Fundamental Analysis – Basics
Fundamental analysis has to do with working out how good a company is likely to be at generating good dividends in future to calculate the ‘real’ value of the share. The ‘real’ value is just the discounted value, now, of the dividends it will declare in the future. So, since the ‘real’ share value is mainly concerned with dividends, we need to look at the company’s profitability, retained income and dividend policy.
All things that help predict the future earnings and dividends of a company, is considered fundamental analysis. This includes internal as well as external influences, such as the economy.
Looking then at the economy, you should some basic questions:
- Is the economy growing or shrinking?
- Are profit margins likely to increase, decrease, or stay the same?
- Are sales likely to increase, decrease or stay the same?
- Or is everything about to drop?
If the economy is really strong and growing, this impacts the profitability of a company quite significantly. There are often timing differences between different types of company, or sectors, which you should be aware of. Often some sectors lead or lag the overall business cycle.
For example…
Packaging and furniture tend to be leading indicators and start reacting positively (or negatively) before other sectors. These are often followed by Beverages, Clothing and Textiles. Finally, engineering, construction and property tend to be slightly lagging in that they only respond later in the cycle – when the economy is showing signs of peaking. As the economy starts a downturn, it is often the leading sectors that respond first, such as manufacturing, packing, etc… When things are at their worst, property tends to hit the bottom, continuing the cycle. It is important to note that some sectors that are less impacted by the business cycle – for example, insurance and food. These are known as ‘defensive’ stocks or sectors.
When trying to work out where in the business cycle the economy is currently at, it is valuable to look at human behaviour around you. What is everyone doing, and how are they feeling. Are we having more or less leisure time, enjoying a higher standard of living, or are we tightening our belts and cutting back. Looking at human behaviour may also guide us in the areas we would want to invest in. For example, new fads, new cultural trends, etc.
A quick warning… You may have friends or family who work in certain industries, or fancy themselves as ‘gurus’, and may keep telling you to invest in certain areas. Don’t just take their word for it, do your own homework and come to your own conclusions. “Never buy a share that you know nothing about”.
Some other things to look at when considering an area to invest in:
Oversupply
Avoid areas where there is an oversupply of goods or services. For example, if there is an oversupply of oil, the oil price is likely to go down, and vice versa. This will not only affect the oil price, but companies whose business is impacted by the oil price.
Company structure
Is this a monopoly, an oligopoly, or is there plenty of competition in the marker.
Nature of Business
The sector the company operates in on the stock market should give you an idea of its primary business. For more detail on its operations, you will need to look a little further. The internet is a great help here.
The Profit Trend, age of business and growth opportunities – You will be interested to see how the company has performed over a number of years. This is linked to its age and the availability of data as well as industry. You will find companies can be divided up into various areas with regards to profits and growth opportunities:
- Well established businesses that have been around for a long time in older industries – quite safe, slow growth, higher dividends, big. Might be looking to diversify, which can go either way.
- New businesses in new industries – higher risk, technology focus, gow quickly, low dividends, singular or smaller focus.
New businesses in older more established industries – may be quicker to market, better users of technology, tend to have a David and Goliath feel, could be the next disruptor in the sector, but could also fail.
Entry Threshold
Linked to the structure, you need to think about if it is easy for new competitors to come into the industry. If there is a large barrier to entry, the company may be more likely to continue to grow profits, but at the same time the company may become ‘stale’ and too set in its ways
Level of Debt
If a company has a high level of debt, as in lots of borrowings, it is more likely to be impacted by changes in interest rates – especially high interest rates, which are directly impacted by the business cycle. This is likely to result is a share price that is highly cyclical as well, since the varying profitability is constantly being discounted into the share price.
Threats and Opportunities
You should be aware of the threats and opportunities pose to the company as well as the threats and opportunities the company poses to others. This will include things such as the company’s responses to the business cycle, impact of imports or exports, changing sources of income nationally and internationally, impacts of exchange rates, new entrants, etc
Company Management
Keep an eye on the management of the company, directors and board members. How has the management done in terms of earnings and dividends relative to similar companies? Is there a significant or regular turnover of management? What is the sentiment in the media towards the management? Consider the earnings yield relative to other companies in the same sector, or to the sector as a whole.
New Technology
Keep an eye out for new ways of doing things and how the company and competitors are adopting this. Technology often brings with it various opportunities as well as risks. Is the new technology proven, or is this still being tested? Is this company a ‘first adopter’, or one of the last companies to change?
Financial statements and earnings announcements
From a fundamental point of view, the company financial statements, as well as what is talked about at earnings announcements can draw a very important picture of the future of the company. You don’t need to create these accounts on the company’s behalf but should have an idea of how to interpret them.
