Fundamental is defined as “Forming a necessary base or core; of central importance”
or “A central or primary rule or principle on which something is based”. Analysis
is defined as “Detailed examination of the elements or structure of something, typically
as a basis for discussion or interpretation.” Therefore, putting these two together
in the context of the financial markets, fundamental analysis can be defined as
the detailed examination of the elements or structure of the necessary core financial
information of a stock or company”. The fundamentals of a company refer to the financial
characteristics of a company. These include the information contained in the financial
documents including assets and liabilities, income statement, etc. These financial
documents provide insight through financial ratios and help understand the financial
health and position of the company and provide clues to future growth and performance.
In addition to the financials, the analysts also review industry and sectoral information,
and general information about the national or world economy.
Approach and Steps in Fundamental Analysis
Fundamental analysis is generally done with a top down approach. The top-down approach
starts by looking at the larger macro picture, examining all aspects at that level,
and then studying specific details at increasingly micro levels. Some analysts also
review stocks from a bottom-up approach. In this, a specific measure or metric or
a set of these metrics is chosen and stocks are selected for analysis on this basis.
Once the stocks are selected, these are then examined at the individual company,
sector and economic level.
The following are the steps in fundamental analysis using the top-down approach:
- Economic analysis: is done to determine the big-picture as to how
the overall economy is doing. In case there is persistent weakness or uncertainty
or recession, the companies are expected to do badly and therefore the stock prices
are expected to stagnate or to fall.
- Industry analysis: is the next step to look at the trends for a
specific industry or sector. While the economy may be doing well, a specific sector
may be underperforming or outperforming due to some specific reasons. For example,
the tech boom in the late nineties meant all technology companies benefitted and
- Company analysis: is the final step where the detailed analysis
of the company is done. This includes analysing all the detailed financial documents,
the management team and their track record, their forecasts, detailed analysis of
Here’s a chart that shows the relative performance of different industry sectors,
as represented by sectoral stock indices, over 12 months:
As you can see from the chart, the technology related sectors such as Internet and
semi-conductor industries did very well during the Internet boom period in 1999
to 2000, as compared to old economy sectors such as banking, oil and gas, etc. Therefore,
while individual stocks may have underperformed or outperformed the overall industry,
it is more likely that an investment in the technology related industries would
provide a better return. Thus, industry analysis is very important in the overall
process of fundamental analysis.
In the bottoms-up approach, the analysts select some metrics that are good indicators
of value or growth for stock selection. These metrics include price earnings ratio,
price to book ratio, Compound Annual Growth Rate (CAGR), Dividend Yield, etc. The
analysts then uses the metrics to shortlist the stocks which meet the criteria for
selection. These stocks are then analysed in detail to ascertain additional information
at a company, industry or sector and then economy level. Thus the approach is reversed
for a bottoms-up analysis.
Fundamental analysts examine all this information to determine whether the stock
price reflects the intrinsic or fair value of the company as borne out by their
analysis. This is used to evaluate suitability of investing in or remaining invested
in a particular stock, or to compare between two or more stocks for investment.
If the analyst believes that the stock is undervalued or that the company has excellent
growth prospects, he expects the price to move up to reflect the fair value. He
can therefore take a decision to buy the stock in anticipation of this increase
to make a profit when such increase does happen. Conversely, if he believes that
the stock price is much higher than the fair value, he would expect the stock price
to correct or stagnate at this level. Therefore, he may opt to switch to another
stock or liquidate his position.
Characteristics of Fundamental Analysis
Fundamental analysis is characterised by the following factors:
- Investing versus trading: Fundamental analysis is used for investing
rather than trading. The key difference is that the investor buys a stock in anticipation
of either returns via dividends or price or capital appreciation over the long term.
- Time horizon: Fundamental analysis is typically done with medium
to long-term time horizon perspective. Fundamental analysis is not appropriate for
Short term or day-trading. It requires a thorough examination of the different factors
which takes considerable time and therefore cannot be used for day to day trading.
- Focus on intrinsic and relative value not price: Fundamental analysis
focuses on the intrinsic value of a stock or a company and the relative valuation
vis-à-vis other companies in the industry or economy. Short term price action is
not a very key or important factor in the analysis, except to determine whether
the stock is expensive or inexpensive relative to its valuation.
- Examination of current financials and fundamentals and projected performance:
Fundamental analysis examines the current financial details of companies and sectors
and tries to use that and other information to project future performance. This
helps in ascertaining future valuation and helps in making a buy or sell decision.
