The fundamental analysis is a key approach for investors who focus on a long-term investment strategy and search for value investing opportunities on the stock market.
This approach focuses on analysing the basic factors that affect the value of a business and its stock. The aim of the fundamental analysis is to understand the financial health of a company and its future potential growth.
Macroeconomic analysis
The macroeconomic analysis examines broader economic trends and factors that can affect the overall market and sectors. Key aspects of this analysis include:
Economic growth
- Evaluation of the GDP growth trend, inflation and rate of unemployment which affect market demand and company performance.
Currency policy
- Analysis of central bank decisions and their impact on interest rates and exchange rates, which can affect business costs and profits.
Geopolitical events
- Evaluation of political stability and risks associated with international conflicts or trade agreements, which may affect global markets.
Sector analysis
The sector analysis focuses on a specific sector of the market in which a company operates.
The key aspects of this analysis include:
Competitive environment
- Evaluation of the strength of competition in the sector, market share of individual players and competitors’ strategies, which helps to identify market opportunities and threats.
Regulatory environment
- Analysis of current and potential regulations and laws that can affect the business environment and the profits of companies in the sector.
Technological innovations
- Evaluation of the trends and innovations in the sector which can affect competitiveness and future growth of companies in the sector.
Financial analysis
The financial analysis is a key element of the fundamental analysis which focuses on the financial results and health of a company.
The main aspects of this analysis include:
Financial performance
- Evaluation of key financial indicators such as ROE (Return on Equity), ROI (Return on Investment), EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) and their trend over time, which helps to evaluate the efficiency and performance of a business.
Growth potential
- Evaluation of possibilities for future growth of sales, profits and dividends based on trends in the financial results and business strategies of a company.
Financial stability
- Analysis of indebtedness, liquidity and cash flow in a company, which helps to evaluate the ability of a business to manage its operations and invest in future growth.
Investment process
The intrinsic value of stock is the estimated value of stock based on a company’s future financial results and revenues. It can be understood as being the individual opinion of any stock market participant of what should be the so-called “fair value” which can be considered fixed in a very short period of time. When comparing the intrinsic value of stock with its market price, we will find out whether the given stock is overvalued, undervalued or correctly valued.
There are several models and procedures for calculating the intrinsic value of stock, including the Discounted Cash Flow (DCF) model, Dividend Discount Model and Income Approach, Equity Valuation Methods (Accounting Method, Substantial Method, Liquidation Value Method). The disadvantage of these models is that they overlook company assets and the need to estimate future free cash flow. To give you an idea, we provide some examples of revenue calculation methods below.
DCF - Entity (CF) – Valuation of Total Company Capital
V = FCFF/WACC
Free Cash Flow/Weighted Average Cost of Capital.
Rd = Cost of Interest-bearing Foreign Capital, t is Income Tax Rate, D is Interest-bearing Foreign Capital, Re is Cost of Equity Capital, E is Equity.
DCF - Entity (CF) – valuation of total company capital
V = FCFF/WACC
Free Cash Flow to Firm /Weighted Average Cost of Capital
Where:
● V = Company Value
● FCFF = Free Cash Flow to Firm
● WACC = Weighted Average Cost of Capital
● Rd = Cost of Interest-bearing Foreign Capital
● t = Income Tax Rate
● D = Interest-bearing Foreign Capital
● Re = Cost of Equity Capital
● E = Equity
DCF - Equity (CF) - Valuation of Company Equity
V = FCFE / Re
DDM method - Valuation of Company Equity
V = DIV / Re
or
V = DIV / (Re - g)
Where:
● V = Company Value
● FCFE = Free Cash Flow to Equity
● DIV = Dividend
● Re = Cost of Equity Capital
● g = Expected Dividend Growth Rate
Financial statements
The basic financial statement and other statements are derived from the balance sheet. The balance sheet expresses the state of the property of a company (assets) together with the resources of its coverage (liabilities), which represents the capital from which the property is financed.
Assets are divided into Fixed Assets. These are assets used by a company on a long-term basis and are subject to gradual wear and tear in the form of depreciation. Current assets, part of the property that is consumed at once, or within a year. Liabilities are divided into equity and external resources.
The profit and loss statement (income statement) records Revenues and Costs for a predetermined period.
Revenues are a monetary expression of the results arising from the management of a company, which means sale of products or services. Revenues record the value of returned consumed assets and increment of assets.
Costs represent a monetary expression of consumption, asset wear and tear or increment of liabilities. Costs are associated with the loss of assets in the balance sheet.
In the Cash Flow statement we will find the values that really affect the income and expenditure of cash. From these values, we can determine the state of cash at a specific time. The difference between the Profit and Loss Statement (Income Statement) and the Cash Flow Statement is that it expresses the real and undistorted fact about cash flows, therefore Cash Flow and Profit are two different categories, and the reason is the time inconsistency between income and expenses and costs with revenues.
Investment process
The right search strategy is crucial for understanding the reasons why you are considering this type of investment opportunity. This involves a selection of a subset from the entire spectrum of securities, which the investor will further investigate. The investor can focus on stocks from a specific country/sector, which meet specific financial parameters (e.g. PE < 10, PB < 2 …), or follow completely different selection criteria.
The second step is to specifically evaluate and determine the intrinsic value of security. The assumption of the selected security must be that its future value (price) will be higher in the future than the price at which the security can currently be acquired on the market. An important characteristic of the research process is to focus on uncertain factors which can significantly affect the process of evaluation, such as insider selling, therefore it is essential to answer the question why my evaluation is more accurate than the general evaluation that forms the current price.
The investor, who will review and evaluate all significant information, will proceed with the purchase. In the case of the last step, the investor needs to realise how the acquisition of a specific security will affect the volatility of his portfolio, what correlation it has with regard to currently held assets.
The fundamental analysis provides investors with a deeper understanding of the value of a company and identifies potential investment opportunities on the stock market. The combination of a macroeconomic, sector and financial analysis and an analysis of intrinsic value of stock allow investors to get a better understanding of the market and minimise the risks associated with investing. It is important for beginner and intermediate investors to understand the basic principles of a fundamental analysis and use it to decide about their investments.