Fundamental analysis measures a security’s intrinsic value using a number of quantitative and qualitative assessments. Investors, day traders, and analysts need to know whether a business’s fundamentals are reflected in the “fair market price.”
If you’re confident in your fundamental factors stock analysis, then spotting an undervalued security could generate decent upside returns if the price rises.
In this article, we’ll explain what you need to know about applying fundamental analysis in practice, including what analysts and investors need to know about a company, its financials, and other key considerations.
What Is Fundamental Analysis?
Fundamental analysis is a way of examining the fundamental factors of a business so you can more accurately judge its share price. It’s more about taking a long-term view of a company rather than worrying about short-term details, such as the end-of-day share price.
Investors who use fundamental analysis usually fall into two categories:
- Growth investors: Examine the future growth potential of a company and pick undervalued long-term investments to increase a portfolio’s returns
- Value investors: Assess whether the current share price accurately reflects the health and financial performance of a company
Conducting a fundamental analysis involves going over the following factors (and several others, depending on how in-depth you want to go):
- A company’s financial statements
- Business model
- Competitive advantage
- Market share, moat, intellectual property (IP) and their unique selling point (USP)
- Macroeconomic and microeconomic weightings
- Share price ratios, e.g., the price-to-earnings ratio (p/e ratio)
- Impact of the global economy
- Management and leadership
- Sector(s) and operating markets for growth, contraction, or stagnancy
Once you’ve collected this information and analyzed it, you might have a different view as to the true value of a security compared to the market and other analysts.
Say the market prices a company at $100 a share, with normal fluctuations. But after applying fundamental analysis, you think it’s undervalued and should be $120. Buying now, before the market catches up, could be a smart move.
On the other hand, if a security is overvalued, it could drop to $80. As with any investment, it’s a data-backed judgment call, and the more data you’ve got for analysis, the smarter decisions you can make.
The goal is to understand the “fair market value” and whether a stock appears to be undervalued or overvalued by other investors.
How Does Fundamental Analysis Work?
Applying fundamental analysis is usually a top-down research task to identify securities that other investors aren’t pricing accurately (giving you an advantage).
To determine fair market value, analysts look into:
- The impact of the economy on specific businesses and sectors
- The sector/industry the company operates in
- A company’s financial statements, profit and loss (P&L), income, cash flow, etc.
What Are the Risks of Fundamental Analysis?
The main risk of fundamental analysis is that your analysis is incomplete, and markets are pricing in something that you’re not aware of or have not given the same weighting too. When you take a value-based approach to fundamental analysis, you are betting on a reversion to the mean.
For example, if your fundamental analysis leads you to believe a stock should be valued at $80, and right now, it’s trading at $60, you’re making a bet that the overall market will reach the $80. In practice, due to macro factors, this may not happen, or it may take many years to happen. There could be a systemic crash that affects all stocks, and that $60 stock could go to $20. Additionally, there is opportunity cost.
Your analysis might be right and the stock does eventually reach $80, but it took 10 years to get there. Your money could have been more effectively used elsewhere. As with any investment, whether it’s $1,000 or $1 million, it’s a judgment call, and fundamental analysis is one way to make a decision.
While these risks exist, famous fundamental investors, like Warren Buffett and Charlie Munger, have had huge success using fundamental analysis to make investment decisions.
Where to Source Data for Fundamental Analysis?
You can source data for fundamental analysis in several ways.
Start with the investor relations sections of companies you’re interested in. Equally useful is the Security and Exchange Commission (SEC) Edgar filings database, where you can pull all of the usual reports: 8-K, 10-Q, 10-K, etc. Investors and analysts can find SEC filings on the SEC Edgar Page, which will require extensive joining of data fields and standardizing across companies, and within companies.
Tiingo already provides standardized fundamental data that uses a combination of machine/statistical processes and human oversight to create a dataset you can compare across companies & industries, and within companies.
Beyond public sources, investors and analysts need a reliable, in-depth high-value source of clean data and financial news.
With high-quality data, analysts and investors can uncover all sorts of nuggets. Take time to make a holistic assessment of the stocks you’re looking at, from P&L and cash flow to the executive team and how the sector is doing economically.
Different Approaches to Fundamental Analysis
Fundamental analysis isn’t just about crunching the numbers and churning through spreadsheets.
Go for a deep-dive mix of quantitative and qualitative factors, such as:
- Business model and leadership team
- Any competitive advantages
- State of the sector, economy, and impact of interest rates
- Balance sheets, P&L, and cash flow
Assuming your analysis shows the markets underestimating the share price, then you could be onto a winner.
Qualitative Considerations for Fundamental Analysis
Qualitative analysis means stepping back and looking at the bigger picture. Investors spend so long going over the numbers that they can overlook other fundamentals, such as whether a company is innovative, led well, and implementing a strong strategy. Market conditions are also important to evaluate.
Here are some good places to start with your qualitative assessment.
Business Model
Start with the basics. Take notes from the company’s website, investor relations, and annual reports. These should answer the following questions for you:
- What’s their business model?
- What are their core products or services?
- Is their revenue recurring or cyclical?
- Who are their customers (e.g., SMBs, enterprises, consumers, etc.)?
From this, you should have a fairly clear top-level overview. Now it’s time to go a bit deeper.
Competitive Advantage
When a competitive advantage is easy to see, the market prices that into a stock. However, if this isn’t as clear to other investors, then it’s worth exploring further. So you need to understand:
- Does the company have a competitive advantage?
- Can you see if they are benefiting from this advantage? (For example, are they ahead of competitors but not so far ahead that the market price reflects this?)
