“Price is what you pay; value is what you get.”
– Warren Buffett paraphrasing Benjamin Graham
Fundamental analysis is the foundation of investing. While technical analysis uses statistics to predict a stock’s price movements, fundamental analysis uses financial statements to determine a fair value for the stock. Many investors use fundamental analysis to determine what stock to buy and technical analysis to determine when to buy and sell the stock, while others exclusively use one or the other.
In this article, we’ll take an introductory look at fundamental analysis in order to understand the language and concepts behind it.
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Fundamental analysis may be largely focused on financial statements, where things like price-earnings (“P/E”) ratios can be calculated, but the first step for most investors is simply learning about the company. After all, a company’s financial statements could look spectacular, but the departure of a key executive could make all the difference in determining where the stock is headed in the future.
There are two ways to go about qualitative analysis:
- Top-down. The top-down approach begins by looking for attractive industries and then drills down to find attractive companies within those industries. For example, a top-heavy market might make large-cap dividend paying stocks more attractive to reduce risk, so top-down investors might start there.
- Bottom-up. The bottom-up approach begins by looking for attractively priced companies regardless of their industry. For example, a value investor might screen for stocks trading with P/E ratios below the S&P 500’s average in order to find potentially undervalued companies across the board.
When looking at an industry, investors should consider factors like industry growth rates (e.g. how fast could the company grow), market share (e.g. how much does the company control), and government regulations (e.g. does the government set prices or determine growth). Reading trade publications or looking at economic forecasts from the U.S. Federal Reserve or government can help investors identify this data.
When looking at a company, investors should consider its business model (e.g. how it makes money), its management team (e.g. are they qualified?), its competitive advantages (e.g. what makes them better?), and corporate governance (e.g. do shareholders have any rights?). Reading SEC filings, listening to conference calls, and looking at insider trading data can help investors identify many of these things.
Financial statements provide investors with a glimpse into the lifeblood of companies. In 10-K and 10-Q filings with the SEC, companies are required to regularly report to investors their overall financial condition and how much money they’ve earned over the period. Investors can then crunch these numbers to determine what an appropriate price to pay is for the company’s stock.
There are three different financial statements:
- Income Statement; this statement shows a company’s revenue, expenses, and profit over a period of time. Often times, these figures are used to measure and project future growth rates and profitability.
- Balance Sheet; this statement shows a company’s assets, liabilities, and shareholders’ equity at a specific point in time. Often times, these figures are used to calculate a company’s solvency risks or net asset values.
- Cash Flow Statement; this statement shows a company’s operating, financing, and investing cash flows over a period of time. Often times, these figures are used to verify the other financial statements.
Investors can look at these numbers in the context of one another to make additional simple calculations. For example, dividing net income by revenue provides investors with net profit margins, while dividing current assets by current liabilities provides the current ratio. These metrics are important for comparing profitability between companies or financial solvency, respectively.
In addition to the financial statements, 10-K and 10-Q SEC filings contain related information that investors might want to consider. The Notes to the Financial Statements contain clarifications about specific reported numbers, which can be useful when something seems out of place. The Management’s Discussion & Analysis section also provides some additional context for the numbers in plain English.
Types of Valuation
Fundamental analysis is ultimately all about coming up with a fair value for a stock given its qualitative factors and quantitative financial condition. While there are countless different ways to value a company, most methods can be divided into either determining a company’s intrinsic value or looking at its valuation relative to other industry peers in order to determine a fair price to pay.
There are two primary forms of financial statement analysis:
- Ratio Analysis. Ratio analysis compares various financial metrics to others within a company or to industry peers. For example, P/E ratios are commonly used to assess whether or not a stock is fairly valued intrinsically (e.g. less than 8x is considered undervalued in general) or relative to peers (e.g. a 50x ratio might be undervalued if the industry trades at 80x).
- DCF Analysis. Discounted cash flow analysis involves projecting a company’s anticipated free cash flow over a period of time and then discounting the future cash flows to the present value to assess what they’re worth. For example, a company might be undervalued if it’s trading for $8 per share when the net present value of its future cash flow amounts to $10 per share.
Ratio analysis makes it easier to compare companies with each other, since many different companies generate different levels of revenue and have different levels of assets. By converting these variable figures into ratios, investors are able to more easily compare stocks of different market capitalization or industries without any issues, as well as determine a company’s position in the context of an average.
Discounted cash flow analysis takes a much more direct approach. By creating a financial model based on a company’s financial statements, investors can project future revenue, expenses, and profits, eventually determine the free cash flow, and then discount those future free cash flows to the present value. The key risk in the process is accurately assessing future growth and using the correct discount rate.
The Bottom Line
Fundamental analysis is a diverse and complicated topic that’s covered in many textbooks and courses. In general, the process involves looking qualitatively at a company and its industry, quantitatively at its financial statements, and then assessing a fair valuation using one of many different valuation techniques. Many investors use fundamental analysis to identify promising opportunities and technical analysis to ensure that they are timing the market in an opportunistic way.