Fundamental Analysis

Introduction

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:

1. 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.
2. 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 grew tremendously.
3. 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 financial ratios.

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.

Key Motive

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:

1. 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.
2. 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.
3. 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.
4. 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 measures.

Type of Inputs Analysed

Some of the inputs or information analysed as part of fundamental analysis include:

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:

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:

1. Value
2. Growth

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.

Advantages

Fundamental analysis has some key advantages:

1. 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.
2. Long term trends: Fundamental analysis is also useful for identifying long term trends – including multi-year and multi-decade trends – and capitalizing on them.
3. 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.
4. Understanding of underlying business model: It also helps in understanding the underlying business and business models.

Disadvantages

However, Fundamental analysis also has some disadvantages:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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 the stock.

Conclusion

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.

References

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