What is Fundamental Analysis of a Company?

What is the fundamental of a company?

The fundamental analysis is a type of stock analysis that tries to establish the theoretical price of a title through the study of all the variables of the accounting statements of a company that affects its value.

Where does the fundamental analysis start?

Next, let’s see from which accounting statements of the company the fundamental information starts, which we will later use to develop our analysis:

Balance

The balance sheet of a company, also known as the Statement of Financial Position, is a financial report that shows the financial situation of a company at a specific moment. It provides information about the assets, liabilities, and equity of the company.

The Balance Sheet of a company offers several key variables for fundamental analysis.

Various subtypes can be distinguished:

  • Book value.
  • Adjusted book value.
  • Solvency.
  • Liquidity or acidity ratio.
  • Leverage ratio.

Income statement.

The Income Statement, also known as the Statement of Income or Statement of Loss and Profit, is a financial report that shows the income, expenses, and profit or loss of a company during a period of specific time.

The Income Statement provides key information for the fundamental analysis of a company. Some of the important variables that can be obtained from this financial statement are:

  • Sales
  • Benefits
  • Gross Margin
  • EBITDA.
  • Other multiples.

Cash Flow Statement

The Cash Flow Statement is a financial report that shows the cash inflows and outflows of a company during a specific period of time. It provides information on how cash is generated and used in operating, investing, and financing activities.

In the Cash Flow Statement, several important variables can be found:

  • Cash flow from operating activities.
  • Cash flow from investing activities.
  • Cash flow from financing activities.
  • Net change in cash.

How to Value Companies?

So, as we have already anticipated in the previous section, once we extract the most interesting information. What do we do with it? How do we value it? Let’s see:

Leverage Ratios

The leverage ratios determine what part of a company’s assets are financed through debt, that is, they measure the amount of debt of a company and the organization’s ability to meet it.

In other words, leverage indicators calculate the proportion or degree of participation of suppliers’ and creditors’ capital in the company’s assets, and the company’s willingness to pay its liabilities with its assets. Therefore:

  • A leverage ratio greater than 1.0 or 100% indicates that the company has more debt than assets.
  • While a debt ratio lower than 1.0 or 100% indicates that the entity has more assets than debt.

The importance of leverage ratios lies in that they are reliable indicators calculated based on quantitative data that reveal the financial health of the company, as well as the stability and sustainability of the business in the medium and long term.

Investors also use these indices to determine the level of risk and ensure that the company is solvent, can meet current and future financial obligations, and can generate a return on its investment.

Here are the main indicators of indebtedness or solvency:

  • Total Liabilities (external resources) / Total Assets
  • Total Liabilities (external resources) / Net Equity
  • Bank Debt / Net Equity
  • Bank Debt / (Net Equity + Bank Debt)

Profitability Ratios

The profitability ratios are mathematical calculations that help us know if a company is earning enough to be able to cover its expenses and also provide benefits to its owners.

In a business there are very different expenses to attend to: personnel expenses, payment of taxes, amortizations, bank interests, etc. So it can happen that a company is profitable in a certain area but has losses in another.

Precisely for this reason, there are several profitability ratios. And precisely these, allow us to compare the results of the company in different parts of gains or losses:

  • Equity Ratio
  • Sales Profitability Ratio
  • Overall Profitability Ratio
  • Total Capital Profitability Ratio

Valuation Ratios

The valuation ratio is a measure of evaluation of the quality of the management or performance of a portfolio of securities and is defined as the alpha coefficient per unit of own or specific risk:

  1. P/E (Price-Earnings Ratio)
  2. P/B (Price to Book Value)
  3. P/V (Price to Sales)
  4. P/CF (Price to Cash Flow)
  5. Dividend yield return ratio
  6. Long-term future earnings growth
  7. Historical earnings growth
  8. Historical sales growth
  9. Cash flow growth
  10. Book value growth

Fundamental Analysis Methods

We continue with our macro approach to organizing everything related to fundamental analysis. We already know where to get the information, and how to group it. But, what kind of analysis can be done with so many numbers and ratios? I’ll explain it to you below:

Bottom-up

The bottom-up analysis in the stock market is an approach used to evaluate and select individual stocks based on a detailed analysis of the characteristics and fundamentals of each company. Instead of focusing on macroeconomic factors or the general state of the market, the bottom-up analysis focuses on the study of companies individually.

That is, it seeks to examine elements such as the company’s financial statements, its cost structure, its business model, the quality of its management, its products or services, its competitive position, its growth strategy, and other specific factors of the company. The goal is to identify stocks that are considered undervalued or that have significant growth potential based on their fundamental analysis.

