.

Lost Opportunities

If the analyst wants to make a quick decision than this analysis may not be useful as it is time-consuming. And detailed analysis leads to delay in decisions. As a result, the actual and timely opportunity might be lost by the investor.

Complicated and Subjective Analysis

As this analysis considers all the micro and macro factors together and multiple areas are analyzed simultaneously. Therefore, it becomes a little complicated. Secondly, it also becomes subjective, because there are so many qualitative factors where putting a numerical value is a combination of experience and personal biases.

Conclusion

Thus, fundamental analysis is the primary and important analysis that helps in making investment decisions in stocks and other related securities and instruments. This is vital for long term investments as in the long run there are various macro and microeconomic factors that affects the business operations and thus the performance of the company’s stocks and securities.

Also read – Fundamental vs Technical Analysis.