As a stock market investor, you may have frequently come across the term fundamental analysis (FA). However, not everyone understands the meaning of FA. It is primarily a method to determine the intrinsic value of a security by examining the financial and economic factors. The objective is to determine if the stock is currently overpriced or under-priced to make an investment decision.
Investing and fundamental analysis
Analysts use different models based on available data to determine the estimated share price of a particular company. If the analyst determines the price to be higher than the current market price (CMP), he offers a “buy” recommendation. In comparison, if the intrinsic value is estimated to be lower than CMP, the recommendation would be “sell”.
Fundamental investing is contrary to technical analysis-based investing because the latter forecasts price movements based on historical price and volume trends.
Quantitative and qualitative fundamental analysis
Fundamentals may include financial numbers like profits and revenues. It may also include other factors like company management. The fundamental variables are classified as qualitative factors that are based on quality or character and quantitative factors that are measurable or may be expressed as numbers.
- Business model: Although this may appear simple enough, it is not as straightforward as it may seem. For example, if a company is selling fast-food, are the revenues earned through sales of these food products or are they derived from franchise fees and royalties?
- Competitive advantage: The long-term success of any business depends on its ability to sustain its competitive advantage. Sustainable and powerful competitive edge creates a moat that allows the company to create effective barriers to keep away the competition and continue growing revenues and profits.
- Management: Several investors believe that the company’s management is one of the most important fundamental factors that should be considered while investing. This is because if the leaders are not capable, even the most robust business model may not be executed properly. You may search online for their past track record and prior work experience to determine their management capabilities.
- Corporate governance: These are various policies within the company showing the responsibilities and relationships between the directors, management, and other stakeholders. These are determined in the charter and company by laws and corporate regulations and laws. You need to evaluate if the management uses fair, ethical, and transparent practices to run the company.
While conducting the fundamental analysis of stocks, you must also take into consideration market share, customer base, business cycles, industry growth, and competition to determine the intrinsic value.
- Balance sheet: This financial statement is a snapshot of the company’s assets, liabilities, and equity at a particular point of time. Assets are resources that are owned by the company and include inventory, land and building, machinery, and cash. Liabilities represent the borrowed funds needed to acquire the assets. Companies also use equity to fund asset acquisition and are contributed by the owners and built through retained earnings over the years.
- Income statement: The income statement is a measurement of the company’s performance over a particular period. It includes information about the revenues, expenditures, and profits generated by the company through regular operations during that period.
- Cash flow statement: It represents the cash inflows and outflows over a period. It focuses on three primary activities:
- Investing cash flows
- Financing cash flows
- Operating cash flows
Financial statements are used by public companies to disclose their financial performance to the external stakeholders, such as shareholders, lenders, and regulatory authorities.
Have you now understood what is fundamental analysis? In addition to the aforementioned, analysts may rely on ratios calculated from the financial statements to determine the intrinsic value of the shares of the company.
It is recommended that you use fundamental and technical analysis to evaluate whether the company is overpriced or under-priced to make an accurate investment decision.