Fundamental Analysis of Stocks
When purchasing shares on the stock market, you are actually acquiring a small part of a company. Therefore, before deciding whether or not to buy shares, it is very important to analyse not just the technical aspects of the stock in question, but also the fundamentals of the business behind the company.
In this article we will explain how to conduct fundamental analysis of stocks and their respective company and what indicators you should be looking at in order to do this. But before we get into any further detail, let's firstly look at what we mean when we talk about fundamental analysis.
What is Fundamental Analysis of Stocks?
Fundamental analysis, in this context, is the estimation of the value of a company with a view to arriving at a "fair value" for its shares.
As shares trade in the stock market, their "market price" fluctuates up and down depending on supply and demand. Comparing a share's fair value to the current market price helps investors to decide whether or not to invest in a share.
Fundamental analysis involves looking at everything that can affect the company's value, from the state of the economy, through industry conditions, to company-specific factors.
By doing fundamental analysis, we will be better positioned to understand if the stock is overvalued or undervalued and its future potential. For this reason, this type of analysis is very valuable for those traders who trade over the long-term.
Fundamental Analysis vs Technical Analysis
Technical analysis evaluates an asset by looking at its previous prices and price-trends, with the goal of identifying patterns which may indicate future price movements of that asset. Here are some of the key differences of these two types of analysis:
- Analysing a company's fundamentals is a must for traders who want to invest in a company over the long term. Likewise, technical analysis is essential for short-term investors
- Technical analysis is supported by technical indicators and statistics, whereas fundamental analysis is based on macroeconomic, company specific data and financial ratios
- Technical analysis measures the probability of future asset price changes, while fundamentals try to measure the real value of an asset
- Technical analysis looks to the past to see what the near future may bring. Conversely, fundamental analysis studies the present to see what the future may look like
- Traders focusing on technical aspects are asking themselves "when should I make my investment?", whilst fundamentalists are asking "where should I make my investment?"
Fundamental analysis can be complementary to technical analysis. Conducting both types of analysis allows us to compare the effect of certain fundamental factors on the price of the asset in the past
In order to better understand how fundamental analysis works, let's look at an example:
Company A is listed on the stock exchange. The company's income statement and balance sheets reflect that it is in good financial health. As well as this, the company belongs to a stable sector of the economy. However, the shares of the company do not appear to reflect its good position and are barely increasing in value. After carrying some fundamental analysis of the company, we may conclude that the company's shares are currently undervalued and, therefore, in the long-term there is upward potential.
For the proponents of fundamental analysis of stocks, the share price of a company will always tend to move towards their real value.
How to do Fundamental Analysis of a Company
There are many different methods of performing the fundamental analysis of a company, each trader will have their own. In this article, we haven chosen a top-down approach, i.e. starting with the general economy and moving down towards the more specific company factors. We will highlight the most important indicators and ratios that serve as a basis for conducting fundamental analysis of stocks.
Macroeconomic analysis looks at the general state of the economy, its strengths and its weaknesses, growth rate and so on. This type of information, which is crucial to our analysis, can be found in the economic sections of news publications and in the official communications of different public organisations. The Economic Calendar is a very useful tool which shows us the date and time of expected announcements and publications, the country the news will affect and a forecast for how each item will impact the economy.
Source: Admiral Markets - screenshot of the Economic Calendar. Date 2 July 2020
The most important macroeconomic indicators for our purposes are GDP, interest rates, inflation, employment rates and, in the case of a company related to the financial or housing sector, the Euro Interbank Offered Rate.
Gross Domestic Product (GDP)
GDP measures the monetary value of all the finished goods and services produced in a country over a given period of time, usually one year. Although considered by some to be incomplete as it does not include elements which are difficult to quantify, such as the informal economy, GDP remains the most widely used indicator for measuring the size of an economy.
The statistical offices of every country usually publish the evolution of GDP on a regular basis. In the USA the data is published by the Government's Office on Economic Analysis, in the Eurozone it is Eurostat and in the UK it is the Office for National Statistics. In addition to these institutions, global organisations such as the IMF usually make estimates of the evolution of GDP of the world's main economies.
