From an economic perspective, fundamental analysis involves researching interest rates, gross domestic product, employment, and other macroeconomic indicators to forecast the future direction of an economy.
For individual companies, fundamental analysis uses a combination of quantitative and qualitative methods to determine a fair value for a company’s stock price. Fundamental analysis examines the company’s operations, management, and profitability to assess its investment prospects.
Quantitative analysis uses measurable factors to value assets, evaluate financial trends, or examine a company’s financial prospects. Quantitative analysis uses historical data, including price data and financial statements, to develop statistical models for investment analysis.
Quantitative analysis is often coupled with qualitative analysis to create a comprehensive approach to financial analysis. However, many investment firms are known as “quant shops,” and exclusively use quantitative investment analysis methods.
Quantitative analysts, also called “quants,” utilize large amounts of data to create mathematical models to track momentum and price securities.
Dividend discount model
The dividend discount model calculates a fair-value stock price that is equal to the present-value of future dividend payments. The model assumes that dividends grow at a constant rate for an indefinite period of time.
There are multiple variants of the dividend discount model, allowing for different assumptions about the dividend growth rate.
Discounted cash flow model
The discounted cash flow model is similar to the dividend discount model. However, discounted cash flow models consider total future cash flows -- often the free cash flow found in the statement of cash flows -- rather than just the dividend payments.
Discounted cash flow models do not require a growth rate input, but they do use forecasted future cash flows. With no constant growth rate, the model user is free to forecast each year independently.
The model returns a discounted cash flow value, which can be used to value the entire business and ultimately a single share of stock.
Qualitative analysis uses factors that cannot be precisely measured to make investment decisions.
Qualitative analysis considers many factors, including the experience of a company’s management team, employee morale, brand recognition, competitive advantage, and other subjective measures to evaluate a company’s investment prospects. Qualitative analysis looks at the subjective “qualities” of a company, while quantitative analysis examines objective, quantifiable information.
Qualitative and quantitative analysis methods are typically combined in investment research in a way that one method reinforces the other. For example, if a company has a favorable investment outlook based on quantitative analysis, qualitative factors would be examined to confirm or refute the quantitative analysis findings.
The three primary financial statements for a company are the income statement, balance sheet, and cash flow statement.
An income statement measures profitability over a period of time. The income statement is also called the P&L or profit and loss statement. Income statements cover a defined period of time, such as one month, one quarter, or one year.
The income statement begins with a company’s sales or revenue and then presents expenses in a progressive fashion until reaching “the bottom line,” or net income. Key metrics before reaching net income are noted, such as gross profit (sales minus cost of goods sold), operating income (gross profit minus operating expenses), and earnings before taxes (operating income minus interest).
The income statement is like a video camera recording all of the company's financial activity for a defined period of time.
A balance sheet displays a company’s assets, liabilities, and equity. The balance sheet shows what a company owns, who the company owes, and who owns the company. The balance sheet balances because the assets listed on the balance sheet’s left-hand side equal the sum of the liabilities and equity on the right-hand side of the balance sheet.
Categories on the balance sheet are listed in order of liquidity for assets and due dates for liabilities. For example, on the balance sheet's asset side, current assets such as cash, accounts receivable, and inventory are listed first, followed by long-term assets such as property and equipment.
Current liabilities are listed first on the balance sheet’s right-hand side, such as accounts payable and short-term debt followed by long-term liabilities. The company’s net worth, or equity, is the difference between assets and liabilities.
When judging liquidity, investors may use a more conservative value, subtracting total liabilities from current assets. If the value is positive --meaning current assets are greater than total liabilities -- the business has a positive "net-net,” meaning the company could pay all obligations with highly-liquid, easily accessed assets.
The balance sheet is like a photo snapshot of the company's financial position at a specific moment in time.
Cash flow statement
A cash flow statement displays the changes that affect a company’s cash account during a specified period of time. The cash flow statement shows the flow of cash through a company and ties together earnings from the income statement with changes in balance sheet line items.
The cash flow statement is divided into three categories: operations, investing, and financing.
Cash flow from operating activities shows the flow of funds from normal business operations.
Cash flow from investing activities shows the flow of funds from the sale of plant and equipment and the liquidation of long-term investments, as well as the purchase of plant and equipment and long-term investments.
