Fundamental analysis is an important component in value investment. By learning this skill you can maximize your investment returns. In this guide I provide tips on what tools to utilize in business analysis,
I’m a fundamental value-oriented investor. Even more specifically, I aim to be a GARP-investor. This means that I look into how the business behind the stock is doing and want to buy the stock when the underlying business is doing better than the stock price.
What is fundamental analysis?
Fundamental analysis according to Investopedia:
- Fundamental analysis is a method of determining a stock’s real or “fair market” value.
- Fundamentalists search for stocks that are currently trading at prices that are higher or lower than their real value.
- If the fair market value is higher than the market price, the stock is deemed to be undervalued and a buy recommendation is given.
- In contrast, technical analysts ignore the fundamentals in favor of studying the historical price trends of the stock.
Fundamental analysis can take many forms. These can be looking into net debt, profit margins, earnings- and revenue growth or other factors. Fundamental analysis doesn’t value companies according to chart technicals or past price movements.
Fundamental analyst tries to assign a fair price to a company and after the grueling analytic process will compare this “fair” price to market price. If the fair price the analyst has come up with is higher than market price, the company stock can be bought for less than what it’s worth.
What are the steps I take to analyze company fundamentals?
When doing fundamental analysis, I have a methodical approach to valuing companies. I look at their
- Net debt position: does the company have net debt? If so, how much and can it be paid back if needed? Indebted companies have higher risk: if the business goes into downtrend, they won’t be able to cover debt payments and will risk bankruptcy. Lower (or zero) the net debt, the better in my book. Investopedia defines net debt as:
- Net Debt=STD+LTD−CCE
- STD (short term debt) = Debt that is due in 12 months or less and can include short-term bank loans, accounts payable, and lease payments
- LTD = Long-term debt is debt that with a maturity date longer than one year and include bonds, lease payments, term loans, small and notes payable
- CCE = Cash and liquid instruments that can be easily converted to cash.Cash equivalents are liquid investments with amaturity of 90 days or less and include certificates of deposit, Treasury bills, and commercial paper
- Net Debt=STD+LTD−CCE
- Revenue growth: the annual growth rate of the company’s revenues. If the company has shown a sustainable growth in its revenues, this is a good sign for the future. This can mean that for example, a company producing shoes has made new contracts to sell these shoes in new markets and thus has been able to increase their addressed market. Here I like small-capitalization stocks as they usually are smaller companies that haven’t saturated their respective markets. This means, in theory, that they have room to expand. If a store or a restaurant does fabulously well in one city, why wouldn’t it be able to do so in the next one? Forecasting this growth means taking into account market growth, incremental market share gains, and pricing power.
Growth Rate Calculation
Incremental Market Share Gains
Calculated Growth Rate
- Earnings growth can be forecasted on the basis of revenue growth. Earnings are a function of revenue (and its growth) and the expenses % of revenue. A company that’s growing revenues and reducing expenses can do extremely well. This is why it’s important to keep an eye on
Expenses (% of Revenue)
Different types of expenses the business will have are (according to Investopedia):
- Direct costs: labor costs, factory overhead, storage, costs of products and their raw materials…
- Indirect costs: executive compensation, general expenses, depreciation, marketing…
- Depreciation: tax-deductible expense that can include computers, furniture, property, equipment…
- Gifts, meals and entertainment
- Interest expenses: interest payments on loans as well as tax expenses
Keeping an eye on these costs will give the fundamental investor an oversight over how much of the revenue will end up as profits. The lower the expenses, generally the better. Sometimes this wouldn’t be the case, though, for example if the company heavily invests into successful growth initiatives.
Other factors important to take into account
Other examples of factors the fundamental investor might want to take into account are net cash position, return on capital employed and even insider ownership.
An example of a fundamentally-sound business with a long track-record of generating shareholder returns is Ocean Biotech. OBCI is a Fort Lauderdale, Florida based business producing, marketing and distributing appearance, performance, and maintenance products for the marine, automotive, power sports, recreational vehicle, home care, and outdoor power equipment markets in the United States and Canada. I wrote an article on Ocean Biochem and why I consider it to be a great GARP-stock.
Every fundamental investor has their own metrics they consider the most important. It’s also important to take into consideration other, more qualitative factors such as the mentioned insider ownership, market capitalization, industry the company operates in, competition and so on. If you want to be a succesful investor, having at least some form of fundamental analysis backing up your stock picks will increase the likelihood of success in your investing career.