The most interesting piece of data for traders looking at the fundamentals of a company is not GDP in its absolute term, but rather its evolution from quarter to quarter and year to year. A positive growth rate indicates that the income of an economy has increased and, therefore, the economy is developing favourably.
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Interest rates are important to consider, as they affect many areas of the economy, such as inflation and consumption. A rise or fall in interest rates will tend to respectively strengthen or weaken the relevant currency. If the company you are analysing is a large importer or exporter, these changes in the currency will have a direct impact on the company's costs and revenues.
Central banks use interest rates as a tool to regulate the economy, controlling inflation and stimulating economic growth.
Lowering interest rates increases consumption, and vice versa. This is one of the reasons why a decrease in the interest rate tends to be good for equities.
Inflation measures the rate at which prices of goods and services in an economy increase.
Each country determines what rate of inflation is considered healthy according to the needs of their economy. For example, developed economies look for an inflation level of around 2%, whereas developing countries can look for levels of up to 7% without panicking investors.
A high level of inflation causes the currency to depreciate as more of the currency will be required to buy the same amount of goods..
The opposite of inflation is deflation. This is when the goods and services become cheaper, increasing the value of money. Deflation points to a lack of consumption in the economy and it feeds on itself, as consumers will tend to delay purchasing goods, waiting for them to get even cheaper. For this reason, deflation is regarded as dangerous to an economy.
Employment reports are very important in any fundamental analysis. If a country has a high unemployment rate, consumption will decrease which will negatively impact the economy's growth. Conversely a high employment rate signifies an economy which is performing well.
From a trading or investment perspective, a significant increase in unemployment will cause a shock to the markets. One of the employment reports which has the greatest effect on market price movements is the Nonfarm Payroll (NFP), which reflects the total number of wage earners in the US, with the exception of agricultural employees and those working for government and non-profit organisations (NGOs).
If you are interested in delving deeper into fundamental macroeconomic analysis, you can watch the following video from our Youtube channel:
As well as analysing the economy where a company is active, it is important to analyse the sector within which it operates. There are several factors which are necessary to understand:
- Regulatory Environment
- The policies which different governments aim at the relevant sector are a crucial consideration for investors when analysing a company.
- For example, if we are looking at the automobile industry and the government wants to increase taxes on fuel, this sector may suffer as a result.
- Growth Potential
- Does the sector have potential to grow in the future? Is it a relatively new sector?
- A sector may be growing fast but if there are too many companies competing in that space, profits will be low.
- Some sectors of the economy have relatively stable dynamics (e.g., food, drink, medicines, etc.) whereas some (e.g. construction, luxury goods, etc.) tend to move up and down depending on what is happening in the broader economy.
- General threats and opportunities of the sector in which the company operates in.
Company Specific Analysis
Once the general economic environment is understood and the relevant sector's strengths and weaknesses have been evaluated, we must turn our attention to fundamental analysis of the company itself. We must study the company's accounts, income, margins, solvency, profitability and so forth. To do this, we need to understand which are the most important numbers for us to focus on.
For listed companies, the most interesting and important reports are those required from a company by regulators on a quarterly, annual and semi-annual basis. In this section, we highlight some of the most important information to look for.
The total sales of the company shows the demand from customers and how the company is doing against its competitors.
A company's Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA) allows us to measure the cash flow of a company - one of the most important measures.
A company's net profit is the result of subtracting all costs (taxes, wages, depreciation, etc.) from their revenue over a certain period of time.
This is an important factor to consider. A company may have incredibly high profits, but if it has high debts then there may be some problems with its viability. Debt is sometimes necessary, but it must be in balance with other factors like revenues, earnings, growth, etc.
Earnings per Share
Earnings per share (EPS) is one of the most important indicators to consider as it measures the profit due to each share in the company. It is, therefore, a key driver of the share's price. As the name suggests, it is calculated by dividing net profits by the number of shares in the market.
