In the stock investing world, there are two major ways to analyze a stock. They are fundamental analysis and technical analysis. To make this stick, you can think of it this way – fundamental analysis tells you what to buy, while technical analysis tells you when to buy.
These topics have an abundance of content that writing about both will be difficult to cover in a single post. Today, we will focus our attention on fundamental analysis.
Due to its popularity, we will look into technical analysis in subsequent posts, but for now, let’s begin with fundamental analysis.
Below is a list of all the topics we will cover in this guide. You can click on any of them to go to that specific section.
When you hear the term fundamental analysis, think of a system for determining the fair value (or intrinsic value) of the stocks of the company in focus. Studying the economic and financial variables of the company is a key requirement of this process.
As a result, investors or analysts that use fundamental analysis study information that can influence the value of the security (stock). This information ranges from company-specific information (like its management) to market-wide information (like the industry the company belongs to).
In a nutshell, what you are trying to achieve with fundamental analysis, is to gather insights from variable sources and try to derive a fair value for the company’s stocks. After arriving at a fair value for the stock, we compare it with its current market price. If the stock price is trading below the fair value, the investor will be happy to buy. If the stock price is above the fair value, the investor may look to sell their stocks.
There are two universal ways to carry out a fundamental analysis of stocks. These are:
When fundamental analysts talk about qualitative analysis, they refer to a system of analyzing difficult to quantify information. For example, innovation in fuel technology which could reduce the need for fossil fuels will be bad news for a fossil fuel company. This new technology will lead to a drop in demand for fossil fuels, and you can see how fossil fuel profitability will suffer. We can project the stock price of the oil company to decline.
The question to ask is “how do you quantify this development”? You can’t come to a consensus measure for how to translate the event into an objective quantitative measure, therefore we call it qualitative analysis.
Let us look at another example, a popular fast-food company that sells Indomie Noodles. This company has a strong economic moat. It sells noodles where it has created a powerful barrier to entry – its brand loyalty.
Millions of Nigerians fed on Indomie noodles without competition for decades. These customers have become comfortable with Indomie and are reluctant to try other brands. This introduces a robust challenge to potential competitors of Indomie noodles. Indomie’s brand reputation can be a tough hurdle to scale.
Analysts consider these intangible factors with difficult to quantify properties as qualitative factors, hence, qualitative fundamental analysis. Indomie’s difficult to quantify brand identity provides the company with an economic moat (a qualitative factor).
Unlike qualitative analysis, quantitative analysis refers to any system of analyzing stocks, using factors that the analyst can quantify objectively. These factors include the company’s assets, liabilities, and cash flow. These factors contain variables that the analyst can quantify, hence the term quantitative analysis.
So when we deal with quantitative analysis, we work with factors like price-to-earnings (PE) ratio, price-to-book value (PB) ratio, price to free-cash-flow, etc.
Quantitative or Qualitative – which is better?
The “which is better?” question comes up every time, and that’s why it makes it into this post. This is, however, one of the times we do not think one is better than the other. The roles produce different outcomes, and we believe these outcomes complement each other.
To get the best results, we recommend starting your analysis with a quantitative approach. This helps you filter the universe of stocks to a number that is reasonable – it is easier to research 10 companies than it is to research 100 companies.
Once the quantitative analysis filters the universe down to a useful list, the analyst can carry out comprehensive quantitative research on the result to refine the list even further.
Primary Categories of Quantitative analysis
Growth Investing Models
Value Investing Models
Our next post, “value investing vs growth investing”, will dig deeper into these two categories.
Advantages of Fundamental Analysis
Some advantages of qualitative analysis are:
Insight – Using fundamental analysis provides the investor with a source of information which, if interpreted, provides insight that few investors will identify. This insight gives the investor an edge and opportunity to profit because they could buy the stocks below fair value.
Performance evaluation – Using quantitative methods, investors can back-test quantified data to see whether that data provides any significant return in the long run. For example, there is a debate that value stocks, with low price-to-earnings, outperform the market. This means that if you search for and rank stocks based on their P.E ratio, buying a portfolio of stocks with lower ratios outperform the market.
Disadvantages of Fundamental Analysis
Steep learning curve – One downside of fundamental analysis is its learning curve. The average requirement for employment as a fundamental analyst includes several professional certifications, years of practice, and a proper understanding of the vocabulary.
While there are no certification requirements it is important to learn the ropes if the investor plans to use the method for his own investing.
Dependence on Pro tools – With fundamental analysis, there’s a ton of information required to come to a useful conclusion. Sometimes, the process of sifting information from the universe of data can overwhelm the non-professional investor.
Professional investors, therefore, use tools and services that simplify this process for them. Tools for fundamental analysis. Some of these major tools that professional investors rely on include:
News aggregation services – to stay up to date with any event that could affect the investor’s portfolio.
Stock screeners – to filter out stocks that meet the investor’s requirements
Stock watch lists – to monitor a basket of stocks that have met the investor’s requirements. It’s like a shopping list – you don’t want to go shopping only to forget what you need to buy.
These tools, though, do not come cheap and for a long time, service providers priced them out of the reach of the non-professional investors. Today, these tools are available from different providers at prices that the non-professional investor can afford.
If you would like to try your hands out on some of these tools, you can head to Investor Hangout and test run these tools for free.
There are still those investors who may think the learning curve for mastering fundamental analysis, even with these tools, is still too steep. Those investors may prefer someone else to do the heavy lifting for them.
For this category of users, a Robo-advisor could be appropriate. A Robo-advisor carries out the entire fundamental analysis process, based on responses that the investor provides to a series of questions asked by the algorithm.
Fundamental analysis is a tested and trusted method investors and analysts use for stock selection. Many funds (mutual funds and ETFs) are created and managed using fundamental analysis models. The amount of skill and tools required for effective fundamental analysis makes it unattractive to the non-professional investor.
With breakthroughs in technology, pro tools which were hitherto available to only professional users are now available to self-directed investors. This has narrowed the gap between pro and non-pro investors. If you are a self-directed investor and would like to get access to some of these tools and don’t know where to go, you can visit Investor Hangout. You can try some of these tools for free (really free – no need to give up your card details until you want to take up a subscription).
I hope this post has been able to shed some light on fundamental analysis. If this post has added value to you, please hit the like button below or share it on your social media platform.
Thank you for taking the time to read this far. Don’t forget to check back for our next post. You can also sign up to receive notifications when we publish our next post. That way, you never get to miss our publications.
Taiwo Megbope is the Co-founder and Chief Growth Officer at Investor Hangout.
He is tasked with ensuring and managing the growth of the Investor Hangout project. His responsibilities include creating and implementing the project's vision as well as executing growth-generating strategies.
Taiwo is an avid researcher and autodidact. In his spare time, he enjoys spending time with his family and friends.