Fundamental analysis is the method of analyzing companies based on factors that affect their intrinsic value. It determines the underlying health and performance of a company by looking at key numbers and economic indicators. There are two sides to this method of analysis: the quantitative and the qualitative.
- When performing a fundamental analysis on an investment opportunity, It’s important to take into consideration both quantitative and qualitative factors.
- Quantitative factors refer to the financial numbers that reflect the health and profitability of a company, such as the company’s assets, liabilities, revenue, and price-to-earnings (P/E) ratio.
- Qualitative factors, however, refer to non-numeric aspects of the company that are somewhat more intangible but nonetheless affect the potential value of a company.
- Examples of qualitative factors include customer satisfaction with the company's products, pending litigation that harms a company's reputation, a change in a company’s management, or a new technology that gives a company a competitive advantage.
- You can use the results of a qualitative analysis to shed additional light on your quantitative analysis, giving yourself a more complete picture of the future growth potential of a company.
What Are Quantitative Factors?
The quantitative side involves looking at factors that can be measured numerically, such as the company's assets, liabilities, cash flow, revenue, and price-to-earnings ratio. The goal of fundamental analysis is to produce a quantitative value that investors can compare with a security's current price, to help determine whether the security is undervalued or overvalued.
The limitation of quantitative analysis, however, is that it does not capture the company's aspects or risks unmeasurable by a number—things like the value of an executive or the risks a company faces with legal issues. The analysis of these things is the other side of fundamental analysis: the qualitative side or non-number side.
How Qualitative Factors Impact Fundamentals
Although relatively more difficult to analyze, the qualitative factors are an important part of a company. Since they are not measured by a number, they tend to be subjective and represent either a negative or positive force affecting the company. But some of these qualitative factors will have more of an effect than others, and determining the extent of these effects can be challenging.
Examples of qualitative factors include customer satisfaction with a company's products, pending litigation that harms a company's reputation, a change in a company’s management, the relationship the company has with key vendors, or ownership of a new technology that gives the company a competitive advantage.
How to Perform a Qualitative Analysis
To start, identify a set of qualitative factors and then decide which of these factors add value to the company, and which of these factors decrease value. Then determine their relative importance. The qualities you analyze can be categorized as having a positive effect, negative effect, or minimal effect.
If, when looking at the company's numbers, you saw good reason to buy the company, but subsequently found many negative qualities, you may want to think twice about buying. Negative qualities might include potential litigation, poor research and development prospects, a reputation for poor customer service, or a board full of insiders. The conclusions of your qualitative analysis either reconfirms or raises questions about the findings from your quantitative analysis.
Example of Qualitative Analysis
In May 2017, Verizon Communications (VZ) beat out rival AT&T (T) in a bidding war to purchase Straight Path Communications, Inc. for $3.1 billion. If you were to look at just the quantitative factors regarding this acquisition, you might wonder why either Verizon or AT&T would think Straight Path was such a coveted prize.
At the time, Straight Path's numbers didn't indicate it was a company worth billions of dollars. Just a few months before the acquisition, the small communications company had a market capitalization of around $400 million, had only nine employees, and was selling for $35 a share. However, the company owned a hugely valuable asset—a treasure trove of Federal Communications Commission (FCC) wireless licenses needed to power 5G, the next generation of high-speed wireless service.
Both Verizon and AT&T knew that whichever company could control these licenses would be a step ahead in building out their 5G business. So, they were willing to pay a premium for Straight Path, causing the company's share price to skyrocket from $35 to the eventual acquisition price of $184 per share. Investors who only looked at Straight Path's financial statements to value the company in a quantitative analysis might have missed out on what gave the company its competitive advantage and made it qualitatively superior, which was its ownership of those highly prized FCC licenses.
The Bottom Line
Fundamental analysis is not as simple as looking at numbers and computing ratios. It is also important to look at influences and qualities that do not have a number value.
The best way to incorporate qualitative analysis into your evaluation of a company is to do it once you have completed the quantitative analysis. The conclusions you come to on the qualitative side can put your quantitative analysis into better perspective and might help you make a better investment decision.