What is Fundamental Analysis?
Fundamental analysis examines the underlying forces that affect the well-being of the economy, industry groups, and companies. As with most analyses, the goal is to derive a forecast and profit from future price movements.
At the company level, fundamental analysis may involve examination of financial data, management, business concepts, and competition. At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy.
To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock’s current fair value and forecast future value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either overvalued or undervalued and the market price will ultimately gravitate towards fair value.
Fundamentalists do not heed the advice of the random walkers and believe that markets are weak-form efficient. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies.
General Steps to Fundamental Evaluation
Although there is no one-size-fits-all approach, a breakdown of the steps an investor could take is provided below. Using a top-down methodology, this technique begins with the economy as a whole and moves down from industry groups to individual businesses.
It’s crucial to keep in mind that all information is relative when doing analysis. Companies are compared to other companies, and industry groups are compared to other industry groups. Typically, businesses are contrasted with those in the same category. For instance, rather than an oil business like Chevron Corp. (CVX), a telecom operator like Verizon Communications (VZ) might be compared to another telecom operator like AT&T, Inc. (T).As part of the analyzing process, it is important to remember that all information is relative. Industry groups are compared against other industry groups and companies against other companies. Usually, companies are compared with others in the same group. For example, a telecom operator such as Verizon Communications (VZ) would be compared to another telecom operator such as AT&T, Inc. (T), not to an oil company like Chevron Corp. (CVX).
Economic Forecast
The first step in a top-down investment approach would be an overall evaluation of the general economy. Think of the economy as the tide and the various industry groups and individual companies as boats. When the economy expands, most industry groups and companies benefit and grow. When the economy contracts, most sectors and companies usually suffer.
Many economists link economic expansion and contraction to the level of interest rates. Interest rates are seen as a leading indicator for the stock market.
Below is a chart of the S&P 500 ($SPX) and the yield on the 10-year note over the last 30 years. Although not exact, there’s a correlation between stock prices and interest rates.
Fundamental Analysis example chart from StockCharts.com
When you have identified whether the overall economy is expanding or contracting, the next step would be to break down the economy into its various industry groups.
Group Selection
If the prognosis is for an expanding economy, then certain groups are likely to benefit more than others. An investor can narrow the field to those groups best suited to benefit from the current or future economic environment. If most companies are expected to benefit from an expansion, then risk in equities would be relatively low and an aggressive growth-oriented strategy might be advisable. A growth strategy might involve the purchase of technology, biotech, semiconductor, and cyclical stocks.
If the economy is forecast to contract, an investor may opt for a more conservative strategy and seek out stable income-oriented companies. A defensive strategy might involve the purchase of consumer staples, utilities, and energy-related stocks.
To assess an industry group’s potential, an investor would want to consider the overall growth rate, market size, and importance to the economy. While the individual company is still important, its industry group is likely to exert just as much, or more, influence on the stock price. When stocks move, they usually move as groups; there are very few lone guns out there. Many times it is more important to be in the right industry than in the right stock!
The chart below shows the relative performance of five sectors over a seven-month timeframe. As the chart illustrates, being in the right sector can make all the difference.
Sector Selection example chart from StockCharts.com
Narrow Within the Group
Once the industry group is chosen, an investor would need to narrow the list of companies before proceeding to a more detailed analysis. Investors are usually interested in finding the leaders and the innovators within a group.
The first task is to identify the current business and competitive environment within a group and future trends. How do the companies rank according to market share, product position, and competitive advantage? Who is the current leader, and how will changes within the sector affect the current balance of power? What are the barriers to entry? Success depends on having an edge, be it marketing, technology, market share, or innovation. A comparative analysis of the competition within a sector will help identify those companies with an edge and those most likely to keep it.
Company Analysis
With a shortlist of companies, an investor might analyze the resources and capabilities within each company to identify companies capable of creating and maintaining a competitive advantage. The analysis could focus on selecting companies with a sensible business plan, solid management, and sound financials.
