Fundamental Analysis

What Is Fundamental Analysis?

Fundamental analysis involves examining a company's financial
statements and broader economic indicators to uncover a security's
intrinsic value. The result of such an analysis should give you the
investment's true worth based on a company's financial health, the market,
and economic conditions. Investors perform fundamental analysis to
gauge whether or not to invest in a company based on it's current and
projected worth.

KEY TAKEAWAYS

 Fundamental analysis is a method of determining a stock's intrinsic

value.
 Fundamental analysts search for stocks trading at prices higher or
lower than their real value.
 If the fair market value exceeds the market price, the stock is
deemed undervalued, and a buy recommendation is given.
 If the fair market value is lower than the market price, the stock is
overvalued, and the recommendation might be not to buy or to sell if
the stock is held.
 In contrast, technical analysts favor studying the historical price
trends of the stock to predict short-term future trends.

Understanding Fundamental Analysis

When performing fundamental analysis, you study the company's revenue
growth, profitability, and competitive advantages within its industry. You
also assess macroeconomic factors such as the overall state of the
economy and the demand for the company's products or services. It also
takes into account the effectiveness of the company's management team.
A skilled and experienced leadership team can navigate challenges and
seize opportunities, driving the company's growth and increasing its value.

This approach to the market often allows you to see behind investor
sentiment and company marketing to determine whether the company has
the potential for long-term success. With fundamental analysis, you can
then gauge if the security's market price is over- or undervalued.

Fundamental analysis typically starts by analyzing a company's financial

statements, including the income statement, balance sheet, and statement
of cash flows. The information in these materials can be used to calculate
and assess a company's financial health and intrinsic value. Key ratios
derived from these financial statements include the price-to-earnings (P/E)
ratio, earnings per share (EPS), return on equity (ROE), and debt-to-equity
(D/E) ratio, among others. Fundamental analysts use measures like these
to determine whether a stock is undervalued or overvalued relative to its
market price and competitors.1

In addition, fundamental analysis frequently involves looking at gross

domestic product, inflation, unemployment rates, industry or sector trends,
and the company's competition. Fundamental analysis thus takes how a
company should perform, not just in the market, but as a producer of
goods and services. This requires looking at the overall economy, sector
performance, and the company's position within the industry to estimate its
value and forecast future performance. This approach not only considers
economic and financial data but also often includes reviewing its business
model, management effectiveness, brand awareness, and potential for
growth and profitability.

Ultimately, fundamental analysis aims to give you a number, a value, for

the company you can use when buying, holding, or selling stocks. It
requires a comprehensive understanding of financial statements and a
strategic view of how external factors could impact the company's future
earnings and market position.

Why Is Fundamental Analysis Important?

Fundamentals allow investors to look beyond short-term price fluctuations
and focus on the underlying factors that drive a company's operations and
long-term performance.

The main benefit of fundamental analysis is to help quantify the value of a

company and its shares. Financial statements offer hard data that reveal
insights into a company's profitability, liquidity, and overall financial
stability. This information, along with an assessment of the company's
management team, competitive advantages, and industry trends, furnishes
a picture of the company's fair or target value. With this knowledge,
investors can make more informed decisions about buying, holding, or
selling a particular stock.

Fundamental analysis can also help investors identify undervalued

companies. By considering a company's sales growth, market share, and
product pipeline, investors can gauge its ability to increase future profits
and grow shareholder value. By investing in companies with solid
fundamentals and promising growth prospects, investors can benefit from
long-term trends and capitalize on emerging prospects. Value investors, in
particular, look for undervalued shares relative to their fundamental
potential.2

Finally, fundamental analysis can help you spot red flags and overvalued
investments. By researching a company's financial health and market
position, investors can more easily avoid stocks that may be more likely to
underperform or experience significant downturns. This is especially
important during economic uncertainty or market volatility when a
company's underlying strength can be the difference between weathering
the storm and being pushed out of the market altogether.

