Fundamental Analysis: Principles, Types, and How to Use It

What Is Fundamental Analysis?

Fundamental analysis involves examining a company's financial statements and broader economic indicators to uncover a security's intrinsic value. The result of such an analysis should give you the investment's true worth based on a company's financial health, the market, and economic conditions. Investors perform fundamental analysis to gauge whether or not to invest in a company based on it's current and projected worth.

Understanding Fundamental Analysis

When performing fundamental analysis, you study the company's revenue growth, profitability, and competitive advantages within its industry. You also assess macroeconomic factors such as the overall state of the economy and the demand for the company's products or services. It also takes into account the effectiveness of the company's management team. A skilled and experienced leadership team can navigate challenges and seize opportunities, driving the company's growth and increasing its value.

This approach to the market often allows you to see behind investor sentiment and company marketing to determine whether the company has the potential for long-term success. With fundamental analysis, you can then gauge if the security's market price is over- or undervalued.

Fundamental analysis typically starts by analyzing a company's financial statements, including the income statement, balance sheet, and statement of cash flows. The information in these materials can be used to calculate and assess a company's financial health and intrinsic value. Key ratios derived from these financial statements include the price-to-earnings (P/E) ratio, earnings per share (EPS), return on equity (ROE), and debt-to-equity (D/E) ratio, among others. Fundamental analysts use measures like these to determine whether a stock is undervalued or overvalued relative to its market price and competitors.

In addition, fundamental analysis frequently involves looking at gross domestic product, inflation, unemployment rates, industry or sector trends, and the company's competition. Fundamental analysis thus takes how a company should perform, not just in the market, but as a producer of goods and services. This requires looking at the overall economy, sector performance, and the company's position within the industry to estimate its value and forecast future performance. This approach not only considers economic and financial data but also often includes reviewing its business model, management effectiveness, brand awareness, and potential for growth and profitability.

Ultimately, fundamental analysis aims to give you a number, a value, for the company you can use when buying, holding, or selling stocks. It requires a comprehensive understanding of financial statements and a strategic view of how external factors could impact the company's future earnings and market position.

Why Is Fundamental Analysis Important?

Fundamentals allow investors to look beyond short-term price fluctuations and focus on the underlying factors that drive a company's operations and long-term performance.

The main benefit of fundamental analysis is to help quantify the value of a company and its shares. Financial statements offer hard data that reveal insights into a company's profitability, liquidity, and overall financial stability. This information, along with an assessment of the company's management team, competitive advantages, and industry trends, furnishes a picture of the company's fair or target value. With this knowledge, investors can make more informed decisions about buying, holding, or selling a particular stock.

Fundamental analysis can also help investors identify undervalued companies. By considering a company's sales growth, market share, and product pipeline, investors can gauge its ability to increase future profits and grow shareholder value. By investing in companies with solid fundamentals and promising growth prospects, investors can benefit from long-term trends and capitalize on emerging prospects. Value investors, in particular, look for undervalued shares relative to their fundamental potential.

Finally, fundamental analysis can help you spot red flags and overvalued investments. By researching a company's financial health and market position, investors can more easily avoid stocks that may be more likely to underperform or experience significant downturns. This is especially important during economic uncertainty or market volatility when a company's underlying strength can be the difference between weathering the storm and being pushed out of the market altogether.

Where to Find Fundamentals for a Company

Some of the most common and reliable sources for the fundamentals of a company include the following:

• Company filings: Public companies are required to file regular reports with the Securities and Exchange Commission (SEC), such as Form 10-K (annual report), Form 10-Q (quarterly report), and Form 8-K (current events report). These filings contain detailed financial statements, management discussions and analyses, and other important information about the company. You can access these filings for free on the SEC's EDGAR database.
• Company website: Most publicly traded companies have an investor relations section that provides financial statements, earnings releases, investor presentations, and other relevant information for shareholders and potential investors. Transcripts of earnings reports can be particularly helpful since company leads typically find it necessary to address company soft spots for journalists.
• Financial platforms: Yahoo! Finance, Google Finance, and MarketWatch, among others, provide financial news, analysis, and fundamental data on publicly traded companies, including financial statements, key ratios, and analyst ratings.
• Broker research reports: Many brokerage firms supply research reports on companies they and their affiliates cover, often with detailed fundamental analysis and investment recommendations.
• Financial data providers: Subscription-based financial data providers such as Bloomberg, FactSet, and Morningstar offer extensive fundamental data and analysis on companies, industries, and markets. Subscriptions are often pricey, so they are more typically used by professional investors and analysts.
• Industry trade journals: Trade publications covering specific industries can provide valuable insights on industry trends, competitive dynamics, and company-specific developments that inform your fundamental analysis.

