What Is Fundamental Analysis?
Fundamental analysis is a method of measuring a stock's intrinsic value by examining related economic and financial factors. Fundamental analysts study anything that can affect the security's value, from macroeconomic factors such as the state of the economy and industry conditions to microeconomic factors like the effectiveness of the company's management.
The end goal is to arrive at a number that an investor can compare with a security's current price in order to see whether the security is undervalued or overvalued.
Understanding Fundamental Vs. Technical Analysis
Understanding Fundamental Analysis
All stock analysis try to determine whether a security is correctly valued within the broader market. Fundamental analysis is usually done from a macro to micro perspective in order to identify securities that are not correctly priced by the market.
Analysts typically study, in order, the overall state of the economy and then the strength of the specific industry before concentrating on individual company performance to arrive at a fair market value for the stock.
If the intrinsic value is higher than the current market price the stock is deemed to be undervalued and a buy recommendation is given. If the intrinsic value is lower than its market price the stock is considered overvalued and a sell recommendation is issued.
Investors go long (purchasing with the expectation that the stock will rise in price) companies that are strong, and short (selling shares that you believe will drop in value with the expectation of repurchasing them at a lower price) companies that are weak.
This method of stock analysis is considered to be the opposite of technical analysis, which forecasts the direction of prices through an analysis of historical market data such as price and volume.
- Fundamental analysis is a method of determining a stock's real or "fair market" value.
- Fundamental analysts search for stocks that are currently trading at prices that are higher or lower than their real value.
- If the fair market value is higher than the market price, the stock is deemed to be undervalued and a buy recommendation is given.
- In contrast, technical analysts ignore the fundamentals in favor of studying the historical price trends of the stock.
The Basics of Fundamental Analysis
Fundamental analysis uses public data to evaluate the value of a stock or any other type of security. For example, an investor can perform a fundamental analysis on a bond's value by looking at economic factors such as interest rates and the overall state of the economy, then studying information about the bond issuer, such as potential changes in its credit rating.
Fundamental analysis is used most often for stocks, but it is 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 fundamental analysis.
For stocks, fundamental analysis uses revenues, earnings, future growth, return on equity, profit margins, and other data to determine a company's underlying value and potential for future growth. All of this data is available in a company's financial statements.
One of the most famous and successful fundamental analysts is the so-called "Oracle of Omaha," Warren Buffett, who is well known for successfully using fundamental analysis to pick stocks.
Quantitative and Qualitative Fundamental Analysis
The problem with defining the word fundamentals is that it can cover anything related to the economic well-being of a company. They obviously include numbers like revenue and profit, but they can also include anything from a company's market share to the quality of its management.
The various fundamental factors can be grouped into two categories: Quantitative and qualitative. The financial meaning of these terms isn't much different from their standard definitions. Here is how the MSN Encarta dictionary defines the terms:
- Quantitative – capable of being measured or expressed in numerical terms.
- Qualitative – related to or based on the quality or character of something, often as opposed to its size or quantity.
In this context, quantitative fundamentals are hard numbers. They are the measurable characteristics of a business. That's why the biggest source of quantitative data is financial statements. Revenue, profit, assets and more can be measured with great precision.
Neither qualitative nor quantitative analysis is inherently better. Many analysts consider them together.
Some Fundamentals to Consider
There are four key fundamentals that analysts always consider. All are qualitative rather than quantitative. They include:
- The business model: This isn't as straightforward as it seems. If a company's business model is based on selling fast-food chicken, is it making its money that way? Or is it just coasting on royalty and franchise fees?
- Competitive advantage: Microsoft owns an operating system that is used by the vast majority of the world's computers. See if the company you're analyzing has a similar edge.
- Management: Listen to the conference calls. Check the resumes of the top brass and the board members. Are they up to the job? On the downside, have they been unloading a lot of their stock shares lately?
- Corporate Governance: This is difficult to measure but you want to do business with a company that is run ethically, fairly, transparently, and efficiently. Particularly note whether management respects shareholder rights and shareholder interests. Make sure their communications to shareholders are clear and understandable. If you don't get it, it's probably because they don't want you to.
An Example of Fundamental Analysis
Take the Coca-Cola Company, for example. When examining its stock, an analyst must look at the stock's annual dividend payout, earnings per share, P/E ratio, and many other quantitative factors.
However, no analysis of Coca-Cola is complete without taking into account its brand recognition. Anybody can start a company that sells sugar and water, but few companies are known to billions of people.
It's tough to put a finger on exactly what the Coke brand is worth, but you can be sure that it's an essential ingredient contributing to the company's ongoing success.
The Concept of Intrinsic Value
One of the primary assumptions of fundamental analysis is that the price on the stock market does not fully reflect a stock's real value. Why else do a price analysis?
In financial jargon, this true value is known as intrinsic value.
For example, say that a company's stock was trading at $20. After doing extensive homework on the company, you determine that it really is worth $25. That is, you determine the intrinsic value of the stock to be $25.
This is clearly relevant because you want to buy stocks that are trading at prices significantly below their intrinsic value.
This leads to a second major assumption of fundamental analysis: In the long run, the stock market will reflect the fundamentals. The problem is, nobody knows how long "the long run" really is. It could be days or years.
This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a firm and find opportunities to buy at a discount. The investment will pay off when the market catches up to the fundamentals.
Criticisms of Fundamental Analysis
Technical analysis is the other primary form of security analysis. Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of stocks.
Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of securities. Using charts and other tools, they trade on momentum and ignore the fundamentals.
One of the basic tenets of technical analysis is that the market discounts everything. All news about a company is already priced into the stock. Therefore, the stock's price movements give more insight than the underlying fundamentals of the business itself.
The Efficient Market Hypothesis
Followers of the efficient market hypothesis, however, are usually in disagreement with both fundamental and technical analysts.
The efficient market hypothesis contends that it is essentially impossible to beat the market through either fundamental or technical analysis. Since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns are almost immediately whittled away by the market's many participants, making it impossible for anyone to meaningfully outperform the market over the long term.