What is Fundamental Analysis ?

Fundamental Analysis

 

Overview

Fundamental analysis is the practice of evaluating a company's stock price by comparing base elements in the company's balance sheets as well as general market factors. It does not include chart analysis, which is the domain of technical analysis.

The main principle of fundamental analysis is to find profitable companies to invest in by comparing revenues, sales, management, etc. There are two types of drivers to look at in fundamental analysis: internal drivers and external drivers. Internal drivers are company specific (e.g. revenue, net income, assets, debts, etc.). External drivers are things that can affect the company's profitability but is not company specific (e.g. the economy, industry averages, etc.).

The analysis of internal drivers can be broken down into two components: balance sheet numbers/valuations (you can calculate); and, news/management/analyst ratings/economic outlook (you cannot calculate). The items you cannot apply numbers to like news, management style, etc., are subjective so discussion of these factors with others will help.

With balance sheet numbers and valuation techniques you can get a general appraisal of whether the company is overvalued or undervalued. This can be done in many different ways. The most common is in the form of a P/E ratio.

The analysis of external drivers is more subjective, as it requires a broad knowledge and, discussion of future industry growth, politics, economy, etc. These influences are important but cannot be easily calculated.

External drivers

 

External drivers are factors which are outside the company's influence that can affect profitability. For example, the economy, inflation, interest rates, politics, bond market, etc. External drivers can be interpreted differently by different individuals (there is no magic formula).

To explain some of the external factors we will begin with Inflation. Inflation is the rate at which the general level of prices for goods and services are rising.

Inflation

Inflation has a direct influence on the stock market. While looking at inflation can be still subjective to the trader, a little history can explain what the effect inflation has had in the stock market's past.

Between1970-1980 there was high inflationary trend. During this period, as inflation was rising and "not in control," the trend was for businesses and individuals to increase debt load. The rationale was to borrow today with more valuable dollars and pay off the debt in the future with less valuable dollars. While this concept is sound in a situation with up-trending inflation, the problem comes in when the inflation trend is stemmed and reversed.

As businesses and individuals continue to borrow and inflation continues to rise, the Federal Reserve (which will be discussed in further detail later) tends to step in to correct the problem. As these controls are activated, the inflationary trend changes direction. As history shows, there will always be a group of individuals and businesses that do not realize the trend has ended. As interest rates climb, they are caught with an excessive debt load which they can no longer service. By 1986 the excessive debt load was being noticed and by the early 1990s a record number of business and individual bankruptcies were declared and resulted in a high unemployment rate (1990-91). There has been a slow economic recovery since this recession and the inflation rate (consumer price index) has been trending downwards since then.

Part of the formula of a strong bull market is when inflation is perceived as being in control. During some of the best bull markets all you needed was a dart board. While the dart board is NOT recommended, these bull markets all had something in common - inflation was in control. This effect can be observed in the following super bull markets: 1920-29; 1949-66; and, in the current bull market.

Inflation also has a direct effect on interest rates. As the inflation rate climbed from the 1970s until the late 1980s, the demand for debt financing was high. Like anything, if the demand is high, so is the price, so interest rates were equally high. In 1990, the recession and the huge number of bankruptcies dramatically reduced the general debt demand. By 1993, interest rates fell about 4%. This drop in interest rates also made CDs and money markets less attractive to investors and led to a significant shift in assets to stocks and bonds (which was the beginning of the new bull market).

Interest rates

The first two types of rates are short term and long term. In general terms, if there is strong economic growth, short term rates will rise. Long term rates are related to the inflationary trend as well as rate differences between foreign countries.

There is also the discount rate and federal rate. These are the rates that are controlled by the Federal Reserve. These rates are also used to control the inflationary trend as well as the interest rate trend, and have a significant impact on investors. The discount rate is the interest rate that member banks use to borrow money from the Federal Reserve. The federal rate is one that banks use to borrow from each other. If the economy is growing too fast, the Federal Reserve will raise the federal rate to hold back the inflationary trend.

Finally, there is also the "real" interest rate. The real interest rate is the average Federal Funds rate minus the inflation rate. Most economists use the real interest rate for analysis to determine the general future direction of interest rates and the overall market.