Remember, when conducting fundamental analysis, it's essential to use several sources to get a well-rounded view of a company's financial prospects and to be aware of any potential biases or conflicts of interest in the information you're receiving.

How to Read a Company's Annual Report

Reading a company's annual report is an essential part of fundamental analysis. Here's a step-by-step guide on how to read and analyze an annual report:

1. Start with the CEO's letter to shareholders: This section gives an overview of the company's performance, key developments, and outlook from the perspective of top management. Pay attention to the tone and content of the letter, as it can give insights into the company's strategy, challenges, and prospects.
2. Review the business description: This section describes the company's main products or services, target markets, competitive advantages, and key risks. It can help you understand the company's business model and the factors that drive its success.
3. Analyze the management's discussion and analysis (MD&A): The MD&A provides a detailed discussion of the company's financial performance, including revenue and expense trends, cash flows, and key financial ratios. It also has management's perspective on the factors that affect the company's performance and outlook for the future.
4. Examine the financial statements: The annual report has the company's audited financial statements, including the income statement, balance sheet, and statement of cash flows. Review these carefully while looking for trends in revenue, expenses, profits, assets, liabilities, and cash flows. From there, you can compute the critical financial ratios.
5. Read the notes to the financial statements: The notes (or footnotes) provide additional details and explanations about the company's accounting policies, significant transactions, and other important information that may not be clear from the financial statements alone.
6. Review the auditor's report: This provides an independent opinion on whether the financial statements fairly present the company's financial position and performance following generally accepted accounting principles. Look for any qualified opinions or disclaimers that may indicate potential issues.
7. Analyze the company's corporate governance: The annual report often has information on the company's board of directors, executive compensation, and other corporate governance matters. Consider whether the company's governance practices align with the interests of shareholders and whether there are any red flags, such as conflicts of interest or excessive compensation.
8. Look for additional disclosures: The annual report may include additional disclosures about legal proceedings, regulatory issues, or environmental, social, and governance (ESG) factors that could impact the company's performance and reputation.

A Closer Look at Financial Statements

The information in financial statements is among the most valuable about a company's financial health and performance. Here's a breakdown of what you can learn from each one:

• Income Statement: This shows how much money a company is making (revenue), how much they're spending (expenses), and then what's left over (profit or loss). By looking at trends in revenue and expenses over time, you can get a sense of whether the company is growing or struggling. You can also calculate important ratios like the company's profit margin, which tells you how much of each dollar in sales the company gets to keep as profit.
• Balance Sheet: This gives you a snapshot of what a company owns (assets), what it owes (liabilities), and what is left over (shareholders' equity). This can help you assess a company's financial stability and liquidity. For example, if a company has a lot more assets than liabilities, that's generally a good sign. You can also look at how much debt the company has relative to its equity to understand its financial leverage and risk.
• Statement of Cash Flows: This shows how much cash is coming in and going out of the company over a given period. It's broken down into three main categories: cash from operations (the money generated by the company's core business activities), cash from investing (the money spent or earned from investments not related to the core business), and cash from financing (the money raised or paid out and used to fund the business). By looking at a company's cash flows, you can better understand its ability to generate cash, pay its bills, and invest in growth.

The cash flow statement is crucial because it's harder for a business to manipulate its cash situation. An aggressive accountant can do plenty of things to manipulate earnings, for example, but it's tough to fake cash in the bank. For this reason, some investors use the cash flow statement as a more conservative measure of a company's performance.

Quantitative and Qualitative Fundamental Analysis

The problem with defining the "fundamentals" is that they can cover anything related to a company's economic well-being. They can include numbers like revenue and profit, but they can also include anything from a company's market share to the quality of its management. Generally, these are all grouped into two categories: quantitative and qualitative:

• Quantitative: information that can be shown using numbers, figures, ratios, or formulas
• Qualitative: rather than a quantity of something, it is its quality, standard, or nature

In this context, quantitative fundamentals are hard numbers, the measurable characteristics of a business. The most significant source of quantitative data is financial statements. The qualitative fundamentals are less tangible. They might include the quality of a company's key executives, brand-name recognition, patents, and proprietary technology. Neither qualitative nor quantitative analysis is inherently better. Many analysts consider them together.

