Fundamental analysis: What it is & how to use it

03 October 2023 by National Bank
A young woman using fundamental analysis with the help of her tablet to make purchasing decisions.

Fundamental analysis is a popular method used by investors to evaluate the intrinsic value of securities. For self-directed investors, understanding the basic principles of fundamental analysis can help you decide which stocks to buy, which ones to sell, and which ones to hold.

What is fundamental analysis?

Fundamental analysis (FA) is a method used to identify a stock's intrinsic or fair market value by examining a range of economic factors and financial metrics. FA let's investors determine if a stock's intrinsic value is lower or higher than its current market price. 

When the FA establishes that a stock's intrinsic value is lower than the market price, it means that the stock is overvalued, and buyers are paying more than it is actually worth. The inverse is also true. If the stock's intrinsic value is higher than the market price, an analyst will conclude that it is undervalued and worth more than what it trades for on the stock market.

When investors analyze securities, they can choose between two different methodologies, fundamental or technical analysis. Unlike fundamental analysis, which focuses on establishing a stock's intrinsic value, technical analysis takes a different approach: It looks at shifts in a stock's trading price and trading volume to determine whether to buy or sell a security. 

How does fundamental analysis work?

The fundamental analysis of a stock involves assigning an intrinsic dollar value to the security that can be used to compare it to the market price. Establishing the intrinsic or real market value allows you to determine if the security is overvalued or undervalued.

At the start of a detailed analysis of a company and its stock, you must look at the state of the economy and other companies operating in the same sector. The information you gather will help you understand the company’s current and future prospects.

By situating the company in the context of the larger economy, providing a measure of how the stock compares to other companies in its sector, and assessing company specific performance, an analyst can calculate a dollar number that represents the stock's intrinsic value.

These factors include large-scale macroeconomic indicators like global economic trends and more detailed microeconomic factors such as a company's management structure or capital expenditures. You can take a top-down or bottom-up approach. 

Either way, the three broad steps to doing the fundamental analysis of a security involve examining the following:

1. Look at macroeconomic indicators. These are trends in the larger economy such as: 

  • economic growth – Is the economy growing or are we heading into a recession?
  • the rate of inflation – low inflation is good for an economy but high inflation is detrimental
  • investor sentiment about the market as a whole – are markets bullish, with stock price averages going up in value, or are they bearish and headed in a downward direction

2. Evaluate sectoral or industry indicators. These include: 

  • the demand for products or services in the industry or sector
  • the company's position in the sector relative to competitors, suppliers, and employees – are they a market leader or is there fierce competition in this industry?
  • the possible arrival of a new alternate product, service, or disruptive technology

3. Assess company-specific variables. These are indicators that show the financial performance of the specific stock and company. Some examples include:

  • consumer sentiment 
  • management experience 
  • income statements 
  • balance sheets

The different types of fundamental analysis

FA can be broken down into two basic parts. The first is quantitative analysis, which examines the numbers and ratios that help determine stock performance and value. The second is qualitative analysis, an approach that goes beyond the numbers and looks at intangible assets and subjective factors.

What is quantitative analysis?

Quantitative analysis is a methodology that focuses on the financial numbers that investors use to understand a company's performance. It involves closely examining a company's annual report and analyzing balance sheets, income, and cash flow statements.

The numbers serve as the raw material for the ratios and percentages used to compare Company X to Company Y. A quantitative analysis uses the available data to help assign an intrinsic value to a stock but are also used to estimate future growth and earnings in order to determine a future price target. It is all about crunching the numbers – no emotions are involved.

What is qualitative analysis?

Qualitative analysis is a methodology based on factors that cannot be put into numbers. These factors include the company's reputation, what people say about it in the media, goodwill, consumer sentiment, brand value, and future trends.

The intangible, subjective and emotional factors are hard or impossible to measure but can significantly affect the value of a security. The qualitative analysis can add value to the numbers and help an investor get a 'feel' for the company and its future prospects.

What investment strategies can benefit from fundamental analysis?

The data points you use to determine a stock's real or intrinsic value will vary depending on your investment strategy. They include key numbers like a company's total revenue, capital expenditures, assets, liabilities, and current and past financing. 

Here are some of the better-known investment styles that use fundamental analysis that investors can use to help make their buying or selling decisions.

  • Growth investing focuses on stocks in rapidly expanding industries like technology. Investors are typically looking for significant appreciation in the value of the security rather than regular dividends. Stocks in the tech sector are a good example, because emerging tech companies can sometimes generate significant gains in a relatively short period of time.
  • Value investing is a strategy based on buying undervalued stocks. The goal is to find stocks with an intrinsic value not reflected in their market price and hold onto the stocks until the market responds and they increase in value. It is a popular strategy with seasoned investors but involves longer time horizons and patience. The approach relies on fundamental analysis to find the undervalued stock that will go up in value down the line.
  • Dividend investing involves buying stocks that pay out an annual or quarterly distribution of profits on a per-share basis. It is a way of generating dividend income while holding securities. It is important to remember that as a dividend stock's price increases its dividend yield decreases. This is because the proportion of dividend per dollar goes down as the stock gets more expensive.
  • Low volatility investing is based on a long-term investment strategy. Investors are looking for securities that have low risk and will weather any market changes with an eye on growth over a longer time horizon. It is considered a relatively risk-averse equity strategy because the asset's value remains stable even when the market shifts. Though there is far less risk of significant depreciation in value, there is also a much smaller chance that an investor will see sizable gains when the market is bullish and increasing in value. 
  • Quality investing focuses on finding companies that have a sustainable competitive advantage in their industry that allows them to have strong market share and brand loyalty. These companies will have strong margins, above average profitability, measured by return-on-equity, low debt levels versus peers and stable earnings.

