Last week, we covered technical analysis, one of the main ways to analyze stocks. This week, we’ll discuss fundamental analysis. While these two methods of stock analyzing are often thought of as direct opposites of each other, many traders use both in their trading strategy—you don’t have to pick one or the other.
Definition of Fundamental Analysis
Fundamental analysis is one way to analyze a security, including bonds and derivatives (however, stocks are the most common). Fundamental analysis measures the intrinsic value of the ticker using factors such as macroeconomics, microeconomics and financials.
Ultimately, fundamental analysts want to determine a price to compare with the current price to determine if the stock is under- or overvalued. Unlike technical analysts, this method of stock analysis does not use historical market data. Fundamental analysts will use factors such as competitive advantage, balance sheets, cash flow statements, and more.
Fundamental analysts typically start with assessing the economic conditions, then move toward a specific stock.
Fundamental Analysis Factors
A good place to start when fundamentally analyzing a stock is to start with the company earnings. You want to know how much a company is making in profit, and what will they likely make in the next few quarters. Every publicly traded company reports earnings each quarter. Typically, when earnings expectations are exceeded, it leads to a higher price, and when earnings miss, they can drive a price lower. Of course, there are always exceptions.
You can also go deeper than just earnings, with ratios including:
- Earnings per share (EPS) – How much of a company’s profit per share
- Projected earnings growth – The expected one-year earnings growth rate of the stock. P/E divided by the growth rate.
- Price-to-earnings ratio (P/E) – Current stock price/earnings per share
Investopedia defines a balance sheet as, “a financial statement that reports a company’s assets, liabilities and shareholder’ equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure.”
- Assets: What a company owns, such as cash on hand and inventory.
- Liability: What a company owes, including worker pay, taxes, rent and more.
- Shareholders’ Equity: Total assets minus liabilities
The cashflow statement details the amount of cash that goes in and out of a business. There are typically three types of cash flow reports:
- Operating Cash Flow – Cash generated from business operations
- Cash from Investing – Cash invested in assets or acquisitions.
- Cash from Financing – Issued or borrowed cash
Some analysts emphasize cash flow due to the fact it’s hard to manipulate. Ultimately, it’s useful to determine how much cash is in the bank for a company. Cashflow is also important so companies can pay dividends and operating costs (such as goods and services needed, wages, utilities, etc).
The more cash positive, the more likely a company will survive a recession or hard economic times. The more debt a company has, the harder it will be to make acquisitions or protect itself during economic hardships.
The income statement details a company’s revenue and expenses during a given period. It reports:
Ultimately, it tells you whether or not the company profited or lost money in the given time period. These are usually released quarterly or annually.
There are four main qualitative factors to consider when conducting a fundamental analysis. Qualitative factors aren’t just hard numbers like revenue or profit but can include things like quality of management, brand-name recognition, and more. According to Investopedia, there are four fundamentals to consider:
- Business Model: How is the company making money?
- Competitive Advantage: How unique is the company, and how many competitors does it have? Does it have a bigger brand name recognition?
- Management: What is the quality of leadership? Did the current leaders perform well at their previous positions? Are they buying/selling large amounts of shares?
- Corporate Governance: What are the responsibilities of the stakeholders? Do they have bylaws and regulations to follow? Do they have transparent communication?
Other qualitative factors to consider include the industry, market share, regulation, customer satisfaction, pending lawsuits, and more.
Fundamental Analysis v. Technical Analysis
Fundamental and technical analysis are the two main types of stock analysis. One may fit your trading strategy better than the other, but you don’t have to pick just one.
Technical analysts believe that a company’s intrinsic value is already incorporated into the stock’s price. Instead of looking at the fundamental data, they focus on analyzing historical data to determine where the price will move next. They will analyze charts and use indicators like MACD, moving averages, support/resistance levels and more.
Limitations of Fundamental Analysis
One limitation of fundamental analysis is that a stock may simply not trade at its intrinsic value. Whether it’s an internal or external catalyst, news, rumors, and economic conditions can affect what happens to a stock.
Another limitation is that it is more time consuming than technical analysis to combine the data and come to a calculated price. Plus, new data and reports can arrive at any time, which will affect your analysis. Additionally, you may need to hold onto a stock for a while before you get to the projected price, depending on the time you enter your position.
Additionally, much of the data fundamental analysis relies on is previous data instead of what is happening in the future.
One last criticism of fundamental analysis is that it can be biased based on your interpretation of the data and company.
Fundamental analysis is just one way to analyze a stock. In this method, analysts seek to find the intrinsic value of the stock by using the overall economic conditions and the company’s financials to determine a value. This method looks at both quantitative and qualitative factors, including earnings, cashflow, management, and more.
You don’t have to pick one way to analyze a stock—you can use many factors, indicators, and catalysts to make informed trading decisions.