Where to Find Fundamentals for a Company

Some of the most common and reliable sources for the fundamentals of a
company include the following:

 Company filings: Public companies are required to file regular

reports with the Securities and Exchange Commission (SEC), such
as Form 10-K (annual report), Form 10-Q (quarterly report), and
Form 8-K (current events report). These filings contain detailed
financial statements, management discussions and analyses, and
other important information about the company. You can access
these filings for free on the SEC's EDGAR database.
 Company website: Most publicly traded companies have an
investor relations section that provides financial statements,
earnings releases, investor presentations, and other relevant
information for shareholders and potential investors. Transcripts of
earnings reports can be particularly helpful since company leads
typically find it necessary to address company soft spots for
journalists.
 Financial platforms: Yahoo! Finance, Google Finance, and
MarketWatch, among others, provide financial news, analysis, and
fundamental data on publicly traded companies, including financial
statements, key ratios, and analyst ratings.
 Broker research reports: Many brokerage firms supply research
reports on companies they and their affiliates cover, often with
detailed fundamental analysis and investment recommendations.
 Financial data providers: Subscription-based financial data
providers such as Bloomberg, FactSet, and Morningstar offer
extensive fundamental data and analysis on companies, industries,
and markets. Subscriptions are often pricey, so they are more
typically used by professional investors and analysts.
 Industry trade journals: Trade publications covering specific
industries can provide valuable insights on industry trends,
 competitive dynamics, and company-specific developments that
inform your fundamental analysis.

Remember, when conducting fundamental analysis, it's essential to use

several sources to get a well-rounded view of a company's financial
prospects and to be aware of any potential biases or conflicts of interest in
the information you're receiving.

Fundamental analysis is used most often for stocks, but it can be useful
for evaluating any security, from a bond to a derivative. If you consider the
fundamentals, from the broader economy to the company details, you are
doing a fundamental analysis.

How to Read a Company's Annual Report

Reading a company's annual report is an essential part of fundamental

analysis. Here's a step-by-step guide on how to read and analyze an
annual report:

1. Start with the CEO's letter to shareholders: This section gives an

overview of the company's performance, key developments, and
outlook from the perspective of top management. Pay attention to
the tone and content of the letter, as it can give insights into the
company's strategy, challenges, and prospects.
2. Review the business description: This section describes the
company's main products or services, target markets, competitive
advantages, and key risks. It can help you understand the
company's business model and the factors that drive its success.
3. Analyze the management's discussion and analysis (MD&A):
The MD&A provides a detailed discussion of the company's financial
performance, including revenue and expense trends, cash flows, and
key financial ratios. It also has management's perspective on the
factors that affect the company's performance and outlook for the
future.
4. Examine the financial statements: The annual report has the
company's audited financial statements, including the income
statement, balance sheet, and statement of cash flows. Review
these carefully while looking for trends in revenue, expenses, profits,
assets, liabilities, and cash flows. From there, you can compute the
critical financial ratios.
5. Read the notes to the financial statements: The notes
(or footnotes) provide additional details and explanations about the
company's accounting policies, significant transactions, and other
important information that may not be clear from the financial
statements alone.
 6. Review the auditor's report: This provides an independent opinion
on whether the financial statements fairly present the company's
financial position and performance following generally accepted
accounting principles. Look for any qualified opinions or disclaimers
that may indicate potential issues.
7. Analyze the company's corporate governance: The annual report
often has information on the company's board of directors, executive
compensation, and other corporate governance matters. Consider
whether the company's governance practices align with the interests
of shareholders and whether there are any red flags, such as
conflicts of interest or excessive compensation.
8. Look for additional disclosures: The annual report may include
additional disclosures about legal proceedings, regulatory issues, or
environmental, social, and governance (ESG) factors that could
impact the company's performance and reputation.

A Closer Look at Financial Statements

The information in financial statements is among the most valuable about

a company's financial health and performance. Here's a breakdown of
what you can learn from each one:

