What is Fundamental Analysis?
Fundamental analysis is the process of examining the investment characteristics, performance, condition and value of a company in order to make an investment decision (or governmental entity in the case of government bonds). Company fundamentals include financial statements, ratios and valuation measures, among others. The impact of the current economic and market environment on these fundamentals is also considered.
Financial Statements
There are three primary financial statements utilized in fundamental analysis (along with scrutiny of footnotes and SEC filings): the income statement, the cash flow statement and the balance sheet. The income statement presents the performance of the company during the period and whether it earned a profit from its primary business activities and peripheral activities. The cash flow statement presents the sources and uses of cash by the company and whether operating cash flow is sufficient to make future investments, repay creditors and make distributions to owners. Note that net income by itself can not be used to pay employees, suppliers, creditors and others – this takes cash flow. A company needs to earn both positive profits and positive operating cash flow over the long term. The balance sheet presents the current financial position of the company; assets or resources and the claims against the resources by creditors and owners. The company needs to have sufficient assets to operate the business efficiently and if necessary sufficient to repay creditors and owners if the company needs to be dissolved.
Ratios
Ratios are created by using financial data from the financial statements to evaluate the company’s liquidity (ability to pay short term obligations), solvency (ability to pay long term obligations), efficiency (utilization of resources), and profitability (ability to generate profits based on sales, assets or owners’ equity). There are numerous ratios which can be created. Here we present one example in each category.
Liquidity: The current ratio (current assets divided by current liabilities) measures whether the company has sufficient current assets such as cash to pay their current liabilities. The higher the ratio the more liquidity.
Solvency: Total liabilities divided by total assets measures how much leverage the company has in their capital structure. The higher the ratio the higher the financial leverage and risk. A lower ratio indicates better solvency (however, debt has positive attributes as well).
Efficiency: Total asset turnover (sales divided by total assets) measures the amount of sales generated per dollar of assets. A high number means efficient utilization of assets and better efficiency.
Profitability: Return on equity (ROE) is net income divided by the total equity investment of the owners over time. For example, an ROE of 12% means the company generates $12 of net income for every $100 previously invested by owners. Higher ROE means higher profitability.
Valuation
In making an investment decision for all investments (whether stocks, bonds or real estate) it is important to forecast the expected cash flows to be received from the investment. The value of the investment is the present value of these cash flows discounted from the future back to today using the rate of return you need to get based on the risk of the investment. This is known as an absolute valuation method.
You should also consider relative valuation which is the value of the security relative to other similar investments. For stocks a popular relative valuation method is the P/E ratio, measured as the price per share divided by the earnings per share from the income statement. A high number indicates the company is selling at a high price relative to earnings (perhaps because earnings are expected to grow in the future or the security is overpriced). A low number indicates the company is selling at a low price relative to earnings (perhaps a good buy or poor growth prospects). Other relative valuation metrics include price to sales (P/S), price to cash flow (P/CF) and price to book value (P/BV).
In the case of fixed income securities (bonds) you can examine the promised yield to maturity relative to securities of similar risk and maturity to determine if your expected return is sufficient for the risk involved.
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