The focus is not on price action or pattern of price movement rather on valuation
Type of Inputs Analysed
Some of the inputs or information analysed as part of fundamental analysis include:
- Business Plan
- Business Model
- Balance Sheet
- Income Statement
- Revenues and Expenses
- Cash Flow statement
- Management discussion and analysis
- Auditor’s report
- Notes and Schedules to Financial Statements
- Risk Factor
From these and related documents, fundamental analysts derive valuation metrics
appropriate for the industry and sector. Some of the important ratios and measures
that are used for valuation include:
- Price to Book value
- Price Earnings ratio
- Price Earnings Growth ratio
- Price / Sales
- Gross margin
- Operating margin
- Return on Equity
- Return on Investment
- Return on Assets
- Return on Capital
- Current Ratio
- Cash Ratio
- Debt to Equity ratio
- Earnings per share
- Payout ratio
- Dividend yield
- Price / Cash flow ratio
Using these ratios, analysts can compare between different companies within and
across different sectors and markets. However, it is important to note that simply
taking one or two of these parameters is not sufficient. For example, in general
a low Price / Earnings ratio indicates that the stock is available at a relatively
cheaper price, than one with a high P/E ratio. However, this needs to be considered
in context of the economic cycle, the industry cycle and maturity and the company’s
lifecycle. Here’s a chart that shows S&P composite real Price-Earnings ratio and
the Interest rates from 1870 to 2008:
We can see from this chart that the P/E ratio varies significantly according to
the different market and economic conditions. The P/E ratio peaks as the stock market
booms, and falls during the bear phases. Therefore, while analysing stocks careful
attention should also be paid to the context of analysis – is the economy and market
booming? Is the industry or technology new with tremendous growth prospects? At
what stage is the company or its main products? All of these will help in determining
the intrinsic value and the relative valuation more accurately.
Application of Fundamental Analysis
Fundamental analysts believe that stocks of good profit making companies with robust
fundamentals will continue to grow and become more valuable and provide returns
in the form of prices rising or through higher dividend payout. Fundamental analysis
is generally driven by two types of investment objectives:
Value based investing attempts to identify companies which are
currently trading at or below their intrinsic or fair value. Using different measures
and metrics, the fundamental analysts try to identify such companies and buy them
at or below their fair value level thus getting them at good value. Companies bought
at such attractive levels offer high margin of safety and are expected to increase
in value as they grow and as markets discover and price them appropriately. Therefore
in essence value based investing tries to find excellent companies with robust financials
available at relatively cheaper valuation.
Growth based investing takes an alternative approach where the
analysts try to identify companies which have excellent potential to grow rapidly
in future. Typically such companies are smaller companies which can grow and become
large industry leading companies. The growth may be expected due to a numbers of
reasons – such as: breakthrough technology or patents, innovative or disruptive
products and services, new partnerships or alliances, etc. The analysts therefore
search for companies which display such tremendous growth potential and try to buy
into the stock at an early stage to be able to capitalize on the growth of the company
and therefore profit from the associated increase in its stock price.
In both these approaches, the common factor is the detailed examination of the companies,
industries and sectors using fundamental analysis.
Fundamental analysis has some key advantages:
- Hidden gems: It is very useful in discovering stocks that may not
be well known, popular or favourites of traders but have high intrinsic value or
tremendous potential for growth. Such stocks represent wonderful opportunities for
investments which can provide magnificent returns in the long term.
- Long term trends: Fundamental analysis is also useful for identifying
long term trends – including multi-year and multi-decade trends – and capitalizing
- Solid foundation: This type of analysis is reliant on thorough
understanding the business and the business model – therefore providing a solid
foundation for calculating value. The fundamental analysts does not invest in a
stock because it is the flavour of the day, rather because it has the right underlying
business model, provides value for money, a high margin of safety, indications of
continued robust performance or potential for high growth of the business.
- Understanding of underlying business model: It also helps in understanding
the underlying business and business models.
However, Fundamental analysis also has some disadvantages:
- Detailed knowledge of company, sector and economy required: This
type of analysis is very involved and specific, and therefore it requires detailed
knowledge of the economy, industry and the company and the specific business models
used. Therefore valuation of a retail company is very different from the valuation
of a pharmaceutical or utility company. Therefore, some fundamental analysts specialise
in tracking and analysing a specific sector or industry as they cannot cover or
understand all the different industries and sectors.
- Time consuming: Analysing so many aspects of the economy, industry
or sector and the company can also be very time consuming. Therefore it is only
suitable for long term investing and not for day-trading.
- Subjective: The interpretation could be subjective – different
analysts may reach different conclusions based on their own understanding, knowledge,
expectations and past experience with the stock. While the underlying facts and
financial statements may be the same, the conclusions reached by analysts may differ
significantly. Moreover, fundamental analysts may get too involved with the underlying
financials and forget market action. While all analysis may be valid, however, one
cannot argue against Mr. Market which may trade against expectations.
- Variation in fair value: Fair value for the stock can be different
for different people and analysts may arrive at diverse valuations. Moreover, valuation
norms for different industries and markets vary significantly. Moreover, high growth
companies are valued differently from high value companies.
- Analyst bias: Analysts can often get attached to specific stocks
and lose their objectivity for their favourites. Therefore irrespective of the underlying
financials, the analysts may often reach the desired interpretation depending on
Fundamental analysis is an important technique for valuation of stocks and companies.
However, it should be used with caution. One should not selectively apply some facets
of Fundamental analysis. It is also inappropriate as a supporting technique for
trading or speculation. While there is a great deal of information that is analysed,
all of the information should be reviewed with a pinch of salt and not be blindly
believed. It is well suited for long term investors who are not regular traders.
S&P Composite real price-earnings ratio image: By SP500pe.svg: Zane Selvans derivative work: AJabberWok (SP500pe.svg) [CC-BY-SA-3.0-2.5-2.0-1.0 (www.creativecommons.org/licenses/by-sa/3.0) or GFDL (www.gnu.org/copyleft/fdl.html)], via Wikimedia Commons