Chapter 4-1 Introduction to Fundamental Analysis
Traders in the equity market generally rely on two basic forms of evaluation to study the markets and predict price movement: fundamental and technical analysis.
What is Fundamental Analysis when Applied to Equities?
Fundamental Analysis is an important part of research for equity traders and investors. While it can be less fun than technical analysis (charting), the value it brings is indispensible. Half of the challenge is fundamental analysis is knowing where to start. Fundamental analysis involves so many different aspects it is very easy to get lost. The goal is to evaluate as much information as you can with regards to the company and its corresponding industry.
The underlying concept to fundamental analysis is to research and analyze the various quantitative aspects of the company. On a basic level, this includes revenue, profit, and debt. There are also many qualitative aspects to investigate, such as a company’s ability to compete with others in the industry. Putting these pieces together will give you the “big picture” of the company and its direction. Beginners will find this more difficult to comprehend than seasoned stock traders. Delving deeper into qualitative factors will be challenging as there is no real way to assign a number to these values. Although analyzing a business might seem like a straightforward activity, there are many flavors of fundamental analysis. Investors often create oppositions and subcategories in order to better understand their specific investing philosophy. In the end, most investors come up with an approach that is a blend of a number of different approaches. Many of the distinctions are more academic inventions than actual practical differences. For instance, “value” and “growth” have been codified by economists who study the stock market even though market practitioners do not find these labels to be quite as useful. In the following descriptions, we will focus on what most investors mean when they use these labels, although you always have to be careful to double-check the real meaning implied by the use of these labels. It’s more of a “touchy-feely” process when forming your opinions, especially when you begin to seriously invest and trade. A few of the most common factors are listed below:
Management – Who is involved? Have they been involved in other successes or failures in the past?
Business Model – What does the company do, and how does it make money?
Competitive Advantage – What, if anything, makes the company better than its competitors? Patents? Advanced processes?
Industry – Is the industry as a whole growing or shrinking in the current economy?
Market Share – Is the company’s market share growing or shrinking? How does it compare to its competitors’ market share?
Looking at quantitative factors is a bit easier, as each factor should have a specific number or yes/no answer. The most important aspects in beginner’s stock trading and investing are as follows:
Financial Statements – Are they audited by an independent auditor?
Income Statement – What are the company’s revenues, expenses, bottom line, and profits (if any)?
Balance Sheet – What are the company’s assets and liabilities valued at?
Loans – How much does the company owe? How soon will they be debt free?
Cash Flow – What is the company’s cash flow value?
Of all the fundamentals, the financial statements are the most important in learning how to trade. Knowing where the company stands in regards to profit, assets, liabilities, and cash flow is a must. Next, the qualitative aspects of the company should be researched. The combination of the two should form an overall representation of the company. Is the company successful now? Will it be successful in the future? Is management making the right decisions and leading the company in the right direction? Once this research is complete you can move on to technical analysis to determine the stock’s trend, along with entries and exits.
Why use fundamental analysis?
The goal of fundamental analysis is to identify a value that investors can compare with the current market price. If the company is undervalued you should buy, and likewise if it is overvalued you should sell. Warren Buffett, one of the most famous users of fundamental analysis, has successfully used this method to turn himself into a billionaire.
Ratios: Revenues, Net Profit Margin, EPS, P/E, Debt to Equity, Current Ratio, Quick Ratio, ROA, ROE, Beta, PEG, all will be explained below.
Revenue is money collected by a company from customers in exchange for a product or service. When you subtract out all relevant costs from revenues you’re left with profits (or earnings). Market Capitalization is the total dollar value of all outstanding shares calculated by multiplying the price of a single share by the total number of shares outstanding.
Mega Cap: Market cap of $200 billion and greater
Big/Large Cap: $10 to $200 billion
Mid Cap: $2 billion to $10 billion
Small Cap: $300 million to $2 billion
Micro Cap: $50 million to $300 million
Nano Cap: Under $50 million
Net Profit Margin
Net profit margin is net income expressed as a percentage of sales. This is calculated by dividing net income by sales. Since it’s a percentage, it tells you how many cents per dollar of sales are pure profits. The higher a company’s profit margin is compared to its competitors, the better.
Earnings Per Share (EPS)
A very important fundamental, EPS is the company’s earnings expressed in terms of the number of shares outstanding. Calculated: EPS = ((net income-dividends on Preferred Stock)) / (average outstanding shares). Essentially, this tells you how profitable the company is. What’s preferred stock? It is a class of ownership in a corporation with a stated dividend that must be paid before dividends to common stock holders.
Price/Earnings Ratio (P/E)
One of the most popular ratios, it is simply Calculated: = (Market value per share) / (Earnings per share (EPS))
EPS from the last four quarters is called trailing P/E. EPS taken from the estimates of earnings expected in the next four quarters is called forward P/E. P/E is referred to as the “multiple” because it shows how much investors are willing to pay per dollar of earnings. High P/E means high projected earnings in the future. It is most useful to compare the P/E ratios of companies within the same industry, to the market in general, or against the company’s own historical P/E.
