Fundamental analysis of stocks: everything you need to know

What is fundamental analysis?

Fundamental analysis — when applied to stocks — involves analysing a company’s financial statements, economic trends and the wider market to discover its intrinsic value.

Intrinsic value is generally considered to be the ‘true’ or perhaps ‘perceived’ value of a company, which may be higher or lower than the market capitalisation. When intrinsic value is lower than the market capitalisation, then it can be described as undervalued, and when it’s higher, the company is considered to be overvalued.

The general idea when conducting fundamental analysis is that you gain an in-depth understanding of a company’s worth, which gives you an advantage when deciding whether or not to invest. Fundamental analysis can either be top down; starting with the market, then the industry, and then the company — or bottom up where you work in the reverse order.

However, while fundamental analysis is meant to be objective, it’s worth noting that it does involve some subjective factors — and can suffer from an irrational market, human error, poor research or even a lack of available information.

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How does fundamental analysis work?

Fundamental analysis works by researching a business’s key financial metrics — including revenue, profit, growth and potential economic moats. You also look at the overall state of the economies the company works in — and compare the business to rivals in the sector.

There are also subjective elements to fundamental analysis. For example, you might consider the capability of the management team, because a competent team can drive growth and protect the company during downturns while the opposite is also true. But the key idea with fundamentals is that it ignores sentiment, marketing and hype, instead giving you insights into a stock’s long-term potential.

You will usually start with analysing public financial information, including the balance sheet, income statement and cash flows. You can then use these, along with the number of shares in issue and share price, to calculate core ratios including most commonly the price-to-earnings ratio, though also price-to-sales, earnings per share, return on equity and several others.

Once you have this data, you can compare your stock with competitors in the same space to start to see whether a company is intrinsically under or overvalued. Of course, this is just the start of a larger research job. Reviewing qualitative data such as the business plan, management and brand power is also critically important.

You also need to look at macroeconomic factors — including GDP, employment rates, inflation and interest rates — there are dozens of potential macro considerations, which allow you to estimate not just how a company will perform relative to peers, but also relative to whole-of-market.

In essence, you are analysing both internal and external metrics to understand the company’s market position and whether this justifies the market capitalisation. This means that you are ignoring short-term price moves and instead focusing on the long-term. This is particularly important to value investors, who are seeking to invest in shares which are undervalued compared to their fundamental, intrinsic value.

But it’s also worth noting that fundamental analysis is just as good at helping you avoid investments as spot them. Overvalued companies, or perhaps ones which are more likely to struggle during recession, can perhaps be more easily avoided — because when the downturn hits, strong underlying financials can protect companies from permanent damage.

What are the key fundamental metrics and where can you find them?

If you’re starting fundamental analysis on a company from scratch, then the best place to start is often the annual report, or alternatively the latest full-year results. The CEO’s letter to shareholders is commonly an underrated piece of data as it gives personal insight into the positives and drawbacks of the investment case.

Within an annual report, there should also be a business description section, which explains the company's main products, target markets and competitive advantages, alongside the Management’s Discussion and Analysis section, which is all about financial performance, revenue trends and cash flows.

Financial statements, often most revealingly in full-year results, provide key insights into a company's operations. Most importantly, they include:

• Income statement — shows revenue, expenses and net income, helping investors determine profitability and growth trends
• Balance sheet — presents a snapshot of a company’s assets, liabilities and shareholders' equity, offering a measure of financial stability
• Statement of cash flows — tracks cash inflows and outflows from operations, investing and financing activities, arguably giving investors the clearest picture

As cash flow is very difficult to ‘polish’ compared to other metrics, many fundamental investors view the statement of cash flows to be the authoritative document when it comes to corporate financial health.

Fundamental analysis can be divided into quantitative and qualitative aspects. Quantitative factors include mathematically measurable data such as revenue, profit margins and financial ratios. Qualitative factors assess intangible attributes like management quality, brand strength, competitive advantages, corporate governance and stakeholder satisfaction.

Neither aspect is superior, but only the latter is subjective. On the other hand, insight into qualitative factors can be the difference between a poor investment and a great one.

On the quantitative side, financial ratios are a fundamental investor’s best friend:

• Profitability ratios — includes gross profit margin, operating profit margin and return on equity, and measure efficiency and financial performance
• Liquidity ratios — include the current ratio and quick ratio, which assess a company’s ability to meet short-term obligations
• Solvency ratios — such as the debt-to-equity ratio and interest coverage ratio, evaluate financial stability and long-term debt management
• Efficiency ratios — for example, asset turnover and inventory turnover, indicate how effectively a company utilises its assets.
• Valuation ratios — the most popular type, include price-to-earnings and price-to-sales ratios, which help investors determine if a stock is undervalued or overvalued

In terms of actually sourcing fundamental information, you might also consider quarterly and annual earnings, which are readily accessible through the website of whichever stock exchange the company is listed on.

This data can also generally be found on the company’s own website within the ‘investor information’ section, alongside masses of other useful information. For growth stocks, the investor presentation can be very useful, though be aware these are both explainers and marketing tools. You might also want to listen to recent earnings calls, as these can contain nuggets of information not available anywhere else.

Otherwise, there are dozens of financial news and data websites, including Google Finance — or subscription services like Bloomberg and FactSet that offer very detailed information. Many stocks also enjoy widespread analyst coverage, where much of the legwork has already been done for you. Of course, some of these services are free, while others can be fairly costly.

Fundamental analysis vs technical analysis

Fundamental analysis and technical analysis are often considered to be polar opposites when it comes to stock analysis. Fundamental analysis seeks to determine a company's intrinsic value based on financial and qualitative factors, while technical analysis focuses on price trends on the stock chart alongside historical market data to predict future movements.

These include patterns and indicators such as the ‘head and shoulders’ formation, with most formations named for their visual resemblance.

The key distinction between the two methods is how they define value. Technical analysts believe that market prices dictate a company's value, as price movements reflect investor sentiment. Meanwhile, fundamental analysts argue that a company's true worth may differ from its market price, as it is based on financial performance and business fundamentals.

In other words, the fundamental analyst does not strictly believe in the efficient market hypothesis. Beyond this, fundamental analysis is usually reserved for long-term buy and hold investing, while technical analysis sports a short-term focus ideal perhaps for trading.

While fundamental analysis is very popular, it’s worth considering the drawbacks. Analysing corporate data is extremely time-consuming, and because it relies on past financial data, it often lags behind market movements. By the time financial statements reflect a company’s improved (or deteriorating) fundamentals, the stock price may have already reacted. Of course, this historical data dependency also means fundamental analysis struggles to account for emerging risks or opportunities.

There’s also a subjectivity problem to contend with. Financial statements depend on the accounting rules used, and most accounting for complex businesses requires discretionary accountant decisions that can make a company’s finances look more (or less) favourable than they really are.

It’s also difficult to objectively analyse qualitative data like brand reputation or management, especially in companies where a single figurehead is key to its success. Investors also need to be wary of their macroeconomic assumptions, which can only ever be estimates that don’t account for black swan events.

Overall, while fundamental analysis is widely used and useful, technical analysis is also valuable — and many traders find a combination of the two approaches to hold significant merit.

Fundamental analysis summed up

• Fundamental analysis of a stock involves analysing a company’s financial statements, economic trends and the wider market to discover its intrinsic value
• It can either be conducted top down; starting with the market, then the industry and then the company, or bottom up
• Fundamental analysis works by researching a business’s key financial metrics, including revenue, profit, growth and potential economic moats
• It also involves analysing the overall state of the economies the company works in, and comparing the business to rivals