What is Fundamental Analysis?
Fundamental analysis attempts to measure a security's intrinsic value by examining related economic and financial factors, which can be both qualitative and quantitative in nature. Fundamental analysts study anything that can affect the security's value, including macroeconomic factors (e.g., economy and industry conditions) and microeconomic factors (e.g., financial conditions and company management). The end goal of fundamental analysis is to produce a quantitative value that an investor can compare with a security's current price, thus indicating whether the security is undervalued or overvalued.
Understanding Fundamental Vs. Technical Analysis
Understanding Fundamental Analysis
All stock analysis attempts to identify whether a security is correctly valued within a broader market construct. Fundamental analysis is usually done from a macro to micro perspective and seeks to identify securities that are not correctly priced by the market. Investors can utilize this information to optimize their portfolio's performance.
Analysts typically study, in order, the broader economic state (bear market or bull market) then industry strength before concentrating on individual company performance to arrive at a fair market (intrinsic) value for the stock. If this intrinsic value is higher than market price then the stock is deemed to be undervalued and a buy recommendation is given. Conversely, if the intrinsic value is lower than market price then the stock is considered overvalued and a sell recommendation is issued.
Investors go long (purchasing with the expectation that the stock will rise in value) companies that are strong, and short (selling shares that you believe will drop in value with the expectation of repurchasing when at a lower price) companies that are weak. This method of security analysis is considered to be the opposite of technical analysis, which forecasts the direction of prices through the analysis of historical market data, such as price and volume.
- Fundamental analysis attempts to measure a security's intrinsic value.
- Fundamental analysis seeks to identify securities that are not correctly priced by the market.
- Investors can utilize fundamental analysis to optimize their portfolio's performance.
- If the fair market value is higher than the market price, then the stock is deemed to be undervalued and a buy recommendation is given.
- Conversely, if the fair market value is lower than the market price, then the stock is considered to be overvalued and a sell recommendation is issued.
The Basics of Fundamental Analysis
Fundamental analysis uses real, public data in the evaluation of a security's value. Although most analysts use fundamental analysis to value stocks, this method of valuation can be used for just about any type of security. For example, an investor can perform fundamental analysis on a bond's value by looking at economic factors such as interest rates and the overall state of the economy. He can also look at information about the bond issuer, such as potential changes in credit ratings.
The term fundamental analysis is used most often in the context of stocks, but you can perform fundamental analysis on any security, from a bond to a derivative. As long as you look at the economic fundamentals, you are doing fundamental analysis.
For stocks and equity instruments, 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. In terms of stocks, fundamental analysis focuses on the financial statements of the company being evaluated. One of the most famous and successful fundamental analysts is the so-called "Oracle of Omaha," Warren Buffett, who is well known for successfully employing fundamental analysis to pick securities.
Quantitative and Qualitative Fundamental Analysis
You could define fundamental analysis as "researching the fundamentals", but that doesn't tell you a whole lot unless you know what fundamentals are. As we mentioned in the introduction, the big problem with defining fundamentals is that it can include anything related to the economic well-being of a company. Obvious items include things like revenue and profit, but fundamentals also include everything 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 all that different from their regular 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 our context, quantitative fundamentals are numeric, measurable characteristics about a business. It's easy to see how the biggest source of quantitative data is the financial statements. You can measure revenue, profit, assets and more with great precision.
Turning to qualitative fundamentals, these are the less tangible factors surrounding a business - things such as the quality of a company's board members and key executives, its brand-name recognition, patents or proprietary technology.
Quantitative Meets Qualitative
Neither qualitative nor quantitative analysis is inherently better than the other. Instead, many analysts consider qualitative factors in conjunction with the hard, quantitative factors. Take the Coca-Cola Company, for example. When examining its stock, an analyst might 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 would be complete without taking into account its brand recognition. Anybody can start a company that sells sugar and water, but few companies on earth are recognized by billions of people. It's tough to put your 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
Before we get any further, we have to address the subject 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. After all, why would you be doing price analysis if the stock market were always correct? In financial jargon, this true value is known as the intrinsic value.
For example, let's 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. In other words, you determine the intrinsic value of the firm to be $25. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value.
This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market will reflect the fundamentals. There is no point in buying a stock based on intrinsic value if the price never reflected that value. 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 thus find opportunities where he or she can buy at a discount. If all goes well, the investment will pay off over time as the market catches up to the fundamentals.
The big unknowns are:
- You don't know if your estimate of intrinsic value is correct; and
- You don't know how long it will take for the intrinsic value to be reflected in the marketplace.
Criticisms of Fundamental Analysis
The biggest criticisms of fundamental analysis come primarily from two groups: proponents of technical analysis and believers of the "efficient market hypothesis".
Technical analysis is the other major form of security analysis. We're not going to get into too much detail on the subject. (More information is available in our Introduction to Technical Analysis tutorial.)
Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of securities. Using charts and a number of other tools, they trade on momentum, not caring about the fundamentals. While it is possible to use both techniques in combination, one of the basic tenets of technical analysis is that the market discounts everything. Accordingly, all news about a company already is priced into a stock, and therefore a stock's price movements give more insight than the underlying fundamental factors of the business itself.
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 produce market-beating returns in the long run, through either fundamental or technical analysis. The rationale for this argument is that, since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns derived from fundamental (or technical) analysis would be almost immediately whittled away by the market's many participants, making it impossible for anyone to meaningfully outperform the market over the long term.