One of the most fundamental questions for investors is how much to pay for a share of a publicly traded company. That, in short, is the question that fundamental analysis attempts to answer.
Understanding fundamental analysis
Fundamental analysis is a method of attempting to determine the intrinsic value of a stock, using publicly available financial information to analyze its business model, financial ratios, financial statements, company management, and other factors.
When financial experts talk about fundamentals, they are referring to how they evaluate influences on a security’s current and future pricing. Fundamental analysis considers external factors that could influence a stock's price, such as macroeconomic events like wars, the state of the national economy, international trade, industry trends, and any other data or circumstances that could affect a stock’s perceived value.
Analysts evaluate this entire mix to come to a number that can, as accurately as possible, be called a stock’s fair market value. If analysts value a stock higher than its current market price, it’s considered to be undervalued, and they’ll recommend investors buy it. If they calculate a lower intrinsic value than the market price, which makes it overvalued, they may issue a sell recommendation.
Types of fundamental analysis
Because fundamental analysts consider so many factors, from hard numbers to less tangible aspects like the quality of a company’s management, they often group factors into two buckets: quantitative and qualitative. Quantitative factors are the hard numbers, and qualitative properties are less measurable (but important) aspects like brand recognition or culture.
Quantitative fundamental analysis
Analysts use the information in a company’s publicly filed annual 10-K report and its 10-Qs, the financial performance reports all public companies file to the U.S. Securities and Exchange Commission (SEC) after the end of each quarter. These reports and filings disclose net income, earnings per share (EPS), net sales, and other numbers that analysts find useful in evaluating a company’s performance. Analysts look at the following three financial statements for the crucial financial information used in quantitative evaluation.
The income statement shows a company’s performance over a specified period. It reveals how much revenue a company generates and how it spends it. The income statement is based on this fundamental equation: Net income = Revenue – Expenses. In other words, it’s a tally of revenue, expenses, and profit from the company’s operations and ends with the bottom line, or net income.
Analysts pay particular attention to earnings per share (the company’s profit divided by the number of shares outstanding), which is included in public companies’ income statements. EPS shows how much profit a company makes per share. Higher EPS indicates that profits are high relative to the share price (and the greater the perceived value by analysts and investors as reflected in calculations of the price-to-earnings ratio).
Unlike an income statement, which shows performance over time, a balance sheet is a snapshot of a company’s total assets, liabilities, and shareholder equity, reported on the final day of the reporting period. It is divided into two sides—a literal “balance sheet” of assets and liabilities. The assets include:
- Short-term assets such as cash; marketable securities that can be easily sold; accounts receivable; inventory; and prepaid expenses such as rent or insurance.
- Long-term assets such as certain investments; fixed assets, including land and machinery; and intangible assets such as intellectual property and good will.
The liability side includes debt, interest payable, wages and dividends not yet paid, accounts payable, earned and unearned premiums, and long-term debt. It also includes the separate category of shareholders’ equity. Analysts can quickly tally assets from the balance sheet using this equation: Assets = Liabilities + Equity.
The cash-flow statement shows how much cash a company is bringing in to pay its debt obligations and fund its expenses. The statement shows how its operations are running, how the company is spending its cash, and where that cash is coming from. It also shows how liquid the business is.
The cash-flow statement has three parts, which reflect:
- Operating activities: What’s coming in and going out tied to operating the business.
- Cash from investing: The money the company is spending on assets, equipment, and other investments in its future.
- Financing activities: Outside capital from lenders or shareholders versus how much of the company is being powered by its profits.
Qualitative fundamental analysis
The qualitative side of fundamental analysis isn’t as touchy-feely as it sounds. Although qualitative analysis deals with aspects that are difficult or impossible to quantify, they are crucial in getting a comprehensive picture of a company’s health. This information comes from policies within a company, such as the company charter and bylaws, the corporate website, and general industry knowledge. Here are four qualitative fundamentals analysts and investors consider.
The business model is how the company is structured: whether it sells a product or a service, who its target customers are, whether its profits are derived from the thing it sells or through franchise or other fees.
If you’ve ever watched an episode of Shark Tank, you’ll be familiar with competitive advantage. What does the company have or do that’s exclusive? Does it dominate an industry, or has it created a unique or proprietary product that can’t be replicated? Maybe it has massive brand recognition that a startup could never match. All these things are examples of competitive advantage and help a company outperform potential competitors.
Many analysts and investors believe that credible, solid management is the bedrock of a company’s performance. After all, even the best business plan can fail with poor execution. Likewise, it’s important that management has general approval from its employees. Low approval generally leads to high turnover, which can be costly for a company. You can research a company’s management and board members on its corporate website, and comb through employee reviews on publicly available employment sites.
Companies put policies in place, such as the bylaws of a company charter, which define how the company is run. Corporate governance is the framework of those rules, and is designed to balance the interests among management, directors, and stakeholders. Analysts and investors look for transparency in corporate governance and how clear it is that a business is run ethically.
Top-down vs. bottom-up fundamental analysis
You can drill even further into fundamental analysis and split the practice into two methods: top-down analysis and bottom-up analysis.
You might visualize top-down analysis as an inverted triangle, where the analyst starts their research at the level of the overall economy, considering inflation, national and international trade, interest rates, and other macroeconomic factors. They begin working their way into the industries and sectors with the most potential, and ultimately focus their research on individual companies in their favored industries.
Conversely, bottom-up analysis starts at the level of the company, then broadens to consider the effect of the overall economy on the stock. The idea for fundamental analysts who do their research this way is that individual stocks can be outliers—performing better than one would expect them to within the context of the industry or economic climate. Bottom-up analysis focuses on the company’s individual metrics.
Fundamental analysis vs. technical analysis
Some analysts rely on technical analysis rather than researching fundamentals to make investment recommendations.
Technical traders don’t attempt to determine a company’s long-term valuation. Rather, they generally make short-term decisions by looking at the patterns in the price and momentum of a stock’s movement. In technical analysis, the stock’s historical price is the driver.
Advantages of fundamental analysis
Fundamental analysis offers a number of advantages, resulting in deep knowledge of a specific company or group of companies and the industry in which they operate. The plusses include:
- Analysts can create a profile of a company over time based on its financial health that assists in evaluating its long-term prospects.
- A company can be compared to other companies within the same industry in the context of the economy. This kind of analysis can lead to a dependable evaluation of whether the security is under- or overvalued.
- The analysts themselves are credible experts in industries, since they must understand how a company is performing within an industry, sector, and ultimately the economy.
Disadvantages of fundamental analysis
Fundamental analysis also has some significant drawbacks and limitations. They include:
- Exhaustive research is a labor-intensive, time-consuming pursuit and doing the work properly can require special training or advanced education.
- Those looking to make quick decisions may have a hard time with fundamental analysis, which favors long-term decision-making.
- Unexpected world events or a sudden change in factors such as interest rates can surprise those dedicated to fundamental analysis.
The bottom line
Fundamental analysis, whether conducted from the top down or the bottom up, gives analysts and investors a comprehensive picture of how a company is functioning in its industry, sector, and the overall economy. Investors who are not professional analysts can do their own research on a company’s fundamentals, because the research is based on publicly available information.