Updated: Jul 13, 2021
Fundamental analysis is used by investors, traders, and analysts to determine the intrinsic or actual value of a share of stock. Along with the technical analysis, the fundamental analysis of an investment gives a deeper understanding of the market.
Analysts consider many factors when carrying out fundamental analysis. These include economic factors, the company's financial state and performance, and other qualitative factors such as media presence and management decisions. Unlike technical analysis, fundamental analysis is done for long term investments.
The ultimate goal of fundamental analysis is to attest if a share or stock is overvalued or undervalued. Investors then compare the actual value of the stock or share with the market value to make investment decisions.
Types of fundamental analysis
Fundamental analysis can be divided into two areas: a quantitative analysis.
Quantitative fundamental analysis: Quantitative analysis involves taking data from financial statements and inferring the fair price of shares or stocks using fundamental tools.
Qualitative fundamental analysis: Qualitative analysis deals with other factors that cannot be quantified but which also affect a company’s share value. These include brand value and management decisions amongst other things. Qualitative factors can be difficult to work out, especially when used as a tool for comparison with other companies.
Aside from qualitative and quantitative analysis, there are two approaches analysts and investors using in stock valuation; these are the top-down and bottom-up approaches.
The top-down method first considers the economic factors affecting the company and later delves deeper into the company itself. Most analysts prefer to use this approach.
How to carry out fundamental analysis
Let’s take a look at how the top-down approach works in practice.
The first step is to understand the company you are analyzing. This involves carrying out economic, industry-wide, and company-wide analysis. In most cases, the growth of the economy spurs the growth of industries or companies, and this would affect their stock. However, industries don't grow at the same rate during economic growth, and this is why you need to pick a company from the right industry.
The next step is to acquire the company's annual and financial statements. The statements include balance sheets, income statements, cash flow statements, etc. The use of financial ratios or fundamental analysis tools will prove to be indispensable for stock valuation.
All the collected data is analyzed and used to get to the real stock valuation and determine the company's prospects. It is also common to compare company data with competitors or rivals to arrive at a valuation.
Important fundamental analysis metrics
The following metrics can be used to give investors in-depth information about the condition of a company and its performance. Once you have your list of companies to invest in, the first thing is to find out how much they earn. This will give you an estimate of their capital appreciation and growth potential. Here are some of the most commonly-used metrics in fundamental analysis.
Book value: The book value is the difference between a company’s total assets and its liabilities. The book value reflects the true or accurate worth of the company. The book value of a company doesn't account for intangible assets such as intellectual property and patents.
Return on equity (ROE): Return on equity shows how well a company is performing in terms of profitability. The value is determined by dividing the company's after-tax income by its book value. If a company generates huge profits with a relatively small book value, then the company is said to be efficient. A similar metric to use would be the return on assets. This is the ratio of a company's income against its total assets.
Earnings per share (EPS): Earnings per share is the ratio of the revenue generated by the company to the amount of shares sold. The EPS shows how well the company is performing and indicates how profitable their stock or share is. The higher the EPS, the better the performance and the more profitable it would be to invest in the company.
Price-earnings ratio (P/E): The price-to-earnings ratio is a more wholesome metric for the performance of a share. It determines if it is undervalued or overvalued. You can find it by dividing the EPS by the share price. A high price-earnings ratio shows that more people are eager to pay for the shares because of high growth potential. It may also suggest that the stock is overvalued. Conversely, a low P/E may mean that the stock is undervalued.
Price/earnings to growth ratio (PEG): As mentioned above, a share with a high price-earnings ratio doesn't necessarily mean it is overvalued. The problem with the price-earnings ratio is that it doesn't account for growth. Some of the fastest-growing companies have stocks with high P/E ratios. PEG is calculated by dividing a stock's P/E ratio by the earnings growth rate. The PEG ratio paints a better picture in the valuation of stock and other commodities. A PEG value which is less than one may suggest that the stock is undervalued and similarly, a high PEG may indicate the stock is overvalued.
Debt/equity ratio: The debt ratio is another critical tool in fundamental analysis. It measures the amount of debt a company owes compared to the stockholders or the shareholders' equity. A high debt/equity ratio may suggest that the company has little financial leverage and more often than not, deters investors—most investors look for companies with a debt/equity ratio lower than 80%.
Dividend yield: Good investors love to find companies with a high dividend yield. It is only natural you would want the best return on your investments. The dividend yield is expressed as a percentage: the dividends you get on a unit share divided by its price.
Why fundamental analysis is important for decentralized assets?
Fundamental analysis is very important for decentralized assets, especially when it comes to long-term investing based on long-term, very long-term patterns. It helps identify and forecast long-term fiscal, demographic, technical, or market trends that can benefit patient investors who chose the right investments, especially in the crypto world.
Another importance of the importance of fundamental analysis is the development of a comprehensive understanding of the market. Following such painstaking research and analysis, the investor would be familiar with the market's main profit drivers. Earnings and earnings expectations can be strong indicators of equity prices.
However, a thorough understanding of the market will help investors avoid investments that are vulnerable to shortfalls and recognize those most likely to reach profitability. In addition to understanding the market, fundamental analysis helps investors understand key value factors and assets within the sector.
Fundamental analysis is crucial for stock valuation and for making proper investment decisions. It takes into account many factors that affect the value of shares. The process can be technical and time-consuming, but over the years it has proven to be very rewarding for those who apply its principles.
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