The Federal Reserve

The Federal Reserve's primary function is to keep the economic system in balance. The Federal Reserve has three economic controls to influence imbalances like high inflation rates. The Federal Reserve can: alter the amount of reserve that member banks are required to maintain; control the discount rate; and, the Federal Funds rate.

During a recession or slow economic growth period, the Federal Reserve will lower interest rates to encourage investors to move assets into stocks and bonds (which will obviously help the stock market). When economic growth is too fast and inflationary pressures begin to build, the Federal Reserve will raise interest rates to encourage investors to move assets into money markets and CDs. This is the Federal Reserve's preferred method of economic control.

During the 1990 recession, the Federal Reserve dropped the rates to the lowest rate in two decades. In 1994, the economy began to rebound and the Federal Reserve raised the rate for the first time since 1990. This signaled the first potential of a change in the trend of the interest rate. Since then, the Federal Reserve has raised the rate 10 consecutive times (as of August 2005) which has quite conclusively made an upward trending interest rate. Even though the rate changes were quite small, it is the perception of the public that the trend has changed that put a bit of a damper on the stock market.

Note: A reasonable method for forecasting interest rates is to look at the Dow Jones Utility index. If the index in trending upwards it indicates that interest rates are trending down, if the index is trending down, it indicates that interest rates are on the rise. Utility stocks are considered sensitive to interest rates and therefore make a good leading indicator towards the interest rate trend as well as the overall market trend. (Some might argue that other indexes work just as well, however this depends on the investor's strategy... Generally speaking the utility index works well for interest rates and for overall market trend).

Internal drivers

 

Internal drivers are company factors that are directly related to the actual business in question. For example, liabilities, assets, revenue, income, products, management, etc. It is these characteristics in a company that you will be comparing to other companies in the same industry. This allows the trader to get a general understanding of where this company "sits" in relation to other companies with similar businesses. A trader can also use these internal numbers to calculate many different ratios that will help determine if the company is currently undervalued or overvalued.

Management

Management who are they? What have they done in the past? What is the quality and diversity of the management team? All these questions can lead to a lengthy discussion about the particulars of each individual in management. Traders should use analysts’ reports, news, internet, and other sources to help make informed decisions about the management team.

Products, product cycles and competition what is the company's product and/or service? How does it compare to other competitive products? What's unique? Why is it better? If you would not be willing to buy the company's product why would you invest in that company? Companies with inferior products, weak development/product cycles, poor quality companies tend not to last very long (I'm sure there are some exceptions to that rule, but it can be considered bad policy to invest in companies with bad products).

Production

Production is very important when it comes to companies that produce oil/gas, wood, power, metals etc. Their value depends highly on their production output as well as the current value of the product. The more a company produces, the more it can earn. As well, these specific commodities vary in cost, the higher the value of the product, the higher the potential for profit. Oil is a perfect example of this relationship. As global oil prices raise so does the value of oil companies.

Profit

Profit margins are important, or for that matte, profit in general is important. Profit can be considered the keystone to fundamental analysis - the more profitable the company, the higher the potential for dividends as well as price growth. Most valuation techniques compare profit in some form or another to that of similar companies.

Companies that have not yet attained net profit are still in the early stages of development. While these companies generally have a larger growth potential, they also have more risk. Companies that are producing net income can generally be considered established in the market place. There is less risk, and typically, the price of the stock will reflect that. The axiom here is that the more the company makes, the more the company is worth.

Institutional presence

Is there an institutional presence? The level of institutional presence is determined by the amount of shares outstanding that are owned by institutional investors (mutual funds, pension funds, investment houses, etc). As small companies mature, there is a point where they will be recognized by institutional investors. When these institutions begin investing in a company, the stock price will reflect that recognition (also when they sell out, it will be noticed in the stock price as well). Larger and more established companies typically have larger percentile institutional presence than smaller companies (micro-caps tend to have little to none).

Share volume

While the study of volume patterns is in the realm of technical analysis, volume can also be used as a fundamental indicator. Does the company you are looking at have enough share volume to sell your shares at a later date? A simple check will keep you from getting trapped.