Qualitative Fundamentals to Consider

There are certain qualitative fundamentals that analysts should always consider when analyzing a company. These include the following:

• The Business Model: What exactly does the company do? This isn't always straightforward. If a company's business model is based on selling fast-food chicken, is it making its money that way? Or is it coasting on royalty and franchise fees?
• Competitive Advantage: A company's long-term success is primarily driven by its ability to maintain its competitive advantage. Competitive advantages, such as Coca-Cola Co.'s (KO) brand name and Microsoft Corporation's (MSFT) long domination of the personal computer operating system, create a moat around a business, allowing it to keep competitors at bay and enjoy growth and profits.
• Management Team: Some think management is the most important criterion for investing in a company. This makes sense: Even the best business model is doomed if the company's leaders fail to execute the plan properly. While it's hard for retail investors to meet and truly evaluate managers, you can look at the corporate website and check the resumes of the top brass and the board members. How well did they do in previous jobs? Have they been unloading a lot of their stock shares lately?
• Corporate Governance and Board Structure: These are provided by the policies within an organization indicating the relationships and responsibilities among management, directors, and stakeholders. These policies are defined and determined in the company charter, its bylaws, and corporate laws and regulations. You want to do business with a company that is run ethically, fairly, transparently, and efficiently. Note whether management respects shareholder rights and shareholder interests. Ensure their communications to shareholders are transparent and understandable. If you don't get it, if there are major issues you know surround the company and they aren't addressed, it's not a sign that they have good answers for you.
• Industry Trends: It's also important to consider a company's industry: its customer base, market share among firms, industrywide growth, competition, regulation, and business cycles. Learning how the industry works will give an investor a deeper understanding of a company's financial health.
• Stakeholder Satisfaction: Employees, managers, customers, suppliers, investors, and other stakeholders should all have positive views on the company and its prospects. Without that, a company's brand equity and image can suffer, which can lead to fewer sales, lower profits, and flagging share prices.

Quantitative Fundamentals to Consider: Financial Ratios

Financial statements are how a company discloses information about its financial performance. Here are some of the most important financial ratios with their formulas:

Fundamental Analysis vs. Technical Analysis

Fundamental analysis contrasts starkly with technical analysis, which attempts to forecast prices by analyzing historical market data such as price and volume. Technical analysis uses price trends and action, often plotted on charts, to create indicators and identify patterns. Some indicators develop patterns that have names resembling their shapes, such as the "head and shoulders" pattern.

A major distinction is where "value" comes from. For technical analysts, the market sets prices, and hence, the changes there give a company its value. For fundamental analysts, there is an intrinsic value that the market can often miss.

Limitations of Fundamental Analysis

Though fundamental analysis can provide investors with insights into the future of a company, it does come with some downsides. Keep these items in mind when performing fundamental analysis:

• It's Time-Consuming: Fundamental analysis involves a detailed examination of financial statements, economic data, industry reports, and company-specific factors. This process requires collecting extensive data, performing complex calculations, and interpreting various financial metrics - which all times time (which leads into the next downside....).
• It's A Lagging Indicator: In addition to being a slow process, fundamental analysis often acts as a lagging indicator because it relies on financial data that reflects past performance. By the time changes in a company’s fundamentals become apparent in its financial statements, the stock price might have already adjusted.
• Relies on Historical Data: Similarly, fundamental analysis is based largely on historical financial information. While this data provides a basis for estimating future performance, it may not fully capture future risks or opportunities, as past performance is not an indicator of what's to come in the future.
• Subject to Accounting Practices: The accuracy of fundamental analysis depends on the integrity and transparency of a company’s financial statements. Keep in mind that things like management estimates, depreciation, or other GAAP-compliant requirements can (perhaps improperly) impact the fundamental analysis.
• Difficult to Value Intangibles: Intangible assets like patents, trademarks, brand reputation, and human capital are increasingly important in today’s economy. However, these assets are challenging to quantify and may not be fully reflected in a company’s financial statements. Consider how some investors would have believed in Apple simply because of Steve Jobs; that notion is not captured in fundamental analysis.
• Economic Assumptions: Fundamental analysis often involves assumptions about future economic conditions such as interest rates, inflation, and economic growth. Again, these are always changing and may not materialize as expected.
• Overlooked Short-Term Opportunities: Fundamental analysis is geared towards long-term investment decisions, focusing on a company’s intrinsic value and potential for growth over time. This long-term focus might cause investors to miss short-term trading opportunities that technical analysis can identify such as price patterns, volume spikes, or momentum indicators.

Example of Fundamental Analysis

Let's analyze a hypothetical company called ABC Inc. using fundamental analysis. We'll examine its financial statements and calculate key ratios to assess its financial health and performance.