This approach involves an exhaustive analysis of financial statements, relevant news, the company’s prospects, and any other relevant data that may affect its performance. Qualitative aspects can also be considered, such as the company’s reputation, its innovation, or the demand for its products.

Top-down

The top-down analysis in the stock market is an approach used to make investment decisions based on the analysis of macroeconomic factors and the general state of the market, and then select the stocks or sectors that are expected to benefit from those conditions.

In top-down analysis, one starts by analyzing macroeconomic aspects, such as economic growth, inflation, interest rates, government policies, and other relevant economic indicators. From there, the impact that these factors can have on different sectors of the economy is evaluated.

Once the sectors that are considered promising are identified, a more detailed analysis of the companies within those sectors is carried out.

Top-down analysis allows investors to make decisions based on macroeconomic trends and prospects. It seeks to identify the sectors or areas of the economy that are expected to have solid performance based on macroeconomic factors, and then select the stocks of companies that are considered most promising within those sectors.

Types of Companies According to Fundamental Analysis

Let’s see what type of companies we can find after our respective analysis:

Blue chips

High market capitalization values, or Blue Chips, are those stocks whose value (share price x the total number of shares) is among the highest in the market.

Blue chip companies in the stock market

When talking about a blue chip we are referring to a mature company, which has been a leader in its market for years, with a very solid balance sheet and a high market capitalization, which translates into high liquidity (high supply and demand for its shares) and stability in prices. They usually distribute a stable and increasing dividend over time.

The term varies depending on each market and there are no established ranges. Since the blue chips of Spain in the United States would be considered small or medium capitalization companies. For example, in our country they would be companies like Inditex, Banco Santander, CaixaBank, or BBVA. While in the United States, they would be companies like Apple, VISA, or Coca-Cola. That is, all of them are consolidated companies in the market, which have been listed for many years, whose market capitalization is very high – the highest in the market – and which, in addition, have a solid balance sheet.

Value stocks

Value stocks are those of companies that operate in mature sectors, usually defensive and usually with strong entry barriers. Value stocks are much less volatile than growth stocks.

Electricity, food, or highway companies could be an example of companies composed of value stocks or value stocks. In general, companies composed of value stocks usually allocate their profits to dividend payments.

Chicharros

The chicharros are values corresponding to small capitalization companies that are listed on the stock exchange, sometimes belonging to values that have had or have had problems in the past, and that, therefore, can present large oscillations in their quotation.

Usually, its price is below one euro, or it is a few cents even, with which the variations in the quotation are accentuated. For example, if a share is trading at 0.10 euros, a variation of one cent (0.01) implies an oscillation of 10%.

Growth Shares

Growth shares are the shares of companies that are in an expansion phase and that are expected to continue growing in the following years. Normally, these are shares of companies that operate in very changing markets and with strong competition, such as the technology sector.

Fundamental analysis vs Technical analysis- What is the difference?

Let’s see more or less synthesized, as we have been doing throughout the article, how each of the stock market analyses differs:

Key Concepts

1. Technical Analysis
  • It considers that the fundamental factors (such as GDP, inflation, interest rates, unemployment, etc.) are already taken into account (incorporated) in the price.
  • On the other hand, the price discounts the two basic emotions of every investor: fear and greed, which cannot be seen or analyzed by fundamental analysis.
  • Price patterns tend to repeat themselves and therefore previous prices can be used to predict future trends.
2. Fundamental Analysis
  • The investor can study the economic indicators, social factors, and government policy (fundamentals) to predict the movement and price trends.
  • If an investor can study the relative health of each country or trading bloc, then they can determine the relative value of each asset traded in the markets related to those countries, such as a currency pair, stocks, indices, etc.

Key Objectives

1. Technical Analysis
  • Predict the direction and extent of future price changes.
  • Refine the entry and exit points of trades in the market.
  • Decide whether to add positions to existing trades or reduce their size.
2. Fundamental Analysis
  • Predict the general direction of markets in the medium and long term based on fundamentals.

Key Elements

1. Technical Analysis
  • Trends.
  • Trend changes.
  • Price ranges
2. Fundamental Analysis
  • Interest rates.
  • Inflation rates.
  • GDP.
  • Growth rates.
  • Unemployment rates.
  • Trade balance and over-indebtedness.
  • For stocks, a series of different elements based on the analysis of the company and its performance are also used.

