What is a Fundamental Analysis?
A fundamental analysis is where you analyze a company’s fundamentals (e.g., revenue, future growth, profit margins) and industry and economic conditions. You use this information to determine if the company’s stock is a good investment.
Value investing is based on fundamental analysis so it’s important to understand it. Below, we break down exactly what a fundamental analysis is and how you can get started analyzing company fundamentals before you invest in value stocks.
- Fundamental analysis helps you recognize high-quality companies so you can buy them at bargain prices.
- It involves analyzing three components: the company, the industry, and the economy.
- The company analysis includes calculating financial ratios like price-to-earnings.
- The industry analysis involves reviewing a company’s competitors, their market share, and the industry overall.
- The economic analysis looks at the health of the overall economy, which sectors are performing well, supply and demand, etc.
- Take either a top-down or bottom-up approach to a fundamental analysis.
Fundamental analysis helps you buy great companies at bargain prices.
As a value investor, you want to 1). find high-quality companies, 2). buy them at bargain prices. A fundamental analysis helps you determine what a company is actually worth and if you’re getting the stock at a good price.
Benjamin Graham and David Dodd are the fathers of value investing. They said that the value of a stock should be based on the research of a company’s fundamentals, rather than the reactions of the market.
A fundamental analysis helps you make an educated guess on a company’s cash flows based on how you think the company, industry, and economy will perform. You then determine what the company and stock are worth (and if it’s undervalued).
Here’s where the fundamental analysis fits in the overall process of determining if you should purchase a particular value stock:
Once value investors have determined that a businesses’ fundamentals are strong, they then calculate intrinsic value and other factors like margin of safety. They buy stocks if the price is lower than the company’s intrinsic value.
Fundamental analysis is opposite from a technical analysis. Through stock price charts and patterns, a technical analysis looks at the price movement of a stock or other asset. This information is then used to predict the future price movement of a stock.
In short, technical analysis tries to identify where a stock will go next. Fundamental analysis, the crux of value investing, tries to identify the actual worth of a stock.
It involves three components.
To get the future profit outlook of a company, a fundamental analysis can be broken down into three parts: a company analysis, industry analysis, and economic analysis.
At a micro-level, you look at the company of the stock you want to invest in. You want an overall picture of the company’s financial health (present and future).
You analyze quantitative factors including financial statements such as the balance sheet, income statement, and cash flow statements.
From these statements, you can calculate important financial ratios:
- The working capital ratio
- The quick ratio
- Earnings per share (EPS)
- Price-earnings (P/E)
- Return on equity (ROE)
You also look at qualitative factors such as the business model, the company’s leadership, organizational structure, and competitive advantage.
Part of a fundamental analysis is better understanding the company’s industry and its health. You review a company’s competitors, their market share, and the industry overall.
It helps you understand opportunities, weaknesses, and how your company compares to other companies in the industry. Here are three potential models for completing an industry analysis:
Do an in-depth dive into a company’s industry so you clearly understand industry conditions and how these conditions will impact the company.
Review the economy as a whole to discover any macroeconomic factors that could impact a company’s growth potential and performance.
Look at factors like the health of the overall economy, which sectors are performing well, supply and demand, etc. Important elements include
- GDP (Gross Domestic Product)
- Interest rates
- Employment data
For example, say that the GDP is decreasing and the economy is performing poorly. But consumer staples could still see steady demand and increasing prices as a result. You might determine that grocery companies are a safe investment.
Fundamental analysis can be either top-down or bottom-up.
A fundamental analysis can be completed in two ways: a top-down or bottom-up approach.
The top-down approach is where you assess the economy and industry components first. You want to determine which sectors are best to invest in based on the course of the economy. Once you’ve analyzed market conditions, you select and analyze different companies. You look at the big picture to make investing decisions.
The bottom-up approach is the opposite. You start by analyzing the company and individual stocks, getting an in-depth understanding of the company’s financial health. You then analyze the industry and overall economy.
Hint: We recommend the bottom-up approach. Start with the company’s fundamentals. This is better for long-term investors because you are concerned with the company’s long-term potential, not the market’s short-term ups and downs. It’s also the approach of Warren Buffett.
Get started with fundamental analysis
In short, a fundamental analysis helps you look at the big picture. There’s no one right way to complete a fundamental analysis, but as a value investor, you should conduct one before buying a company’s stock.
You then have an in-depth understanding of your chosen company’s market and sector before making an investing decision.