Fundamental analysis is a deep dive into a stock’s intrinsic value. It assumes that the stock’s trading price doesn’t necessarily reflect the true value of the underlying company. It uses valuation metrics to determine if a stock is worth more or less than its current price. Let’s take a look at this invaluable tool and see how you can make it your own.
What is fundamental analysis?
Fundamental analysis presumes that the market has incorrectly priced certain stocks. The fundamental analyst’s job, then, is to dig beneath the face value of a stock. The analyst looks into a company’s fundamentals, such as revenue, expenses, assets, liabilities and growth potential. The analyst also considers the larger context in order to arrive at a more accurate valuation. This includes considering the state of the economy, the company’s market sector and industry, and the performance of competitors.
Fundamental analysis isn’t just for stocks, however. A fundamental analyst could turn their eye to any security, including bonds, commodities and cryptocurrencies. The analyst could examine a bond’s value by comparing its interest rate against prevailing rates, and studying the bond issuer’s creditworthiness.
Whatever the security, fundamental analysis is based on the notion of “intrinsic value.” That is, a security has a fundamental value that is independent of current market prices. The fundamental analyst looks to the long term, believing the market will gradually reflect the “fair price” of the underlying company. That true value could emerge after few years.
How does fundamental analysis work?
Fundamental analysts use public information to estimate an asset’s intrinsic value. This information can be split into two groups: quantitative and qualitative information.
A company’s quantitative information is its hard numbers, such as earnings, liabilities, assets and cash flow. These numbers typically come from a company’s financial statements. The three most important are the balance sheet, income statement and cash flow statement.
- Balance sheet: A balance sheet lists a company’s assets, liabilities and equities. It’s called a “balance” sheet, because to meet its short-term obligations, a company must balance its liabilities and assets. Fundamental analysts use balance sheets to determine if a company is able to pay its debts and expand its business.
- Income statement: Also called a profit and loss statement, this summarizes a company’s revenues, costs and expenses during a specific period (quarterly or annually, for instance). The income statement tells you if a company has generated more earnings, or incurred more losses, in a period. Fundamental analysts use income statements to answer the questions, “Is this company profitable?” and “Will this company remain profitable over the long term?”
- Cash flow statement: The cash flow statement tells us the exact amount of cash that flows in and out of a company. Fundamental analysts use cash flow statements to understand if a company is generating enough cash to expand the business.
Fundamental analysts often uses data from these financial documents to create ratios. These ratios can help an analyst decide if a stock is attractively priced. Four of the most common ratios include:
- Earnings per share (EPS): EPS is a company’s net profit (minus its preferred dividends) divided by the number of outstanding shares. The resulting number tells you how profitable a company is on a per-share basis.
- Price-to-earnings (P/E) ratio: The P/E ratio is a company’s current share price divided by its EPS. The resulting number tells you how much the market values a company when compared with other companies in its industry. A high P/E ratio might indicate that a company is overvalued, while a low P/E might mean it’s undervalued.
- Price-to-earnings-growth (PEG) ratio: The PEG is a company’s P/E ratio divided by its expected annualized earnings growth. The resulting number tells you if a company is growing quicker than other companies in its industry.
- Price-to-book ratio (P/B): The P/B ratio is a company’s current stock price divided by its book value (total assets minus liabilities). The lower the P/B ratio, the more likely a stock is undervalued.
Qualitative information is more subjective than quantitative factors, requiring fundamental analysts to interpret rather than measure. In general, fundamental analysts use qualitative factors to decide if certain qualities add value to a company, or if certain ones subtract value. These factors include:
- Competitive advantages: Companies have a greater opportunity for long-term growth if they have advantages over similar companies. For example, a company may be able to produce goods at a lower cost than competitors, or it may have a “network effect,” becoming more valuable as more people use it.
- Management: Management of a company is one of the most important qualitative factors to consider. Companies with a strong and ethical leadership are more likely to succeed than those with less qualified leaders.
- Brand value: Companies with stronger brand names have a greater chance at long-term success.
Fundamental analysis versus technical analysis
Fundamental analysis is often contrasted with technical analysis. Unlike fundamental analysis, technical analysis assumes a stock’s price reflects all public information. Technical analysts try to predict a stock’s future price by looking at past price movements and trading volume, as well as current market sentiment and trends.
Technical analysts are keenly interested in tracking the change of a stock’s price over time. They believe that price changes aren’t random, but rather follow patterns that will repeat in the future. In other words, “history repeats itself.” It’s the technical analyst’s job to buy when the curve is at its historic low and sell when it’s at its historic high.
Technical analysis has some serious limitations, however. The assumption that stock prices move according to pre-determined patterns has been defeated on numerous occasions. Technical analysts can’t predict market-disrupting events, such as business announcements, weather disasters or even pandemics. Many critics also challenge the foundational premise that history repeats itself, arguing that making decisions based on historical price movements is about as accurate as flipping a coin: you have a fifty-fifty chance at being right.
To be fair, technical analysis might work in a stable economic environment in which human action is the primary factor moving stock prices. Even so, technical analysis is limited to short-term decisions. In other words, technical analysis can’t seriously predict price movements outside a small window of time (such as movements within a day or a week). When an investor’s time horizon is longer, technical analysis becomes less accurate.
Here at the Motley Fool, we don’t use technical analysis to predict stock price movements. While technical analysis might benefit some day traders, it rarely produces the type of long-term growth that we recommend for our investors.
Foolish bottom line on fundamental analysis
Fundamental analysis can help you find companies that you believe are great long-term investments. By looking past current market prices to a stock’s intrinsic value, you can decide if the company in question is worth investing in for the long run, or if you should invest your money somewhere else.