As a beginner trader, it is important to learn the basic concepts of trading before you set out to invest large sums of money. One of these concepts is fundamental analysis. Essentially, fundamental analysis is the process of measuring the intrinsic value of securities by evaluating the related financial and economic factors that are likely to affect the value of that security, including microeconomic and macroeconomic factors.
Although it is a broad topic, this post will look at the basics to ensure that you, as a novice trader, have the right concepts and tools to begin your trading journey. The post will focus on some of these key topics:
- understanding the fundamentals
- the qualitative and quantitative fundamentals
- the financial reports
- the tools used for fundamental analysis
- the fundamentals of intrinsic value
- critical aspects
The core of fundamental analysis
Although every type of stock analysis tries to determine whether experts have correctly valued a commodity in the market, fundamental analysis tries to find out but from a micro and macro perspective. It does this to identify those securities that the market has not correctly valued.
Before analysts determine the fair market value, they study the general economic situation and evaluate the industry-specific strengths before focusing on a company’s performance.
Therefore, this type of analysis uses public data to assess stock value. For example, as an investor, you can perform a fundamental analysis of a bond’s value by evaluating economic factors such as the state of the economy and interest rates. You then study information about the issuer of the bond, such as possible changes in credit ratings.
In stock trading, the fundamental analysis uses various concepts such as future growth, revenue, return on equity, or the company’s profit margins to determine the underlying value of a company. It is also a good way to find out the growth potential of a company. You can easily get this information from the financial statements of the companies.
Correlation between fundamental analysis and investment
As a beginner, you can create a basic model that will help you determine the estimated value of a company’s stock based on publicly available data. However, it would help if you kept in mind that this value estimates the stock price based on what is currently trading in the market.
When financial analysts such as accountants are done calculating the stock’s value and determining that the value is higher than the current market price, they can resort to two options. First, they can publish an overweight or buy recommendation for that stock. Therefore, it would be an ideal recommendation for shareholders to use such information.
Second, if the result is a significantly lower intrinsic value, an accountant may consider the stock to be overvalued. The implication here is that he must issue underweight or basically a sell recommendation.
This means that an investor who likes to follow these recommendations believes that he can buy such securities with favourable recommendations. This is because such securities can easily go up over a period of time. The opposite is also true for stocks with unfavourable evaluations, which are ideal candidates for short positions.
The Qualitative and Quantitative Fundamentals
Quantitative fundamentals essentially refer to hard numbers; in other words, they are measurable. This explains why many analysts prefer to get their quantitative data from financial statements. It is easy to measure profits, sales or assets accurately.
In contrast, qualitative fundamentals refer to intangibles such as:
- Brand name recognition.
- Proprietary technology.
- Key executives.
However, it is not possible to clearly categorise one foundation as better than another. That’s why many experts use these foundations together to get the best results.
Basic qualitative fundamentals
When valuing a company, there are four key fundamentals that experts consider:
- Competitive Advantage: The ability of a company to be successful in the long run depends entirely on how competitive the company can remain during that period.
- Corporate Governance: It is basically describing the company’s policies that describe the responsibilities and relationships between the directors, management and shareholders. All these things fall under one cloud – the corporate charter.
- Business Model: It mainly refers to what the company does, and the structures set up to do what they do.
- Management: Many traders rely on information from management to make their investment decisions. If a company’s managers are not up to the task, then the company is doomed, and so are the investors.
What quantitative tools should you consider using?
As a business, the best way to reveal the financial health of your operation is through financial statements. Using these financial statements can help show your financial performance. Below are some of the most common statements that traders can use to gather information.
- The Balance Sheet: Basically, balance sheets are hard numbers that record a company’s liabilities, equity, long-term and short-term assets. It is also referred to as the balance sheet. Essentially, you get a company’s assets by adding its liabilities to its equity. Liabilities are basically debts and can be short term or long term and are a source of funding. Equity, on the other hand, is all the capital that investors have put into a company. Tangible assets include things like cars and buildings.
- Income Statement: the information refers to the measurement of a company’s financial performance over a period of time. It is usually done quarterly and annually. You can get information about profits, expenses and income for a particular period from the income statement.
- Statement of Cash Flows: This statement of cash flows represents how funds flow in and out of business over a period of time. Some of these cash flow statements are:
⭕ Cash from financing (CFF): This is the money that comes in or goes out by borrowing and spending money.
⭕ Cash from investing (CFI): the funds used to invest in assets or the proceeds a company receives from the sale of other businesses, long-term assets, or equipment.
⭕ Operating cash flow (OCF): The funds that a company generates from its day-to-day operations.
These are other tools to consider:
- Earnings-per-share (EPS): the EPS ratio represents the earnings that are attributable to each share of company stock. To get the number, you need to divide the company’s net income by the total number of shares outstanding.
- Dividend Yield: It is a ratio expressed as a percentage that shows the annual dividend compared to the stock price. To get the dividend yield, you should divide the annual dividend payments per share by the stock value.
- Price to Book Ratio (P/B): The ratio compares the book value of the stock to that of the market. You need to divide the last closing stock price by the book value of the stock for the last quarter.
- Price-to-earnings ratio (P/E): It compares the selling price of a stock and the company’s earnings per share.
- Price-to-Sales Ratio (P/S): It is a method of evaluating a company’s stock price about its revenues. It is also known as revenue multiple, sales multiple or simply PSR.
- Projected Earnings Growth (PEG): It is a projection of a security’s growth rate from the company’s annual earnings.
- Return on Equity: To get this value, you need to divide a company’s net income by its equity.
- Dividend payout ratio: It compares all dividends paid to shareholders with the company’s net income.
Fundamental analysis’ basics of Intrinsic Value
The fundamental analysis primarily assumes that the current stock price in the market does not accurately reflect the value of a company, which is supported by publicly available data. It also asserts that the value of a company noted on the fundamentals is likely to be the true value of that stock.
This is why experts refer to it as intrinsic value. However, it would be best if you kept in mind that in other fields such as options trading or stock valuation, the term “intrinsic” may mean something different.
When it comes to option valuation, analysts use standard calculations to find intrinsic value. When it comes to options valuation, analysts use standard calculations to find intrinsic value, whereas, with equities, they use a range of complex models.
There are two main criticisms:
- In the case of the efficient market hypothesis, experts argue that it is virtually impossible to find a gap in the market using technical or fundamental analysis. They argue that a market continuously prices all stocks efficiently, which means that any chance of excess returns is immediately thwarted by the many participants. For this reason, it becomes impossible for traders to outperform a market in the long run.
- In technical analysis, investors base their investment decisions solely on the volume and price action of stocks. Therefore, they use charts and many other tools, ignoring the use of fundamentals. The idea behind this is that the market has a way of discounting everything. This means that everything about a company is priced into its shares. Therefore, stock price movements can easily provide more insight compared to fundamentals.
If you are a beginner learning about fundamental analysis, you can know which tool to use depending on the securities you want to invest in. Therefore, after this post, you now know how to proceed and where to apply fundamentals.
I hope you found this post helpful in taking a profitable trading path. Don’t forget to share it with your friends and family on Facebook, Twitter and any other social forum and let’s discuss further.