What Are Fundamentals?
Fundamentals include the basic qualitative
and quantitative information that contributes to the financial or
economic well-being of a company, security, or currency, and their
subsequent financial valuation. Where qualitative information includes elements that cannot be directly measured, such as management experience, quantitative analysis (QA) uses mathematics and statistics to understand the asset and predict its movements.
What Is Fundamental Analysis?
Understanding Fundamentals
In business and economics, fundamentals represent the primary
characteristics and financial data necessary to determine the stability
and health of an asset. This data can include macroeconomic, or large-scale factors, and microeconomic, or small-scale factors to set a value on securities or businesses.
Analysts and investors examine these fundamentals to develop an estimate
as to whether the underlying asset is considered a worthwhile
investment, and if there is fair valuation in the market. For
businesses, information such as profitability, revenue, assets, liabilities, and growth potential are considered fundamentals. Through the use of fundamental analysis, you may calculate a company's financial ratios to determine the feasibility of the investment.
While fundamentals are most often considered factors that relate to
particular businesses or securities, national economies, and their
currencies also have a set of fundamentals that can be analyzed. For
example, interest rates, gross domestic product
(GDP) growth, trade balance surplus/deficits, and inflation levels are
some factors that are considered to be fundamentals of a nation's value.
Macroeconomic and Microeconomic Fundamentals
Macroeconomic fundamentals are topics that affect an economy at-large, including statistics regarding unemployment, supply and demand, growth, and inflation,
as well as considerations for monetary or fiscal policy and
international trade. These categories can be applied to the analysis of a
large-scale economy as a whole or can be related to individual business
activity to make changes based on macroeconomic influences. Large
scale, macroeconomic fundamentals are also part of the top-down analysis of individual companies.
Microeconomic fundamentals focus on the activities within smaller
segments of the economy, such as a particular market or sector. This
small-scale focus can include issues of supply and demand within the
specified segment, labor, and both consumer and firm theories. Consumer theory investigates how people spend within their particular budget restraints. The theory of the firm states that a business exists and makes decisions to earn profits.
Fundamentals in Business
By looking at the economics of a business, including the overall management and the financial statements,
investors are looking at a company's fundamentals. Not only do these
data points show the health of the business, but they also indicate the
probability of further growth. A company with little debt and sufficient cash is considered to have strong fundamentals.
Strong fundamentals suggest that a business has a viable framework or
financial structure. Conversely, those with weak fundamentals may have
issues in the areas of debt obligation management, cost control, or
overall organizational management. A business with strong fundamentals
may be more likely to survive adverse events, like economic recessions or depressions,
than one with weaker fundamentals. Also, strength may indicate less
risk should an investor consider purchasing securities associated with
the businesses mentioned.
Fundamental Analysis
Investors and financial analysts are interested in evaluating the
fundamentals of a company to compare its economic position relative to
its industry peers, to the broader market, or to itself over time.
Fundamental analysis involves digging deep into a company's financial
statements to extract its profit and growth potential, relative
riskiness, and to ultimately decide if its shares are over, under, or
fairly valued in the market.
Often fundamental analysis involves computing and analyzing ratios to
make apples-to-apples comparisons. Some common fundamental analysis
ratios are listed below.
- The debt-to-equity ratio (DE) measures how a company is financing its operations.
- The quick ratio measures the company’s ability to meet its short-term obligations.
- The degree of financial leverage (DFL) measures the stability or volatility of the earnings per share (EPS).
- The price-to-earnings (P/E) ratio compares investment to earnings dollars.
- The DuPont analysis looks at return on equity (ROE) by looking at asset use efficiency, operating efficiency, and financial leverage.
Fundamental analysis should be carried out with a holistic approach,
utilizing several ratios and including a bottom-up as well as a top-down
analysis to come to specific conclusions and actions.
Real World Example
In the fourth quarter of 2018, according to Market Watch, large-cap tech
companies Microsoft and Apple had similar market caps for the first time
since 2010. Although the two companies had similar market caps of about
$850 billion, they had very different fundamentals. For example,
Microsoft was trading at 45X earnings while Apple was trading at 15X earnings.
Also, while Microsoft’s earnings were predicated on software as a
service (SaaS) and software sales, Apple’s were still primarily
dependent on hardware sales. Apple’s revenue base is about 2½ times
Microsoft’s; the global market for its devices is far more saturated
than the global market for Microsoft’s software.
Though both companies had a similar market cap, they had very different
fundamentals, which would need to be considered when choosing them as
potential investments, particularly in determining future growth
prospects.