The Basics of Fundamental Analysis

The Basics of Fundamental Analysis

Looking to invest in stocks but don't know where to start? Analyzing a business can become complicated unless you have a basic road map. Here are some guidelines that can get you started.

By Anna B. Wroblewska

Are you looking to invest in stocks but don't know where to start?

Fundamental analysis is the process of trying to understand the value of a company by analyzing its business, industry, and its exposure to the overall economy. In other words, investors who use fundamental analysis are concerned with the fundamental prospects of the business. Based on their conclusions, fundamental investors then consider whether a company is a good investment.

Because analyzing a business can become as complicated as you make it, it helps to have a road map. This guide will help you to get started.

Start with the big picture

Rather than jumping straight into complicated SEC filings or financial statements, start with the basics: what does the company do and where does it fit in with its industry? From there, you can dive more deeply into the specific quantitative and qualitative factors that will affect performance.

First, start with the company's story:

  • What is the company's history? Where does it have its roots and what have been the key products or drivers of its growth over time?

  • Have there been any major external factors that changed the company's strategy or product mix?

  • Who's the boss? Is the company led by a strong founder or early leader, or does management change often?

    Understanding the history is a great way to gain insight a company's culture and decision-making style of its management. For example, a firm that routinely changes strategy might be opportunistic -- or just unfocused. One that saw an opportunity to change course may have set off on a path for the better -- or for the worse.

    See what you can find out about the company's narrative. The rest of the pieces (and your opinion of them) will start to form once you dive a bit deeper.

    Next, you'll want to understand how the company does business. The most important question here is incredibly simple: how does the company make money? Make sure you really understand the answer. Albert Einstein once famously admonished that you probably don't understand something you unless you can explain to a six-year old, which is a useful guide in situations like these. If you can't understand it, maybe take a step back and think about whether you really want to invest in it.

    In answering the question of how a business makes money, you'll start to gain insight into other relevant factors. For example:

    • How big is the company? Is it a major mover in its market or a smaller niche player?

    • How specialized is the company? Does it focus on doing one or a handful of things really well or is it very diversified?

    These questions will naturally lead you into the products and services the company offers and how they fit in with the overall marketplace.

    Diving more deeply into strategy

    Now that you know what the company is selling and how it’s products or services have changed over time, you can start looking at the present -- and eventually the future.

    Start with the company's products and customers:

    • What are the key revenue drivers for this firm? How sensitive are they to economic changes, geography, and regulations?

    • Fill in the blank for this statement: People will stop buying this companys products or services if __________. Pretty much every firm on earth has a sensitive point: be sure you know it.

    • Who are the company’s customers? What are they concerned about? What makes them loyal -- or are they?

    These questions will lead you to some of the key strategy decisions the company's management is facing. By way of example, a company that sells food basics might start to make fewer sales as incomes rise and people choose more expensive foods. So, what is it doing to protect its margins? You'll want to be sure this question is answered. Perhaps the company is moving into international lower-income markets or diversifying into higher-margin foodstuffs. If it's doing nothing to address its sensitive point, there might be a problem.

    The importance of competition

    The question of how a company is growing or adapting to its market environment is important because firms rarely operate alone. Competition is a key factor in understanding a business because competitors can make or break even the best idea.

    The basics you want to understand are the intensity of the competition (i.e., how many competitors there are and how much of a threat they pose) and how easily customers can switch to a competitor's offerings.

    For example, when it comes to tomatoes it’s unlikely you’re very brand loyal. You would think that means tomato-growers have little to no opportunity to set themselves apart -- unless grocery stores are loyal because they care about predictability and quality. Understanding these types of market features will help you understand the ways a company can set itself apart -- and whether or not it’s doing a good job.

    If the positioning is logical and the company is investing heavily in protecting it, you might have a good prospect -- depending, of course, on how the competition is behaving and whether or not the company can afford the investment.

    Getting to the numbers

    Whether a company can execute its strategy hinges very critically on the numbers.

    Two key figures you want to understand are cash and liabilities. Specifically:

    • How much money does the company have to reinvest or pay out to investors?

    • How leveraged is it?

    • Can it afford to take on debt to finance a new product or enter a new market?

    • Are any of its units underperforming or putting the rest of the firm at risk?

    Try to find out what’s going on behind the scenes before getting too caught up in ratios and prices. Knowing the key pressure points and opportunity areas will help you make sense of all the rest, and it will ensure that your take is balanced by real information.

    In other words, it’s not enough to just look at net income or a price-to-earnings ratio to make a decision: it’s important to understand what mechanisms underlie the numbers themselves. For every figure or ratio you come across, ask yourself: what makes this number high or low? What are the risks and benefits to the company?

    From there, your foray into fundamental analysis can get deeper and deeper. There’s no end to the number of questions you can ask yourself or the financial levers you can tinker with. But by starting with history and focusing on strategy, you’ll have given yourself a very solid foundation. Armed with this information, you’ll know where to focus and what questions to ask.