 Income Statement: This shows how much money a company is

making (revenue), how much they're spending (expenses), and then
what's left over (profit or loss). By looking at trends in revenue and
expenses over time, you can get a sense of whether the company is
growing or struggling. You can also calculate important ratios like the
company's profit margin, which tells you how much of each dollar in
sales the company gets to keep as profit.
 Balance Sheet: This gives you a snapshot of what a company owns
(assets), what it owes (liabilities), and what is left over (shareholders'
equity). This can help you assess a company's financial stability and
liquidity. For example, if a company has a lot more assets than
liabilities, that's generally a good sign. You can also look at how
much debt the company has relative to its equity to understand its
financial leverage and risk.
 Statement of Cash Flows: This shows how much cash is coming in
and going out of the company over a given period. It's broken down
into three main categories: cash from operations (the money
generated by the company's core business activities), cash from
investing (the money spent or earned from investments not related to
the core business), and cash from financing (the money raised or
paid out and used to fund the business). By looking at a company's
cash flows, you can better understand its ability to generate cash,
pay its bills, and invest in growth.
The cash flow statement is crucial because it's harder for a business to
manipulate its cash situation. An aggressive accountant can do plenty of
things to manipulate earnings, for example, but it's tough to fake cash in
the bank. For this reason, some investors use the cash flow statement as
a more conservative measure of a company's performance.

A "balance sheet" gets its name because the three sections it contains—
assets, liabilities, and shareholders' equity—must balance out using this
formula:

Assets = Liabilities + Shareholders' Equity

Quantitative and Qualitative Fundamental Analysis

The problem with defining the "fundamentals" is that they can cover
anything related to a company's economic well-being. They can include
numbers like revenue and profit, but they can also include anything from a
company's market share to the quality of its management. Generally, these
are all grouped into two categories: quantitative and qualitative:

 Quantitative: information that can be shown using numbers, figures,

ratios, or formulas
 Qualitative: rather than a quantity of something, it is its quality,
standard, or nature

In this context, quantitative fundamentals are hard numbers, the

measurable characteristics of a business. The most significant source of
quantitative data is financial statements. The qualitative fundamentals are
less tangible. They might include the quality of a company's key
executives, brand-name recognition, patents, and proprietary technology.
Neither qualitative nor quantitative analysis is inherently better. Many
analysts consider them together.

Fundamental analysis relies on using financial ratios drawn from data on

corporate financial statements to make inferences about a company's
value and prospects.

Qualitative Fundamentals to Consider

There are certain qualitative fundamentals that analysts should always

consider when analyzing a company. These include the following:

 The Business Model: What exactly does the company do? This
isn't always straightforward. If a company's business model is based
 on selling fast-food chicken, is it making its money that way? Or is it
coasting on royalty and franchise fees?
 Competitive Advantage: A company's long-term success is
primarily driven by its ability to maintain its competitive advantage.
Competitive advantages, such as Coca-Cola Co.'s (KO) brand name
and Microsoft Corporation's (MSFT) long domination of the personal
computer operating system, create a moat around a business,
allowing it to keep competitors at bay and enjoy growth and profits.
 Management Team: Some think management is the most important
criterion for investing in a company. This 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 do in previous jobs? Have they been unloading a
lot of their stock shares lately?
 Corporate Governance and Board Structure: These are provided
by the policies within an organization indicating the relationships and
responsibilities among management, directors, and stakeholders.
These policies are defined and determined in the company charter,
its bylaws, and corporate laws and regulations. You want to do
business with a company that is run ethically, fairly, transparently,
and efficiently. Note whether management respects shareholder
rights and shareholder interests. Ensure their communications to
shareholders are transparent and understandable. If you don't get it,
if there are major issues you know surround the company and they
aren't addressed, it's not a sign that they have good answers for you.
 Industry Trends: It's also important to consider a company's
industry: its customer base, market share among firms, industrywide
growth, competition, regulation, and business cycles. Learning how
the industry works will give an investor a deeper understanding of a
company's financial health.
 Stakeholder Satisfaction: Employees, managers, customers,
suppliers, investors, and other stakeholders should all have positive
views on the company and its prospects. Without that, a
company's brand equity and image can suffer, which can lead to
fewer sales, lower profits, and flagging share prices.

