Beginner's Guide to Fundamental Analysis
Make a smug face to the market — Invest with confidence using Fundamental Analysis!
In our writeups, we’ve covered the general strategies investors use while investing and trading. Moving deeper, two types of analyses are generally employed: technical and fundamental. Technical and fundamental analysis in investing is the two spectrum opposites of the investment analysis method.
Most experienced investors you’ll find around are from either one of these two schools. However, many nowadays are taking a more flexible approach by employing both methods into a somewhat hybrid concoction of their own liking.
What is Fundamental Analysis in Investing?
Fundamental analysis in investigating refers to a method where investors seek an asset’s intrinsic or real value. It is done by looking at the asset itself, such as a company’s share value, and by looking at the surrounding market conditions.
Investors that use the fundamental analysis method usually want to see if a particular asset is overvalued (not worth the price) or undervalued (actually worth more).
Core principles in fundamental analysis
Stock prices don’t fully reflect the actual value of companies.
The first core belief that many fundamental analysts have is that the market price of a certain asset does not properly reflect the asset’s actual worth. That is to say, the asset could actually be worth more, or it could even be worth less. Things like emotions, irrationality, and other factors may actually cloud the market’s judgment on the asset — thus the inaccurate price.
What fundamental analysts seek to do is to clear out all these noises and look for the actual value of a certain asset — in the hope that once people start to appreciate these assets for their actual worth, the price would go up (or down, if they’re shorting the asset).
Find out more about “shorting” here.
The actual value can be found in companies’ financial data.
If technical analysts use historical market data as their main compass, fundamental analysts use companies’ financial data for their evaluation process. Companies’ financial data can come in many forms — financial reports, announcements, government reports, market reports, and more.
Where do you find companies' financial data?
There are many ways to do so, but here are a few places you might want to look at:
- Financial reports (quarterly reports/annual reports).
- Company announcements.
- Company information.
- Government agency reports.
- Industrial reports.
- Economic reports.
- Market reports.
How to do Fundamental Analysis for investing?
The general practice is that a fundamental analyst will usually do a top-to-bottom analysis when doing fundamental analysis.
How it works is that the analyst will first look at the situation in the economy, as in the market data as a whole — they would usually research the performance and financial data at the industry and sector level.
After that is done, they will look at the specific company’s performance, whether it outperforms the market, is it moving in line with the market or does it underperform.
So, let’s give it an example:
You’re interested in the IT business.
So, based on the above, you’d first have to look into the economic data that is available in general. This can be found by looking into things like inflation, GDP growth, interest rates, export-imports data, and more. This is to get a general picture of how the economic weather is looking at the moment.
Now that you have established how the economic weather is — say, the economy is a bit gloomy now — you move on to the next step, by looking at sector data.
Try to find the performance of the sector as a whole. The usual performance indicators that they will look for are revenue growth, price-to-earnings (P/E) ratio, debt-to-equity, return on equity, return on assets, return on investment, quick ratio, price-to-free-cash-flow, and revenue per employee.
Now, once you get the data you need from above, you move in a little bit more specifically into industrial performance.
What you’re going to do is look for the kind of companies you like. For example, if you’re interested in the chip manufacturing business, look for chipmakers. (You don’t have to look for all of them, just look for ones with good prices — if you can look at all it’s better). Find the same performance indicators as above.
Once you found that, now move specifically into the companies that you have your eyes on, it could just be your gut feelings for all we know but try to look for ones with reasonable prices. Again, look for the performance indicators abovementioned.
When you have the performance indicators for all three. Compare it! See if the company is performing better, in line with, or worse than its industrial and sectoral counterparts.
So, when you draw your conclusions, it should sound something like — “when the economy is gloomy, Company ABC performs better than the industrial and sectoral performance”. Of course, in real life, the answer is usually not that clear-cut.
Note: Sector refers to the economic activity as a whole (for example, the IT sector can be any company within the IT realm), while industry refers to a group of companies that have the same characteristics in one particular sector (for example, Intel and AMD are both chip manufacturers).
However, there's more than that…
That was on the general approach of how fundamental analysis was done. If we are moving a bit specifically, there are two types of fundamental analysis that are usually done: qualitative and quantitative.
Most seasoned investors would look into both of the methods to properly get a full picture of an asset’s performance.
The qualitative method is where they are looking at things that are not very much based on numbers, but rather subjective traits like how good the management team is, etc. Under the qualitative method, they would usually look into –
Business model: It’s basically how the business makes money, and mind you, it’s not usually very straightforward. For example, you might think gas station franchisees make money from selling gas, but many of them generate the real deal from the convenience store they have at the gas station.
Competitive advantage: How well-placed is the company within the industry compared to its competitors? Industry giants usually have bigger advantages over its competitors.
Management: This will look into how well the management team is. Let’s be frank — if the balance sheet is good but the names are leading the headlines with fraud scandals, you might want to look for some other options.
Corporate governance: Looks into the policy within the company. Determines how ethical is the business operations.
Industry: Your concern here would be on how big the market is, how would your consumer base look like, how well is the industry in general, how good the growth prospect is, the company’s market shares, and so on.
The quantitative method of fundamental analysis would usually look at the financial statements of the company — this is where numbers and formulas reign. These are a few of the things that they would look at:
Balance sheet: This is to get an overall perspective of a company. From the balance sheet, you’ll learn about the company’s assets, liabilities, and equities.
Income statement: This is to look at the performance of the company by evaluating its revenues, expenses, and profit.
Cash flow: Cash flow is a very straightforward way to look into how well a company is doing. Unlike income statements, cash flow is quite hard to be manipulated (some accountants manipulate earnings by either making the revenue and gains look bigger or by reducing expenses).
There are generally three types of cash flow for you to look at: operating cash flow, cash from financing, and cash from investing.
Fundamental vs Technical Analysis
- Fundamental analysis aims to look if a certain asset is overvalued or undervalued.
- Fundamental analysts believe that the market price of an asset doesn’t reflect the actual value, which can only be found by looking at companies’ financial statements.
- There are generally two angles from which fundamental analysis is done: qualitative and quantitative.
- Fundamental analysts would usually work using the top-to-bottom method, i.e., by looking into the economy first, and then the sector, the industry, followed by the individual asset itself.
- Fundamental analysis takes time, so it’s better for medium to long-term investment purposes.
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None of the material above or on our website is to be construed as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. Investors should carefully consider if the security and/or product is suitable for them in view of their entire investment portfolio. All investing involves risks, including the possible loss of money invested, and past performance does not guarantee future performance.