What is fundamental analysis and how does it work?

The aim is to determine whether a stock is undervalued or overvalued based on its current market price. By examining a company's financial statements, such as the income statement, balance sheet and cash flow statement, investors can gain insights that help them make informed decisions about whether to buy, hold or sell shares.

The intrinsic value derived from fundamental analysis allows investors to look beyond short-term market fluctuations and focus on the underlying factors that drive a company's performance over the long term. This approach is particularly useful for those wishing to adopt a buy-and-hold investment strategy, as it emphasises the importance of a company's financial health and growth potential.

The difference between fundamental and technical analysis

Fundamental analysis and technical analysis are two distinct methods for assessing investments. Each approach has its unique focus and techniques.

Fundamental analysis focuses on the financial health of a company, considering aspects such as earnings, revenue, profit margins and general economic conditions. It aims to determine the intrinsic value of a stock by analysing financial statements and ratios. Investors using fundamental analysis often look for stocks that are trading below their intrinsic value, indicating that they may be good investment opportunities.

Technical analysis on the other hand, focuses primarily on price movements and trading volumes. It uses historical market data, charts and patterns to predict future price movements. Technical analysts believe that all relevant information is already reflected in a stock's price, and that historical price patterns can provide insights into future market behaviour. This approach is typically favoured by short-term traders looking to capitalise on market trends and price fluctuations.

Understanding the differences between these two methodologies is crucial for investors to choose the approach that best suits their investment goals and risk tolerance.

How to use fundamental analysis in trading

Using fundamental analysis to trade means taking a systematic look at a company's financial status and market standing. Here's what you can do:

1. Gather financial statements: Start by getting the most recent financial statements. Look for the profit and loss account, balance sheet and cash flow statement. You can usually find these in annual reports or on the investor relations page of the company's website.
2. Analyse the profit and loss account: Look at key figures such as revenue, gross profit, operating profit and net profit. Consider the revenue growth over time and how it compares with competitors. Steady revenue growth can indicate a strong business model.
3. Examine the balance sheet: This document shows the company's assets, liabilities and equity. Look for ratios such as the current ratio and the debt-to-equity ratio. A strong balance sheet, where assets exceed liabilities, indicates financial health.
4. Review the cash flow statement: Focus on cash flow from operating, investing and financing activities. A positive operating cash flow indicates that the company can maintain its operations and invest in future growth.
5. Calculate key financial ratios: Look at important ratios such as price-to-earnings (P/E), earnings per share (EPS) and return on equity (ROE). These ratios will help you understand the company's and efficiency in returning value to shareholders.
6. Assess industry and economic conditions: Consider the broader economic environment and industry trends that could affect the company's performance. Understanding factors such as interest rates and industry competition is key to making wise investment decisions.
7. Evaluate qualitative factors: Don't forget to look at non-numerical factors. Assess the quality of management, competitive advantages, brand reputation and market position. Strong leadership and a sound business model can have a significant impact on long-term success.

Examples of fundamental analysis

To illustrate how fundamental analysis works, let's consider a hypothetical company, XYZ Corp. By examining its financial statements and calculating key ratios, we can assess its financial health and investment potential.

1. Financial statement overview:
   • Income Statement: XYZ Corp has reported revenues of €2 million, cost of goods sold of €1 million, resulting in a gross profit of €1 million. Operating expenses are €500,000, giving an operating profit of €500,000. After deducting interest and taxes, the net profit is €300,000.
   • The balance sheet: The company has total assets of €5 million and liabilities of €1 million, giving equity of €4 million.
   • Cash flow statement: XYZ Corp generates €400,000 in cash from operations, spends €100,000 on investments and raises €50,000 through financing activities.
2. Calculate the ratios:
   • Gross profit margin: (€1,000,000 / €2,000,000) * 100 = 50%
   • Net profit margin: (€300,000 / €2,000,000) * 100 = 15%
   • Return on equity (ROE): (€300,000 / €4,000,000) * 100 = 7.5%
   • Current ratio: Assuming current assets of €3 million and current liabilities of €1 million, current ratio = €3,000,000 / €1,000,000 = 3.0
3. Interpretation:
   • The gross profit margin of 50% indicates that XYZ Corp. retains a solid portion of its revenue after taking into account the cost of goods sold, suggesting efficient production.
   • A net profit margin of 15% shows that the company is profitable after covering all its costs, which is a positive indicator for investors.
   • A return on equity of 7.5% can be considered moderate and it's important to compare this figure with industry peers to assess competitiveness.
   • A current ratio of 3.0 indicates that the company has sufficient liquidity to cover its short-term liabilities.

