What is Fundamental Analysis?
Fundamental Analysis Overview
Last month we discussed technical analysis, which essentially answers the question of “when to buy and sell”. This month, we will discuss fundamental analysis, which answers the question of “what to buy”. This type of analysis can be done on a wide variety of types of securities but for this article we will focus on stocks.
Fundamental analysis is a method of measuring a stocks value by studying its financial data. Fundamental analysis looks at the things that can affect the stocks value, from macroeconomic factors such as the economy and the industry, to microeconomic factors like sales, cash flow, debt, and the company's management.
The goal of fundamental analysis is to determine a company’s valuation that an investor can compare with a stocks current price to see if the stock is undervalued or overvalued. Ideally, we want to invest in fundamentally solid companies that are also undervalued.
Details of Fundamental Analysis
When analyzing stocks, fundamental analysis utilizes things like sales, cash flow, earnings, eps, equity, future growth, return on equity, and profit margins to determine a company's current value and potential for future growth. This data is available in a company's financial statements.
Fundamental analysis aims to develop a model to determine the estimated value of a company's stock price. This value is an estimate of what the company's share price should be worth compared to the current market price.
If fundamental analysis determines that a stock's value should be significantly higher than the stock's current market price, the stock is considered a buy. If fundamental analysis determines a lower share value than the current market price, the stock is considered a sell. Investors who subscribe to this type of analysis will expect that they can buy stocks with favorable fundamentals because these stocks should have a higher probability of rising in price. However, stocks with unfavorable fundamentals are expected to have a higher probability of falling in price.
2 types of fundamental analysis:
Quantitative - These fundamentals are related to data that can be shown in numbers. It is the measurable characteristics of a business found in the financial statements, such as the income statement, balance sheet, and statement of cash flow.
Qualitative - These fundamentals are less tangible. They include the quality of a company’s business model, its competitive advantages, its management, and overall corporate governance.
2 criticisms of fundamental analysis:
Technical Analysis - This type of analysis bases investing decisions entirely on the price and movement of a stock. This approach uses charts and technical indicators and ignores fundamental analysis. Technical analysis theory holds that the market discounts everything, all news about a company is already priced into the stock. Hence, the stock's price movements give more insight than the underlying fundamentals of the business.
At Verdia, we utilize both fundamental and technical analysis to make our investing decisions.Efficient Market Hypothesis (EMH) - This hypothesis holds that it is essentially impossible to beat the market through either fundamental or technical analysis. Since the market efficiently prices all stocks on a real-time basis, any opportunities for higher returns are eroded by the market's many participants, making it impossible for anyone to outperform the market over the long term.
Example of Fundamental Analysis
Let’s use Starbucks for this example. When examining its stock, fundamental analysis must look at things like the stock's annual dividend payout, earnings per share, P/E ratio, and many other quantitative factors. However, no analysis of Starbucks is complete without taking into account qualitative factors such as its brand recognition. Anybody can start a company that sells coffee, but few companies are known to billions of people. It's tough to put a finger on exactly what the Starbucks brand is worth, but you can be sure that it's essential to contributing to the company's stock price and its success.
For example, say that Starbucks stock is trading at $50, and after extensive fundamental research it is determined that the market has not priced it properly and it ought to be trading at $58. The fundamental analyst would buy Starbucks shares, believing that the market will eventually realize its error and the share price will rise to correct this market imbalance.
Fundamental Analysis Conclusion
At Verdia, we rely heavily on both technical and fundamental analysis in our TradePro trading. We use fundamental analysis to find great companies to invest in and technical analysis to determine when to buy and sell those great companies.
Happy Trading, Verdia