What is Fundamental analysis: Complete guide

Analyzing a company may seem more difficult than it is due to the large number of ratios that exist.

That is why a deep study of the company must be done, where to obtain the different ratios we will have to go to the following financial statements:

• Balance, to see the structure and financial position;
• Income statement, to see if the company makes money and how it does it
• Cash flow statement, which together with the income statement will help us understand if the company is able to generate cash or not.

So, in this article, we will see which are some of the most relevant ratios that can help us the most when doing the fundamental analysis.

What is Fundamental Analysis?

Fundamental analysis is based on the study of the variables that impact the performance of a financial title. In this way, it seeks to determine if the intrinsic value of the asset corresponds to its current quotation in the market.

In other words, fundamental analysis, as its name indicates, looks at the fundamentals of a financial value. These can be related to both external and internal factors.

Before citing what variables are part of fundamental analysis, it is important to understand that this is done by those investors who operate in the stock market. If the price of a share, for example, is far above the intrinsic value, it can be suspected that it is overvalued.

On the other hand, if the quotation of a title is located very below the intrinsic value calculated, this could mean that the asset is undervalued.

What are Financial ratios? | Main fundamental analysis ratios to analyze companies

Financial ratios are indicators of the company’s situation. They establish a relationship between financial units, with which it is possible to make a detailed analysis of the company’s economic situation or balance sheet.

Comparing the different ratios over a period of time gives concrete answers about the proper management of the company.

Solvency Ratios

Debt to Equity (D/E)

The debt/equity ratio (or Debt to Equity ratio) measures the relationship between liabilities and the capital contributed by shareholders. It is a debt index used to measure the financial leverage of a company. It also shows to what extent the shareholders’ capital can meet the obligations of a company to creditors in case of liquidation.

• Debt/equity ratio = Total liabilities / net equity

Interpretation of the Debt to equity ratio

Generally, a high debt/equity ratio indicates that a company cannot generate enough cash to meet its debt obligations. However, low debt/equity ratios can also indicate that a company is not taking advantage of the higher profits that financial leverage can bring.

Liquidity Ratios

The liquidity ratios are indicators that allow one to know the capacity that a company has to face its debts and short-term obligations. For this reason, it is a very important indicator both for the company, which must take into account its liquidity when making financial decisions and for potential investors in it.

• Current Ratio: To calculate the ratio, analysts compare a company’s current assets with its current liabilities. The current assets that appear on a company’s balance sheet include:
  • Cash
  • Accounts receivable
  • Inventories
  • Other current assets (OCA) that are expected to be liquidated or converted into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, short-term debt, and the current portion of long-term debt. I leave you with the Current Ratio formula
  • Current ratio = current or circulating assets / current or circulating liabilities
• Quick Ratio – Acid Test: The truth is that to perform the formula you must previously know several data:
  • The cash and equivalents, which are the most liquid current assets in the balance sheet of a company, such as savings accounts,
  • The term deposits with a maturity inferior to 3 months and the Treasury bills;
  • Negotiable securities refer to liquid financial instruments that can be easily converted into cash.
  • The accounts receivable is the money owed to the company for providing customers with goods and/or services.
  • The current liabilities are the debts or obligations that mature within one year.

So, the formula is as follows:

• Acidity ratio = cash and equivalents + deposits + negotiable securities + accounts receivable/current liabilities.

Net Cash Ratio – Cash Ratio: The treasury ratio is used to perform the economic and financial analysis of a company.

• The treasury ratio allows to measure the capacity of a company or institution to pay the debts that mature in the short term. It shows the company’s ability to meet debts in a period of time less than one year, keeping the available and the debts in its favor.

Treasury Ratio = (Available assets + realizable assets) / Current liabilities.

Profitability Ratios

Profitability ratios are mathematical calculations that help us know if a company is making enough to cover its expenses and also provide profits 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. They allow us to compare the results of the company in different parts of gains or losses.

