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What is fundamental analysis in the stock market?

Fundamental stock analysis is the process of analysing the underlying factors within a company  that drive share price movements over the long term. Also called a “bottom  up” approach, the aim of fundamental analysis is to quantify a security’s  value by looking at economic and financial factors for example a company’s  balance sheet, and income statement in order to  quantify a company’s fundamentals. On a  macro level these can be the broader economy and industry evolution as well  as consumer sentiment and purchasing behaviour. The primary goal of  fundamental analysis is using multiple data points to create a single data  point of a security’s price and then comparing this to the trading price to  deduce whether the security is undervalued or overvalued. Over time  securities are expected to revert to their valuation. It’s a common  occurrence for the best performing companies to be overvalued as investors  place a greater weight on future events.

When to use fundamental analysis?

If you  are a medium-term to long-term investor it’s important to always use  fundamental analysis as part of your investment rationale when analysing  securities. A majority of the time just looking at company fundamentals alone  gives you a good starting point for further due diligence at a single stock level. Once you find and highlight companies that are trading at a discount  to their fair value it’s valuable to dig deeper and understand the reasons why. Typically this will coincide with recently share price under performance  and present an opportunity for patient investors. A great investor once said  “in the short run markets are a voting machine and in the long run they’re a  weighing machine.” With fundamental analysis we hope to take advantage of the  times where investor “votes” are driving abnormal company valuations and hold on until the fair value of a company is realised.

How is fundamental analysis done?

Fundamental stock analysis is somewhat of a science plus an art, as such there are different ways that investors analyse the fundamentals of a company. Because the successful methods have become widely publicised, incremental changes are required to get a deeper understanding of a company fundamentals. Instead of relying on just a single data point, what we try to do is use multiple data points and combine them on a scoring system. One such method can be to look at the current earnings for a company and compare this against its trading price. We can then use this ratio to compare a given company against other companies in the same industry.Another technique, which requires assumptions about the future, can be to try and discount future cash flows of a company to get a value for that company today. This technique is definitely more towards the “art” end of the spectrum.With price ratio’s we can build several e.g. for earnings, for book value, for free cash flow, and use all of these to compare against a company’s competitors. At Stocktive we do stock analysis using beautiful charts so you can see at a glance which companies are attractively priced.

How is fundamental analysis different from technical analysis?

When comparing technical analysis vs. fundamental analysis, we can refer to the former as top-down and the latter as bottom-up. When we look bottom-up we get a deeper understanding of the core reasons why a company’s earnings may grow in future and thus imply that its future share price may be higher. The primary purpose of technical analysis is by looking for patterns or lines on a chart on a top-down approach.Ultimately both aim to understand the same information; is a company’s future valuation going to be higher or lower than it is today. With price alone you’re generally looking at past data and tend to have limited information. For example, is regulation going to change the landscape in future? Is it likely this company get’s acquired by a competitor? To answer these questions we really need a bottom-up approach. Technical analysis tends to be used by short-term traders and any technique ultimately formulates around either mean reversion or momentum techniques.

Why is fundamental analysis important?

Fundamental analysis is important to really understand the long term driving factors of a  security’s valuation. We can use sector trends, such as increased adoption of  electric vehicles, to understand how the forward revenue of a company is  going to develop. We can then look at competitor pressure to understand how  margins (and therefore earnings) are going to be impacted. With all of this  data we get a very rich understanding of forward company earnings that will  help us determine the fair valuation of that company today. Fundamental  analysis most importantly helps us uncover hidden trends or patterns long  before they materialise in the share price of that company. Buying a company  cheap to it’s fair value gives us a margin of safety on our investment. It’s  widely accepted amongst the most profitable investors that fundamental  analysis is a strong starting point when choosing investments.

How do I do value investing and growth investing with fundamental analysis?

Value  investing is concerned with finding company’s that are cheap to their fair  valuation today. What we’re typically looking for is profitable companies  with low price/earnings, low price/book and a fair dividend pay out ratio. We  hope to use these ratios or forward expected earnings to derive a valuation  for the company today then buy companies that are cheap to that valuation.  Growth investing is concerned with finding company’s where future earnings  growth is going to be much more attractive than today, these company’s will  typically be fairly young and be growing revenue fast but likely  unprofitable. For us to profit from this we need to believe that a company is  going to grow faster than the market currently believes. Typically if a  company is able to increase ARPU by up-selling consumers into new products or  business vertices and it’s at a very early stage in this process, this will  present an opportunity for growth investors as the share price would be expected to climb over time.