Price-to-sales is calculated by dividing a company’s current stock price by its revenue per share. The price-to-sales ratio can vary substantially across industries; therefore it’s most useful when comparing similar companies. Also, it is important to consider that price-to-sales does not account for debt!
Price-to-book is calculated by dividing the current closing price of the stock by the latest quarter’s book value (book value is simply total assets minus intangible assets and liabilities). A low Price-to-Book ratio could mean the stock is undervalued, or something is very wrong with the company.
A relative measure of how much debt a company has: Calculated = ((Total Liabilities) / (Shareholders Equity)), essentially long-term funds provided by creditors divided by funds provided by shareholders. A higher debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings.
The Current ratio is a good measure of the liquidity of a company, or how easily it can ‘cough up’ cash. This is commonly used as an indicator of a company’s ability to pay short-term obligations; calculated by dividing current assets by current liabilities. The higher the ratio the more liquid the company! Consider what types of companies and industries this ratio might be very important to.
Like current ratio, this gives a measure of a company’s financial strength: Calculated = ((Current Assets – Inventories) / (Current Liabilities)). It is a measure of how quickly a company’s assets can be turned in cash. You subtract inventories so you can check and see if a company has sufficient liquid assets to meet short-term operating needs. (Note that current ratio did not subtract inventories.)
Return on Assets (ROA)
Also sometimes called “Return on Investment” or ROI, this is a measure of what earnings were generated from capital investment back into the company. Calculated = ((net income) / (Total Assets)). This calculation is always given as a percentage. Think of it as, “How much money (income) was generated from a company’s investment into itself (capital investment or company assets)?”
Return on Equity (ROE)
It is a measure of how much, in earnings, a company generates in four quarters compared to its shareholders’ equity. ROE is a good measure of profitability. Calculated = ((net income) / (Shareholder’s Equity)). It is also measured as a percentage. For instance, if ABC Corp. made $1 million in the past year and has shareholders’ equity of $10 million, then the ROE is 10%. Some use ROE as a screen to find companies that can generate large profits with little shareholder investment in the company.
A measure of a security or portfolio’s volatility, or systematic risk, in comparison to the market as a whole (usually calculated with S&P 500 Index). Think of beta as the tendency of a security’s returns to respond to swings in the market. A beta of 1 indicates that the security’s price will move EXACTLY with the market. A beta less than 1 means that the security will be LESS volatile than the market while a beta greater than 1 indicates that the security will be MORE volatile than the market.
Price/Earnings to Growth (PEG)
Calculated = ((Price / Earnings Ratio) / (Annual EPS Growth)). PEG can give you an idea of a stock’s potential growth since it divides by Earnings per Share (EPS) by annual growth rate, but is based on analysts’ estimates! If a company has a P/E of 20 and analysts expect its earnings will grow 15% annually over the next few years, you’d say it has a PEG of 1.33. Anything above 1 is suspect since that means the company is trading at a premium to its growth rate.
With these ratios a company’s current, as well as future, financial state becomes much clearer. There are many other ratios out there to help you get an idea of what the financial health of a company is, but these are the most widely used.
What is Fundamental Analysis when Applied to Currencies?
Fundamental analysis when applied to Forex is essentially the study of a nation’s overall economy. The idea of this “Big Picture” approach is that the strength of a nations’ economy will affect the supply and demand for its currency, which will in turn affect the price of the currency.
On the other side of the “fence” is technical analysis where the currency price is assumed to reflect all news and fundamental factors, and the charts are the objects of analysis. The core belief here is that prices tend to follow patterns, and by analyzing past price patterns a trader can predict the future direction of the price.
Successfully employing fundamental analysis strategies requires a basic understanding of supply and demand, which is the most elemental force behind all financial markets. Since the value of a currency comes from the economic health of its respective country, macroeconomic changes can have a significant impact on currency rates. Several factors can have a strong influence on rates, some of the more significant are: politics, economic strength, speculation, economic projections, inflation rates, capital movement, interest rates, and quotas and tariffs.
Fundamental analysis itself can be broken down into two broad subcategories: capital flows and trade flows.
A country’s capital flows are the net quantity of currency being traded through various investments: capital, equity market, fixed income market, etc. Trade flows measure the net of imports and exports of a particular country, and the resulting effects that such flows can have on a nation’s currency. The reason that trade plays such a strong role in determining strength of a currency is that importers are required to sell currency used to purchase goods and services which are exported. A country which has a positive trade flow (more exports than imports) runs surpluses that serve to increase their currency; the opposite is true for the net importer. Traders who perform fundamental analysis study various economic indicators to evaluate economic strength. Some of the more significant indicators include: The Gross Domestic Product (represents the total market value of all goods and services produced), Retail Sales (measures the total receipts of all retail stores), Industrial Production (shows the change in production of factories, mines, and utilities), and Consumer’s Price Index (measure of the change in prices of consumer goods).
