Throughout my own investment journey, I have studied how the best investors out there choose the companies that they decide to bet on and invest their fortunes in. It is a big decision to make, and one you should not take lightly.
If you have ever wondered how Warren Buffett, the renowned “Oracle of Omaha,” consistently makes sound investment decisions, or how Benjamin Graham, the father of value investing, built his investment philosophy, then you’ve come to the right place.
These investing titans are not fortune tellers; instead, they are masters of a time-honored investing strategy called fundamental analysis. This approach is not a secret formula or a get-rich-quick scheme. Instead, it is a methodical, research-intensive technique that, when employed judiciously, can help identify undervalued stocks with long-term potential.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”
Warren Buffet
With fundamental analysis, you will be better equipped to find those wonderful companies. So, let’s get started.
What is fundamental analysis?
At its core, fundamental analysis is a method of evaluating a security (in this case, a stock) in an attempt to measure its intrinsic value. It involves scrutinizing related economic, financial, and other qualitative and quantitative factors. The end goal? To make investment decisions that are not just informed, but profoundly insightful.
Another popular approach is technical analysis, which stand in contrast to fundamental analysis by focusing more on studying chart patterns. You can learn more about investing with technical analysis here.
5 steps to analyze stocks using fundamental analysis
Step 1: Understand the company
Before diving into any company’s financials, it is essential to understand what the company does. Read the company’s quarterly financial reports and investor relations content. Check the company’s website, recent news, and its market, competition, and regulatory environment.
You should be able to answer: What products or services does it provide? What makes it unique or competitive? Who are its customers?
Step 2: Review financial statements
The company’s balance sheet, income statement, and cash flow statement offer valuable insights into its financial health. The legendary investor Benjamin Graham has laid out several criteria in relation to this topic:
- Financial condition (balance sheet): A current ratio (current assets divided by current liabilities) over 2. A positive net working capital (current assets minus current liabilities) and more long-term debt than working capital.
- Earnings stability: Positive earnings for the past five years.
- Dividend record: Uninterrupted dividend payments for the past 20 years.
- Earnings growth: A minimum increase of one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.
The criteria above are not exhaustive but provide a solid foundation for evaluating a company’s financial strength.
Step 3: Analyze financial ratios
Financial ratios further distill financial statements into meaningful comparisons. Let us look at a few of the most important ones:
- Price/Earnings (P/E) ratio: This is the ratio of a company’s stock price to its earnings per share. A lower P/E ratio could suggest that the stock is undervalued, but it can also indicate that the market expects slow growth.
- Price/Book (P/B) ratio: This ratio compares a stock’s market value to its book value. A lower P/B ratio could mean the stock is undervalued.
- Debt/Equity (D/E) ratio: This ratio indicates how much debt the company is using to finance its assets relative to the value of shareholders’ equity. A high D/E might suggest higher risk.
Step 4: Estimate intrinsic value
Intrinsic value is what you believe a stock is worth, irrespective of its current market price. It is where the art meets the science in fundamental analysis. To estimate it, you can use the Discounted Cash Flow (DCF) model.
In the DCF model, you estimate the company’s future cash flows and discount them back to the present using an appropriate discount rate, often the Weighted Average Cost of Capital (WACC). The sum of these discounted cash flows gives you the intrinsic value of the company. If the intrinsic value is significantly higher than the current stock price, the stock might be undervalued.
Step 5: Implement and review
After conducting your analysis, you should have a comprehensive understanding of the company. If your research suggests that the company is undervalued, you might decide to purchase shares. However, this kind of investment is not a one-and-done deal. It is essential to continue reviewing the company’s performance and adjusting your analysis accordingly.
Conclusion
Fundamental analysis is a powerful tool, but it is not foolproof. It requires a serious commitment to ongoing research and the patience to wait for long-term results. However, the benefits can be truly spectacular. Happy investing!
