FUNDAMENTAL ANALYSIS
WHAT IS FUNDAMENTAL ANALYSIS?
Fundamental analysis, as the name implies, is the practice of investigating the fundaments of a business; its financial situation, the nature of its management, and the marketability and competitiveness of its product(s). Fundamental analysis is opposed to technical analysis, in that fundamental analysis attempts to assess investment potential on the basis of a comprehensive understanding of a business, its operations and its finances.
There are several ways that fundamental analysis is put to use as an investment strategy. Fundamental analysis used to identify undervalued businesses is called value investing and is thought by some, such as one of the founders of value investing, Benjamin Graham, to be the mark of the true investor, all other approaches to financial analysis being mere “speculation”. Graham called fundamental analysis “Security Analysis”, which was the title of his seminal book on the subject. Growth investing, one of the more common alternatives to value investing that employs fundamental analysis, uses this form of financial analysis to identify businesses that offer investment opportunity because of their potential for growth. It is possible to employ a hybrid value/growth investment method for the application of fundamental analysis. Indeed, this is how Benjamin Graham’s most famous student, Warren Buffett, may most accurately be said to approach investment, though his primary focus is still on finding value.
Fundamental analysis presupposes that the financial markets are, to some extent, inefficient markets. The reason for this is that, in an efficient market, the accurate security valuations for all securities traded in the market are immediately reflected in the market prices of the securities. These prices include all available information about the future valuation of the securities, including all information about the finances, management and product potential of the underlying business. Hence, according to efficient markets theory, there is no point in conducting fundamental analysis for the purpose of securities valuation and the identification of investment opportunity.
HOW IS FUNDAMENTAL ANALYSIS PERFORMED?
Fundamental analysis has three main components: the financial statement analysis of a business, an assessment of the business’s management and structure, and the identification of the market potential of the business’s product(s). The analysis of financial statements is the quantitative component in fundamental analysis, and research into the nature of the management, structure and product of the business are the qualitative components. All contribute to the valuation of the business from the perspective of the fundamental analyst.
There are six basic questions that fundamental analysis seeks to answer about a business:
1) Is its revenue growing?
2) Is it turning a profit?
3) How competitive is the business?
4) Does it have a product that will be lucrative in the future?
5) Is the management effective in maintaining growth and profit?
6) Is the management honest with investors about the state of the business?
The first two questions above require wholly quantitative financial research, based on investigation of the financial statements of a company. The rest require both quantitative analysis and qualitative analysis into the nature of the management and industry of the business.
QUANTITATIVE ANALYSIS
Financial statement analysis aims to establish a current value of the business, answering directly the first two questions above and providing important information for answering the rest. As such, financial statement analysis might be said to be the backbone of fundamental analysis. The goal of quantitative analysis for the fundamental analyst is to digest the immense amount of numerical data in the financial statements of a corporation in a way that will enable, in conjunction with the results of a thoroughgoing qualitative analysis, the most accurate assessment of the fair market value of the relevant security under analysis.
The first step in financial statement analysis is to compile the three primary sources of data from the financial statements: the Income Statement, Cash Flow Statement and the Balance Sheet. In the case of a publicly traded company, the primary sources for this information are a corporation’s quarterly and annual official financial statements lodged with the Securities and Exchange Commission (SEC): forms 10-Q and 10-K. The Income Statement contains information about the revenues and expenses of the firm, as well as the resulting income of the firm, during the relevant period. The Cash Flow Statement specifies the sources of cash to the firm from both operations and new financing, along with the uses of this cash, during the relevant period. The Balance Sheet contains a summary of the assets owned by a firm along with their book values, and the kinds of financing, both debt and equity, that the company has utilized.
The main aim of the fundamental analyst is to distill the most important information from the financial statements, namely the company’s assets and liabilities (the Balance Sheet), how much the company is making (the Income Statement) and where the money the company has is going (the Cash Flow Statement). The most thorough fundamental analysis requires the construction of a financial model utilizing the plethora of data in the financial statements. This financial model must provide a valuation of the company—its intrinsic value—as well as enable projection of the financial statements into the future. This may involve the employment of multiple complex valuation methods, for example, in terms of discounted cash flow, trading multiples or precedent transactions. Another common task in valuation is devising an accurate comparative company analysis, in which financial models of businesses in the same industry are normalized to one another and then submitted to relevant quantitative comparison. In the end, a fundamental analyst’s quantitative analysis should provide a flexible and complete financial model that the financial analyst can use along with qualitative analysis of the company to determine the investment potential of its securities.
