Fundamental Analysis

What is Fundamental Analysis?
Fundamental analysis can be explained as a method of estimating a security which involves attempting to evaluate its basic value by assessing allied financial, economic, and other quantitative and qualitative factors. Fundamental analysis aims at studying everything which affects the value of the security, including macro-economic factors (such as the overall economy and industry conditions) and company-specific factors (including financial condition and management). It uses real data to evaluate the value of a security. Even though most analysts use fundamental analysis to evaluate stocks, this technique can be used for almost any type of security.

There are certain economic indicators, or reports, that forex traders can observe in order to determine the strength of an economy. These reports are released by governments and independent bodies who collect and analyze the data prior to publishing it. They are released at set times and can be released weekly, monthly, quarterly or annually, depending on the report. Traders will generally look at the latest result of each report, as well as any changes to the results from the last published report.

Why use Fundamental Analysis?
The main goal of carrying out fundamental analysis is to generate a value that an investor can weigh against the current price of the security, with the goal of outlining the type of position to take with that security (underpriced = buy, overpriced = short or sell). In terms of stocks, fundamental analysis emphasizes on the financial statements of the company being assessed.

Overall, fundamental analysis uses supply and demand as an indicator of where price could be headed is easy. The hard part is analyzing all the factors that affect supply and demand. You have to understand the reasons of why and how certain events like an increase in unemployment affect a country’s economy, and ultimately, the level of demand for its currency.

Fundamental analysis is built on the idea that the stock market may price a company wrong from time to time. Profits can be made by finding underpriced stocks and waiting for the market to adjust the valuation of the company. By analyzing the financial reports from companies you will get an understanding of the value of different companies and understand the pricing in the stock market.

After analyzing these factors you have a better understanding of whether the price of the stock is undervalued or overvalued at the current market price. Fundamental analysis can also be performed on a sectors basis and in the economy as a whole.

How does it work?
The idea is that if a country’s current or future economic outlook is good, their currency should strengthen. The better shape a country’s economy is, the more foreign businesses and investors will invest in that country. This results in the need to purchase that country’s currency to obtain those assets.

Let’s say that the U.S. dollar has been gaining strength because the U.S. economy is improving. As the economy gets better, raising interest rates may be needed to control growth and inflation. Higher interest rates make dollar-denominated financial assets more attractive. In order to purchase these US assets, traders and investors have to buy some USD first. As a result, the value of the dollar will increase.

Fundamental analysis also calculates future price movements by looking at a business’s economic factors, known as fundamentals. It includes economic analysis, industry analysis and company analysis. This type of investing assumes that the short-term market is wrong, but that stock price will correct itself in the long run. Profits can be made by purchasing a mispriced security and then waiting for the market to recognize its mistake. It is used by buy and hold investors and value investors, among others.

Fundamental analysis looks at financial statements, including balance sheets, cash flow statements and income statements, to determine a company’s intrinsic value. If the price of stock falls below this intrinsic value, its purchase is considered a good investment. The most common model for valuing stock is the discounted cash flow model, which uses dividends received by the investor, along with the eventual sales price, the earnings of the company or the company’s cash flows. It also considers the current amount of debt using the debt to equity ratio.

For a fundamental analyst, the market price of a stock tends to move towards its ‘intrinsic value’, which is the ‘true value’ of a company as calculated by its fundamentals. If the market value does not match the true value of the company, there is an investment opportunity.

Example of this is that if the current market price of a stock is lower than the intrinsic price, the investor should purchase the stock because he expects the stock price to rise and move towards its true value. Alternatively, if the current market price is above the intrinsic price, the stock is considered overbought and the investor sells the stock because he knows that the stock price will fall and move closer to its intrinsic value. To determine the true price of the company’s stock, the following factors need to be considered.

What to have in mind when using Fundamental Analysis

1. The Revenue

This is just the amount of sales a company has taken in over a set period of time, usually reported on a quarterly and annual basis. The key here is to look at the direction of revenues. Obviously, rising sales are a good thing. If sales have fallen, it’s important to note why that might be. Does it look like the drop is a one-time glitch, or is it possible that sales could continue to fall due to the success of a competitor, or decreasing demand for the company’s products? Does a rise in sales in the fourth quarter necessarily mean the company’s prospects are looking up, or is it simply a seasonal uptick due to the holiday season?

2. Earnings per share (EPS)

While revenue is important, earnings are really the bread and butter of corporate success. If a company’s sales are increasing, but they are not able to retain those revenues due to excessive expenses or poor management, that’s a red flag. You want to invest in companies with rising margins, and therefore rising EPS. You can find historical EPS for most companies as well as EPS estimates for future quarters on most investing websites.