First, let's look at some data from ABC Inc.'s financial statements for the previous fiscal year:

Now, let's calculate some key ratios:

Profitability Ratios:

• Gross profit margin = ($1,000 - $600) / $1,000 = 40%
• Operating profit margin = $200 / $1,000 = 20%
• Net profit margin = $150 / $1,000 = 15%
• Return on assets (ROA) = $150 / $1,500 = 10%
• Return on equity (ROE) = $150 / $1,000 = 15%

ABC Inc.'s profitability ratios suggest that the company is generating healthy profits from its operations. Its gross margin is 40%, operating margin is 20%, and net margin is 15%. Its ROA and ROE of 10% and 15%, respectively, indicate that the company is generating solid returns on its assets and equity.

Liquidity Ratios:

• Current ratio = $750 / $250 = 3.00
• Quick ratio = ($200 + $150 + $200) / $250 = 2.20

Assuming ABC Inc.'s current assets are $750 million, with $200 million in cash, $150 million in marketable securities, and $200 million in accounts receivable, and its current liabilities are $250 million, the company's liquidity ratios are strong. A current ratio of 3.0 and a quick ratio of 2.2 suggest that ABC Inc. has ample liquidity to cover its short-term obligations.

Solvency Ratios:

• Debt-to-equity ratio = $500 / $1,000 = 0.50
• Debt-to-assets ratio = $500 / $1,500 = 0.33

ABC Inc.'s solvency ratios indicate that the company has a manageable level of debt relative to its equity and assets. A debt-to-equity ratio of 0.5 and a debt-to-assets ratio of 0.33 suggest that the company is not overly leveraged and has the financial flexibility to meet its long-term obligations.

Valuation Ratios (Assuming ABC Inc. has 100 million shares outstanding and its stock price is $25 per share):

• Price-to-earnings (P/E) Ratio = $25 / ($150 / 100) = 16.67
• Price-to-book (P/B) Ratio = $25 / ($1,000 / 100) = 2.50
• Price-to-sales (P/S) Ratio = $25 / ($1,000 / 100) = 2.50

ABC Inc.'s valuation ratios suggest that the company's stock is trading at a reasonable valuation relative to its earnings, book value, and sales. A P/E ratio of 16.67 aligns with the broader market, while P/B and P/S ratios of 2.5 indicate that the stock is not overly expensive relative to the company's assets and revenue.

In addition to these quantitative measures, we can also consider certain qualitative fundamentals:

Competitive Advantages:

• Has strong brand recognition in its industry and high customer loyalty
• Proprietary technology that differentiates its products from competitors
• Efficient supply chain and distribution network, enabling faster delivery and lower costs

Management Quality:

• It has an experienced management team with a proven track record of success.
• The CEO has been with the company for 15 years and has led the company through several periods of growth.
• Management has demonstrated a commitment to creating new goods and services and has strategic investments in research and development.

Industry Trends:

• The industry in which ABC Inc. operates is growing at a steady rate of 5% per year.
• There's increasing demand for eco-friendly and sustainable products, which aligns with ABC Inc.'s product offerings.
• The regulatory environment is becoming more favorable for the company's products.

Growth Prospects:

• ABC Inc. has a robust pipeline of new products set to launch in the next 12-18 months.
• The company has been expanding into new geographic markets and plans to enter two new countries next year.
• Recent acquisitions have provided opportunities for synergies and increased market share.

Corporate Governance:

• ABC Inc. has a diverse and independent board of directors.
• The company has a strong track record of transparency and timely financial reporting.
• Executive compensation is aligned with long-term shareholder interests.

ESG Factors:

• ABC Inc. has set ambitious targets for reducing its carbon footprint and increasing its use of renewable energy.
• The company is committed to diversity, equity, and inclusion, with programs in place to promote a diverse workforce.
• ABC Inc. engages with local communities and supports various philanthropic initiatives.

Based on this hypothetical fundamental analysis, ABC Inc. appears to be a financially healthy and potentially attractive investment. However, it's important to remember that this is just a simplified example. In practice, investors would need to conduct a more thorough analysis, considering the company's competitive position, industry trends, management quality, and growth prospects, before making an investment decision.

The Bottom Line

Fundamental analysis is used to value a company and determine whether a stock is over- or undervalued by the market. It considers the economic, market, sector-specific, and financial performance.

Financial ratios generated from financial reports and government industry and economic reports are used to assess a company. Not every analyst uses the same tools or views stocks similarly—you might determine a stock is valued differently than another analyst. What's important is that the stock you analyze meets your criteria for value and that your analysis creates actionable information.