Fundamental Analysis 101

Fundamental Analysis 101

Fundamental analysis is the tool investors use to determine the true value of a financial security. Investors use fundamental analysis to answer questions like profitability, viability, strength of a business model, and more. Fundamental analysis is essentially the opposite of technical analysis.

Financial statements, economic factors, and anything that can affect the value is used to perform fundamental analysis. It is mostly used for evaluating stocks, bonds, and commodities but can be used on other financial instruments. Value investors and disciples of Warren Buffet use fundamental analysis as their main investing strategy.

Basic Principles of Fundamental Analysis

  • Fundamental Analysis is used to evaluate a stocks real or “intrinsic value.”
  • A fundamental analyst uses financial facts and information that is measurable.
  • The main idea is to wholly understand a company, the industry, it’s profitability, competitive advantage, and future potential.
  • If the market price is lower than the determined intrinsic value, the stock is considered undervalued and vice versa.

Key Financial Documents

  • Statement of Cash Flows: Cash flow statements show how well a company is managing its cash.
  • Balance Sheet: A balance sheet is the summary of a firm’s financial position. It provides the company’s assets, liabilities, and shareholders equity. 
  • Income Statement: The income statement includes the company’s profit and loss statement as well as a summary of revenues and expenses.
  • Annual Financial Report (10-K): The 10-K form is required by the US Securities and Commission Exchange (SEC). It is a comprehensive report that gives a summary of a company’s financial performance.
  • Earnings Press Release: The earnings press release is the official statement of the company’s earnings over a specific time period.
  • Quarterly Financial Report (10-Q): The 10-Q is another comprehensive report required by the SEC that gives a summary of a company’s performance over a quarter.

Quantitative Fundamental Factors

Quantitative fundamental factors uses data that can be counted, measured, and expressed with numbers.

Cash Flow

You will want to study the cash flow from operations, investing and financing. 

  • Cash flow from operations will show an investor how well the company is profiting from its day to day business operations. 
  • Cash flow from investing determines how much the company has spent on investments and the amount of cash flow generated from investments.
  • Cash flow from financing shows how the company borrows money, raises capital, pays dividends, and repays debt. 

Net Sales

Determining the net sales is necessary for calculating other important factors like net profit. Net sales helps to put the company’s growth, current/future performance and financial health in perspective.

Net Profit

Net profit is the amount left after subtracting the total expenses from revenue. It’s an important factor that shows how much a company is earning or losing within a specific time period. Net profit is often referred to as the bottom line or net earnings.

Dividend

A company will use dividends to distribute corporate profits to its shareholders. It’s important to analyze the dividend history over the long term. Companies that consistently increase their dividend tend to be better long-term investments. Not all stocks pay dividends. Investors would instead focus on the share price increasing. This is known as capital appreciation.

Earnings Per Share (EPS)

The EPS is the amount of net profit earned per share of outstanding stock. This is how much each share of stock gets if all the yearly profit is distributed to the shareholders. Higher earnings per share indicates the company is more profitable. Compare the EPS over the years and against other companies within the same industry. Ideally, you will want the EPS to consistently improve each year.

Book Value Per Share (BVPS)

Book value is the difference between the company’s total assets minus all of its liabilities. Book value is also referred to as carrying value or intrinsic value. To get the book value per share, you divide the book value by the number of outstanding shares. Book value per share is used to determine if the company is under or overvalued compared to the current market value.

Return on Equity (ROE)

The return on equity is the return a shareholder receives. It is calculated by dividing the net income by the shareholder’s equity. High ROE indicates a company is producing good returns for the shareholders. Low ROE can indicate poor performance or poor management. Compare the ROE to the company’s debt, because high debt levels can inflate ROE. This isn’t necessarily a bad thing but could be a problem in poor market conditions and if the business is slowing.

Qualitative Fundamental Factors

Qualitative fundamental factors uses data that’s defined based on characteristics and is not able to be expressed numerically.

Business Model

Study the business model of the company and get a deep understanding of what the company does. You will want to know how the business creates value, who its customers are, and how it makes money.

Customer Base and Satisfaction

Study the customers of the business, are they within a specific demographic? Is the customer base growing or decreasing? How satisfied are its current customers? If the business has loyal customers it can be taken as a good sign. If the customer base is dissatisfied, there could be larger issues ahead.

Competition and Economic Moat

Determine the business’s advantage over its competitors. Find out who the competition is how and how they compare. Companies with no advantage over their competitors will have weak or decreasing profit margins.

The economic moat is the company’s ability to consistently maintain its advantage over its competitors. A company with a large economic moat means its long-term profits are protected against competition.

Management

How a business is managed is very important, a poorly managed company can destroy even the biggest companies (take a look at GE for example). Listen to conference calls, read management comments, pay attention to decisions made by the management team. Study the CEO, CFO, COO and other key members of management. Analyze their track records and experience.

Questions to Ask while Performing Fundamental Analysis

  • Is the company profitable?
  • What is the industry outlook like?
  • Does the company have high employee turnover
  • Is the company an industry leader? Why or why not?
  • Is the company overburdened with debt?
  • How will the company perform in a bear market or recession?
  • Is the market price currently over or undervalued?
  • Does the company have any serious threats to its current business model?
  • Does the company have consistent growth?