What is Fundamental Analysis?
Fundamental analysis is a method of evaluating the value of a stock by examining the financial performance, business strategy, competitive position, and growth prospects of the company that issues it. Fundamental analysis also considers the macroeconomic and industry factors that affect the demand and supply of the stock in the market.
Objective of Fundamental Analysis:
The main objective of fundamental analysis is to estimate the intrinsic value of a stock, which is the true or fair value of a stock based on its fundamentals. By comparing the intrinsic value with the current market price, an investor can determine whether a stock is undervalued or overvalued by other investors and decide whether to buy, sell, or hold it.
Fundamental analysis can be applied to any type of stock that has publicly available financial data, such as earnings, revenues, assets, liabilities, cash flows, dividends, and growth rates. It can also be used for different time horizons, ranging from short-term to long-term.
Fundamental analysis can be used for different purposes, such as assessing the financial health and profitability of a company, identifying its competitive advantages and risks, evaluating its growth potential and future prospects, and estimating its dividend payouts and returns.
Data sources of Fundamental Analysis:
The main sources of fundamental analysis are financial statements, annual reports, earnings releases, conference calls, analyst reports, news articles, and industry publications.
These sources provide quantitative and qualitative information about a company’s performance, operations, plans, goals, challenges, opportunities, and outlook. An investor can use various tools and techniques to analyze these sources and derive meaningful insights and conclusions about a company’s fundamentals.
Main tools of Fundamental Analysis:
The main tools of fundamental analysis are financial ratios, valuation models, and benchmarking. Financial ratios are numerical calculations that measure various aspects of a company’s financial performance and position, such as profitability, liquidity, solvency, efficiency, growth, and valuation.
Financial Ratios for stock analysis:
Financial ratios can be classified into different categories based on their purpose and use case. Some of the common categories are:
- Profitability ratios: These ratios measure how well a company generates income from its operations and assets. Some examples are return on equity (ROE), return on assets (ROA), net profit margin (NPM), gross profit margin (GPM), and earnings per share (EPS).
- Liquidity ratios: These ratios measure how well a company meets its short-term obligations and maintains its cash flow. Some examples are current ratio (CR), quick ratio (QR), cash ratio (CAR), and operating cash flow ratio (OCFR).
- Solvency ratios: These ratios measure how well a company meets its long-term obligations and manages its debt. Some examples are debt-to-equity ratio (D/E), debt-to-assets ratio (D/A), interest coverage ratio (ICR), and times interest earned ratio (TIE).
- Efficiency ratios: These ratios measure how well a company utilizes its resources and assets to generate revenue and income. Some examples are asset turnover ratio (ATR), inventory turnover ratio (ITR), receivables turnover ratio (RTR), and payables turnover ratio (PTR).
- Growth ratios: These ratios measure how well a company grows its revenue, income, assets, liabilities, equity, dividends, and earnings over time. Some examples are revenue growth rate (RGR), earnings growth rate (EGR), dividend growth rate (DGR), book value per share growth rate (BVPSGR), and dividend payout ratio (DPR).
Valuation Models for Stock Analysis:
Valuation models are mathematical formulas that estimate the intrinsic value of a stock based on its expected future cash flows or earnings. Valuation models can be classified into two types based on their approach: absolute valuation models and relative valuation models.
- Absolute valuation models: These models calculate the present value of a stock’s future cash flows or earnings by discounting them at an appropriate rate of return or cost of capital. The most common absolute valuation models are discounted cash flow model (DCF) and residual income model (RIM).
- Relative valuation models: These models compare the value of a stock with the value of similar stocks in the same industry or market by using multiples or ratios based on common financial metrics. The most common relative valuation models are price-to-earnings model (P/E), price-to-book model (P/B), price-to-sales model (P/S), price-to-cash flow model (P/CF), and price-to-free cash flow model (P/FCF).
Benchmarking for Fundamental Analysis:
Benchmarking is the process of comparing a company’s fundamentals with those of its peers or industry averages to evaluate its relative performance and position. Benchmarking helps an investor identify the strengths and weaknesses of a company as well as its opportunities and threats in the market.
Benchmarking can be done using various criteria such as size, growth, profitability, efficiency, liquidity, solvency, valuation, and quality.
Assumptions for Fundamental Analysis:
Fundamental analysis is based on several assumptions and principles that guide its application and interpretation. Some of these are:
- The market price of a stock does not always reflect its intrinsic value due to various factors such as market inefficiency, information asymmetry, investor psychology, and external events.
- The intrinsic value of a stock can be estimated by analyzing the fundamentals of the company that issues it and the macroeconomic and industry factors that affect it.
- The intrinsic value of a stock changes over time as new information becomes available or as expectations change.
- The market price of a stock will eventually converge to its intrinsic value in the long run, creating opportunities for investors to profit from undervalued or overvalued stocks.
Advantages and disadvantages of Fundamental Analysis:
Fundamental analysis has many advantages and disadvantages that investors should be aware of before using it. Some of the advantages are:
- It can help identify undervalued or overvalued stocks that have high potential for capital appreciation or dividend income.
- It can help assess the financial health and sustainability of a company and its ability to withstand market shocks or crises.
- It can help evaluate the competitive advantage and growth prospects of a company and its ability to create shareholder value.
- It can help diversify and optimize a portfolio by selecting stocks from different sectors, industries, or markets.
Some of the disadvantages are:
- It can be time-consuming and complex to collect and analyze a large amount of data and information from various sources.
- It can be subjective and inconsistent depending on the choice of methods, models, assumptions, and estimates.
- It can be influenced by biases and errors such as anchoring, overconfidence, confirmation bias, or hindsight bias.
- It can be ineffective or misleading when faced with unpredictable events or changes in fundamentals.
Fundamental analysis is not an exact science or a guarantee of success in the stock market. It is an art that requires judgment, experience, and constant learning. It is also a complement rather than a substitute for technical analysis.
Investors should use fundamental analysis as one of the tools in their toolbox to enhance their decision-making process.
The following is an example of fundamental analysis applied to a stock:
This is an income statement summary of Tesla comapny from 2016 to 2020. The income statement shows the revenue, costs, expenses, and profits or losses of a company over a given period of time.
An investor can use various tools and techniques to analyze this data and derive meaningful insights and conclusions about Tesla’s fundamentals.
One tool is financial ratios. An investor can calculate various profitability ratios for Tesla such as gross profit margin (GPM), operating profit margin (OPM), net profit margin (NPM), return on equity (ROE), return on assets (ROA), and earnings per share (EPS).
These ratios measure how well Tesla generates income from its operations and assets.
GPM = Gross Profit / Revenue
OPM = Operating Income / Revenue
NPM = Net Income / Revenue
ROE = Net Income / Shareholders’ Equity
ROA = Net Income / Total Assets
EPS = Net Income / Weighted Average Shares Outstanding
Using these formulas,
the GPM for Tesla in 2020 was 19.23%,
the OPM was 6.30%,
the NPM was 1.97%,
the ROE was 4.88%,
the ROA was 2.24%,
the EPS was $0.64.
These ratios show that Tesla improved its profitability in 2020 compared to previous years, as it achieved positive operating income, net income, and EPS for the first time in its history. However, these ratios also show that Tesla’s profitability is still low compared to some of its peers in the automotive industry, such as Toyota, Honda, or Volkswagen, which have higher margins, returns, and earnings.
Another tool is valuation models:
An investor can estimate the intrinsic value of Tesla’s stock using various valuation models such as discounted cash flow model (DCF) or price-to-earnings model (P/E). These models use different inputs such as future cash flows, earnings.