Types of fundamental analysis

Fundamental analysis can be divided into two main types: quantitative analysis and qualitative analysis. Both types are essential for a comprehensive evaluation of a company. By combining these approaches, we can gain a complete understanding of a company's financial health, market standing and long-term prospects.

Quantitative analysis: Quantitative analysis focuses on numerical data from financial statements. It provides a clear, objective basis for assessing a company’s performance. This type of analysis relies on data that can be measured and statistically assessed. Important elements of quantitative analysis include:

1. Financial ratios: Financial ratios are essential tools for evaluating a company's performance. Here are some key ratios:
   • Price-to-earnings (P/E) Ratio: This ratio compares a company's share price to its earnings per share (EPS). A high P/E might indicate growth expectations, while a low P/E could mean the stock is undervalued or facing challenges.
   • Earnings per share (EPS): EPS shows a company's profitability per share. It's calculated by dividing net income by outstanding shares. Rising EPS usually signals growth.
   • Return on equity (ROE): ROE measures how well a company uses shareholder equity to generate profits. A higher ROE means better efficiency in creating profit.
   • Debt-to-equity ratio: This ratio compares total liabilities to shareholder equity. A lower ratio is often better, showing less reliance on borrowing.
2. Historical performance: Reviewing historical performance is also crucial. Looking at trends in revenue, profit margins and cash flow over time helps us spot growth patterns and potential issues. For example, steady revenue growth with stable margins indicates a healthy company, while declining metrics may raise red flags.
3. Market metrics: Tracking market capitalisation, dividend yields and investment returns adds further context to a company's performance.
   • Market capitalisation: This is the total market value of a company’s shares, categorised as large-cap, mid-cap or small-cap. It helps us assess the size and stability of a company.
   • Dividend yield: This measures the annual dividend relative to the stock price. A higher yield can attract income-focused investors and suggest stability.
   • Investment returns: Examining total returns, including capital gains and dividends, helps us assess an investment’s performance compared to benchmarks.

Qualitative analysis: Qualitative analysis looks at the non-numerical factors that influence a company's success. It offers insights that numbers alone may miss. Key areas of qualitative analysis include:

1. Management quality: Assessing the skills and experience of executives is crucial. Strong leadership often drives growth and strategic direction. We should look at management’s history in overcoming challenges and fostering innovation. For example, a CEO known for turning around struggling firms can boost investor confidence.
2. Business model: Understanding a company’s operations and revenue generation is vital for evaluating its sustainability and growth potential. A solid business model shows how a company creates value, manages costs and stands out from competitors.
3. Competitive advantages: Identifying unique strengths, like brand loyalty or proprietary technology, gives a company an edge. Those with strong advantages can better handle economic downturns. For example, a well-known brand often attracts customers more easily than newer competitors.
4. Industry positioning: Examining a company's market share and competitive position helps us to evaluate future growth potential. Understanding industry dynamics, market trends and regulations is crucial for evaluating a company's long-term performance. A market leader a growing industry may find more expansion opportunities than its rivals.

Steps to do fundamental analysis

1. Collect financial statements

   The first step in fundamental analysis is to gather the company’s financial documents. You’ll need the income statement, balance sheet and cash flow statement. You can usually find these reports on the company’s official website in the investor relations section.

   Each document has a specific role:

   • Income statement: Shows performance over time, detailing revenues, costs and profits.
   • Balance sheet: Snapshot of assets, liabilities and equity at a given moment.
   • Cash flow statement: Displays cash movement in three areas (operating, investing and financing activities).
2. Analyse the income statement

   Once you have the financial statements, start with the income statement to evaluate key metrics.