Cash flow from financing activities shows the sale of bonds, common stock, preferred stock, and other activities, as well as the retirement or purchase of securities and the payment of cash dividends.
Intrinsic value is an estimated measure of a business’ true worth, regardless of its current market value. This intrinsic value may be above current market value, meaning the business is “undervalued”, or intrinsic value could be below market value, suggesting an “overvalued” business.”
For example, through quantitative or qualitative analysis, or a combination of both, an investor determines the value of company XYZ's stock should be $100 per share. If XYZ stock’s current market price is $90 per share, then its intrinsic value is higher than the current market value, and the stock is undervalued. Intrinsic value may be determined in many ways and is subjective.
A stock's intrinsic value may be calculated through valuation techniques such as discounted cash flow analysis, financial ratios, or by valuing a company's assets individually (sum of the parts). The intrinsic value of an investment is often tied to expectations of the company's future cash flows.
Value investing is an investing style that seeks to identify and invest in securities trading below their intrinsic value. Through fundamental analysis, value investors try to buy what they perceive to be undervalued stocks and then sell the shares when the valuation target is reached.
Hallmarks of value investing include buying stock with low price-to-earnings ratios, low price-to-book ratios, high dividend yields, strong free cash flow, and a positive net-net. Value investors calculate the intrinsic value of a security and purchase the security if a sufficient margin of safety is available in the investment.
Margin of safety means the intrinsic value is sufficiently above the current security price. The investor still has room for error if the market does not fully recognize their calculated intrinsic value, and they can still make money on the position because of the margin of safety.
Value investing is generally a long-term stock-picking strategy, and is often contrarian to the ideas of the majority of market participants. Value investors do not believe that the market is always efficient in pricing securities and that stock price movements do not always correspond with the company's long-term fundamentals.
Benjamin Graham is said to be the father of value investing, and Warren Buffett is perhaps the most widely known value investor in the world. Benjamin Graham's investment definition from The Intelligent Investor is regarded among value investors as the standard for investing: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
Ratio analysis is a fundamental analysis method that uses relationships between financial statement items to determine value, assess risk, analyze trends, and evaluate efficiency. Ratios can be broadly applicable to all types of companies or be industry-specific.
No single ratio tells the full story of a company, so multiple ratios are typically reviewed to add context to otherwise absolute numbers.
Profitability ratios measure a company’s ability to earn money based on sales, assets, or invested capital.
The profit margin describes the percentage of sales that becomes net income for a company. The higher the profit margin, the more money the company makes from each dollar of sales.
The higher the profit margin, the better the performance.
Return on assets
Return on assets describes the percentage return (net income) from a company’s investment in assets. The higher the return on assets, the more effective the company’s assets are in generating profit.
The higher the return on assets, the better the performance.
Return on equity
Return on equity describes the percentage return (net income) for the company’s equity. Return on equity can be broken down into various components such as profit margin, asset turnover, and financial leverage to better pinpoint the driver of a company’s returns.
The higher the return on equity, the better the performance.
DuPont analysis multiplies all the ratios together and cancels the results of the typical return on equity formula.
DuPont analysis demonstrates how a business can grow their return on equity by increasing profitability, becoming more efficient with assets, and increasing leverage through debt financing.
Asset utilization ratios
Asset utilization ratios measure the efficiency with which a company deploys its assets, such as accounts receivable, inventory, or long-term assets. Accounts receivable is the dollar value of payments owed to the business by customers.
Receivables turnover describes how many times a company’s accounts receivables turnover throughout a year. If a company has $100,000 of credit sales in a year and an average accounts receivable balance of $10,000, then the receivables turnover is 10 times.
The higher the accounts receivable turnover, the better the quality of the receivables.
Average collection period
The average collection period describes how long it takes, on average, for a company to collect its accounts receivables. If a company has an accounts receivable balance of $10,000 and has average daily credit sales of $250, then the average collection period is 40 days.
The average collection period should be compared to the credit terms a company typically extends its customers. If a company requires customers to pay their bill within 30 days of purchase and the average collection period is 40 days, then customers are, on average, 10 days late paying their bill.
The shorter the average collection period, the better the performance.
Inventory turnover describes how many times a company’s inventory turns over during the course of a year. If a company has $100,000 of sales in a year and an average inventory balance of $10,000, then the inventory turnover is 10 times.