QUALITATIVE ANALYSIS
The main aspect of qualitative analysis that pertains to the internal operations of a business under fundamental analysis is an assessment of the management style and business model of a corporation.
Examination of the business model is often the first step in fundamental analysis. This will enable the financial analyst to discern much about the product, operations, and financial and management structure of the business. In turn, such information can form the first test of whether a company may be a worthy investment or not, as well as being crucial to later, more rigorous tests to this effect.
The history and structure of management are important to fundamental analysis also, as they will illuminate many of the specific qualities of the existing managers and the ongoing relationship between the business and its management. Thus, an examination of the history of management contributes significantly to an answer to questions five and six above.
Statements made by management to shareholders may be compared with the results of the financial statement analysis to determine whether management follows a policy of transparency. Moreover, the consistency of results reported on the Income Statement, Cash Flow Statement and Balance Sheet portions of the financial statements should be assessed. Likewise, the fundamental analyst should take note of the transparency of the style with which management has decided to report results on the financial statements. A salient example would be whether management has reported inventory expenditures on the balance sheet as First In First Out (FIFO) or Last In First Out (LIFO), since the choice of accounting method here, particularly if it goes against Generally Accepted Accounting Principles (GAAP), can be an indicator of a desire to obscure the cost of goods sold (COGS) in relation to other aspects of the financial statements of the business, particularly those indicating income. The overall aim of such obfuscation is, of course, overstating profit or understating loss.
Like its counterpart in the quantitative analysis, the comparative company analysis, comparative qualitative analysis of a business within the industry it operates is a crucial aspect of fundamental analysis. This qualitative analysis is particularly germane to questions three and four above. The main objects of research here are salability of the business’s product in relation to its competitors and the overall salability, particularly in the future, of the industry's product. Other factors, such as governmental regulation, are relevant here, as regulation may make the industry unprofitable despite high demand.
WHAT IS THE DIFFERNCE BETWEEN FUNDAMENTAL ANALYSIS AND TECHNICAL ANALYSIS?
The essential difference between fundamental analysts and technical analysts is that the fundamental analysts are interested in the actual business operations and finances of the company underlying a security while the technical analysts focus only on statistical and other abstract mathematical features of the data about the security’s performance in the market. One way the difference between fundamental analysis and technical analysis can be seen is in the fact that the fundamental analyst makes extensive use of data from the finances of a business under analysis while technical analysts do not. The underlying theoretical fact that divides fundamental analysis from technical analysis is the fact that a much greater degree of market inefficiency is assumed by the fundamental analyst's method.
WHICH ASPECTS OF FUNDAMENTAL ANALYSIS ARE TAUGHT BY THE INVERSTMENT BANKING BOOTCAMP?
The Investment Banking Institute's Investment Banking Bootcamp is a fast and exceptionally rigorous way to learn fundamental analysis in nearly all of its facets. In particular, the quantitative analysis performed by fundamental analysts, such as valuation and financial modeling, are taught by the Investment Banking Institute to the high standards required to engage in investment banking and private equity transactions. There is a need for exceptional rigor in the financial modeling required by investment banking activities simply because of the huge amounts of money at stake. What is more, the inherent complexities in constructing accurate financial models for the companies under financial analysis—which may be highly distressed, young start-ups with no positive cash-flow (particularly in cases of venture capital investment) or businesses novel enough to be difficult to compare—make the valuation of companies for investment banking purposes particularly difficult. The student of the Investment Banking Bootcamp will learn comparable company analysis, how to assess the capital structure of a company, as well as other advanced valuation methodologies. As a result, the graduate of the Investment Banking Institute’s course will be able to build full-blown financial models and conduct such crucial and advanced financial modeling techniques as stress-testing a company’s capital structure with relevant sensitivities. The Investment Banking Bootcamp culminates in the construction of leveraged buy out (LBO) and merger and acquisition (M&A) models, which is the ultimate test of the students’ knowledge of valuation and financial modeling. In addition, the Investment Banking Bootcamp provides a detailed overview of the qualitative analysis skills relevant to fundamental analysis, such as the assessment of management and business models.
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