The Basics of Fundamental Analysis

Widely known for it being Warren Buffett’s choice of strategy, Fundamental Analysis (FA) is a form of investment analysis used every day by investors all over the world. FA can be used on all forms of securities however is most popular amongst stock traders. This article will investigate the principals of this type of analysis before commenting on the drawbacks of such a strategy.

An Introduction

The process of FA is to evaluate a security’s intrinsic value by examining related economic and financial factors. The intrinsic value (also known as a ‘real’ or ‘fair market’ value) refers to the perceived value of a security based on future cash flows or, put more simply, the price a rational investor is willing to pay for an investment.

The aim of this type of analysis is to then compare the current market price to the calculated intrinsic value to see whether the security is undervalued or overvalued. A security would be considered undervalued if the intrinsic value is higher than the current market price. Meanwhile to be considered overvalued, the intrinsic value would have to be lower than the current market price.

FA works in a macro to micro perspective, meaning that overall economic conditions as well as the conditions of the individual market and/or firm must be considered in its valuation. Consequently, there are many factors that could alter the intrinsic value of a security.

Quantitative or Qualitative

The methods used within FA can be categorised into two groups. Firstly, there is Quantitative FA. This looks at the hard numbers and financial metrics of a firm, making companies’ financial statements extremely useful to the investor. With this information, investors look to gage companies’ economic prospects and do so using a range of key-performance indices.

Qualitative FA focusses on the less tangible, harder to quantify side of a business and is more subjective. The list of what this encompasses is practically endless, but some examples would include management quality, brand notoriety or current fashions and trends. Tesla is an example of a company that, during a Qualitative FA assessment, may have their intrinsic value increased. The global notoriety of their CEO, Elon Musk, as well as the growing popularity of electric vehicles cannot be ignored when evaluating the car manufacturer due to the impact these characteristics have on the markets, which potentially is not apparent in their financial data.

The combination of both Quantitative and Qualitative analysis is required for a more realistic calculation for the security’s intrinsic value.

Key Financial Metrics

FA is subjective and different investors can have different opinions on the same security. With that said, there are some staple financial metrics and indices acting as some of the most important quantitative indicators.

Earnings per share (EPS) is an extremely useful financial metric calculated as a company’s profit divided by the number of outstanding shares. EPS indicates how much money a company generates per share and so is an important metric for investors looking at the profitability of a company. The higher the EPS, the more attractive the investment should be as it indicates higher profit levels.

The Price-to-Earnings (P/E) ratio is a metric used to determine the market value of a stock compared to its earnings. Essentially, it is used to show what the market is willing to pay today for the stock based on past and future earnings. A high P/E ratio can be perceived as either overvalued, or an indication that the market expects high growth rates in the future. Conversely, a low P/E ratio is a suggestion of an undervalued stock, or a stock that the market does not have high hopes for. The P/E ratio is of specific interest to investors as it standardizes stocks of different prices and earnings levels, making it a great metric for comparison.

Return on Equity (ROE) is a calculation used to determine the efficiency of a company when using the equity of shareholders. Shareholder equity (the net worth of a company) divided by the company’s income gives a percentage figure of how well the company is using the shareholder equity to create income. Therefore, the higher the ROE figure, the more efficient the company and thus potentially more attractive to investors.

The Debt-Equity (D/E) ratio is a metric used to evaluate a company’s financial leverage (how much of their operations are financed by debt). It is calculated by dividing the total liabilities of a company by their shareholder equity (both which can be found in a company’s financial statements) and reflects the shareholders’ ability to cover the company’s debts in the event of a downturn. A high D/E ratio could therefore be considered less attractive to investors as, in the event of a downturn, they may be expected to use their money to pay off the debts. Although it can vary per industry, the general consensus is that a D/E ratio should not exceed two.

Discussed above are only a few of the hundreds of different metrics used every day by investors to make financial decisions. The successful use of FA is about utilising these metrics together and not exclusively. The combination of the use of metrics paints a much clearer picture than the use of just one or two, enabling greater returns.

The Drawbacks of Fundamental Analysis

Whether it be Fundamental or Technical or even artificial-intelligence-based, the most successful of investors use a combination of various types of investment analysis. That being said, there are certainly some drawbacks of FA that lead investors to choose different equilibria of investment analysis methods.

Most notably, FA is time consuming as it requires each investment decision to be considered in minute detail. Consequently, this type of analysis, when used on its own, is ultimately for mid to long-term investors.
Making investment decisions using FA also limits the information you receive about short term market conditions. Whilst you may find out about a company’s current financial health, short term price volatility cannot be forecast from the financial statements output by the company. This is evidence as to why it is necessary for investors looking at the short, mid and long-term to use a combination of techniques.

Another drawback of FA is that it requires investors to take everything at face value whilst there can be, and have been, scenarios where the information found in companies’ financial information is falsified or misrepresented. For example, the Wirecard accountancy scandal in June 2020 revealed a €1.9billion hole in their finances. [1] Following the reveal of the scandal, the FinTech company’s shares fell by 75% leaving once hopeful investors at a loss. [2] Whilst arguably nothing could have been done for the investors who believed the information Wirecard produced, it is certainly something that all would have wanted to avoid.

To summarise, Fundamental Analysis is a hugely popular and vast method of valuing prospective investments and it is possible to amass great success doing so. Whilst new analysis strategies (such as Artificial Intelligence) are gaining traction in the financial world, FA will continue to be used by investors across the world due to its proven track record.