A Guide to Fundamental Analysis

  • Neelam Tyagi
  • Feb 03, 2021
  • Financial Analytics
A Guide to Fundamental Analysis title banner

In recent years, a huge interest can be seen in the global finance market, especially the equity market,  especially the high return potential of equity markets attract much interest. 

 

On the other side, many investors have suffered massive losses while investing in the incorrect stock, therefore, the crucial understanding of companies is demanded before investing in them. One of the several methods of equity analysis is renowned as the Fundamental analysis. 


 

What is Fundamental Analysis?

 

In simple words, fundamental analysis is the evaluation process of analyzing a business at an utmost basic or fundamental financial level. For example, key ratios of the business are examined to determine its financial health. 

 

Also, this analysis can provide a sense of the value in regards to what’s the company stock predicted to trade, depending on the approximate appraisal of similar companies. It takes into account several factors such as revenue, asset management, business yield, interest rates, etc. 

 

Fundamental analysis is the study of underlying factors that can influence the worthiness of the economy, industries and companies. It aims to derive anticipations and profit from forthcoming price movements.

 

For example, at an organizational level, the fundamental analysis includes investigation of financial data, management, business knowledge and rivalry. At the industrial level, an examination, on supply and demand forces for offered products, is conducted. 

 

In accounting and finance, fundamental analysis is the method of determining the intrinsic value of a security by examining many microeconomic and macroeconomic factors. Aiming to quantify the intrinsic value of a security that can be correlated with the current market price to assist in making investment decisions.

 

(Also read: Economic growth vs economic development)

 

Moreover, for the national economy, the fundamental analysis concentrates on economic data to determine the present and future expansion of the economy. In order to anticipate the forthcoming stock prices, the analysis incorporates economic, industry and company analysis for extracting out the adequate value of current stock and forecasted future value. 


 

Top-Down vs Bottom-Up Fundamental Analysis

 

Fundamental analysis can be conducted either a top-down or bottom-up, 

 

For top-down analysis, an investor takes into account the overall health of the company and analyzes the various macroeconomics elements such as the interest rates, inflation, and GDP levels. He/she attempts to determine an entire course of the economy and also discovers which industries and sectors are providing the best investment chances.

 

After it, an investor embraces particular prospects, favourable circumstances under the recognized industries and sectors. In the end, he inspects and picks out specific stocks under the utmost potential industries. 

 

The alternate of this is the “bottom-up approach”, 

 

Under this approach, an investor dives directly into the analysis of individual stocks rather than starting analysis from the larger-scale. The hypothesis behind the bottom-up approach is that individual stocks can function much more efficiently than the complete industry.

 

Precisely, the bottom-up approach converges on several elements of the microeconomic such as earnings and financial analysis and measurements of the company. Analysts design an extensive evaluation of each company in order to gain important insights and its operations’ understanding.


 

Benefits and Drawbacks of Fundamental Analysis

 

Listing below some essential benefits;


 

  1. Fundamental analysis diverges on the long term approach, analysts, who identify industry trends and the best-positioned companies to benefit from them, can derive the dividends precisely.

  2. Investors can discriminate amid several opportunities while share markets deviate in a group, for instance, oil company share price will move up or down on the basis of supply and demand and price of Brent crude, that can cover the distinctness between rival companies and the edges they can have.

  3. Anticipated earnings can propel share value since fundamental investors conduct thorough research on the business and domains (resources) that can provide them with the relevant information. 

 

(Related blog: factors affecting the PED)

 

  1. Fundamental analysis aids traders and investors to accumulate the correct information for making deliberate decisions regarding what action to take, it helps in limiting chances for personal biases.

  2. It determines the value of an asset so that marketers can view the market in enough time instead of fixing entry and exit points. After obtaining the numerical value of an asset, marketers can correlate it to the current market value to establish whether the asset is worth in terms of undervalued or overvalued while aiming to get profit from the market amendment.

 

Following are the drawbacks of Fundamental analysis;

 

  1. One of the main weaknesses of the fundamental analysis is “the time consuming”, conducting the fundamental research needs lots of time, gathering all the information from the business plans to financials and determining ratios, even analyzing and studying each report consumes plenty of time that can delay the investment on time.