Return on Equity
Return on Equity (ROE) measures the capacity of the company to generate returns for its shareholders. It is calculated by dividing net profits by equity.
Return on Assets
Return on Assets (ROA) calculates the profitability of a company's assets. This is done by dividing the net profits by total assets and multiplying the outcome by 100.
The dividend yield expresses the dividend due to each share as a percentage of the share's price. . For an investor, it is useful to compare the dividend yield against the interest rate she would gain by buying government bonds or depositing the money in a bank. This important measure is calculated by dividing the value of the dividend per share by the share price, then multiplying it by 100.
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Price to Earnings
The Price to Earnings (PE) ratio compares the price of a company's shares with the profits it records in a given period of time. It is calculated by dividing the current share price by the EPS.
If the PE is low, it could mean that the company's share price is currently undervalued. This ratio is very useful when you make a comparison of the PE with other companies in the industry. If it falls below the industry average then it could mean that the company is undervalued.
The EV/EBITDA is similar to the PE but calculated at a company level.. It compares the value of the whole enterprise, known as the Enterprise Value (EV), with the EBITDA value for the whole company. To calculate the EV, you must add market capitalisation to the company's total debt and subtract any cash it currently holds.
Price to Book Ratio
The Price to Book Ratio (P/B ratio) is calculated by dividing a firm's share price (P) by its book value per share (B).
A company's total Book Value is the net asset value of a company calculated as: total assets minus any depreciation of those assets, minus intangible assets (patents, goodwill, etc.), minus liabilities.
This Book Value is then divided by the number of shares to give us the Book Value Per Share (B).
In situations where P/B is smaller than 1, the market is valuing the company below the value of its assets.
Companies with very low Price to Book Value ratios are attractive to "Value Investors", who constantly search for shares which are under-valued by the market.
Price/Earnings to Growth
Everything else being equal, investors tend to give more value to companies that are growing faster. This means that faster growing companies will have higher PE ratios so will tend to look overvalued. To iron this out, we can use the PEG ratio.
This compares the PE to the expected future growth of the company, usually over the next five years. To calculate the PEG, you must divide the PE by the forecast annual growth rate of the EPS expressed as a percentage.
The lower the PEG, the more undervalued the company will look.
The Payout ratio reflects the percentage of profits that a company devotes to remunerating its shareholders in the form of dividends. It is calculated by dividing Total Dividends by Net Profit.
The Cash Flow generated by a company is an extremely important measure of health when analysing any company. It illustrates a company's ability to generate cash to meet its payments and make future investments. There are several ways to measure Cash Flow but one of the most commonly used measures is EBITDA.
Sum of the Parts
Sum of the Parts (SOTP) is a useful number to know if the company we are analysing is a holding company. This process values the individual parts owned by the holding company and adds them up to calculate how much they would be worth in total if they were sold separately. This total is then compared to the current market capitalisation.
In cases where the SOTP is higher than the current market capitalisation the holding company can be considered to be under-valued. In these cases "Activist Investors" will sometimes buy the shares and then lobby the company to break itself up or sell the more under-valued component businesses.
Comparability & Trend Analysis
The items in this section are not always very useful on their own but extremely useful when compared across different companies (preferably in the same sector) or across multiple time periods.
For example, seeing one company's revenue for one year doesn't tell you much but looking at it over 5 years tells you whether the company is growing or shrinking and how fast.
Similarly, looking at one company's PE ratio is interesting but comparing PE ratios for a group of companies in the same sector tells you which are more highly valued by the market and which might be under-valued.
There are many variables for conducting fundamental analysis of stocks looked at in this article but which ones you use depend on your investment style.
Some investors are guided mainly by the overall health of the economy. Some will take a view of the likely fortunes of a whole sector and either buy or short a basket of companies from that sector, without necessarily looking in too much detail at the individual companies. You might, for example, have strong views on the future of oil companies, or the auto industry.
Even for investors driven by the individual companies, some focus on looking for fast growth, some on undervalued companies and some on cash generation.
Therefore, every investor gives more weight to some of these measures than others.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or recommendation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.