The higher the inventory turnover, the more efficient the company is at ordering inventory. A low inventory turnover may signal low product demand or inventory that is out of favor with customers. If inventory turnover is too high, perhaps the company is losing sales due to stockouts.
Generally, the higher the inventory turnover, the better.
Fixed asset turnover
Fixed asset turnover describes the amount of sales relative to the company’s fixed assets. Asset-intensive businesses, like those in the manufacturing industry, compare sales to fixed assets to determine if the capital invested in fixed assets is generating revenue for the company.
If a company’s fixed asset turnover is declining from year to year, perhaps the fixed assets are becoming obsolete (i.e., an assembly line declining in productivity).
Generally, the higher the fixed asset turnover, the more productive the company’s fixed assets.
Total asset turnover
Total asset turnover describes the amount of sales relative to the company’s total assets. A company’s assets represent the company’s investment in its business operations. Total asset turnover shows how productive the company’s assets are at generating revenue.
Generally, the higher the asset turnover, the more productive the company’s assets.
Liquidity ratios measure a company’s ability to pay off its short-term liabilities.
The current ratio describes a company’s ability to pay off its current liabilities with current assets. Assets are current if they are cash or can be converted into cash within one year. Therefore, the current ratio compares a company’s current assets to its upcoming liabilities.
If a company has a current ratio of 2, then the company has $2 of current assets for every $1 of liabilities due within one year.
Generally, the higher the current ratio, the stronger the company’s financial position.
The quick ratio describes a company’s ability to pay off its current liabilities with its most liquid assets (cash, marketable securities, and accounts receivable).
The quick ratio is a stricter measurement of liquidity than the current ratio and is more conservative because inventory may not be liquid at book value. By discounting inventory, the quick ratio only considers the assets that are most readily available to pay off current liabilities.
Generally, the higher the quick ratio, the stronger the company’s financial position.
Debt utilization ratios
Debt utilization ratios measure a company’s indebtedness relative to its assets and earnings ability.
Debt to total assets
The debt to total assets ratio describes the level of debt relative to the company’s total assets. The debt to total assets ratio is a measure of financial leverage because it shows what percentage of a company’s assets have been financed.
If a company has a debt to total assets of 0.5, half of its assets have been paid for through equity, and half of the company’s assets have been paid for through borrowings.
Generally, the lower the debt to total assets, the more conservative the company is financed.
Times interest earned
The times interest earned ratio describes a company’s ability to pay its interest obligations with income from operations. If a company’s income before interest and taxes is $40,000 and its interest expense is $10,000, then the company has 4 times as much income available to pay interest as it does interest expense.
Generally, the higher the times interest earned, the stronger the company’s financial position and ability to pay its obligations.
Fixed charge coverage
The fixed charge coverage ratio describes a company’s ability to pay its fixed obligations with income from operations. Fixed obligations for a company are expenses like rent and interest that do not vary with a company’s operations.
Similar to the times interest earned ratio, if a company’s income before fixed charges and taxes is $50,000 and its fixed charges are $20,000, then the company has 2.5 times as much income available to pay fixed charges as it does fixed charges.
Generally, the higher the fixed charge coverage ratio, the stronger the company’s financial position and ability to pay its obligations.
Trend analysis of financial ratios is the comparison of a company’s performance year over year. Trend analysis is used by investors to compare performance over a period of time to determine if a company is improving its operations or experiencing a decline.
For example, if a company’s profit margin increases from 5% in year 1 to 10% in year 2 to 15% in year 3, then the company is improving its performance over time.
Trend analysis is useful in providing context to a single year’s performance relative to past performance to get a more comprehensive picture of a company’s operating results.
Top-down analysis is an approach where broad, global economic indicators are considered first in the investment selection process before company-specific data.
Business cycles, monetary and fiscal policy, and other economic indicators are taken into consideration first. An industry analysis is then conducted, where industry structure, competition, government regulation, and other industry-specific factors are considered. Finally, company-specific analysis is conducted, including an analysis of earnings, cash flow, and financial ratios.
The top-down approach considers global, industry-specific, and finally company-specific factors in succession for the investment selection process.
Bottom-up analysis describes investment selection that is independent of broader economic analysis or industry-specific factors. Bottom-up analysis begins and ends with company-specific factors such as earnings, cash flow, and financial ratios.
Bottom-up analysis operates in contrast to top-down analysis, where broader economic factors are taken into consideration first.