  2. While conducting the financial analysis, it becomes necessary to research as per the company or industry, and individual approach must be different for each of the company or industry, and hence that is difficult to understand which approach needs to be adopted.

  3. The valuation is based on financials, provided by the company itself and that can be biased since a company can alter its financials to increase or decrease its share price.

 

(Recommended blog: Capitals in economics)

 

 

Fundamental Analysis Tools

 

Incorporating suitable fundamental analysis tools helps in creating a new picture of how the stock is valued; also, most of these tools focus on earnings, growth, and value in the market. Below are some tools used by analysts for research;

 

  1. Earnings per share (EPS): Only earnings and shares cannot state the worth of the company on its own, but integrating them can be a favourable ratio used for company analysis. 

 

It tells the quantity of the company’s profit assigned to individual shares of stock and calculated as net income (after deducting dividends on selected stock) divided by the number of outstanding shares of the company. 

 

It is significant as it makes investors understand the wealth aggregation strengths of the company’s shares.

 

(Must read: Financial analysis introduction)

 

  1. Price-to-earnings ratio (P/E): This ratio can be measured by dividing the price of the shares (current sale price) in the market to the earnings per share.

  2. Projected earnings growth(PEG): It predicts the earnings growth rate per year of the stock and gives a good picture of the growth projects of the company. Everything being equal, stocks with better growth prospects, etc are imperative than lower growth rates.

  1. Price-to-sales ratio(P/S): It recognizes the price of the stock as related to the revenues, and sometimes known as the PSR, Revenue Multiple, or Sales Multiple. It also aids in knowing the progress of the share price over the revenue made in the year.

  2. Price-to-book ratio(P/B): Also known as the price-to-equity ratio, it compares the book value of a stock to its market value, where a book value is the value of an asset as it reflects in the company’s book. It can be derived by dividing the most recent closing price of a stock to last quarter’ book value per share and provides an idea over a company’s stock price as compared to its assets. 

  3. Dividend payout ratio: To compare the dividends paid out to the stakeholders out of the total net income (profit) of the company, the dividend payout ratio is used. Plus, to get retained earnings of the company, ie, income that is not paid out, but kept for potential growth.

  4. Dividend yield: It is the ratio that provides annually dividends in comparison to share price and expressed in percentage. Basically, split the dividend payments per share by the value of a share in a year. 

  5. Return on equity: It is measured by dividing the net income of the company by stakeholders’ equity and provides the return made on the equity of the company, also expressed as company’s return on the net worth.


 

Fundamental vs Technical Analysis

 

Where fundamental analysis directs underlying factors in economic and financial areas that can influence a business, on the other side, leveraging prior stock knowledge and data, technical analysis anticipates future price fluctuation. So, let’s understand some core point of differences;

 

  1. Firstly, fundamental analysis begins with the financial statements of the company that seeks/determines the intrinsic value of the company by analyzing its income statement, balance sheet and cash flow statement. 

 

Basically, the intrinsic value of a stock can be measured by discounting the value of future estimated cash flows to the net current value. If the stock trades beneath the intrinsic value of the company, you can invest in it.  

 

On the other hand, the technical analysis initiates with the charts and supposes that a stock value depicts or incorporates everything that could influence a company. 

 

 

  1. As a time-horizon, the fundamental analysis takes the long-term approach, under this, you have to consider a long time till an intrinsic value of the company gets reflected in the stock market. 

 

As opposed to this, the technical analysis approaches short-term as the time horizon, under it, stock charts could be delimited in weeks, days or even in minutes.      

 

 

  1. Working on different visions, fundamental analysis expects to make long-term investments, whereas technical analysis needs you to make various short to medium term businesses.

 

(Related reading: 5 elements of financial analysis)


 

Conclusion


While approaching correctly with cautions, fundamental analysis can be most valuable. You must have a basic understanding of some terminologies that are being used while performing fundamental analysis, for instance, fundamental analysis demands the ability to read financial statements, a basic understanding of macroeconomic and microeconomic economic factors, familiarity with assessment techniques, etc.

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