What is Fundamental Analysis?
Fundamental analysis is one of methodology adopted by investors to evaluate fair value of the business based on company’s financial, it’s future earnings growth outlook and various valuation methodology (relative valuation, Discounted Cash Flow etc)
Two basic approaches adopted in fundamental analysis of a stock are Top-down approach and Bottom-up approach. Top-down approach begins with the study of Macro Environment >> Industry >> Sector >> Company while Bottom-up approach begins with the study of Company which is likely to report healthy earnings growth >> Sector >> Industry >> Macro Environment.
There are two methods of doing fundamental analysis – Qualitative and Quantitative analysis.
Qualitative analysis is a subjective analysis that is more concerned with non-statistical data which cannot be computed. It is non-numerical in nature and helps to understand & interpret company culture as well as management quality. Examples - Management expertise, industry cycles, market leadership, corporate governance, business model, etc.
Quantitative analysis is a study of financial data and is numerical in nature. It is used to evaluate financial health of a company by capturing likely earnings growth in the form of financial statements, computing key financial ratios and valuations multiples. Examples – Profit Margins, Earnings per share, Debt/Equity, Free Cash Flow, Return Ratios, Price/Earning multiple etc.
Intrinsic Value or Fair Value is a very important metric in fundamental analysis used to take buy/sell decision in a stock. It is the underlying value or the real value of a company and is determined using both qualitative & quantitative factors of the company. Fair value of a business can be defined as the present value of all future free cash flows (FCF) discounted at the rate of weighted average cost of capital (WACC). If the intrinsic value of a business is high than its market value, it means the stock is undervalued and can be bought and vice versa. Fair value of the business can also be computed using relative valuation methodology.
“The stock investor is neither right or wrong because others agreed or disagreed with him; he is right because his facts and analysis are right” – Benjamin Graham, The Intelligent Investor