• FCF – Free Cash Flow: it is a financial report or indicator that basically measures cash or cash flows. This flow comes from the money generated by the business or the company’s productive activities, deducting production expenses. The final result of the Free Cash Flow allows us to identify how much money is available to pay investors and creditors. On the other hand, it gives the possibility of segregating the capital to know in what it can be reinvested.
• ROI: ROI is the English acronym for “Return on Investment”. It is a metric used to know how much the company earned through its investments. To calculate the ROI it is necessary to raise the total income, subtract these expenses and finally divide that result by the total costs.
• ROE: ROE is the return on equity. To obtain this ratio, we will divide the profit after paying the debt interests by the equity (net worth). This indicator measures the accounting return of the shareholder.
• ROA: It is the return on the assets that the company has. To obtain this ratio, we will divide the profit after paying the debt interests by the assets. This indicator measures the economic return of the company.

• ROCE: Return on Capital Employed is a profitability ratio used to evaluate a company’s performance based on its total capital management. ROCE has a lot in common with ROIC, another profitability ratio used to determine the efficiency of invested capital
• ROIC: Return on Invested Capital translates to return or profitability on invested capital. As its name implies, the ROIC ratio attempts to quantify the profitability generated by a company with respect to the capital it uses to generate that benefit.
• BPA: Earnings per share or BPA is a ratio closely followed in the Stock Exchange. It is about determining the net profit divided by the number of shares of the company, that is, how much of the result obtained by the company as a result of its activity would correspond to each share.👉 More information: Earnings per share: What is it and how is it calculated?
• Dividend yield: The dividend yield tells us how much of the investment we can recover only with the distribution of the company’s dividends. Dividends are one of the main ways to get returns by buying shares. It is a way to measure the productivity of the investment.

Valuation Ratios

And finally, we have the most consulted ratios in financial investments: The valuation ratios. And its functions can be multiple:

• Compare companies of different sizes
• Analyze the evolution of the company over time.
• Establish the differences between the current situation of the company and the ideal
• Compare the results of the company with those obtained by companies in the sector.
• Analyze the differences with the main competitors.

And now, let’s go with the ratios:

• Price to Book Value: it is the price of the shares of a company divided by the book value per share of said company. It reflects how much investors are willing to pay for the assets of a company in relation to the accounting value of those assets. The difference between both magnitudes is directly related to the growth prospects of the company. It is used to relate the real accounting value of a company to the value it is trading on the market. In this way, an estimation can be made as to whether the company is trading at a discount or not.
• EV/EBITDA (Enterprise Value/ EBITDA). This multiple is obtained by dividing the Enterprise Value (Market Capitalization + Net Financial Debt), by the EBITDA. One of its main advantages is its objectivity (it excludes controversial or difficult-to-homogenize terms such as amortization provisions). It does not suffer distortions, unlike the PER, due to the different levels of leverage of the different listed companies. It is useful for the valuation of cyclical companies. Its interpretation is similar to the previous ratios, the lower the multiple, the more undervalued or cheap the company will be compared to its comparables or to its historical price, depending on who we are comparing it to.
• PER (Price/Earnings Ratio): PER is the most well-known and used ratio by the general market. This multiple puts the price in relation to the net profit. A PER of ten times applied means that with the current quotation and given profits, the company would recover its value through profits in ten years. It would also be the time it would take an investor to recover their investment if all their profits were distributed as dividends. Despite all its limitations, net profit is the most consistent magnitude declared with the company’s free cash flow, but it can be severely conditioned by extraordinary results of different signs.✅ Its main advantage is precisely its easy use and ease of making future projections because expected EPS is commonly projected by analysts.❌ And its main disadvantage, is its high sensitivity in cyclical companies. Distortions due to the level of leverage of the different listed companies.
• PCF (Price/Cash Flow): The price/cash flow is one of the first ratios used as a complement or nuance of PER. It puts the market capitalization in relation to the cash flow (net profit plus amortizations). In the long term, the dividend yield will tend to be the inverse of the Free Price/Cash Flow, hence its importance.✅ Its main advantage lies in the fact that, by using the companies’ cash flows, it eliminates distortions that can cause certain accounting entries such as amortizations or extraordinary income. It can be illustrative for a comparison between companies in the same sector, especially if they maintain a capital structure (level of indebtedness) similar.❌ But, it is not comparable between sectors as it does not take into account the different CAPEX needs. Therefore, its interpretation is summarized as, a lower current PCF compared to the historical ratio, the company will be cheaper and lower PCF compared to competitors, cheaper compared to its equals.
• PVC (Price/Book Value): This multiple puts in relation to the stock market capitalization with the company’s own resources. It is a patrimonial and static approximation to the valuation and does not take into account the different profitability that a company may be obtaining on its investment. It allows, therefore, to know the goodwill that the market offers for the company or sector. It is a ratio that, although theoretically comparable between sectors with a similar capital/debt financing structure, in practice presents, even forgetting the dynamic character proper of a company, many problems (old real estate patrimony accounted for at cost price, different amortization policies).In this case, a company is considered undervalued if the PVC multiple is lower than one, that is if the market is paying less for the company than its book value.
• PEG: The PEG ratio, which translates to PER to growth, is the relation between the PER and the Earnings Per Share (EPS) growth rate. If a stock has a PER of 25 and its earnings grow at a rate of 25%, the proportion between PER and growth is 1. That is, the PEG value is equal to one. It is equally expensive/cheap as a stock with a PER of 10 that grows at 10%, although this is an excessive simplification. If a stock has a PEG equal to or less than 1 it could be said that it is fundamentally undervalued. While, if it exceeds 1 it can be understood that it is an overvalued stock. But like the PER and the PCF, a relative indicator must be compared with the values of the same sector or with the average of the sector or market in which the value is located and with the expectations of development and benefits of the same.
• Payout: The payout is a financial measure that expresses the percentage of profits that a company dedicates to the shareholder’s remuneration. If a listed company establishes in its shareholder remuneration policy a payout of 50%, half of its attributed net profit will be distributed among them.

