Fundamental analysis attempts to determine the value of a company by analysing the financial data from the annual report and using other qualitative data about the company and the environment in which they operate. This value is often called ‘intrinsic value’. Fundamental analysis assumes that over the long term, a stock price will reflect the company’s intrinsic value.

Definition

A sound fundamental definition comes from Investopedia.  They define fundamental analysis as:

A method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security’s value, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management).

For further reading and an online video from Investopedia go to the fundamental analysis page.

Quantitative analysis

Fundamental factors that are capable of being measured or expressed in numerical terms form the quantitative measures component of fundamental analysis. Fundamental analysts focus on the underlying business of the company being evaluated and specifically look at quantitative measures such as:

• Revenues
• Earnings
• Assets
• Debts

These financial measures are often combined to produce fundamental or financial ratios that analysts can use to compare the company they are analysing to:

• other companies in the same industry
• the overall market
• previous periods results for the same company.

Ratios that you may be familiar with include:

• Dividend yield
• Price to earnings ratio (PE)
• Return on equity (ROE)

For a more detailed look at fundamental ratio definitions and formulae explore the AIA paper Fundamental analysis ratios.

Qualitative analysis

Qualitative information that can’t be expressed in numbers but relates to the nature of the company itself is also very important in assessing the future performance of a company. Types of qualitative information may include:

• management performance and experience
• competitive advantage
• business model
• branding.

Pros & cons

Let’s explore the advantages of fundamental analysis:

Objectivity	Uses sound mathematical and statistical principles to produce ratios so that there is no room for personal bias.
Long term focus	Markets are usually driven by fundamental factors over the long term. Fundamental analysis can look at  long-term economic, demographic, technologic or consumer trends.
Value	By determining an intrinsic value, fundamental analysts can determine appropriate buy prices that represent ‘good value’.
Increased understanding	Research into fundamentals provides the investor with a better understanding of the company and its business.
Sleep at night factor	Investors know that they are investing in fundamentally sound companies because they have done their ‘due dilgence’ analysis.

Now let’s look at some of the disadvantages of fundamental analysis:

Time consuming	Fundamental analysis can be hard work and be overly complicated.  Given the time and difficulty contraints, it may be difficult to get an edge.
Market sentiment	In the short term, markets will not always move in the same direction as fundamental value meaning that often short term momentum will overide the fundamentals.
Timing	Six monthly issuing of financial information may mean a company’s fundamentals have significantly changed and means a time lag for investment decisions.  This appplies especially to a lack of opportunity to react quickly to exit stocks.
Based on assumptions	Fundamental analysis for future estimated value can only be based on assumptions so a best and worst case valuation model may need to be considered. No valuation model can take into account any unexpected negative economic, political or legislative changes. Another important point to consider is that most information considered in fundamental analysis comes from the company itself and assumptions have to be made that the company is providing accurate and true information.

Other resources

The following are just a few suggested resources that you may want to explore to learn more about fundamental analysis: The ASX has an excellent Shares course.  Look for Lesson 10 on  Fundamental analysis. Investopedia has an excellent fundamental analysis tutorial Stockcharts have a great overview on fundamental analysis Building Wealth Through Shares has some excellent free articles available. Stockwatch have a series of informative fundamental analysis articles.