The Science Behind Fundamental Analysis

Introduction

Fundamental analysis is an investment technique which focuses on economic indicators and company metrics in order to evaluate the intrinsic value of a financial asset. Fundamental analysts study a vast array of internal and external factors, as well as both current and historical information, to determine an asset's true value and potential for growth.

What is Fundamental Analysis?

Fundamental analysis is a method of predicting the future value of a security by analyzing a company's performance and environmental conditions, rather than relying solely on technical analysis of historical price action.

What Do Fundamental Analysts Do?

The goal of fundamental analysis is to uncover the true value of a security or an asset, so that investors can make informed decisions about whether to buy or sell the asset. Fundamental analysts study economic, financial and other factors such as:

• Financial statements
• Interest rates
• Inflation
• Industry risks
• Competition
• Market conditions and trends

Benefits of Fundamental Analysis

Fundamental analysis is a type of investment analysis that seeks to measure a company or security’s value by analyzing quantitative and qualitative factors in its environment. This approach is based on the theory that understanding a company’s underlying economics is necessary in order to make accurate predictions about its future stock performance. There are numerous benefits to using fundamental analysis when making investment decisions.

Understanding the economics of a stock

Fundamental analysis is based on analyzing financial reports, such as balance sheets and income statements. By studying this data, investors can understand the economics of a stock and its underlying performance. This information can then be used to make educated decisions about whether to purchase, hold, or sell an investment.

Develop a deeper understanding of the company or security

Fundamental analysis goes beyond looking at a company’s financials – it looks at the wider environment of the company or security. This means considering factors, such as the industry that the company operates in, its competitors, and its management, in order to gain an understanding of the company as a whole.

Being able to predict swings in price

Fundamental analysis can help investors to predict swings in the price of a stock. By analyzing macroeconomic trends, such as the strength of the US dollar or the price of commodities, investors can understand how these factors may impact the stock’s performance.

Furthermore, fundamental analysis can provide investors with an insight into a company’s value. This allows investors to make educated guesses as to whether a stock is trading at a fair price or if it is under or overvalued.

The Science Behind Fundamental Analysis

The concept of fundamental analysis has been under the microscope of academic research for decades. Even though the traditional approach to fundamental analysis involves looking at the intrinsic value of securities, modern research employs the scientific principles of economics and finance to achieve a more accurate representation of a firm's worth. Here is a look at some of the science behind fundamental analysis.

Source of Valuation

Fundamental analysis measures the intrinsic value of a company by looking at the company's current financial position. This is known as the source of valuation and this method enables investors to determine the legitimate value of a company or asset. This source of valuation involves examining a company's balance sheet, income statement, cash flow statements, sales and margin information, based on the facts and figures provided in the financial statements.

Brownian Motion

To accurately measure the intrinsic value of a company or asset, financial analysts have to consider the impact of Brownian motion. Brownian motion is also known as “random fluctuations” which impacts the market prices of securities. This much-studied phenomenon is seen to give rise to complex dynamics in the prices of assets due to the fact that the effects of a large number of random events contribute to the overall direction of the price. To cope with the Brownian motion, it is important to employ an investment philosophy that incorporates both fundamental and technical analysis.

Tracking Earnings Trends

It is important to track the earnings trends of a company or asset as it has a significant influence on its fundamental value. Analysts measure the financial performance of a company over a period of time by looking at the revenue, cost, and profit trends in order to produce a better gauge of the security's worth. To ensure systematic tracking of earnings trends, analysts employ scientific concepts like regression analysis and correlation studies.

Financial Tools Used in Fundamental Analysis

Fundamental analysis is a standard method of evaluation in the stock market. By examining a company’s financial statements, including its earnings, balance sheets, and cash flows, an investor can determine how financially sound the company is, what the market value of its stock should be, and whether investing in the company is a wise decision. To accurately measure and analyze a company, investors must take advantage of several financial tools.