Although there are other significant indicators that may be monitored, these are the most common and provide a basic analysis of a country’s economic strength, and hence currency stability. These reports are released on a regular basis by various government agencies and non-government organizations. A trader who utilizes fundamental analysis typically will have the report schedules on hand and closely monitor the reports, as well as the effects they may have on currency prices. Following this for a period of time will help the trader determine better what impact on the currency prices each of the reports may provide. Technical analysts will use price charts and patterns to anticipate price changes in both direction and range. While both fundamental and technical analysis of the Forex market provides very useful information, they each have their strengths and weaknesses. The “Big Picture” of fundamental analysis is good at identifying general long-term trends in price movement, but it does not give enough detail to provide entry and exit points for a trader. Technical analysis, on the other hand, is typically more effective in predicting short-term trends (under three months), but it can suffer by being “blind-sided” by significant price swings brought about by one or more fundamental factors.
By combining both fundamental and technical analysis of the Forex market a Forex trader will have a solid, balanced trading plan. By monitoring various indicators on both sides of the “fence” over time a trader can gain a better understanding of what will work best for his or her own particular trading plan and style.
Quantitative Analysis – Buying the Numbers
Pure quantitative analysts look only at numbers with almost no regard for the underlying business. The more you find yourself talking about numbers, the more likely you are to be using a purely quantitative approach. Although even fundamental analysis requires some numerical inputs the primary concern is always the underlying business, focusing on things like management’s expertise, the competitive environment, the market potential for new products, and the like. Quantitative analysts view these things as subjective judgments, and instead focus on the incontrovertible objective data that can be analyzed.
One of the principal minds behind fundamental analysis, Benjamin Graham, was also one of the original proponents of this trend. While running the Graham-Newman partnership, Graham exhorted his analysts to never talk to management when analyzing a company and focus completely on the numbers, as management could always lead one astray. In recent years, as computers have been used to do a lot of number crunching, many “quants,” as they like to call themselves, have gone completely native and will only buy and sell companies on a purely quantitative basis, without regard for the actual business or the current valuation – a radical departure from fundamental analysis. “Quants” will often mix in ideas like a stock’s relative strength (a measure of how well the stock has performed relative to the market as a whole). Many investors believe that if they can just find the right kinds of numbers they will always be able to find winning investments.
Many quantitative analysts use “screens” to select their investments, meaning that they use a number of quantitative criteria and examine only the companies that meet these criteria. This approach has increased in popularity because it is easy to do with the widespread use of computers. Screens can look at any number of factors about a company’s business or its stock over many time periods. While some investors and traders use screens to generate ideas and then apply fundamental analysis to assess those specific ideas, others view screens as “mechanical models” and buy and sell purely based on what comes up on the screen. The Market Scholar team utilizes these screens daily to propagated real time trading strategies. By utilizing the screens, traders are able to remove emotions from the trading and investing process. (Those who do not use screens would counter that using a screen mechanically also removes most of the intelligence from the process.) Eric Ryback highly advocates using screens as a starting point, and one of the most famous advocates of screens as a mechanical system is James O’Shaughnessy.
Arguments against Fundamental Analysis and Quantitative Analysis
Those who do not use fundamental analysis have two major arguments against it. The first is that they believe that this type of investing is based on exactly the kind of information that all major participants in publicly traded markets already know, so therefore it can provide no real advantage. If you cannot get a leg up by doing all of this fundamental work understanding the business, why bother?
The second is that much of the fundamental information is “fuzzy” or “squishy,” meaning that it is often up to the person looking at it to interpret its significance. Although gifted individuals can succeed, this group reasons that the average person would be better served by disregarding this kind of information.
Because quantitative analysis hinges on screens that anyone can use, many of the pricing inefficiencies quantitative analysis finds are wiped out soon after they are discovered as computing horsepower becomes cheaper and cheaper. If a particular screen has generated 40% returns per year and becomes widely known, the returns will start to suffer if lots of money flows into the companies that the screen identifies. As “fuzzy” as fundamental analysis might be, there are often times that knowing even a little about the company you are buying can help a lot. For instance, if you are using a high-relative strength screen, you should always check and see if the companies you find have risen in price because of a merger or an acquisition. If this is the case, then the price will probably stay right where it is, even if the “screen” you used to pick this company has generated high annual returns in the past.
Using fundamental analysis, though time consuming, can be effective when used correctly. As with technical analysis, discretion must be used in order to increase accuracy. However, when fundamental analysis is properly absorbed and implemented, trading and investing results dramatically improve, especially when used in conjunction with technical analysis.