   • Revenue: Check if it's growing, stable or declining.
   • Gross profit: Revenue minus cost of goods sold (COGS) shows production efficiency.
   • Operating income: Profit from core operations, excluding non-operational expenses.
   • Net income: Total profit after all expenses, taxes and costs.

   Look for patterns across reporting periods. Rising revenue and profits suggest growth, while falling numbers may signal trouble. Graphing trends can help visualise performance.

3. Examine the balance sheet

   Next, check the balance sheet for insights into the company’s financial health.

   • Current ratio: Current assets divided by current liabilities. A ratio over 1 shows good liquidity.
   • Debt-to-equity ratio: Compares liabilities to shareholder equity. A lower ratio indicates less reliance on debt.
   • Shareholder equity: The company's net value to shareholders. Increasing equity may signal growth.

   A solid balance sheet reveals manageable debt, good liquidity and positive equity, showing the company can endure economic ups and downs.

4. Review the cash flow statement

   The cash flow statement is key for understanding cash management.

   • Operating cash flow: Shows cash generated from core operations. Positive cash flow indicates sustainability.
   • Investing cash flow: Reveals cash spent on growth initiatives. Heavy investment can signal future growth, but excessive spending may raise concerns.
   • Financing cash flow: Details cash from investors or loans, along with dividends paid. Knowing how a company funds growth is vital for assessing long-term viability.

   A company might show profits but still struggle with cash. Evaluating cash flow is crucial for understanding true liquidity and health.

5. Calculate key financial ratios

   After analysing the statements, calculate important financial ratios: Price-to-earnings (P/E) ratio, earnings per share (EPS), equity (ROE), higher ROE signals efficient management. The current ratio measures liquidity and short-term obligation ability.

   Compare ratios with industry standards and historical data. A high P/E might be justified in a high-growth sector.

6. Assess industry and economic conditions

   TheUnderstanding the economic landscape and industry trends is crucial for evaluating a company’s performance. Look at factors like interest rates, inflation and unemployment. For instance, rising interest rates can increase borrowing costs, impacting profits.

   Analyse competition, tech changes, and regulations:

   • Market growth: Is the industry growing or shrinking? A larger market means more room for success.
   • Competitive landscape: Identify key players and their market shares. A strong position helps maintain profitability.
   • Regulatory environment: Watch for laws or policies that could affect operations.

   Conduct a SWOT (strengths, weaknesses, opportunities, threats) analysis for more context on external influences.

7. Make an informed investment decision

   After completing your analysis, put everything together for informed investment decisions. Balance quantitative data with qualitative insights. A company might show strong numbers but face risks, while a weaker company could have unique strengths. Create a thesis explaining why you believe a stock is a buy, hold or sell based on your analysis. Remember, this isn’t a one-time task. Keep an eye on performance, industry trends and economic factors. Regularly reassess your thesis to stay updated with new information.

How reliable is fundamental analysis?

Although fundamental analysis is widely considered to be a crucial part of long-term investment, its reliability depends on various factors, such as the quality of the data, market conditions and the assumptions made during the evaluation process. While it provides valuable insights into a company’s true value, it is not infallible. Unexpected changes in market sentiment, macroeconomic conditions or management decisions can cause a company’s stock price to deviate from its intrinsic value in the short term. Furthermore, as fundamental analysis relies on historical data and projections, sudden shifts in consumer behaviour or technological innovation may not be fully captured.

Nevertheless, in the long term, fundamental analysis remains one of the most trusted methods for identifying undervalued opportunities and assessing the sustainability of a company’s growth. Successful investors often combine fundamental analysis with other approaches, such as technical or sentiment analysis, to gain a more comprehensive understanding of market dynamics and mitigate risk.

Fundamental analysis on the DEGIRO platform

At DEGIRO, we know that solid fundamental analysis is key for informed investment decisions. Our platform offers a range of tools and resources to help with this analysis. Users can access detailed financial reports, live market data and in-depth company profiles easily.

We also provide advanced charting tools and analytics to help you calculate important financial ratios and understand industry trends. With these features, you can integrate fundamental analysis into your investment strategy. This helps in finding opportunities and managing risks confidently.

Whether you're just starting out or have years of experience, we give you the right tools to navigate the financial markets with confidence.