Last Updated on 1 month by Antony C.
“Do you know what is the fair value of a stock?”
As an investor, we want to avoid overvalued stocks and buy undervalued stocks. Experienced investors use fundamental analysis and technical analysis to find investment opportunities in all market conditions.
Fundamental analysis is used by smart investors to find undervalue stocks and succeed in investing.
What Is Fundamental Analysis?
Fundamental analysis (FA) is an approach to evaluate the intrinsic value of a security by analyzing the various economic and financial indicators when making any investment decisions.
The fundamental analysis includes analysis of the following;
- Understanding the company’s financial health which is based on the company’s financial statements such as the balance sheet, income statement, and cash flow statement.
- Understanding the macroeconomic environment of the overall economy such as the industry trends and market conditions at a regional, national, and global level.
- Understanding the microeconomics environment, the market sentiment on the behaviors from a specific company’s perspective, and the effectiveness of the company’s management down to the consumer level.
With the help of fundamental analysis, an investor is able to get a better insight into the past, current, and future company’s performance and determine if a company’s stock is currently overvalued, fair value, or undervalued.
Why Is Fundamental Analysis Important In Investing?
Fundamental analysis is important because it helps investors to better understand the company’s true value and potential performance of a company objectively.
Without fundamental analysis, investors will find themself flying blind when determining which company’s stock is a good investment for a potential return.
Prevent Emotion-Based Investing (EBI)
Oftentimes, newbie investors without financial education buy and sell a stock controlled by their emotions of greed and fear.
“Emotion-based investing (EBI)” is when an investor,
- Buy when there is a lot of greed in the market.
- Sell when there is a lot of fear in the market.
Encourage Logic-Based Investing (LBI)
Fundamental analysis allows an investor to take most of the emotions out of the equation when making any investment decisions and utilize “logic-based investing (LBI)” or what is more commonly known as “value investing”.
“Logic-based investing (LBI)”, aka. value investing is when an investor,
- Buy when the company is undervalued or at fair value.
- Sell when the company is overvalued or at fair value.
In a nutshell, fundamental analysis lets you determine if a company’s stock is a good investment decision for your portfolio with the available historical data and current market sentiments.
It allows investors like you to take advantage of mispriced in the short term for a potential gain in the long term.
If you ask me, “Fundamental analysis is like buying an investment (real estate, business, etc.) at an auction house with insider information about how much the investment is actually worth.”
What Are The Methods of Fundamental Analysis?
Fundamental analysis involves analyzing anything that is related to the economic well-being of the company to determine the fair market value of a company’s stock. The various fundamental factors can be defined into two different methods;
- Qualitative: analysis focuses on more subjective factors where the company’s performance is determined by the macroeconomic and microeconomic environment of the company such as; management, product quality, branding, and competitive advantage.
- Quantitative: analysis uses more objective measurements where the company’s performance can be shown using numbers, figures, ratios, or formulas; such as return on investment, earnings per share, and leverage ratios.
Qualitative and quantitative fundamentals of the company are required to make an informed decision when investing in a stock.
Both of them are just as important as an investor.
Experienced investors such as Warren Buffett, Peter Lynch, and Bill Ackman use both Qualitative and quantitative fundamentals when making any investment decisions.
What Are The 3 Layers Of Fundamental Analysis?
Fundamental analysis to assess the financial health and potential of an asset can be broken down into three main layers: economic analysis, industry analysis, and company analysis.
- Economic analysis is the overall big picture of the current economic sentiment of the market.
- Industry analysis is the industry-specific analysis of the trends and where the industry is heading.
- Company analysis is specific to the company on how the company is performing in relation to self.
Depending on the order of the analysis, an investor can follow either a top-down approach or a bottom-up approach when analyzing the company’s stocks.
Top-Down Approach
A top-down approach is when the analysis starts by considering the 3 layers of fundamental analysis in the following order:
- Economy
- Industry
- Company
With this approach, the analysis goes from the bigger picture to the specifics of how the company performs.
The focus is based on the overall macroeconomic factors such as interest rates, inflation, unemployment rates, and GDP levels before going deep-dive into the companies in which the investor invests.
Bottom-Up Approach
A bottom-up approach is when the 3 layers of fundamental analysis are performed in the following order:
- Company
- Industry
- Economy
With this approach, the analysis goes from how the company performs to the overall economy in the current market.
