What is Fundamental Analysis?
Fundamental analysis is a means of comparing a company’s stock price with its underlying worth, or intrinsic value, to discover whether it represents a good investment or not. Read on to learn the types of fundamental analysis and how you can put them into practice.
Stock analysis is the process of researching companies to identify those with attractive share prices. The two main types of stock analysis are: technical, which focuses on interpreting patterns in historical stock prices, and fundamental, which makes use of a much wider set of information, such as the company’s accounts, management competence, the economic background, competitive threats, and other factors that could influence the business’s fortunes.
Fundamental analysis focuses on establishing a company’s true worth, or ‘intrinsic value’, using publicly available data and other information.
Analysts calculate a share price that reflects this value and compare it with the current share price. The share price may be lower or higher than its intrinsic value because stock prices are subject to a variety of factors – including investor sentiment. When investors in general are feeling optimistic, they may overvalue a company, and vice versa.
There are two main types of fundamental analysis: quantitative and qualitative.
Quantitative fundamental analysis
With quantitative fundamental analysis, statistics are the focus.
Quantitative analysts use the data found in a company’s accounts to work out its intrinsic value via a range of financial calculations. These can range from simple formulas such as earning per share (EPS) to more complicated ones, such as a company’s discounted cash flow.
EPS is calculated by dividing the company’s profit by the number of shares it has issued. Discounted cash flow, put simply, tells investors what the company’s future earnings are worth in today’s money.
The statistics used in quantitative fundamental analysis include revenue, earnings, profit margin, debt, and return on equity, which measures financial performance by dividing net income (profits after tax) by shareholder equity. The last of these is the difference between a business’s assets and its liabilities, which is the value of a company after deducting what it owes from what it owns.
For example, imagine that the ACME company has a factory, machinery and equipment plus an inventory of goods it can sell that are valued at £50 million. It has a bank loan of £30 million. The shareholder equity in this example would be £20 million.
The main drawback with quantitative analysis is that, like all financial models, it is only as good as the data you put into it. The discounted cash flow and similar calculations will vary depending on the assumptions made by the analyst – and those assumptions will differ from one person to another. Consequently, the estimates of a company’s intrinsic value could vary widely.
Qualitative fundamental analysis
Qualitative fundamental analysis focuses on a host of non-statistical factors, such as the business strategy a company is pursuing, the strength of the competition it faces, the ability of the management team, and the loyalty of employees and customers.
These factors are more difficult to assess than those found in quantitative analysis. They may involve regular meetings with a company’s management, analysis of the competition, and the study of any regulatory or technological barriers, which prevent competitors from entering the market.
It may also be necessary to identify threats to the company’s market share and profits from, for example, disruptive new technologies, new legislation, a deterioration in the economic outlook or the prospect of a sharp increase in the price of raw materials essential to the company’s goods.
Again, all of this information is subject to interpretation. One analyst may feel impressed after a meeting with a company’s management while another may not. So different analysts may well come to different conclusions.
Is fundamental analysis better than technical analysis?
Fundamental analysis and technical analysis are the two main schools of thought when it comes to determining whether a stock represents good value or not.
Fundamental analysis seeks to interpret the economic, financial and human factors that influence a business, while technical analysis strives to predict future stock-price movements by analysing historical data. Fundamental analysis tends to take a long-term approach to investing.
Technical analysis focuses on short-term profits by buying and selling undervalued stocks quickly and capitalising on market trends. Many investment professionals prefer fundamental analysis, believing that the merits of technical analysis are unproven.
Technical analysis is also subject to the criticism that there is no reason why previous performance should influence the future: the phrase ‘past performance is not a guide to the future’ is a common warning in investment literature.
However, the best approach may be to consider both types of analysis when evaluating a stock and, over the long term, decide which form of stock analysis works best for you.
How accurate is fundamental analysis?
It is almost impossible to say whether the fundamental analysis employed by major investment managers is accurate or not.
Some researchers have suggested you are better off investing in a low-cost fund that tracks an overall index than giving your money to a professional fund manager who will pick stocks using fundamental analysis and charge a higher fee. But you can also find those that suggest these stock-picking funds are preferable to index trackers.
Moreover, the relative performance of managed funds and tracker funds varies over time, so there are periods when one style performs better than the other and vice versa.
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
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Anthony is a BBC-trained journalist. He has worked in financial services and specialised in investments for over 20 years, writing for various wealth managers and leading news titles. Read more