How to use fundamental analysis?

Fundamental analysis aims to determine the real value of a company's stock by looking at the security's fundamental metrics and the broader macroeconomic factors that affect its value. Ultimately, it doesn't matter if you take a top-down or bottom-up approach as long as you consider all the critical indicators.

Here is an example of a bottom-up FA that starts with examining the microeconomic indicators, working up to the broader macroeconomic factors. This approach can establish a security's intrinsic or real market value and help an investor decide if they should buy, sell, or hold a stock.

1. Look at recommendations from different research providers to see what they have to say about the prospects of a stock, bond or exchange-traded fund (ETF). Most, online brokers will provide their clients access to research reports where the analysis has already been completed. The client is provided with a summary and a target price.

2. Use FA tools to assess the position of a stock. Most of the key metrics will be available on the NBDB trading platform (sign in to access). Compare the numbers to stocks from other companies operating in the same industry or sector. The comparative analysis provides a larger frame of reference and improves the quality of the assessment.

3. Look for any qualitative information. Have you heard anything about the company in the news? Have you read the company's annual report? Does the company's future sound positive and oriented towards growth? Is the management sound, and do they uphold a set of values that you share about community or environmental stewardship?

4. Examine the key numbers in the financial statements included in the company's annual and quarterly reports. All companies trading securities on the stock market must make this information publicly available. Search online to find this information.

5. Read the news to follow more significant economic trends. Is a war or a natural disaster going to affect oil prices or the availability of silicon chips? Is a new technology going to change the way an industry operates? Will the government try to control the inflation rate by raising interest rates, increasing the likelihood of an economic slowdown and a bearish market?

What is the difference between fundamental and technical analysis?

Unlike fundamental analysts, technical analysts don't try to determine a security's intrinsic value. They believe that by looking at statistical trends, such as the movement in a stock's price and changes in trading volumes, they can determine if a stock is worth buying or selling.

Using the stock's historical performance and past investor behavior, technical analysts will try to predict the direction of the stock. It is a technique typically used for making decisions along a short- to mid-term investment horizon.

Nevertheless, even though fundamental and technical analysis represent different schools of thought, they are not mutually exclusive. Many investors will use both types of analysis to make their investment decisions. For example, many fundamental investors will use technical analysis to see if a security is bullish. 

On the other hand, technical analysts might do an initial screening of a group of securities using fundamental analysis to filter out the less desirable stocks or to make sure they have specific characteristics like high-paying dividends. After the triage, they will submit the selected securities to a technical analysis before deciding which ones to buy or sell. 

What is the role of fundamental analysis?

Fundamental analysis is important because buying stocks blindly or based on rumor is a recipe for financial disaster. FA can be used to guide an investment plan and strategy. Although technical analysis can help with short-term price movements, beyond twelve months, it becomes harder to determine a stock's price direction. On the other hand, purchasing stocks using FA not only serves as an effective tool over a longer time horizon, it also helps investors avoid serious mistakes and make better purchasing decisions.

Does my online broker offer fundamental analysis?

Fundamental analysis brings together a host of factors to determine a stock's real or intrinsic value, but getting the FA right each time isn't a certainty. We all know that investing in the stock market can be risky, so it's not surprising that many investors are uncomfortable doing their own research or are unsure of where to begin. 

That is why NBDB offers its clients tools to screen for securities using quantitative data criteria and the ability to filter different investment ideas. NBDB also provides investors access to various resources that use fundamental analysis via the research report section (sign in to access). The research report section gives investors access to hundreds of reports including 12-month price targets with financial metrics and detailed analyses of specific stocks, ETFs. 

Our clients can also consult research reports from National Bank Financial and Morningstar, and price targets from Fundamental Insight, a powerful investment analysis tool available on the NBDB platform.  

Fundamental analysis is a powerful methodology that can help you make better self-directed investment decisions, and the NBDB trading platform is a great resource to help get you started. However, it is always important to remember that investing involves some level of risk. To help grow your portfolio, do your research, invest wisely, and stick to your investment strategy!

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Key Takeaways

  • Fundamental analysis (FA) is method investors use to determine purchasing decisions.
  • FA seeks to establish the intrinsic value of a security.
  • Intrinsic value helps investors determine if a stock is overvalued or undervalued in relation to its market price.
  • FA considers macroeconomic and microeconomic factors based on qualitative data and quantitative data.
  • Fundamental analysis is often compared to technical analysis. While fundamental analysis focuses on determining the intrinsic value of a stock, technical analysis uses movements in a stock's price and sales volume to help investors make buying and selling decisions.

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