What is Fundamental Analysis?
Fundamental analysis is a method of evaluating the attractiveness of an investment. It relies on financial reports issued by public companies to gauge their performance and predict the likelihood they will outperform or underperform over a certain timeframe.
To understand the subject, our fundamental analysis consultants stress that it is important to first understand how a company’s value is calculated on the stock market. The total value or market capitalization for a publicly traded company is calculated by multiplying the current share price by all shares outstanding, also known as its ‘float’. If a company has 1 million shares outstanding and its share price is $10, then it has a market capitalization of $10 million (1 million times 10).
The subject matter of fundamental analysis includes looking at factors like revenue growth, margin expansion and changes in debt levels to judge a company’s prospects.” “Also called market-based or value investing — the idea being that attractive price/earnings ratios are often justified. Comparing a company’s fundamentals with the market’s view of those same fundamentals is one of the ways investors make decisions about buying or selling a stock. The strength or weakness of the company’s fundamental information is usually expressed as an earnings yield, which is a measure of the profit available to shareholders if they sell their shares at today’s price.
A company’s fundamentals are basically the three main financial statements—the income statement, balance sheet, and cash flow statement. It is also important to look at supplementary materials that provide more of a big-picture view of the business. In other words, investors should use a fundamental analysis to make an educated assessment of what the future might hold for a certain stock.
Fundamental analysis relies on the company’s financial reports to determine if it is worth more than it was previously. The fundamental analysis of a stock is all about projecting future growth and then looking at the historical performance and comparing that with the projections based on its fundamentals. Changes in fundamental analysis are said to occur when there is a change in the overall economic environment, prompting a change in governmental regulation, changes in competition and so on.
If there is a change in cash flow (earnings), it may be argued that this changes the fundamental value of an investment. By examining historical cash flows, an analyst can identify trends in earnings and determine what kind of earnings a company will generate over time.
More than any other kind, fundamental analysis is central to investing success. Unfortunately, most people don’t understand what it involves. As a result, it can turn into a form of skimming – reading reports and using a very basic calculator to look for net operating profits (NOI) and net cash flow.
Fundamental analysis focuses on three things:
1. financial metrics of a company;
2. information about the company’s competitors; and
3. market factors that affect the company.
A company’s capital structure directly impacts its profitability and cash flow since it deals with the industrial and financial leverage of a company. The main reason for this is because the more debt a company has, the more interest it will have to pay on that debt. As such, it will have less cash flow left over to pay out to shareholders as dividends. Companies that have a large amount of debt generally do not make attractive investments because the interest payments take away from future earnings. However, some companies can use debt in an effective way to help them grow their business faster than they could if they were relying solely on equity capital. This is called ‘leveraged buyout’ and can be used by companies that are able to pay down debt with their earned profits. In the end, this is a riskier investment strategy that can lead to a company not being as profitable as they could have been, but it can also help them gain market share in a specific industry.
The other element of fundamental analysis is to look at the various growth rates of an investment over time. A steady growth rate is generally attractive for an investment, whereas a rapid and erratic growth rate may not be sustainable for most investments.
Other factors that can impact the fundamental analysis of a company are the degree to which they are regulated, the stability of their executive management and their other risks.
The best way to start analyzing a company is by looking at its financial statements and getting familiar with some of its key financial metrics. A number of these financial metrics are broken out in a standard set called the ‘Institutional Data’. These include free cash flow, operating income , operating margins , net profit margin and return on equity (ROE). To further deepen your understanding, go here to read about the 5 different types of finance reports. The most important thing when it comes to fundamental analysis is that all investment strategies and principles should be based on solid research.