Quantitative Fundamentals to Consider: Financial Ratios

Financial statements are how a company discloses information about its

financial performance. Here are some of the most important financial ratios
with their formulas:
Key Financial Ratios
Category Ratio Formula
Profitability Gross profit (Revenue - Cost of
margin Goods Sold) / Revenue
Higher margins and returns generally Operating Operating Income /
indicate a more profitable and efficient profit margin Revenue
business.
Net profit Net Income / Revenue
Margin
Return on Net Income / Average
assets (ROA) Total Assets
Return on Net Income / Average
equity (ROE) Shareholders' Equity
Liquidity Current ratio Current Assets / Current
Liabilities
A higher ratio suggests that the company Quick ratio (Cash + Marketable
has enough liquidity to cover its near-term Securities + Accounts
liabilities. Receivable) / Current
Liabilities
Solvency Debt-to-equity Total Liabilities / Total
ratio Shareholders' Equity
These ratios measure a company's ability to Debt-to-assets Total Liabilities / Total
meet its long-term debt obligations. Lower ratio Assets
debt ratios and higher interest coverage
ratios generally indicate a more financially
stable company.
Interest Operating Income /
coverage ratio Interest Expense
Efficiency Asset turnover Revenue / Average
ratio Total Assets
These ratios measure how effectively a Inventory Cost of Goods Sold /
company manages its assets to generate turnover ratio Average Inventory
sales. Higher turnover ratios suggest that
the company is using its assets more
efficiently to generate revenue.
Receivables Revenue / Average
turnover ratio Accounts Receivable
Valuation P/E Market Price per Share /
Earnings per Share
Lower ratios may indicate that the stock is Price-to-book Market Price per Share /
undervalued, while higher ratios may (P/B) ratio Book Value per Share
suggest that it is overvalued.
Price-to-sales Market Price per Share /
(P/S) ratio Revenue per Share
Dividend yield Annual Dividends per
Share / Market Price per
Share
Fundamental Analysis vs. Technical Analysis
Fundamental analysis contrasts starkly with technical analysis, which
attempts to forecast prices by analyzing historical market data such as
price and volume. Technical analysis uses price trends and action, often
plotted on charts, to create indicators and identify patterns. Some
indicators develop patterns that have names resembling their shapes,
such as the "head and shoulders" pattern.

A major distinction is where "value" comes from. For technical analysts,

the market sets prices, and hence, the changes there give a company its
value. For fundamental analysts, there is an intrinsic value that the market
can often miss.

Fundamental vs. Technical Analysis

Fundamental Analysis
 Estimates the intrinsic value of a company from its operations
 Considers a company's financial statements and qualitative factors
 Longer-term focus (months/years)
 Best for buy-and hold investing

Technical Analysis
 Looks at price and market trends to uncover market psychology
 Considers historical prices and chart patterns
 Shorter-term focus (days/weeks)
 Best for short-term or swing trading

Limitations of Fundamental Analysis

Though fundamental analysis can provide investors with insights into the
future of a company, it does come with some downsides. Keep these items
in mind when performing fundamental analysis:

 It's Time-Consuming: Fundamental analysis involves a detailed

examination of financial statements, economic data, industry reports,
and company-specific factors. This process requires collecting
extensive data, performing complex calculations, and interpreting
various financial metrics - which all times time (which leads into the
next downside....).
 It's A Lagging Indicator: In addition to being a slow process,
fundamental analysis often acts as a lagging indicator because it
relies on financial data that reflects past performance. By the time
changes in a company’s fundamentals become apparent in its
financial statements, the stock price might have already adjusted.
 Relies on Historical Data: Similarly, fundamental analysis is based
largely on historical financial information. While this data provides a
basis for estimating future performance, it may not fully capture
future risks or opportunities, as past performance is not an indicator
of what's to come in the future.
 Subject to Accounting Practices: The accuracy of fundamental
analysis depends on the integrity and transparency of a company’s
financial statements. Keep in mind that things like management
estimates, depreciation, or other GAAP-compliant requirements can
(perhaps improperly) impact the fundamental analysis.
 Difficult to Value Intangibles: Intangible assets like patents,
trademarks, brand reputation, and human capital are increasingly
important in today’s economy. However, these assets are
challenging to quantify and may not be fully reflected in a company’s
financial statements. Consider how some investors would have
believed in Apple simply because of Steve Jobs; that notion is not
captured in fundamental analysis.
 Economic Assumptions: Fundamental analysis often involves
assumptions about future economic conditions such as interest
rates, inflation, and economic growth. Again, these are always
changing and may not materialize as expected.
 Overlooked Short-Term Opportunities: Fundamental analysis is
geared towards long-term investment decisions, focusing on a
company’s intrinsic value and potential for growth over time. This
long-term focus might cause investors to miss short-term trading
opportunities that technical analysis can identify such as price
patterns, volume spikes, or momentum indicators.