Fundamental analysis is the practice of evaluating a company’s stock price by comparing base elements in the company’s balance sheets as well as general market factors. It does not include chart analysis, which is the domain of technical analysis.
The main principle of fundamental analysis is to find profitable companies to invest in by comparing revenues, sales, management, etc. There are two types of drivers to look at in fundamental analysis: internal drivers and external drivers.
Internal drivers are company factors that are directly related to the actual business in question. For example, liabilities, assets, revenue, income, products, management, etc. It is these characteristics in a company that you will be comparing to other companies in the same industry. This allows the trader to get a general understanding of where this company “sits” in relation to other companies with similar businesses. A trader can also use these internal numbers to calculate many different ratios that will help determine if the company is currently undervalued or overvalued.
Who is the management? What have they done in the past? What is the quality and diversity of the management team? All these questions can lead to a lengthy discussion about the particulars of each individual in management. Traders should use reports, news, internet, and other sources to help make an informed decision about the management team.
What are the company products and/or services? How does it compare to other competitive products? What’s unique? Why is it better? If you would not be willing to buy the company’s product why would you invest in that company? Companies with inferior products, weak development/product cycles, poor quality companies tend not to last very long. (I’m sure there are some exceptions to that rule, but it can be considered bad policy to invest in companies with bad products).
Production is very important when it comes to companies that produce oil/gas, wood, power, metals etc. Their value depends highly on their production output as well as the current value of the product. The more a company produces, the more it can earn. As well, these specific commodities vary in cost, the higher the value of the product, the higher the potential for profit. Oil is a perfect example of this relationship. As global oil prices rise so does the value of oil companies.
Profit margins are important, or for that matter, profit in general is important. Profit can be considered the keystone to fundamental analysis - the more profitable the company, the higher the potential for dividends as well as price growth. Most valuation techniques compare profit in some form or another to that of similar companies.
Companies that have not yet attained net profit are still in the early stages of development. While these companies generally have a larger growth potential, they also have more risk. Companies that are producing net income can generally be considered established in the market place. There is less risk, and typically, the price of the stock will reflect that. The axiom here is that the more the company makes, the more the company is worth.
Is there an institutional presence? The level of institutional presence is determined by the amount of shares outstanding that are owned by institutional investors (mutual funds, pension funds, investment houses, etc). As small companies mature, there is a point where they will be recognized by institutional investors. When these institutions begin investing in a company, the stock price will reflect that recognition (also when they sell out, it will be noticed in the stock price as well). Larger and more established companies typically have larger percentile institutional presence than smaller companies (micro-caps tend to have little to none).
While the study of volume patterns is in the realm of technical analysis, volume can also be used as a fundamental indicator. Does the company you are looking at have enough share volume to sell your shares at a later date?
External drivers are factors which are outside the company’s influence that can affect profitability. For example, the economy, inflation, interest rates, politics, bond market, etc. External drivers can be interpreted differently by different individuals. Remember, there is no magic formula.
Alex Martin is an senior analyst with MHP Systems Inc. http://www.chartfilter.com
