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What is fundamental analysis and how to use it

We all have heard that fundamental analysis, used by some of the most successful investors, is the tool to achieve profitable investments but, can it really predict how price will evolve?

What is fundamental analysis and how to use it

What is fundamental analysis?

Fundamental analysis involves using a variety of information about a company to estimate its actual or 'intrinsic' value to be able to make an informed investment decision.

The technique attempts to anticipate the behaviour of the share price since, based on the principle of efficient markets, the price of a stock should converge to its intrinsic value over time. Fundamental analysis should not be used to predict the short term price movement, where technical analysis tends to be a more popular approach to use.

Value vs price

Value and price are terms commonly intertwined by the general public, but there are major differences, especially in the financial world.

Price can be defined as the agreed amount between buyer and seller to complete a trade. This information is public and objective. Due to its nature, price is driven by rational elements such as a company’s ability to generate revenue and profits, but also by irrational factors such as an individual’s attitude towards a company and media perception.

Fundamental analysis is used to estimate the intrinsic value of a stock, ignoring short-term trends and investor enthusiasm, to determine the true price that a company should be trading at. Quoting the iconic Warren Buffett: 'price is what you pay, value is what you get'.

Once we obtain this figure, we should compare it with the market price and make an investment decision based on whether the company is undervalued (value > price) or overvalued (value < price). As value is an estimation, it would be wise and advisable to include a margin of safety or deviation in the value of around 20%-30%.

Different types of fundamental analysis

Fundamental analysis has as a primary goal to estimate the intrinsic value of a company, this is, the value at which the price should tend to over time. Also known as a target price, it can be achieved using several methodologies, mainly divided in two categories: quantitative and qualitative.

The former is based on the four main financial statements (balance sheet, income statement, cash flow statement and statements of shareholder’s equity) from which metrics such as price-to-book, debt-to-equity, price-to-earnings (P/E) ratio, return on equity (ROE) and pay-out ratio can be obtained. The most relevant metrics will be analysed in subsequent articles within this fundamental analysis series.

In this piece, we will be focusing on the qualitative analysis, which studies the quality of business models and its positioning against competitors – we will be focusing on the following four methods: top-down or bottom-up approach, Porter’s Five Forces, SWOT analysis and economic moats.

Top-down vs bottom-up approach

In order to identify investment opportunities, there are two main approaches: a top-down approach or a bottom-up approach.
Top-down investors start their study using global macroeconomic metrics, including GDP, unemployment rates, inflation and interest rates to identify favourable countries and regions. Once the list is narrowed for the top performers, the investor then looks for stand out industries within the economy which will also involve analysis the number of participants, average net profit margin or price elasticity. Finally, the remaining list is refined to the best business in those sectors.

The bottom-up model follows an opposite filtering order, going from analysing individual companies and, once obtained, conduct the relevant studies on the sector and country/region they are in.

Porter’s Five Forces

Michael Porter developed a framework which analyses the intensity of competition within an industry, based on five key variables. The infographic below shows each of these.

SWOT analysis

SWOT analysis is a method focussed on identifying a company’s strengths, weaknesses, opportunities and threats.

Strengths and weaknesses are internal attributes of the organisation, such as talent or brand reputation, while opportunities and threats are based on the external environment, for example a country’s legislation or how fast the industry is growing.

Economic moats

A term coined by Warren Buffett, economic moats measure a business ability to maintain a competitive advantage over its competitors over time. Used as a metaphor for a medieval castle, an economic moat helps to protect a firms profits from outsiders.

Investors should look for businesses that currently have and will be able to maintain a competitive advantage, as this allows the company to outperform its competitors over the long run. Main types of economic moats are:

Investing styles

Depending on factors such as investment time horizon, risk appetite and portfolio style, fundamental analysis can be adapted for different styles of investing:

  1. Value investing: seeks to identify potentially undervalued companies. Key metrics that are used include a low price-to-book or P/E ratio, economic moats and a high dividend yield. Value investors look to buy 'cheap' companies, this is, those than offer the highest margin of safety

    Benjamin Graham is considered by many as the father of the value investing and wrote the iconic book 'The Intelligent Investor'. One of his former students and employees is Warrant Buffet, the CEO of Berkshire Hathaway and is #4 on Forbes’ list of the richest people in the world

    In their search for undervalued companies, a value investor will prioritise the quality of the business, as summarized by the Buffett quote 'It's far better to buy a wonderful company at a fair price, than to buy a fair company at a wonderful price'

    This investment style is generally intertwined with contrarian investing, as they both argue that going against the crowd or prevailing sentiment at the time (buy when everyone is selling, sell when everyone is buying) tends to offer positive rewards
  2. Growth investing: developed by Thomas Price and popularised by Philip Fisher with his book 'Common Stocks and Uncommon profits', growth investing focusses on companies with a high growth potential even if share price appears expensive in terms of metrics

    Instead of investing in an already established company, the investor will take a risk on companies that have the potential to continue growing at a higher-than-average rate. Growth companies can be found predominantly in the technology or pharma sectors
  3. GARP investing: a growth at reasonable price strategy blends aspects of both value investing and growth investing, with investors seeking companies with exponential growth but at a competitive price

    Popularised by investment manager Peter Lynch, and developed with his book 'One up on Wall Street', it uses a financial ratio called price-to-earnings growth (PEG) as its main way to identify attractive companies. Once a company is analysed, it is divided into one of six different categories based on growth potential (slow, stalwart, fast, cyclicals, turnarounds and asset plays) to which a concrete metric is given, helping to identify growth shares that are trading at a reasonable price

    Lynch also uses subjective criteria such as the customer’s satisfaction. As an example, he claims that his best investment in Taco Bell was driven by the fact that 'he like their sandwiches'

Fundamental analysis summed up

Fundamental analysis has been shown by many to be a profitable long-term strategy. Investing requires a large amount of due diligence and we hope this article has given you some insight into the wide range of approaches that some of the best investors use. These will undoubtedly give you a better understanding of a company in order to take a more informed investment decision.

For more information on the topic, further analysis breaking down the most used ratios will be published in the following weeks.

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Publication date : 2020-11-19T16:20:00+0000

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