Tools or Analysis Sources

1. Technical Analysis
  • Trend identification indicators.
  • Indicators and oscillators for identifying price ranges.
  • Price charts.
  • Graphical patterns and trend lines to identify trends and price ranges
2. Fundamental Analysis
  • Data and statements are provided in speeches by important economists and politicians (such as the president of a central bank).
  • Important events in the economic calendar and key economic indicators.
  • Important economic reports.
  • Underlying economic factors.
  • In the case of stocks, traders use other data sources to analyze companies, such as financial statements among others.

Time horizon

1. Technical analysis
  • Since price patterns are fractal in nature, traders can see the same patterns in different time frames. Thus, any time frame can be chosen by the trader to trade using these tools. It is often used to trade in shorter, intraday time frames (5 minutes, 15 minutes, 30 minutes, 1 hour, etc).
2. Fundamental analysis
  • Longer-term approach (Days, weeks, months or years)

Investment styles

Technical analysis
  • Daytrading and swing trading strategies.
Fundamental analysis
  • Swing trading, position trading, value investing strategies…

Main criticisms

1. Technical analysis
  • It is seen as a form of black magic without any real basis with tools pulled out of the sleeve
  • The price does not always discount everything.
  • The efficient market hypothesis (EMH).
2. Fundamental analysis
  • Fundamentals do not necessarily reflect in the price.
  • It can be a bit subjective.
  • The fundamentals are already taken into account (incorporated) in the price.

Value philosophy investors of fundamental analysis

Let’s see the most important investors in history and at the moment, who popularized the idea of fundamental analysis as one of the most sensible and profitable that exist.

Benjamin Graham

Benjamin Graham was born in London from where he moved with his family to New York shortly after his birth, after living a few years in poverty and suffering the death of his father, he graduated from Columbia being one of the most outstanding students of his promotion. After his graduation, he began to work on Wall Street and later founded the Graham-Newman Partnership.

Benjamin Graham, father of the value philosophy

Throughout his career as an investor, he developed the investment philosophy of value investing along with David Dodd, based on investing in companies with a low stock price in relation to its valuation by fundamentals. Among some valuation ratios of this philosophy are the dividend yield, the price-earnings ratio, or the price-book ratio.

Warren Buffett

Warren Buffett, born in Omaha in 1930, is an American investor and entrepreneur known as the Oracle of Omaha. President of the investment firm Berkshire Hathaway, he is one of the richest and most influential men in the world, not forgetting his important philanthropic work.

From an early age he showed a great interest in economics and investments. Such has been the successes achieved by Warren Buffett in the world of investments that he is considered the best investor of all time.

Peter Lynch

Peter Lynch is one of the great investors in history. Like other great references in the world of trading, he has become a legend among enthusiasts and professionals in the capital markets.

Lynch managed between 1977 and 1990 the most important hedge fund in the United States: Fidelity Investments’ Magellan. From there he forged a remarkable career, in which he achieved profits for Fidelity of between 29% and 30% on average annually. A real madness, which represents the efficiency of this man to make investments.

David Dodd

David LeFevre Dodd (August 23, 1895 – September 18, 1988) was an American educator, financial analyst, author, economist, and investor. As a student, Dodd was a protégé and colleague of Benjamin Graham at Columbia Business School.

David Dodd, author of the book Security Analysis

The Wall Street Crash of 1929 (Black Tuesday) nearly wiped out Graham, who had begun teaching the previous year at his alma mater, Columbia. The crash inspired Graham to look for a more conservative and secure way to invest. Graham agreed to teach on the condition that someone take notes. Dodd, then a young instructor at Columbia, volunteered. These transcriptions served as the basis for a 1934 book Security Analysis (Security Analysis), which galvanized the concept of value investing. It is the longest-running investment text ever published.

FAQs

How can fundamental analysis help identify undervalued or overvalued stocks?

By examining a company’s financials, competitive advantages, market trends, and management quality, investors can USE fundamental analysis to assess whether the current stock price accurately reflects the company’s worth.

What sets value investing apart from growth investing?

Value investing focuses on finding undervalued stocks with solid financials, while growth investing seeks companies with high growth potential, even if their valuations appear higher. Value investors prioritize the current value, while growth investors emphasize future growth prospects.

How do economic cycles and market conditions influence value investing strategies?

During economic downturns, value investors may find more opportunities as market pessimism drives down prices. In contrast, during market upswings, finding undervalued stocks becomes more challenging. Value investors adapt their strategies based on prevailing economic and market conditions.

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