13.2.1 Overview Of Fundamental Analysis

Overview of Fundamental Analysis

Fundamental analysis is a method of evaluating capital market conditions, economic conditions (both domestic and global), industry conditions, and the condition of individual companies. The primary aim is to measure the intrinsic or fundamental value of a security. By comparing the intrinsic value against the security’s current price, investors can determine whether the security is overvalued or undervalued.

Fundamental analysts study various factors that can affect a security’s value, including:

• Macroeconomic Factors: Examples include the economic outlook for Canada’s trading partners.
• Industry Factors: These could be factors such as the growth stage of a particular industry.

Among these factors, the most significant is the actual or expected profitability of the issuer. In this regard, fundamental analysts use profitability ratios to determine whether a company can properly service its debt and pay current dividends.

Considering the broad range of factors influencing stock valuation, we examine fundamental analysis from both macroeconomic and industry perspectives. In the subsequent chapter (Chapter 14), we will delve specifically into company analysis and profitability ratios.

Did You Know?

Our focus in this chapter is the application of fundamental analysis in valuing equities. However, this method is not limited to equities alone. For example, in valuing bonds, you could consider an economic forecast for the future direction of interest rates or the credit rating of an issuer.

Key Concepts of Fundamental Analysis

To successfully conduct fundamental analysis, it is essential to understand and analyze various economic indicators and financial statements. Below is a brief overview of some key concepts:

Economic Indicators

Economic indicators provide insights into the overall health of an economy. Common indicators include:

1. Gross Domestic Product (GDP): Measures the total value of goods and services produced in a country.
2. Inflation Rate: The rate at which the general level of prices for goods and services is rising.
3. Unemployment Rate: The percentage of the labor force that is jobless and actively looking for work.
4. Interest Rates: The cost of borrowing money, typically set by a country’s central bank.

Financial Statements Analysis

Fundamental analysis relies heavily on financial statement analysis to assess a company’s performance. The three main financial statements are:

1. Income Statement: Shows the company’s revenue, expenses, and profits over a period.
2. Balance Sheet: Provides a snapshot of a company’s assets, liabilities, and shareholders’ equity at a specific point in time.
3. Cash Flow Statement: Tracks the flow of cash in and out of the business.

Profitability Ratios

Profitability ratios are crucial in determining the overall efficiency and performance of a firm. Common profitability ratios include:

• Gross Profit Margin: \( \text{Gross Profit Margin} = \frac{\text{Revenue} - \text{Cost of Goods Sold}}{\text{Revenue}} \times 100 \)

• Net Profit Margin: \( \text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}} \times 100 \)

• Return on Assets (ROA): \( \text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}} \)

• Return on Equity (ROE): \( \text{ROE} = \frac{\text{Net Income}}{\text{Total Equity}} \)

Frequently Asked Questions (FAQs)

What is the primary goal of fundamental analysis?

The primary goal of fundamental analysis is to determine the intrinsic or fundamental value of a security and to compare this with its current market price, identifying whether the security is overvalued or undervalued.

Can fundamental analysis be used for securities other than equities?

Yes, fundamental analysis can be applied to various types of securities, including bonds. For bonds, analysts may examine economic forecasts for interest rates and the credit ratings of issuers.

How do macroeconomic factors influence security valuation?

Macroeconomic factors such as GDP growth, inflation, and interest rates affect the overall economic environment and, in turn, impact the profitability of companies, thus influencing security valuation.

Glossary

• Intrinsic Value: The perceived or calculated true value of an asset, investment, or company based on fundamental analysis.
• Profitability Ratios: Financial metrics used to evaluate a company’s ability to generate income relative to revenue, assets, equity, and other factors.
• Macroeconomic Factors: Large-scale economic factors that affect an economy as a whole, such as gross domestic product (GDP), unemployment rates, and inflation.
• Credit Rating: An assessment of an issuer’s creditworthiness, which affects their ability to borrow money and the interest rates they are charged.

Key Takeaways

• Fundamental analysis is used to determine the intrinsic value of a security by considering a broad range of factors including macroeconomic conditions, industry trends, and company performance.
• Economic indicators and financial statements are vital in this analysis.
• The profitability ratios such as Gross Profit Margin, Net Profit Margin, ROA, and ROE play an essential role in accessing a company’s performance.
• Fundamental analysis is not limited to equities; it can be applied to various types of securities, including bonds.

Example of Security Valuation Using Fundamental Analysis (Schematic Diagram)

    flowchart TD
	    A[Start
	    Security Valuation Using 
	    Fundamental Analysis] --> B[Assess Macroeconomic Conditions]
	    B --> C[Evaluate Industry Trends]
	    C --> D[Analyze Company Financial Statements]
	    D --> E[Calculate Profitability Ratios]
	    E --> F[Determine Intrinsic Value]
	    F --> G[Compare Intrinsic Value with Market Price]
	    G --> H[Decide: Overvalued or Undervalued]

Remember, understanding fundamental analysis is a crucial skill for any serious investor. Through consistent practice and deep dives into financial statements and economic indicators, you will grow more adept at identifying valuable investment opportunities.

Publication Date: July 2021