3. P/E Ratio

The price to earnings ratio of a company is simply the current stock price divided by its annual earnings per share. So if company XYZ is trading at $27 and it earned $1.50 per share during the past 12 months, its P/E ratio would be 18. That means it’s trading at 18 times its annual earnings. When analysts refer to a company’s valuation, they are often referring to its P/E ratio. What’s a good P/E ratio? That can depend on who you ask, and it can also vary by sector. For example, high growth stocks like those of technology companies often trade at much higher P/E ratios whereas stable, lower growth companies trade at lower valuations. This should make sense intuitively because if a company has huge growth prospects, then one should be willing to pay a much higher price relative to its current earnings. Analysts often disagree on what constitutes a cheap stock because there is so much debate about what a specific P/E ratio actually means for a given company or industry. There is no “one size fits all” when it comes to P/E ratios.

4. Sector Fundamentals

A single company’s performance can be heavily influenced by the sector in which it operates. During economic slowdowns, for example, “defensive sectors” like consumer staples and utilities tend to do better, whereas technology, transportation and financials do better when the economy is on an upswing.

5. Economic Overview

It’s always a good idea to keep the macroeconomic climate in mind when choosing your asset allocation as well as your specific investments. Where are we in the economic cycle? Are we at the beginning, middle, or end of a recession or boom?

Strengths of Fundamental Analysis
Fundamental analysis is good for long-term investments based on very long-term trends. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies.

Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.

One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock’s price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are high-risk (tech), low-risk (utilities), growth oriented (computer), value driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).

Stocks move as a group. By understanding a company’s business, investors can better position themselves to categorize stocks within their relevant industry group. Business can change rapidly and with it the revenue mix of a company. This happened to many of the pure Internet retailers, which were not really Internet companies, but plain retailers. Knowing a company’s business and being able to place it in a group can make a huge difference in relative valuations.

Weaknesses of Fundamental Analysis
Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it is quite brash to imply that the market price, and hence Wall Street, is wrong.

Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time-consuming, which can limit the amount of research that can be performed. A subscription-based model may work great for an Internet Service Provider (ISP), but is not likely to be the best model to value an oil company.

Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, an average-case valuation and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so.

The majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, “there are lies, damn lies, and statistics.” When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals. Only buy-side analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-side analysts who work for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine Weber, DLJ to name a few). These brokers are also involved in underwriting and investment banking for the companies. Even though there are restrictions in place to prevent a conflict of interest, brokers have an ongoing relationship with the company under analysis. When reading these reports, it is important to take into consideration any biases a sell-side analyst may have. The buy-side analyst, on the other hand, is analyzing the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases this may be as a large shareholder.

When market valuations extend beyond historical norms, there is pressure to adjust growth and multiplier assumptions to compensate. If Wall Street values a stock at 50 times earnings and the current assumption is 30 times, the analyst would be pressured to revise this assumption higher. There is an old Wall Street adage: the value of any asset (stock) is only what someone is willing to pay for it (current price). Just as stock prices fluctuate, so too do growth and multiplier assumptions. Are we to believe Wall Street and the stock price or the analyst and market assumptions?

It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However, because so many companies were and are losing money, it has become popular to value a business as a multiple of its revenues. This would seem to be OK, except that the multiple was higher than the PE of many stocks! Some companies were considered bargains at 30 times revenues.

Comparing Fundamental and Technical Analysis

In a nutshell, fundamental analysis aims to determine intrinsic value by looking at the strength of the business, a financial analysis and the operating environment including macroeconomic events. Technical analysis analyzes past market performance by looking at the chart activity of price movements, volume, moving averages and the statistics of various outcomes. Fundamental analysis assumes the efficient market theory holds in the long run and attempts to take advantage of inefficiencies in the short run.

Technical analysis assumes fundamentals are already priced in and tries to find patterns that lead to outcomes with high probabilities of occurring. Technical analysis also captures the psychological aspects of the market in the review of past patterns, whereas fundamental analysis fails to factor in investor psychology but believes fundamentals will rule in the long term, so short-term psychological blips will correct themselves.

Fundamental analysis takes a long-term approach to analyzing the market, considering data over a number of years. So fundamental analysis is more commonly used by long-term investors as it helps them select assets that will increase in value over time.

Technical analysis takes a comparatively short-term approach to analyzing the market, and is used on a timeframe of weeks, days or even minutes. So it is more commonly used by day traders as it aims to select assets that can be sold to someone else for a higher price in the short term.

However, there is a perception that a mix of fundamentals and technical analysis could prove more beneficial to investors. Therefore, the best approach to investing likely involves some combination of fundamental and technical analysis.