What is fundamental analysis, and how does it work?
April 28, 2021
7 minutes to read
There are several ways of determining whether now is the time to buy or sell a share. Most investors who want to make investment decisions from a long-term view start with a fundamental analysis of a share.
Using fundamental analysis, you determine whether the future value of a company is correctly reflected in the current price of the share.
In a fundamental analysis, you examine everything that could affect the value of a share. This might include macroeconomic factors (inflation, economic growth, unemployment, etc.) or microeconomic factors (dividend yields, pricing, earnings, value of buildings and equipment, etc.).
The purpose of fundamental analysis is to arrive at a price that you can then compare with the current price of a share. If, in your opinion, that price is higher than the current price, the share is undervalued (buy). If the price is lower, the share is overvalued (sell).
This method is seen as the opposite of technical analysis, which attempts to predict the direction of the share by looking at price patterns derived from past performance.
How does fundamental analysis work?
Fundamental analysis uses (mainly) public data to assign a value to a share. With this method, you usually study the general state of the economy first, and then the strength of the specific industry or sector, before focusing on the performance of an individual business.
Fundamental analysis is usually initiated by looking at economic factors such as growth figures, consumer and business confidence, industrial production figures and the general state of the economy and the sector. There are hundreds of economic and sectoral indicators, and we explain the most important ones here.
After that, you might carry out a fundamental analysis of revenue, earnings, future growth, return on equity, profit margins and other data, to determine a company’s underlying value and its future growth potential. All this data can usually be found in the company’s financial reports.
Some commonly used business indicators:
- Earnings per share (EPS): tells you how much of a company’s profits are allocated to each share. EPS is calculated as the net income (after dividends on preference shares) divided by the number of shares issued.
- Price-to-earnings ratio (p/e): compares the current price of the share to the earnings per share.
- Forward price-to-earnings ratio (Forward P/E):is the current price divided by the expected earnings (according to stock market analysts) for the next 12 months.
- Trailing price-to-earnings ratio (Trailing P/E): the current price divided by the profit made in the last four quarters.
- Cyclically adjusted price-to-earnings ratio (CAPE): a cyclically weighted p/e ratio. This compares the market value of the company with the average profit over the past 10 years.
- Projected earnings growth (PEG): the expected earnings growth of the share over one year.
- Price-to-sales ratio (P/S): this ratio measures a company’s share price compared to its income.
- Price-to-book ratio (P/B): compares the book value of a share with its market value. You derive this ratio by dividing the price of the share by the book value per share in the last quarter.
- Price-to-cash flow ratio (P/CF): evaluates the price of a company’s share in relation to the cash flow generated by the company. You derive this ratio by dividing the price of the share by the operating cash flow per share.
- Dividend payout ratio: the ratio of dividends distributed to shareholders to the company’s total net income.
- Dividend yield: this is another ratio, of the annual dividends to the share price. It is expressed as a percentage.
- Return on equity: you divide the net income of the company by the equity to find the return on equity.
This also takes into account the value of physical assets (land, equipment or buildings owned by a company) and intangible assets (trademarks, patents or intellectual property).
As many models as there are analysts
In fundamental analysis, you use a fixed model to determine and compare the value of a share. However, this value is a personal estimate of what the share price of the company ought to be worth compared to the current market price. There is no universal model for fundamental analysis.
Because there are - a slight exaggeration - as many models as there are analysts, even professional analysts do not always agree on the future value of a company. This is because analysts rarely use fundamental analysis alone to arrive at a valuation, but also use and combine it with other analysis methods. While one analyst therefore sees a strong buying opportunity for a particular share, it is quite possible for another analyst to believe it is time to sell that share.
Follow an analyst, or choose your own model?
Putting together your own model is quite a task. Private investors therefore often follow the recommendations of professional analysts. If an analyst judges that the value of a share should be substantially higher than the current market price of the share, he may publish a buy or overweight rating for the share. This acts as a recommendation for investors who follow the analyst. If the analyst calculates a lower intrinsic value than the current market price, the share is considered overvalued and a sell or underweight rating is given.
If you want to get started without building your own model, you can use existing models. Whether you want to invest specifically in growth shares, value shares or dividend shares, you can find all kinds of strategies and tools based on fundamental analysis on the internet and in the library.
One of these models is the Magic Investing Formula, which is described in The Little Book That Beats the Market by Joel Greenblatt. He uses a straightforward step-by-step plan and simple formulae to explain how you can find value shares that are worth buying by using fundamental analysis.
Want to get started with fundamental analysis?
Performing your own analyses takes a lot of time and dedication. That is why we let you use our Global Analyzer at Keytrade Bank. This tool gives you an overview of different analyses and measures: the valuation, the conclusions of professional analysts, technical analysis, financial health and risk. Log in to keytradebank.be, locate the share, and then select the Global Analyzer tab.