The focus is based on identifying the company of interest and the various microeconomic factors associated with the company such as the company’s operation, the company earnings, and financial health before looking at the overall economy of the current market.
Stock Fundamental Analysis Tools
When performing fundamental analysis, there are a few fundamental indicators that are commonly used by investors to determine the true value or fair value of a stock.
Most of the information can either be calculated or obtained from the financial information made publicly available by the companies.
- Balance Sheet
- Income Statement
- Cash Flow
All listed public companies must submit a quarterly or annual financial report to the Securities and Exchange Commission (SEC) as regulated by the authorities.
There are many methods of evaluating the value of a company, and these are some of the best fundamental analysis tools that most investors love to use to know when to buy and sell a stock investment.
Valuation Ratios
The valuation ratios show the relationship between the current market value of a company’s stock and certain fundamental financial metrics of the company.
It is a critical ratio that helps to indicate if the company is undervalued, fair valued or overvalued.
- Price-to-earnings (P/E) ratio
- Price-to-book (P/B) ratio
- Price-to-sales (P/S) ratio
- Price-to-earning growth (PEG) ratio
- Earnings per share growth (EPS) ratio
Leverage Ratios
Leverage ratios indicate the level of financial leverage incurred by the company in relation to its assets, liabilities, and equity.
Probably the most important ratio to understand the inherent risk is if the company can service its financial obligation.
- Debt-to-equity ratio
- Quick ratio, which is also known as acid-test or liquidity ratio
- Current ratio
Dividend Analysis
Dividend analysis is only limited to dividend-paying stocks for income and dividend investors who are looking to build a passive income or are interested in passive income investing.
The analysis of the dividend is used to calculate the relationship of the dividend in relation to the current market value, the company’s earnings, or the company’s cash flow.
- Dividend payout ratio
- Dividend yield
- Dividend growth rate
For dividend investing, there are many other terms you may also need to gain an understanding, here are just some of the most common terms:
- Dividends Per Share
- Special Dividend
- Ex Dividend Date
- Dividend Cushion
- Dividend Reinvestment Plan or DRIPs
Management Performance Analysis
Measurement of the management performance of a company gives you an insight into how efficient is the management team in allocating their resources to bring in profitability and returns to the investor.
- Return on Equity (ROE)
- Return on Capital (ROC) or Return on Invested Capital (ROIC)
Competitive Advantages
A company’s competitive advantages are an important part of the fundamental analysis when determining if it is the right stock to buy.
- Economic MOAT such as; Toll Bridge, Secret, Brand, Price and Switching.
- Industry trends and possible technological advantages that will disrupt the future of the market.
What Is The Focus Of Fundamental Analysis?
Unlike technical analysis which focuses on the short-term fluctuation of the market, fundamental analysis focuses on the long-term fundamentals of the company and looks for a mismatch of the price of the current market against the intrinsic value of the stock.
Fundamental analysis gives investors an edge to have a clearer picture of how the future of the company looks, instead of relying on emotions during investing which often leads you to make the wrong decision at the wrong time.
Personally, I rely mainly on fundamental analysis, but before I purchase any stocks, I often look at the technical indicator, to see what is the general market sentiment. By utilizing both fundamental and technical analysis we can grasp a better picture of the company’s performance in both short-term and long-term.
What Does Fundamental Analysis Mean To You?
Fundamental analysis is an indispensable tool to make investment decisions if the company’s stock is undervalued, fair valued, or overvalued by the current market. But like all tools, different investors have their own preferences, in what approach they want to analyze a stock.
No one tool is better than others, and not every investor uses the same tool or views the same company stocks equally.
No two investors are the same.
I have my own preference on which tools should I use when doing dividend investing or growth investing, or which tools should I use when we are facing a bear market with a market crash or a bull run.
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Antony C.
Founder & Financial Writer at Income Buddies | Website | Posts by Author
Antony C., is an entrepreneur, course creator, published author of the book "Start Small, Dream Big", an investor with +15 years of experience, a certified PMP® holder and an accomplished financial writer. Having used and tried many business software and tools in his professional career and personal business, he recognize the need for unbiased, quality information based on real-life experience. Sharing his journey and expertise to assist aspiring entrepreneurs in creating and growing their online business and building wealth, he have created IncomeBuddies.com. Antony has been featured in global news outlet including Yahoo Finance, Nasdaq and Non Fiction Author Association (NFAA).
