FUNDAMENTAL ANALYSIS IN EQUITY RESEARCH
Fundamental analysis is the cornerstone of investing. In fact, some would say that you aren’t really investing if you aren’t performing fundamental analysis. It is all about getting an understanding of a company, the health of its business and its future prospects. It includes reading and analyzing financial statements, to get an understanding of the company’s comparative advantages, competitors, and its market environment.
It evaluates a security, by attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors.
It is built on the idea that the stock markets may price a company wrong from time to time. But, by analyzing the financial reports of companies, we can understand the value of different companies and understand their pricing in the stock market. Profits can be made by finding underpriced stocks and understand that whether the price of the stock is under-valued or over-valued at the current market price.
For a fundamental analyst, the market price of a stock tends to move towards its ‘intrinsic value’, which is the ‘true value’ of a company as calculated by its fundamentals. If the market value does not match the true value of the company, there is an investment opportunity.
- If the current market price of a stock is lower than the intrinsic price, the investor should purchase the stock because he expects the stock price to rise and move towards its true value.
- If the current market price is above the intrinsic price, the stock is considered overbought and the investor sells the stock because he knows that the stock price will fall and move closer to its intrinsic value. To determine the true price of the company’s stock, the following factors need to be considered.
- Earnings: This is the key element for consideration by all investors. Before investing in a company, you want to know how much the company is making profits. Future earnings are a key factor, as the future prospects of the company’s business and potential growth opportunities are determinants of the stock price. A simplified view of the earnings is – earnings per share (EPS). EPS denotes the amount of earnings for each outstanding share.
- Profit Margins: Revenue doesn’t tell the entire story. Increasing earnings are good, but if the cost increases more than revenues, then profit margins are not improving. The profit margin measures how much the company keeps in earnings out of every dollar of their revenues. This measure is therefore very useful for comparing similar companies, within the same industry.
To get a better understanding of profit margins it is good to compare two companies with alternative margins, see table below.
Higher profit margin indicates that the company has better control over its costs.
Profit margin is displayed in percentages and a 10 percent profit margin denotes that the company has a net income of 10 cents for each dollar of their revenues.
- Return on Equity (ROE): Return on equity (ROE) is a financial ratio that does not account for the stock price. This ratio is a measure of how efficient a company is in generating its profits. It is a ratio of revenue and profits to owners’ equity (shareholders are the owners). Specifically, it is:
Let us take an example –
Company A and company B both generate net profits of $1 Million, but company A has equity of $10 Million, but company B has equity of $100 Million.
Their ROE would be 10% and 1% respectively meaning that company A is more efficient as it was able to produce the same amount of earnings with 10 times less equity.
- Price-to-Earnings (P/E): As the name suggest, it is the current market price divided by earnings per share (EPS). It is an easy way to get a quick look of a stock’s value. A high P/E indicates that the stock is priced relatively high to its earnings, and companies with higher P/E, therefore, seem more expensive.
The PE ratio can be a very informative figure, especially for fast growing and cyclical companies. In this one ratio you get an understanding of the company’s earnings, growth expectations and whether it is trading at a reasonable price relative to its fundamentals.
- Price-to-Book (P/B): A price-to-book (P/B) ratio is used to compare a stock’s market value to its book value. It can be calculated as the current share price divided to the book value per share, according to the previous financial statement. In a broader sense, it can also be calculated as the total market capitalization of the company divided by all the shareholders equity.
This ratio gives an idea of whether you are paying too high price for the stock as it denotes what would be the residual value if the company went bankrupt today.
A higher P/B ratio than 1 denotes that the share price is higher than what the company’s asset would be sold for. The difference indicates what investors think about the future growth potential of the company.
Watch the video on how to do ratio analysis.
The end goal of fundamental analysis is to produce a value that investors can compare with current market price in the hope of figuring what sort of position to take in that particular stock/company.
So, if the security is under-priced, then go for ‘Buy’, and if the security is overpriced then, ‘Sell’.
It is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time. Technical analysis uses a wide variety of charts that show price over time.
Technical analysis is applicable to stocks, indices, commodities, futures or any tradeable instrument where the price is influenced by the forces of supply and demand over a specific time frame. The time frame can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data and last a few hours or many years.
A technical analyst believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends. The objective of the analysis is to forecast the direction of the future price.
Technical analysts consider the market to be 80% psychological and 20% logical. Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation.
Difference between Fundamental Analysis and Technical Analysis
In light of the above, we can conclude that analysts use both fundamental and technical analysis to determine which stock to buy and which to sell. Both the methods of analysis have their own well-established set of concepts and theories for analyzes.
Where on one hand, fundamental analysis are based more on facts and figures, on the other hand, technical analysis are based more on graphs, chart and economic factors. Hence, a wise investor should use both the methods for determining the value of stock and invest its funds in the market.