Fundamental Analysis

Fundamental Analysis: Income Statement, Balance Sheet, Stmt. of Cash Flows

By definition:

Fundamental analysis is a method of evaluating and analyzing financial instruments, such as stocks, bonds, or currencies, by examining the underlying economic, financial, and qualitative factors that may affect their intrinsic value. The goal of fundamental analysis is to assess the true worth of an asset and make informed investment decisions based on its underlying fundamentals.

Fundamental analysis is commonly used by long-term investors who seek to identify undervalued or overvalued assets based on their intrinsic value. It contrasts with technical analysis, which focuses on historical price and volume patterns to predict future price movements. Investors often use a combination of both fundamental and technical analysis to make well-informed investment decisions.

How we use fundamental analysis:

To find the best of the best of the companies, the financial gold minds if you will. And then deploying capital based on financial metrics and key findings from said companies financial statements.

The Financial Holy Grail: The balance sheet, income statement, and statement of cash flows

When using fundamental analysis, we are typically analyzing three financial statements. The three statements are the balance sheet, income statement, and the statement of cash flows. Each tells us important financial figures about the economic health of the company. When done properly, we can find companies that will create immense wealth for the shareholers.

Income Statement:

Want to find a company with a competitive advantage? The answer should be YES! Why? Because we want companies that perform extremely well over the long-run, which is what companies with durable competitive adantages do. On the income statement, any gross profit margin less than 20% is likely to be in a competitive industry. This doesn’t mean the company is any less valuable or doesn’t have a competitive advantge. This just tells us to be weary of other financial metrics. On the income statement we also look for net earnings as a percentage of revenue, net earnings (income), earnings-per-share (EPS), expenses, and operating profit (EBIT – earnings before interest & taxes).

Balance Sheet:

Where assets, liabilities, and equites can be found. On the balance sheet we look for the current ratio, PP&E as a ratio of debt, total assets and return on assets, debt to equity ratios, treasury stock buybacks, preferred stock, and return on equity. All of these tell us a story about the economics of the company and how it is performing. Without a keen eye, treasury stock buybacks may look uninteresting. But to us, we LOVE treasury stock buybacks. Using adjusted debt to equity ratio to include treasury stock buybacks, we can find some of the best value stocks.

Statement of Cash Flows:

If I were to rank the three statements, the statement of cash flows would be the least important of the three. However, without analyzing the statement of cash flows, we can miss metrics that will completely throw off our analysis of a company. On the statement of cash flows, we look for CapEx, or Capital Expenditures, and CapEx as a ratio of Net Income. If we have high CapEx to Net Income, the company is likely not focusing on increasing shareholder value, which is what we are after. Using these three statements can help with investing in stocks.

How do we use fundamental analysis to find AWESOME investments?

Sometimes, the stocks current price may be much more than the intrinsic value. For example, if a stock earned $10 per share annually, and the long-term borrowing rate was 10%, we would expect the price of the stock to be $100 ($10 / 10%). If the stock was trading at $200, would we consider that a good investment? No, we would not. But now let’s say the stock is underperforming and is $50. Now THAT is a great investment!

Fundamental Analysis vs. Technical Analysis

A common misconception is the two are related. In my opinion, they are only related because they both deal with the financial markets. Other than that, they are completely different.

Fundamental analysis and technical analysis have completely different time horizons, different data sets, different concepts and techniques, and different objectives.

Technical analysis:

Traders may be looking to capitalize on short term stock price swings. Or even shorter stock price movements by day trading. Day trading has become increasingly popular over the recent years. It can be extremely difficult to swing or day trade using technical analysis.

Fundamental analysis:

Here, investors focus more on the long-term and generating wealth. I would classify this as investing vs. trading. As mentioned above, fundamental analysis focuses on the financial statements of the companies. A day trader couldn’t care less about a companies financial statements for comparison. A fundamental analysis trader would likely be searching for the best value stocks to make investments in. Fundamentals are essential to finding the amazing invesments that will grow your wealth.

Fundamental Analysis Educational Videos:

Fundamental Analysis: The complete breakdown

Fundamental analysis is a crucial methodology employed by investors and analysts to evaluate the intrinsic value of financial assets, such as stocks, bonds, and currencies. It involves a comprehensive examination of various economic, financial, and qualitative factors related to the underlying entity, with the aim of making informed investment decisions based on the true worth of the asset.

One of the primary focuses of fundamental analysis is the assessment of a company’s financial health through a detailed examination of its financial statements. These financial statements, including the balance sheet, income statement, and cash flow statement, provide a snapshot of a company’s economic performance over a specific period. Analysts scrutinize key financial metrics such as revenue growth, earnings, and profitability to gauge the overall financial strength of the company. By understanding a company’s financial health, investors can gain insights into its ability to generate sustainable earnings and weather economic uncertainties.

Earnings reports

Earnings reports play a pivotal role in fundamental analysis. Investors keenly analyze a company’s earnings trends, looking for consistency and growth over time. Earnings per share (EPS) and the price-to-earnings (P/E) ratio are fundamental metrics used to assess the profitability of a company and its valuation relative to its earnings. A company with a history of increasing earnings and a reasonable P/E ratio may be considered attractive to investors, signaling potential for future growth.

Valuation metrics are integral to fundamental analysis, aiding investors in determining whether a financial asset is overvalued or undervalued. Ratios such as the price-to-book (P/B) ratio, price-to-sales (P/S) ratio, and dividend yield are commonly used to assess the relative value of stocks. A low P/B or P/S ratio may indicate that a stock is undervalued, presenting an opportunity for investors seeking assets with growth potential.

Beyond financial metrics:

Fundamental analysis extends its scope to qualitative factors that may impact the intrinsic value of an asset. Industry trends, competitive positioning, and the overall economic environment are considered in this analysis. For example, a company operating in a rapidly growing industry may have better growth prospects than one in a declining sector, influencing investment decisions.

Management quality and corporate governance are critical aspects of fundamental analysis. Investors evaluate the effectiveness of a company’s leadership, assessing their track record, strategic decisions, and transparency in financial reporting. Sound governance practices are indicative of a well-managed company that prioritizes shareholder interests.

Fundamental analysis is not limited to individual stocks; it is applicable to various financial instruments and markets. In the realm of fixed-income securities, analysts assess factors such as interest rates, credit risk, and economic indicators to determine the value of bonds. In currency markets, fundamental analysis involves evaluating economic indicators, government policies, and geopolitical events that may impact exchange rates.

To conclude:

Fundamental analysis provides investors with a comprehensive framework for evaluating the intrinsic value of financial assets. By delving into financial statements, earnings reports, valuation metrics, and qualitative factors, analysts aim to make informed investment decisions based on the fundamental health and prospects of the underlying entity. While not without its challenges, fundamental analysis remains a cornerstone of long-term investing, allowing investors to navigate financial markets with a deep understanding of the assets in which they choose to invest.