- Does the business have a moat, a defensible position? Market leaders usually have a fairly strong position, but you’re looking for companies with a moat (e.g., IP, patents, innovative products, loyal customers, etc.) that most investors haven’t spotted yet.
- What’s their USP, and does this give them an advantage over competitors?
Market and Sector Growth
The strength of a sector ⏤ whether it’s growing, contracting, or stagnant ⏤ can directly impact a company’s health. In most cases, this is factored into the share price. However, using fundamental analysis, you could spot what others have missed, such as:
- Is the company diversifying into high-growth sectors?
- How reliant is their business model on their core sector vs. other markets/sectors they operate in?
- What percentage of their revenue comes from domestic vs. overseas markets?
Leadership Team Track Record
Look into everything you can about a company’s leadership, such as track record, performance, execution of the strategic plan, compensation, targets the board has set, and whether they’ve been buying or selling stock options recently.
A leadership team can make or break a company. For investors, you could be picking an undervalued stock if the market underestimates the C-suite.
Quantitative Data for Fundamental Analysis
Now it’s time to crunch some numbers, go deep into the data, and find those undervalued diamonds! Here’s some of the qualitative data to look at.
Balance Sheet, Income, and Profit and Loss
A balance sheet is a snapshot of a company’s assets, liabilities, and equity. The formula for whether these figures balance is: Assets = Liabilities + Shareholder Equity
Likewise, assessing a company’s P&L is always useful. You need to know whether they’re making a profit or losing money, and if so, what are their earnings before interest and taxes (EBIT)?
EBIT is an important one to know as this shows how much income a business is generating from core operations, thereby giving investors a clear view of net profit.
Share Price Ratios
Stock price ratios make it easier to understand if the fundamentals align with how a security’s priced. For this analysis, you’ll need access to high-quality financial data.
Cash flow, share price ratios, and credit ratings are just a few of the fundamental company financial metrics you’ll want to dig deeper into.
It takes time to build an accurate picture of a business, especially when operational leaders and accountants are keen to publish materials that paint them in a positive light. As an analyst or investor, you’ve got to look more closely into the real metrics, including market data and historical data.
Here’s what to look into:
- Earnings per share (EPS): To calculate this, divide gross operating profit by the number of shares. A higher EPS ratio indicates a profitable business. But does this mean it’s undervalued? To understand that means checking this against the other key share-based metrics in this list.
- Price-to-earnings ratio (p/e ratio): Use p/e to compare EPS to the share price and get a more complete picture. A high p/e ratio could indicate the stock is overvalued. A low p/e suggests the market could have undervalued the stock. On the other hand, a low p/e could also mean it’s accurate, and this is an unattractive investment.
- Price/earnings-to-growth (PEG): This metric is only applicable when shares have been going up based on earnings. PEG is p/e divided by the annual earnings growth per share. When PEG is above 1.0, it could mean a share is undervalued. But it’s worth checking against competitors and industry averages.
- Price-to-book ratio (P/B): This compares current pricing to the book value. Any valuation of around 3.0 indicates a market-factored valuation, whereas ratios around 1.0 could mean the stock is undervalued.
Cash Flow and Income Statements
It’s always worth looking into a company’s statement of cash flows, as this shows the inflow and outflow of money.
Cash flow is an indicator of the overall financial health of a company. There are a number of public ways a business has to demonstrate this, such as operating cash flow (OFC), cash from financing (CFF), and cash from investing (CFI).
Out of those three, operating cash flow is the most important as it shows how much revenue a company is generating from core activities. Ideally, a company should have more coming in from sales than investing or financing.
If that’s not the case, then either they’re in too much debt or their business model means that non-core activities generate more revenue than their main products or services.
Economic Factors
Analyzing the economy and its potential impact on the robustness of businesses you’re interested in is also important. You can look at indices, like the Consumer Price Index or Purchasing Managers’ Index. You can also consider metrics like the gross domestic product (GDP) in the countries a company operates in as well as interest rates.
Fundamental Analysis vs. Technical Analysis
Fundamental analysis is the opposite of technical analysis. Which someone uses is usually a matter of personal preference.
Both methods rely heavily on data. However, technical analysis is a method of forecasting future price movements based on historical share price analysis and trading volumes over a fixed period (e.g., six months, two years, etc.). Price trends and actions are compared to other companies in that sector or asset class.
Investors and analysts can use a number of approaches, such as finding a symmetrical triangle or the wedge to assess how one security compares to similar businesses.
In some cases, investors try to get as close to real-time data analysis as possible to make faster investment decisions. For that approach, you need vast amounts of market data, clean data sets, and machine learning tools to help make quick trades.
Fundamental analysis can still play a role; although more so in narrowing down securities to focus your efforts on when trading in the stock market. In this scenario, market data and historical data is useful, as is a clear understanding of the fundamentals of the companies you’re interested in.
Fortunately, it’s not an either-or situation. You can use fundamental and technical analysis combined to get an even clearer picture of the strength, value, and potential of companies you’re interested in.
Use Clean, Complete Data for Your Fundamental Analysis
Using the data points and metrics listed above, investors can reach an intrinsic value for any security. Making it easier to determine whether a company is undervalued or overvalued.
Every investor and analyst will have their own view on “value,” so this research aims to collect enough data to reach an accurate valuation. One of the best ways to conduct effective fundamental analysis is to have access to the best, most reliable, and cleanest financial data on the market.
Tiingo ticks all of those boxes. It’s an enterprise-grade financial API with generous usage limits, cost-effective access for small to enterprise firms in the financial sector, and support for business customers. With Tiingo, you can access anything from crypto data to the Fundamental Data API specifically designed for fundamental analysis.
Sign up for Tiingo’s reliable financial markets API to access the clean financial data.
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