In terms of stock, fundamental analysis deals with the determination of a security’s value and the factors that have a direct influence over the company’s business and also its future plans are mainly concentrated upon. Fundamental analysis could also be performed over industries or the entire economy.
Fundamental analysis acts as a tool in answering questions like whether the revenue of the company is in the state of growing or not? Is a profit actually being made or not? The strength of the company, whether it is strong or not or whether it is in a state to rise high above its competitors? Whether it is in a condition to payback its debts? Whether the management has a tendency to “cook the books”?
Fundamental analysis is most commonly performed on stocks but it is related to anything that has economic fundamentals in it.
Fundamental analysis involves everything that deals with the economic health of a company. Apart from revenue and profit which form the most obvious items, it also involves issues relating to the company’s market share as well as the management of the company.
Quantitative and Qualitative, these are the two categories into which the different factors of fundamental analysis can be categorized.
Quantitative aspects of fundamental analysis deals with those entities of a business that can be measured in terms of numbers as for example the financial statements which form a big source and revenue, profit, assets and other financial details could be obtained with accuracy.
The qualitative factors include aspects that are less tangible like the quality of the most important executives of the company, technology it deals with, patents to its name and recognition in the form of its brand name.
Fundamental analysis often known as the “bottom up” method of valuation of a company is used to evaluate the “intrinsic” value that is evaluate the value of a stock in the market, the market value of common share or the value of equity security.
For a fundamental analyst, the market value of a stock has a tendency to move towards the intrinsic value. The current value of the market is below the intrinsic value of the stock then it is most likely that the investor would make a purchase of the stock. If the circumstances are just the opposite, that is the market value of the stock is above the intrinsic value of the stock then it is most likely that the investor would sell it.
Business model of a company is another qualitative approach that fundamental analysis takes into consideration. Unless and until one is very sure about the company’s business strategies, one may not feel comfortable enough to make investments in the company.
Competitive advantage is yet another aspect which is taken into consideration. The stronger the company and tougher on competitors, the better and more secure it is for shareholders.
Management and corporate governance are the two other qualitative aspects that are taken into consideration during fundamental analysis. Management deals with the quality of management. Whether it gears towards profit or not is an important factor to be considered. Corporate Governance deals with the policies of the organization that defines the basis of connections existing between the different levels of the organization that is management, directors, stakeholders.
Customer forms an important part of the analysis. Some companies provide services to a very few number of customers whereas some have more than thousands. Depending on the few customers for big sales is considered n to be a negative implication as loss from a single customer could have drastic effects over business revenues.
Market share is important because it tells one the position of the company in the market. The stronger the company, higher it is as compared to the position of its rivals and in a better-of position to take in the high costs.
Industry Growth is another factor of the analysis. It is concerned with the company’s growth potential in the market, the customer base and potentials to increase the customer base in the market. In the absence of new customers, the company has no option other than stealing market share for growth.
Competition or rather the number of competitors is quite enough to tell about the competitive scenario of company in the market. Pricing power poses one the big risks in the high competitive industry.
Regulation plays a crucial role. For some industries like the drug industry the regulations are such one drug has undergo several steps before coming out into the market. As per the U.S.FDA, new drugs need to undergo several clinical procedures before being introduced out in the market. This takes several years and millions of dollars more than what the company had invested in the research and development.
During fundamental analysis, the income statement allows investors get information about the company’s performance. Very simply, whether the company is bringing in more profits or incurring loss. It shows in detail what the company generates (revenue), what it spent (expenses) and the difference between these two (profit) taking into consideration a certain time period. Higher profit-margins ensure the company’s protection during the tough times. Net income is the profit that the company gains after all the financial expenses get paid. It is more commonly called the “bottom line” and is it is that which people say to be the “profit” or “earnings”.
The balance sheet gives a brief overview of the company’s financial status. It shows what the company has to its name (assets), what it has to give out (its liabilities). The difference between the two, that is, the assets and the liabilities is what is commonly known as the “net assets” or “shareholders equity”. The balance sheet provides information about the debts of the company, about what it should obtain from the customers and the time taken to do so, what it has in its possession, and what it has given as a output over the time. Also, when inventory overpowers sales, it is an obvious sign of negative fundamentals.
The cash flow statement is critical because it helps to understand the fundamentals of a company. It also helps to understand the capability of the company for its future investments and plans. DCF or Discounted Cash Flow method is an important tool via which a company’s value can be ascertained. Another tool that needs mention is the Management Discussion and Analysis (MD&A) which helps investors get a better insight about the doings of the company and many a time points out areas where it performed well.