Fundamental Analysis

What is Fundamental Analysis?

While technical analysis evaluates the share price action of a stock, fundamental analysis evaluates the actual business operations to determine the financial health of the company, project future growth prospects and determine current and future valuation. Fundamental analysis can be performed quickly with various widely available financial tools or be extensive depending on how much time and effort the investor wants to commit.

How Does Fundamental Analysis Work?

Fundamental analysis uses publicly available information usually disclosed by the company through SEC filings to build an accurate assessment of the business. It is believed that a company’s fundamentals are the key long-term driver for share prices. While short-term market fluctuations impact immediate stock prices, the market will eventually price a stock correctly in the future. Fundamental analysis attempts to extract a fair valuation for the company to determine if the markets have overvalued or undervalued the shares. Based on this thesis, investors can decide if the shares are an attractive investment now or wait for a better valuation later.

Components of Fundamental Analysis

This various components of research include analysis of the earnings reports, company business model/strategy, catalysts, and financials including assets/liabilities, financing/debt obligations, credit facilities, rumors and press release documents. Additional research on the company’s sector/industry and peers can also be performed. It also involves staying current on any executive changes with the management and board of directors. Intensive fundamental analysis can be tedious and time consuming for an individual investor.

Research Departments

To attract and maintain clients, full service brokerage firms assign the heavy legwork to in-house financial analysts that specialize in specific sectors, industries and companies. Many online discount brokers have also beefed up their research departments to retain customers. The most widely followed analysts run intricate fundamental analysis through various qualitative and quantitative models to forecast future earnings results known as consensus analyst estimates. Meeting, beating or missing these estimates have an immediate and material impact on share prices.

Who is Fundamental Analysis For?

Long-term investors benefit the most with fundamental analysis, since valuations and stock prices ultimately reach parity in the longer run. Swing traders benefit depending on their holding period and premises for holding (IE: undervalued assets or buy the rumor, sell the news into a scheduled event). Intra-day traders are mostly affected when news, events or rumors trigger price volatility and spur momentum on heavy volume, often resulting in price gaps up or down in the pre and post-market. Earnings report releases generate the heaviest volume and price action, which is why traders look forward to each earnings season. For biotechnology companies, clinical trial data and FDA decisions tend to generate the most volatility.

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Basics of Fundamental Analysis

Fundamental analysis requires information provided by the company to develop a thesis about the business. These are some of the factors that should be included in the thesis.

Understand a Company’s Real Value

Perception is reality in the financial markets. Different investors and analysts will have differing valuations for a company. Where one analyst sees a dying legacy pipeline, another may see an undervalued asset. For example, when retail big box stores suffered declining sales, private equity focused on the undervalued valuations of their real estate assets. This sparked a rally in the sector based on a new perception. However, the continued declining sales forecasts caused the sector to plummet, when the earnings reports revealed even larger revenue declines, as perception shifted negative again.

Sentiment Influences Perception

The markets are the ultimate judge and jury as to which valuation pricing prevails and when. Sentiment influences perception, which is why stocks tend to overshoot their valuations in strong bullish markets and undershoots during weak bearish markets, as the adage of a “rising tide lifts all boats” rings true. Astute fundamental analysts will work to develop their own valuation models using specialized metrics to calibrate them to any catalysts or events. Companies can be valued based on financial metrics as well as assets that may not be efficiently priced in. The “parts are worth more than the whole” is a common justification for under valuation, which assumes that the company may spin-off or sell certain assets to improve shareholder equity.

Reading Financial Statements

Publicly traded companies are required to file financial statements with the United Stated Securities and Exchange Commission (SEC). Investors can access this information directly from the SEC website through the EDGAR database. The three key documents every self-directed investor should be familiar with are the 10-K quarterly report; most recent annual report and recent 8-K filings of material events.

Quarterly earnings are initially disclosed in a press release and filed as a 10-K document afterwards. Companies will usually pair the earnings release with a conference call an hour afterwards or the next morning. The conference call can be very revealing, especially the question and answer session with analysts. Often times the company may disclose a bombshell item in the conference call including future earnings guidance estimates which may be increased or decrease from consensus analyst estimates, regulatory issues, impending lawsuits and major contract wins or losses, which can result in significant share price volatility

Understanding Industry Trends

Stocks are segmented by sector and industry. To ascertain the true performance of a stock, it should be evaluated amongst its competitors within the industry. When a particular sector or industry is very strong, it tends to lift most of the companies within. The leaders in the particular industry usually establish the industry trends. Therefore, it is prudent to stay abreast of the industry trends for your particular stocks. An effective way to pursue this is by identifying the top three leaders in the sector or industry. The performance of the industry leaders sets the sentiment with the group. For example, when a leading stock in the heavy machinery industry slashes its earnings guidance, it generates a top-down ripple effect for the peer stocks as well. It is guilt by association until proven otherwise as share prices sell-off.

Accounting for Company Growth

There are two types of accounting that is used with earnings reports. The official numbers are reported under Generally Accepted Accounting Principles (GAAP), which take into account all expense items including non-cash compensation like restricted stock and options. Companies like to also provide non-GAAP numbers, which excludes non-cash items. The purpose is to allow shareholders to better gauge the growth of the core business without being sidetracked by factors that don’t affect cash flow. However, critics argue that non-GAAP accounting is deceptive. Any and all compensation must be accounted for especially when existing shareholders face further dilution in shareholder equity.

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Using Financial Ratios

There are a number of widely used financial ratios that can be used to help investors gauge valuation and assess how a company stacks up against its peers. These ratios are standard on broker platforms as well as most popular search engines. Just as with technical analysis, financial analysis should be performed using multiple financial ratios to help paint a clearer picture of the operations.

Price-Earnings (P/E) is perhaps the most commonly used financial ratio. It measures the profitability of the company relative to the share price. All sectors have an average P/E, which can be found quickly by looking up the heaviest traded exchange-traded-funds (ETF) which track the specific index. This ratio can be used to compare a specific company with the industry, peers and or benchmark indices. For example, if the consumer discretionary sector has a P/E of 20 and your stock has a P/E of 55, it may be overvalued. Some sectors traditionally have higher P/Es than others, like technology compared to utilities. The S&P 500 has a historical P/E ratio of 21. Keep in mind that a company needs to generate profits in order to have a P/E. There are more ratios that can be used in the absence of profits.

Price-Sales (P/S) and Price-Book (P/B) are comparative valuation ratios that indicate if a stock is trading at a premium or discount compared to its peers and sector/industry. If a stock is trading at a very deep discount like .3 P/S compared to industry average of 2.5 P/S, then there could be an inherent structural problem with the business or could be overlooked by Wall Street and presents an undervalued investment situation and warrants further investigation.

Cash-Per-Share (CPS) and Book Value (BV) are two valuation ratios that can help determine if the stock has been overly punished by investors. When a company trades under the CPS or BV, it has virtually valued the business operations at zero presenting either a very undervalued situation or potential bankruptcy. The cash burn rate and debt should also be investigated. Biotech stocks are notorious for these situations. These ratios don’t apply well to financials like banks and insurance companies that tend to trade at or below CPS and BV, due to federal banking regulations and off balance sheet entities.

Keep in mind that every sector and industry has an average financial ratio, which can be used as a measuring stick. However, just because a stock has an aggressively high financial ratio doesn’t necessarily mean it is overpriced. Momentum stocks are notorious for exorbitant ratios.