This is Part 3 of our Company Financial Health Series
Is used as an aid to successful investing and is a process of analysing the financial statements of a business (Balance Sheet, Profit & Loss, Cash-flow Statement), as well as creating ratios of some of the figures, to determine the financial health and assess the management of the business before making an investment by comparing the results with other businesses.
Fundamental analysis attempts to determine the value of a company by analysing the financial data from the annual reports and using other qualitative data about the company and the environment in which they operate. This value is often called ‘intrinsic value’. Fundamental analysis assumes that over the long term, a stock price will reflect the company’s intrinsic value.
A sound fundamental definition comes from Investopedia. They define fundamental analysis as:
…a method of evaluating a security in an attempt to measure its intrinsic value by examining related economic, financial and other quantitative and qualitative factors. Fundamental analysts attempt to study everything that can affect the security’s value, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management). For further reading and an online video from Investopedia go to the fundamental analysis page.
Quantitative factors are those capable of being measured or expressed in numerical terms, measures such as:
- Revenue and growth of Revenue from year to year
- Earning / Profit
These financial measures are commonly combined to produce fundamental or financial ratios that analysts can use to compare the company they are analysing to:
- Prior trading period results
- Other companies in the same industry
- The overall market
Well-known Ratios include:
- Debt to Equity(DE)
- Return on Capital (ROC)
- Return on equity (ROE)
- Dividend yield
- Price to earnings ratio (PE)
Qualitative factors are those that are not in numbers – more like assessments and opinions/evaluations. So they can be subjective, and may include:
- Management performance and experience
- Competitive advantage
- Economic environment and head/tail winds/changes
- Business model
- Branding strength
Pros and Cons
Some Pros of fundamental analysis include that it can be objective (the quantitative parts), has a long-term focus, provides a guide to real stock value
Some Cons include being subjective to our own biases, the time involved to prepare/study, that market sentiment doesn’t always follow our own reasoning, the assumptions used, data looks back so the future can easily change the outcome.
Fundamental analysis is used as an aid to successful investing and is a process of analysing the financial statements of a business (Balance Sheet, Profit & Loss, Cash-flow Statement), as well as creating ratios of some of the figures and assessing to determine the financial health and assess the management of the business before making an investment.
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