Fundamental analysis is a term you may have encountered in your investing journey. You'll find that most professional analysts who research shares for a living use one of two primary forms of assessment: fundamental analysis or technical analysis.
While we Fools don't necessarily agree with that dichotomy, we think all investors should have a basic understanding of fundamental analysis.
What is the point of financial analysis?
Before we discuss fundamental analysis, we should first understand the purpose of financial analysis.
When an equities analyst analyses a particular share, they are trying to determine its intrinsic value. They might use a variety of complex financial models and calculations, but they are all trying to answer the same question: how much is the share really worth?
Once they've assessed the share's intrinsic value, analysts compare this against the share's current market value. If the share's market value is less than their assessment of its intrinsic value, this signals that the market undervalues the share, and it might be a good buy.
When the opposite is true, and the share's market value is above its intrinsic value, the market is likely overvaluing it. Meaning it might be a good time to sell. If the stock price and the intrinsic value are equal, the market is fairly pricing the share.
So, the whole point of financial analysis is simply to make better-informed investing decisions. However, it's important to remember that assessments of intrinsic value can be quite subjective. This means one analyst's 'buy' might well be another analyst's 'sell'.
Analysts may reach very different conclusions about a share's intrinsic value depending on their analysis, the financial models they use, the data inputs they choose, and their personal views on the economic outlook.
This means it is essential to come to your own conclusions about a share's intrinsic value. But don't be put off. You don't need to be a financial egghead to understand basic fundamental analysis techniques and terminology.
What do we mean by fundamental analysis?
When someone refers to fundamental analysis, they describe one way an investor might value a company. At its core, fundamental analysis is about assessing a company's 'fundamentals' to determine its value and, by extension, an appropriate share price.
The primary focus of fundamental analysis is determining how much money is coming in and going out of a company. This information is readily available on a company's financial statements.
This often means looking at a company's sales volumes, expenses, net income, and profit margin. However, this type of company analysis can also incorporate macroeconomic factors like the current interest rate or inflation rate.
Fundamental analysts and investors use the data gathered through this process to determine whether the market's price for a company's shares accurately reflects the company's underlying valuation.
They then use this assessment to decide whether a share is worth buying (the fundamentals tell the investor that the company is undervalued) or selling (the fundamentals indicate an overvaluation).
Fundamental analysis is often described as the opposite of technical analysis, which uses share price charts to determine a company's share price trajectory.
How fundamental analysis works
Fundamental analysis is partly a game of probability. A fundamental analyst might ask two common questions: 'How likely is it that this company can continue to grow its revenue at x%?' and 'How much of a market can this company capture?'
Qualitative and quantitative analysis
A fundamental analysis investor might start the valuation process by looking at a company's market capitalisation, history, and place within its industry. A logical progression would be to examine the company's financial statistics. These might include its revenue generation and the percentage of this it keeps as earnings and profits.
A thorough examination of the company's balance sheet and income and cash flow statements is vital. Then, the investor might look at how these numbers have been growing (or shrinking) over time. This is referred to as 'quantitative analysis' because it relies on numbers, mathematical calculations, and statistics.
After developing a deep understanding of these numbers, the investor might look at how the market values the company, perhaps contrasting its valuation against any direct industry or sector competitors using the price-to-earnings (P/E) ratio, the debt-to-equity ratio, and its return on equity.
Following this, an assessment of external factors that might affect the company could be considered. This might include whether the company has a 'moat' or an intrinsic competitive advantage (such as a powerful brand).
At this point in the analysis, the investor will also likely consider how broader economic factors and the current stage in the business cycle might affect a company's growth outlook. For instance, a cyclical company would probably take a harder hit in an economic downturn than a defensive company.
This sort of analysis is known as 'qualitative analysis' because it relies on subjective judgement.
At the end of this process, if the investor decides a company is worth buying because it is undervalued, they have to consider why the market has come to a different conclusion and whether 'going against the crowd' is a good idea.
Of course, every investor who calls themselves a fundamental analyst will have a different process. And they might even reach entirely different conclusions!
At the end of the day, fundamental analysis is a guidebook, not a rulebook.
When should investors use fundamental analysis?
We Fools think fundamental analysis is essential in making good long-term investing decisions. When you buy shares, you are purchasing part ownership in a business.
Any good business owner will tell you that understanding the nuts and bolts of 'your' company is paramount to understanding its future (and, therefore, what its share price is likely to do over the long term).
If your neighbour asked you to go into business with them, wouldn't you first like to look at what kind of business they want to build? You'd be asking questions like, 'How is this business going to make money?' and 'What's the competition like?'
Well, the same logic extends to buying ASX stocks. Therefore, having a sound fundamental analysis process for share investing is a good idea for any aspiring investor. Almost all of the most successful investors — including the globally renowned Warren Buffett — use a form of fundamental analysis. There's a good reason why!
