Sat, May 18, 2024

A Short Introduction to Fundamental Analysis By A Pro

Fundamental

Have you ever thought about getting a proper introduction to fundamental analysis? Are you interested in learning more about company analysis, valuation, financial ratios, portfolio management, industry and macroeconomic analysis, and more?

If so, you should keep in mind that the fundamental analysis represents a specific method used in accounting and finance to evaluate a company’s financial statements. It includes its assets, liabilities, and earnings, as well as its competitors and the wider market. Enthusiasts should keep in mind that it considers external factors that may impact a company’s financial performance, such as:

  • Interest rates
  • Production levels
  • Employment trends
  • GDP
  • Housing
  • Manufacturing
  • Management

This particular analysis provides investors with a clear vision of a company’s financial health and growth prospects, enabling them to make informed investment decisions.

In terms of the stock market, fundamental analysis talks about the, well, fundamentals of a company.

But…

What do the fundamentals represent?

In a nutshell, “fundamentals” refer to all the factors that may affect the company that issues the stock. There are two types of fundamentals:

  • Qualitative factors
  • Quantitative factors

Remember:

Qualitative factors are those that you can’t count (but there’s still a good dose of math involved, unfortunately). Rather, they’re the intangible ‘qualities’ of a business.

people doing analysis on a table

Major Financial Statements

The most important financial statements you must look at include the following:

  • The balance sheet
    • Assets
    • Liabilities
    • Equity
  • The income statement
  • Statement of cash flows
    • The Cash flows from operating activities
    • Cash flows from investing activities
    • The Cash flows from financing activities
  • 10-K and 10-Q
  • Management discussion and analysis (MD&A)
  • Auditor’s report

The Concept of Intrinsic Value in Fundamental Analysis

Fundamental analysis also revolves around the concept of intrinsic value—the real value of a company’s stock.

For fundamental analysts, the stock market doesn’t always fully reflect the true value of a stock. And that’s where you can play on the price of the stock.

  • Undervalued stocks are those that cost lower than their intrinsic value.
  • On the other hand, overvalued stocks are those that cost higher than their intrinsic value.

Here’s an Example:

You want to invest in stock A, whose current market price is $10. You perform fundamental analysis to find out if it’s undervalued or overvalued.

After careful analysis, you figure its intrinsic value is $20, or double its market price. This means that the stock is a good buy. It’s undervalued, meaning there’s a chance its price will appreciate in the future.

Buy Low, Sell High

Because of the factors they consider, fundamental analysts follow the concept of buying low and selling high. Typically, they search for undervalued stocks and go long on them.

When the market finally reflects the real value of the stock, and when all the fundamentals are topping out, they cash in by selling the stock for a higher price.

What Do Efficiency Ratios Represent?

Efficiency ratios are an essential component of fundamental analysis. These ratios provide valuable insights into a company’s operations and financial performance by measuring its ability to use its resources effectively. 

The Inventory Turnover Ratio – Explained

The inventory turnover ratio, for instance, assesses a company’s efficiency in managing its inventory by measuring how quickly it sells and replaces its inventory. Similarly, the accounts payable turnover ratio assesses a company’s efficiency in managing its accounts payable by measuring how quickly it pays off its outstanding debts. To get a better idea of a company’s efficiency, investors often compare its ratios to the industry average.

The Working Capital Ratio – Explained

The working capital ratio is also an important metric to consider when analyzing a company’s financial health. By comparing a company’s current assets to its current liabilities, this ratio assesses its capacity to fulfill short-term obligations. Investors prefer companies with a higher ratio, as it indicates that the company has enough short-term resources to meet its obligations.

Besides financial metrics, a SWOT analysis can also provide valuable insights into a company’s position in the market. By analyzing a company’s strengths, weaknesses, opportunities, and threats, investors can gain a better understanding of its competitive position, bargaining power of suppliers and buyers, and potential economic benefits from its intangible assets.

In conclusion, fundamental analysis is a vital tool for investors to evaluate a company’s financial health and growth prospects. By analyzing a range of financial and non-financial metrics, investors can make informed investment decisions that align with their investment goals and risk tolerance.

What to Note While Analyzing the Company’s Health?

Analyzing a company’s financial health requires a comprehensive approach considering fundamental and technical factors. Key metrics include the debt service coverage ratio, current ratio, and shareholders’ equity. Additionally, the bargaining power of buyers and suppliers and the ability to pay off long-term liabilities are essential considerations.

Fundamental analysis involves examining a company’s financial statements, industry averages, and economic factors to determine its health. Technical analysis uses charts and indicators to predict future price movements. By evaluating both approaches, investors can make informed decisions about a company’s potential for growth and profitability.

The accounting equation plays a crucial role in determining a company’s financial health. It states that assets must equal liabilities plus equity. The current ratio, which compares a company’s current assets to its current liabilities, is a key metric derived from the accounting equation. It indicates whether a company can cover its short-term obligations and is a crucial factor for investors to consider when evaluating a company’s financial strength. A ratio of 2 or greater is normally considered favorable, indicating that a company has sufficient liquidity to meet its immediate needs.

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