How can I use fundamental analysis to find an undervalued stock?

There  are currently three widely regarded ways:
1. Look at a variety price ratios  such as price/earnings, price/book and compare against similar stocks (you  can find out more in Benjamin grahams book, The Intelligent Investor)
2. Calculate  the net present value (NPV) of expected future cash flows. This requires  making estimates for future cash flows. And
3. Liquidation value – what are  the expected proceeds if a company were to be dismantled and the assets sold  off. This is where we take aggregate tangible assets and ignore intangibles  such as goodwill. (You can find out more in Seth Klarman’s book, Margin of  Safety)

What are some common fundamental analysis terms?

Price/Earnings Ratio (PE Ratio) - Value of outstanding shares divided by trailing twelve months earnings. We use this for companies that are profitable. This gives us a number we can use to compare against companies in the same sector. Typically newer high growth companies will have a high P/E ratio and mature companies will have lower P/E ratio's.
Price/Earnings/Growth (PEG Ratio) - Price earnings divided by growth. We ideally want this below 1.
Price/Sales Ratio (PS Ratio) - For unprofitable (high growth) companies we can use Price/Sales ratio to compare against comps.
Price/Sales/Growth Ratio (PSG Ratio) - Similar to PEG, we can also divide P/S by growth. There's some alpha in the 0-0.2 range.
Price/Book - We calculate this as value of outstanding shares divided by total assets minus intangibles and liabilities. This gives us an indication of how much am I paying for this company relative to its book value. Ideally we want to buy companies lower than its book value so we want this ratio to be less than 1.
Assets vs Liabilities - Ideally we want this less than 50%.
Debt vs Equity - Ideally we want this less than 50%
Return on Investment - For every $1 the company spends (invests) how much do they generate in net profits? It gives us a picture for how efficiently a company can generate a return from its products or services. Ideally we want this to be high. Too low a number likely means the company is subject to competitive pressures and lacks pricing power.
Free Cash Flow Yield - This is the free cash flow a company generates as a percent of market value. High free cash flow yield and growing free cash flow is good.
Net Present Value - Present value of expected future cash flows. This equates to a price which we can compare directly against the stock price to deduce if the stock price is cheap or expensive. This technique isn't without its limitations as we have to make assumptions about future earnings.
Dividend Payout Ratio - what percent of company earnings is paid out as dividends? If the payout ratio is too high it will signal an upcoming dividend cut which the market doesn't respond to particularly well.

What is a good fundamental analysis strategy?

One of the most publicised strategies of doing stock analysis by using fundamentals would be from Benjamin Graham who suggested to filter for companies that have P/B less than 1.2, assets vs liabilities less than 0.7, debt vs equity less than 0.5, and a P/E ratio less than 10, and a dividend yield over 1%. Very few companies fall inside this filter nowadays due to it’s widespread adoption. Graham added additional rules saying make sure you have a diversified portfolio of 30 or more stocks and sell a stock after a 50% rise in price. Also he advocated selling a stock if it hadn't advanced in price at the 2 year mark regardless of the stock price.

What are the limitations of using fundamental analysis?

One of the main limitations of doing fundamental analysis is that fundamentals never present good entry points into a trade. Fundamental analysis will highlight companies that are "cheap" or "expensive" to their valuation however a stock that you buy can always become cheaper, and the market can remain irrational longer than you can remain solvent. We can combat this issue with combining traditional fundamental analysis with other data points such as momentum. If you buy cheap companies that have started to gain momentum, you avoid the issue of waiting a long time for the market to start pricing in your view on a given stock. By doing this you give up a tiny bit of the upside (as you won't get in at the low print) but your investments are typically realised quicker which means you can turn over your portfolio more to achieve greater returns across the year.

Can A.I. do fundamental analysis?

In theory A.I. can be applied to any mathematical problem in order to solve it so for the most part, yes A.I. can do fundamental analysis. However, if we're just using basic price ratios and inputting these into an A.I., there won't be much alpha if at all as the market prices in all available information into the stock price very quickly. Where A.I. comes into its own is really through analysing huge unstructured datasets and performing analysis on this without human bias.
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