How to Measure the Growth of a Company?

In the case of investors, to achieve success in stocks is to understand the different factors that affect or influence market expectations and how these change over a certain period. Some factors can positively or negatively influence market expectations regarding the fundamentals of a company.

Company Growth Forecast

Perhaps the main factor when valuing a company is its own ability to generate profits and distribute dividends. There are different ways in which a company has the possibility of increasing its profits such as through:

1) Expansion of the company
Depending on the sector, companies have the possibility of increasing their sales by deciding to enter new markets, through agreements with new partners and from joint ventures, which will allow them to expand based on new contracts translating into new customers, always based on the development of new products or an upgrade of their brand through marketing to enter new markets.

2) Increase the price of their products or services
​If the economic situation allows it, the company can decide to raise the prices of its products or services in case of an increase in demand. Although sometimes companies increase their prices due to needs from increased internal costs or increased raw materials.

3) Reduction of expenses
The third aspect is when the company needs to improve its profitability by reducing its expenses, although according to the price or product or need depends on which aspects they must cut.

When measuring this aspect, investors review the statistics of administrative expenses, sales, and marketing, plus interests and the percentage of sales, in order to determine the degree of solvency in the management of the business. In addition to analyzing the operating profits including the percentage of sales (called margin) to know the profitability of the analyzed company.

Possible Risks that May Discourage Investors

There are a series of risks that can make investors doubt possible negative results, slowing down the possible growth and fall of the company’s shares and profits:

• Operational risk
• Political risk
• Currency risk (or exchange rate)
• Legal risk
• Insolvency risk.

Where to Consult the Fundamentals of a Company for Free?

Although the accounts of a company are public and their history can be consulted in the investor relations section of each company or on the website of the regulator.

Screeners

Many investors use screeners or databases to consult valuation and analyst estimation ratios, historical multiples, and other data. However, some of these screeners are paid.

These paid screeners include:

• Finviz
• Tikr
• Zacks.

Databases

They have a high cost and generally can only be accessed from universities or companies that pay the software license

• Reuters
• Bloomberg
• Morningstar
• FactSet

Conclusion

Therefore, when analyzing a company by fundamentals, we will mainly have to take into account the company’s balance sheet, income statement, and statement of cash flows. Some ratios such as the PER, Price to book, ROE, or dividend yield will give us relevant accounting and financial information that will help us have our own valuation of the company.

It should be noted that this type of data helps us to do the quantitative analysis, then we would also have to delve into the qualitative analysis, although these ratios and data also give us clues about the quality of the company.

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