Business Plan
The business plan, model, or concept forms the bedrock upon which all else is built. If the plan, model, or concepts are subpar, a business lacks hope. For a new business, you may want to look for answers to questions like: Does its business make sense? Is it feasible? Is there a market? Can a profit be made?
For an established business, the questions may be: Is the company’s direction clearly defined? Is the company a leader in the market? Can the company maintain leadership?
Management
To execute a business plan, a company requires top-quality management. Investors might look at management to assess their capabilities, strengths, and weaknesses. Even the best-laid plans in the most dynamic industries can go to waste with bad management. Alternatively, even in a mature industry, strong management can make for increased success. Some of the questions to ask might include: How talented is the management team? Do they have a track record? How long have they worked together? Can management deliver on its promises? If management is a problem, it is sometimes best to move on.
Financial Analysis
The final step in this analysis process would be to take apart the financial statements and devise a valuation method. Below is a list of potential inputs into a financial analysis.
Accounts Payable Accounts Receivable Acid Ratio Amortization Assets – Current Assets – Fixed Book Value Brand Business Cycle Business Idea Business Model Business Plan Capital Expenses Cash Flow Cash on hand Current Ratio Customer Relationships Days Payable Days Receivable Debt Debt Structure Debt:Equity Ratio Depreciation Derivatives-Hedging Discounted Cash Flow Dividend Dividend Cover Earnings EBITDA Economic Growth Equity Equity Risk Premium Expenses
Good Will Gross Profit Margin Growth Industry Interest Cover International Investment Liabilities – Current Liabilities – Long-term Management Market Growth Market Share Net Profit Margin Pageview Growth Pageviews Patents Price/Book Value Price/Earnings PEG Price/Sales Product Product Placement Regulations R & D Revenues Sector Stock Options Strategy Subscriber Growth Subscribers Supplier Relationships Taxes Trademarks Weighted Average Cost of Capital
The list can seem quite long and intimidating. However, an investor will learn what works best after a while and develop a set of preferred analysis techniques. There are many valuation metrics, and much depends on the industry and stage of the economic cycle. A complete financial model can be built to forecast future revenues, expenses, and profits, or an investor can rely on the forecast of other analysts and apply various multiples to arrive at a valuation. Some of the more popular ratios are found by dividing the stock price by a key value driver.
Ratio
Company Type
Price/Book Value
Oil
Price/Earnings
Retail
Price/Earnings/Growth
Networking
Price/Sales
B2B
Price/Subscribers
ISP or Cable Company
Price/Lines
Telecom
Price/Page Views
Website
Price/Promises
Biotech
This methodology assumes a company will sell at a specific multiple of its earnings, revenues, or growth. An investor may rank companies based on these valuation ratios. Those at the high end may be considered overvalued, while those at the low end may constitute relatively good value.
Putting it All Together
After all is said and done, an investor will be left with a handful of companies that stand out from the pack. Over the course of the analysis process, an understanding will develop of which companies stand out as potential leaders and innovators. In addition, other companies would be considered laggards and unpredictable. The final step of the fundamental analysis process is to synthesize all data, analysis, and understanding into selecting individual stock or securities.
Strengths of Fundamental Analysis
Long-term Trends
Fundamental analysis is good for long-term investments based on very long-term trends. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies.
Value Spotting
Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett, and John Neff are considered champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.
Business Acumen
Gaining a deep grasp of the company is one of the most evident, if less concrete, benefits of fundamental research. An investor will understand the primary sources of a company’s revenue and profit after undergoing such extensive study and analysis. Equity prices can be strongly influenced by earnings and earnings expectations. That’s even true for some technical analyzers. A thorough understanding can assist investors in identifying businesses that consistently deliver and avoiding those that are prone to failure.
In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock’s price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify high-risk opportunities (tech), low-risk (utilities), growth-oriented (computer), value-driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).
