Fundamental analysis is the study of the various factors that affect a company's earnings and dividends. Fundamental analysis studies the relationship between a company's share price and the various elements of its financial position and performance.
Fundamental analysis also involves a detailed examination of the company's competitors, the industry or sector it is a member of and the broader economy.
Fundamental analysis is forward looking even though the data used is by and large historical. The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects. This intrinsic value can be compared to the current value of the company as measured by the share price. If the shares are trading at less than the intrinsic value then the shares may be seen as good value.
Many people use fundamental analysis to select a company to invest in, and technical analysis to help make their buy and sell decisions.
Factors affecting future earnings prospects of a company:
- Change in senior management
- New efficiency measures
- Product innovations
- Acquisition of another business
- Industrial action
Analysing individual companies
The analysis of an individual company has two components:
- The 'story' - what the company does, what its outlook is
- The 'numbers' - the financials of the company, balance sheet and income statement and ratio analysis.
Unfortunately, balance sheet and ratio analysis is probably the most daunting part of fundamental analysis for non-professional investors. A large number of numerical techniques appear to be used. However, you can make it less painful by adopting a methodical approach and by always remembering that behind all the numbers is a real business run by real people producing real goods and services, this is the part we call "the story".
It is unlikely that you will need to do the number crunching for every company, your time will be more profitably spent developing the company story. Balance sheets and ratio analysis, both historical and forecast, can be obtained from either a full service or discount stockbroker.
What are you trying to learn about a company?
Before trying to leap into the calculations behind fundamental analysis there are some basic questions that are worth considering as a starting point:
- Where is the growth in the company coming from?
- Is the growth being achieved organically or through acquisition?
- Is turnover keeping pace with the sector and with competitors?
- What about the profit margin - is it growing? Is it too high compared to competitors? If it is too high then new competitors could enter on price reducing margins. Low earnings could suggest control of the cost base has been lost or factors outside the company's control are squeezing margins.
- To what extent do profits reflect one-off events?
- Will profits be sustainable over the long term?
Companies are multidimensional. For example, debt funding may have increased - this may be a positive move if the funds produce new productive assets.
Fundamental analysis (Summary)
When you buy shares you are becoming a part owner in that business.
To make an informed decision if you want to be an owner in that business, it is important to understand how that company operates and what its prospects are.
To understand a company, you can read its annual report which is one of the most important publications it releases to the market.
Analysing an annual report gives you the ability to build a good picture of how that business has performed over the past 12 months and what its prospects might be for the future.
To compare the annual reports and prospects of different companies, there are commonly used financial ratios, these include dividend per share, dividend yield, PE ratio and earnings per share.