Fundamental analysis is one of the basic methods for assessing the attractiveness of investment on the capital market. It relies on information about the company and its environment, especially the economy. As its name implies, it is based on the foundations, the economic basis of the company.
Fundamental analysis consists of five basic steps:
- macroeconomic analysis,
- sector analysis,
- analysis of the company’s situation,
- financial analysis of the company,
- stock valuation of the company.
Macroeconomic analysis is about assessing the attractiveness of an investment on a given market. This analysis takes into account the country’s economic situation, its economic policy, fiscal and monetary policy and the country’s investment risk, for example by credit rating. In today’s globalization, the global situation is also taken into account.
First of all we need to find out in what phase of the business cycle is the economy, in the recession phase, or vice versa in the recovery phase. The situation in the economy is translated into profits of companies, and thus the valuation of shares of these companies. However, keep in mind that the stock market is generally ahead of the economy. This means that the stock market will start to grow when there is no sign of recovery in the economy and vice versa, the capital market may begin to decline when there are still signs of recession. Key indicators measuring the economic climate are GDP growth rate, inflation rate, budget deficit, fiscal policy and central bank monetary policy. The ideal economic situation of the country is characterized by:
- greater than projected GDP growth rate,
- fall in inflation rate,
- decrease of the budget deficit and public debt,
- increase in positive balance of trade and payment balance,
- drop in unemployment rate,
- lowering the cost of credit by reducing interest rates,
- reduction of taxes,
- less protectionism from politicians,
- the fall of the importance of trade unions etc.
Sectoral analysis consists in evaluating the entire sector in which the company operates. The following factors are considered in the sectoral analysis:
- rate of return on investment in a given sector,
- the level of risk in the analyzed sector,
- the sensitivity of the sector to the economic situation, a good example is the mining sector heavily dependent on commodity prices and hence on the economic climate,
- the phase in which a particular sector is located, may be pioneering start-ups, growth acceleration, stabilization and mature growth, slowing down and disappearance of the sector. The most favorable situation is the location of the sector in the second phase.
Analysis of the company’s situation
Analysis of a company’s situation refers to the company itself being surveyed for the product being offered and the company’s management, rather than the financial situation. We should analyze the following areas:
Product specificity, it means product differentiation, product dependency, on which the company has no influence, potential substitutes or the possibility of their appearance.
Specificity of the market on which the product is offered, i.e. barriers to market entry, competition, position of the company on the market.
Company suppliers and their impact on the business situation. Does the company cooperate with several suppliers of products necessary for running a business, the number of suppliers is very large and thus the better negotiation situation of the company in terms of lowering the price of delivered materials.
The technology used by the company, the modern technology, the higher the better.
Company employees play an important role in every company. The assessment of this area should include the qualifications of people employed in the company, the company’s policy on employee motivation and compensation, increased qualifications through training, co-financing for industry certifications, etc. It is also important to motivate employees to grow and integrate with the company.
Managing a company is a key element of your business. However, this is not an easy area to evaluate as it requires a great deal of analyst knowledge in this regard. It is necessary to analyze the company’s financial management, operational and strategic management.
Financial analysis of the company
The financial analysis of the company examines the financial condition of the company by analyzing the financial statements. Financial statements are prepared by the public companies quarterly and at the end of the financial year, usually coinciding with the calendar year. The financial statements consist of:
- balance sheet,
- income statement,
- statement of cash flows,
- statement of changes in equity.
Balance sheet is the combination of two items, assets and liabilities. Assets are the property of the company, and liabilities are the source of the company’s financing. Assets always equate to liabilities.
Income statement presents the income and expense information that the company incurs and reports the financial result of the company. The financial result can be twofold, profit or loss. In the income statement, there are two types of operations, operating and financial. Operational activity consists in the production of products and services, and financial operations belong to financial activities.
Statement of cash flows is a very important element of the financial statement because it contains cash flows in a given company during the period considered. It represents the actual cash change rather than book values that may not reflect the true image of the company. In the cash flow statement, there are three types of cash flows:
- cash flows from operating activities, such as core business activities such as proceeds from the sale of company products, salary outflows, payments for materials etc.,
- cash flows from investing activities taking into account changes in the purchase or sale of non-current assets, such as machinery, real estate,
- cash flows from financial activities involving the issuance of shares, bonds, borrowing, repayment of loans, etc.
Statement of changes in equity is a rarely analyzed element of the financial statements. It includes changes in equity by reporting the initial and the end of the period, as well as the reasons for these changes.
Financial statements may be subjected to indicator analysis, which will normally include the following set of indicators:
- liquidity ratios,
- debt ratios,
- activity ratios,
- profitability ratios,
- market value ratios.
The first four groups of indicators are calculated for the substitution of the balance sheet and the income statement, and this information may be subject to manipulation, so-called creative accounting. Often the manipulation is net profit, and a great example was the downfall of Enron, whose accountants showed a very high net profit until the company collapsed. So for an investor and a financial analyst, the most important part of the financial statement should be cash flows that will make such adjustments that eliminate any manipulation.
Valuation of shares
Stock valuation may be carried out as the last stage of fundamental analysis, or separately, without mentioning the above. There are a lot of methods of valuation of shares. These are as follows:
- accounting approach,
- winding-up approach,
- optional approach,
- multiplier approach,
- income approach.
The multiplication method consists in estimating the value of shares by comparing it to shares of companies with similar activity, from one sector, industry. The most popular multiplier is Price / Earnings. Estimated share price is obtained by multiplying the average Price / Earnings of companies in one sector by the estimated earnings per share (EPS) of the estimated company for the following year. The problem may be to find companies with a very similar business profile and reliable data on the forecasted profit. The norm is that companies in the initial guides overstate the forecast. Other popular indicators are:
- Price/Book Value,
- Price/Cash Flow,
- Price/Cash Flow from Operations.
Income method is the most popular method of stock valuation. More specifically, the Discounted Cash Flow method is used. However, the key problem we have to solve is to determine what we mean by cash flows. And so the method of discounted cash flow can be divided into:
Discounted Dividend Model, in which share-based cash flows are identified with dividends received,
Discounted Free Cash Flow Model, which will include free cash flow to the shareholder in the calculation, funds for shareholders after repayment of all liabilities. There is also free flow to the company, which means funds for the shareholders and creditors of the company,
Residual Income Model is applied when the company does not pay dividends and free cash flows are negative. Residual (economic) profit is the difference between net profit and profit that we should get at the required rate of return.
Fundamental analysis is a rather complicated process for identifying the best investment assets but certainly should not be ignored by long-term investors, but also by mid-term speculators taking positions up to several weeks. Certainly for short-term players, day traders or people holding positions for up to several days, the technical approach will be much more applicable. There are also people who combine both methods of analyzing financial markets, which seems to be the most appropriate approach, at least for medium-term speculators.
The discussion between followers of technical analysis and a fundamental approach to investing can be considered more academic as a debate. It is hard to imagine an investor wishing to invest in a particular industry, and his investment is planned for several years not to analyze the macroeconomic situation in a given country, sector, company situation etc. It is difficult to expect from a day trader operating on a minute chart to analyze the financial statements of the company the stock has just bought and will probably sell them in a moment, and will do so before the end of the session.