Financial Ratios

Financial Ratios are one of the most important financial tools used in fundamental analysis. Ratios are used to compare financial information such as sales growth, earnings, and debt along with stock performance. Ratios can help investors identify opportunities and make decisions about a company’s prospects. The most common ratios are the Price-Earnings ratio (P/E) and the Price-to-Book ratio (P/B). Other less commonly used ratios include the Price-to-Sales (P/S) ratio, Earnings Per Share (EPS) ratio, and Return on Equity (ROE) ratio. Knowing the financial ratios of a company can be a powerful tool for investors.

Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is a calculation used to determine a company’s cost of capital. WACC helps investors determine the required rate of return on their stock investments. It is calculated by taking a weighted average of a company’s cost of equity, debt and preferred stock. To calculate WACC, investors must know the company’s cost of equity, cost of debt and cost of preferred stock. WACC is an important financial tool as it helps investors decide whether an investment is worth making.

Weighted Average Share Price

The Weighted Average Share Price (WASP) is a measure of the average price of a company’s common stock over a period of time. This financial tool is used to determine the value of a company’s equity in the stock market and to analyze the company’s performance. WASP is calculated by taking the sum of the total number of shares divided by the total number of shares outstanding. WASP helps investors identify the market value of a company’s stock and gives them an idea of the company’s performance in the stock market.

Income Statement Analysis

Fundamental analysis is the process of evaluating security prices and trends by analysing financial statements and economic trends. Financial statements include a company's income statements and balance sheets, among other documents. An analyst will evaluate the company's performance over a period of time and make predictions about future performance.

Income statement analysis involves a study of a company's performance from a fiscal standpoint, taken from the income statement. It is important to analyze the income statement as it helps to understand the financial performance of a company. A company's performance includes income, expenses, and profits for the period.

The following are some of the different components of the income statement that can be analyzed:

• Gross Profit Margin - This is the ratio of the total revenue generated by the company compared to its total costs. This helps to analyze the efficiency of the company in terms of generating profit.
• Operating Margin - This is the ratio of the operating profit to the total revenue generated by the company. It helps to understand the company's efficiency in generating profits from its operations.
• Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA) - This is a measure of a company's operating performance, which includes the costs of operating the business and excludes non-operating expenses such as interest and taxes. It helps to understand the profitability of the company's operations.

Ratio Analysis for Valuation

Ratio analysis involves comparing a company’s various financial metrics, allowing investors to gain an in-depth view of its performance and health. It is especially useful to investors looking to make fundamental analysis by evaluating the financial health of a company and making investment decisions based on the results. Three primary ratios used for valuation are the Price to Earnings (P/E), Price to Book (P/B), and Market to Book (M/B).

Price to Earnings (P/E)

The Price to Earnings (P/E) ratio compares the current stock price to the company’s reported earnings. This provides an overview of the company’s performance and how that relates to the stock price, providing a metric investors can use to compare one company versus another. A higher P/E ratio could indicate that the current stock price is overvalued and the company performance is lagging, while a lower P/E could indicate that the current stock price is undervalued and the company performance is strong. These metrics help investors get an overall picture of a company’s financial strength and performance.

Price to Book (P/B)

The Price to Book (P/B) ratio compares the current stock price with the company’s book value. This allows investors to calculate the overall value of the company and what they can expect to receive in the case of liquidation. A higher P/B ratio means that the company is significantly overvalued, while a lower P/B ratio means that the company is undervalued and may represent a good value for potential investors. The P/B ratio is especially useful for companies with extensive assets or heavy investments in fixed assets.

Market to Book (M/B)

The Market to Book (M/B) ratio compares the current market capitalization of the company with the book value of its equity. The ratio can help investors identify companies with strong balance sheets and assess the overall value of the firm’s assets. Companies with a higher M/B ratio may be overvalued and companies with a lower M/B ratio may be undervalued. As with the other ratios, M/B is useful to investors looking to make an informed decision when evaluating a company’s fundamentals.

Conclusion

Fundamental analysis is rooted in the science of finance and economics. It is the art of analyzing stocks and shares based on their intrinsic value to make smart and informed investment decisions. Its importance is in essential in achieving long-term success in financial matters. Fundamental analysis requires keeping track of macro-economic shifts and trends such as changes in government policies, central bank decisions, and other global events. A wise and successful investor must always stay updated with the latest financial trends to make sound decisions.